- Crypto set out to offer finance real innovation.
- So far it hasn't succeeded, writes Wolfgang Münchau.
- Instead the industry keeps repeating old scams, 'stupid' schemes and crashes.
Wolfgang Münchau is a columnist for DL News. He is co-founder and director of Eurointelligence, and writes a column on European affairs for UnHerd. Opinions are his own.
Some of the folklore from boomer-era finance, the pre-crypto world of financial markets, does not apply to cryptocurrencies.
But a lot of it does.
If you cut it down to its bones, finance consists of three activities: lending, investing and insurance. All financial products fall into one or more of these categories.
For most of history, financial innovation was a euphemism for ways to reduce the friction that is inherent in these activities or — more often than not — to hide them.
Crypto is different in one important sense: it constitutes real innovation.
Tokenisation breaks down big claims into smaller ones. Decentralised finance promises to replicate all of the main functions of a financial market by cutting out rent-extracting intermediaries. Bitcoin constitutes a modern instrument to insure against currency debasement.
It is quite possible that crypto will end up delivering only a few of those benefits. Bitcoin has succeeded as an investment, but so far not really as a transaction currency, the purpose for which it was originally designed.
It is also not clear whether Defi will cut out the middleman, as Amazon did, to the extent we thought of a few years back, or whether it will end up facilitating rent extraction by an oligopolistic financial industry.
Wisdom of boomers
The wisdom of boomer-era finance has no notions for real financial innovation.
Subprime mortgages and collateral debt obligations, or CDOs, were as sophisticated as they would ever get in that world.
But there are ideas and wisdom from the olden days that carry over.
If you set up an investment business with borrowed money to invest in Bitcoin in the hope that it would never fall below some imaginary “support level,” this is downright stupid.
This is the oldest finance scheme in the book: borrow money to invest in a volatile, risky asset.
It’s just dumb. It’s been done many times before.
An equally futile, but more sophisticated scheme in the crypto-world is the strategy of looping.
It is a bit more sophisticated than naked borrowing, but it, too, is a version of a very old-school trick — the pyramid scheme.
You take an asset that you have, some cryptocurrency, and use it as collateral against which you borrow another cryptocurrency, say a stablecoin. Then you buy more of the original asset with that borrowed money.
Rinse and repeat.
A version of this is how the 1929 stock market crash happened.
As a young financial journalist, I covered the bull market leading up to the 1987 stock market crash. The craze back then was securitised lending and the rise of asset-backed securities, which people then considered the greatest financial innovation of all time.
There are legitimate uses for securitisation. It breaks large binary loan contracts into smaller, more flexible securities, but it is ultimately just repackaging.
The subprime mortgages of the early 2000s were the ultimate securitisation scam: You buy a house with a teaser-rate mortgage.
The value of the house rises. You take out a home equity loan against the higher value and use the money as a down payment to buy another house with a teaser-rate mortgage.
The brilliance of Michael Burry, the legendary hedge fund investor of that era, was not that he analysed this correctly in real time, but that he managed to persuade Goldman Sachs to sell him credit default swaps that allowed him to bet against the collateral debt obligations — wrappers of dodgy subprime loans.
Each bubble, each crisis has its own specialities that obscure underlying patterns of risk.
Once you look deeper, you see a Ponzi scheme.
Do Kwon
There is also nothing new about financial fraud. T
erra’s bankruptcy is one of the largest in financial history, with losses of $40 billion, for which its founder, Do Kwon, was sentenced to 15 years in prison in the US this month.
The judge called it “fraud on an epic, generational scale.”
Big though it was, it was not the biggest.
The world champion of financial fraudsters remains Bernie Madoff, who ran the largest Ponzi scheme in history with $64 billion in fictitious accounting entries. It was discovered in 2008.
Madoff was later sentenced to 150 years in jail and died in prison in 2021.
The crimes and misdemeanours of the crypto world may be brazen but not as remarkable as people might think. As with all financial innovations of the past, crypto, too, offers new ways to cheat others, and many more to cheat yourself.
The lessons of boomer finance also hold true for asset valuation.
Contrary to popular opinion, the arrival of exchange-traded funds can have no permanent impact on the value of a crypto asset, though it does affect it in the short run. If you make it easier for investors to buy cryptocurrencies, then you also make it easier for them to sell them.
Liquidity-driven bubbles always burst. The long-term behaviour of an asset price is always and everywhere a function of the underlying characteristics of the asset itself.
For traders, market micro-infrastructure matters a great deal. For investors with a long-term horizon, it does not, except that it increases the risk of making a very large loss if they buy a volatile asset at the wrong moment.
So if the price of an asset is determined by its value, then what determines its value?
It is at this point where the story becomes interesting, and where boomer-era finance fails spectacularly. You cannot run time-series models to predict the future value. Artificial intelligence fails for the same reason.
When people make silly predictions that Bitcoin would fall to $10,000 or rise to $1.5 million, they are either pulling those numbers from thin air or using some questionable extrapolation.
When an asset price is growing as fast as Bitcoin has, it is impossible to rely on past trends.,
“Don’t know” is the only one correct answer to the question of what Bitcoin will be worth at the end of next year, or the end of the decade.
The only model that stands any chance of success is one that makes no assumptions about demand. In other words, you want to take liquidity out of the equation. You can research a company and assess its long-term earnings potential.
With Bitcoin, all you have is a view of its future value in terms of its core functions: as a transaction currency, or as a store of value to hedge against monetary debasement.
These are the only independent functions I can see.
Both would constitute a bet against the fiat money system in general and the dollar in particular.
The cavemen of boomer finance and economics will not acknowledge the latter. That is where they get Bitcoin and the entire crypto-verse wrong.
This is why I think it makes sense to bet against the macro-financial and macro-economic consensus. But the old rules about financial exuberance still apply.
