The Crypto Token Economy Is Second-Order Fraud


The cryptocurrency meltdown is regularly described as a liquidity crisis by industry insiders and uncritical media outlets. The story goes something like this: a downturn in crypto markets, perhaps the result of negative trends in the broader economy, triggered a liquidity crisis that led to cascading bankruptcies across the industry.

By this telling, the trouble began back in May when the Terra (UST) stablecoin began to de-peg from the dollar as its sister cryptocurrency, Luna, crashed in value. The price of both cryptocurrencies fell to practically nothing within a few days, wiping out $US45 billion in market value. The immediate fallout resulted in a loss of value of $US300 billion across cryptocurrency markets within the week. (That figure has since grown to over $US2 trillion as prices have continued to slump.) Highly leveraged cryptocurrency investment firms suffered staggering losses. In June, Three Arrows Capital, a major crypto hedge fund that had borrowed heavily to leverage their own crypto investments, could not meet margin calls and was quickly forced into liquidation.

With so many loans going into default, crypto lenders started to go under as well. At the time of liquidation, Three Arrows Capital owed lenders $US3.5 billion, with little ability to repay. Voyager Digital, a major crypto lender, was left on the hook for $US370 million in Bitcoin and another $US350 million in USDC stablecoins that they had loaned Three Arrows. Celsius Network, another major crypto lender, had loaned Three Arrows $US75 million in USDC—and that was just the beginning of their troubles. Suffering its own heavy investment losses, Celsius acknowledged a $US1.2 billion hole in its balance sheet. In truth, the hole was far larger, as their assets included billions in obscure cryptocurrencies issued by Celsius itself and similar firms, as well as almost a billion in loans to such entities. Though cryptocurrency is generally thought of as liquid—Bitcoin has been called “digital cash”—these more obscure digital assets proved illiquid and, ultimately, of little real value as the firms issuing them began to fail.

Though not regulated as such, these crypto lenders were operating as banks, offering lavish returns to depositors putting up their own cryptocurrency as collateral. Without even FDIC insurance on their settlement accounts, depositors rushed to get funds out before the firms collapsed. Without sufficient cash on hand, Voyager and Celsius paused withdrawals before filing for bankruptcy in July.

In November, FTX, a major cryptocurrency exchange branding itself as the responsible, good-faith actor in an otherwise dodgy industry, was the next domino to fall. Leaked balance sheets from FTX’s sister company, Alameda Research, revealed that the trading firm was holding most of its assets in FTX’s house “token,” FTT. This raised questions about the unusually close relationship between the two firms (it was later revealed that FTX was secretly and illicitly funneling depositors’ funds to Alameda to fund risky crypto investments), as well as their solvency. FTT, like similar assets held by recently failed crypto firms, was highly illiquid.

In response to the leak, the CEO of Binance, the largest cryptocurrency exchange by trading volume, announced that it would liquidate its entire substantial holdings in FTT, which caused the token to crash in value. Following a now-familiar arc, depositors rushed to withdraw funds from FTX, forcing the exchange to pause withdrawals for lack of liquidity. Within five days, FTX, Alameda Research, and various subsidiaries—having been recently valued at well over $US40 billion, collectively—began the bankruptcy process as well.

The industry contagion continues. Last week, Genesis, yet another leading crypto lender, also declared bankruptcy. The firm, a subsidiary of crypto venture capital firm Digital Currency Group, owes approximately $US3.5 billion to its top 50 creditors. Digital Currency Group, in addition to investing in hundreds of crypto companies, owns several other subsidiaries as well, including the major crypto asset management company Grayscale Investments, which claimed to hold over $US50 billion in digital assets as of 2021 and now, amid market uncertainty, refuses to show proof of its own reserves due to “safety and security” concerns. We can only speculate which firms go down next.


The above narrative emphasizes the liquidity crisis spreading across crypto firms at risk of overlooking their fundamental insolvency. A liquidity crisis is a cash flow problem—immediate financial obligations cannot be met as they come due. While an accounting liquidity crisis can certainly lead to defaults and bankruptcy, the term implies that the organization is otherwise solvent.

In the case of recently failed cryptocurrency firms, this was clearly not the case. During a liquidity crisis, distressed organizations seek out loans to cover immediate operating expenses. If they truly are solvent, they may well find lenders. Insolvent firms, on the other hand, usually cannot. No one wants to throw good money at organizations that are going to fail anyway—not other firms, not even central banks acting as lenders of last resort during industry-wide financial crises.

Since central banks would not be bailing out unregulated cryptocurrency firms, they had only one another to turn to. Early in the crisis, FTX was known for shoring up or acquiring smaller crypto firms in financial trouble. They bailed out crypto lender BlockFi over the summer by offering a $US400 million lifeline of credit, which kept that firm alive until FTX also collapsed. With much of the cryptocurrency industry melting down, FTX had fewer places to turn, especially for a firm their size. Binance was the only cryptocurrency exchange doing more volume than FTX. But while Binance announced plans to save FTX through an acquisition and merger, they backed out the next day after a peek at their financials.

A leaked balance sheet gives some insight into why. FTX was claiming $US9 billion in liabilities but only $US900 million in liquid assets. Most of their assets were marked either “less liquid” or “illiquid.” As with other failed crypto firms, FTX was holding the lion’s share of their assets in obscure cryptocurrencies issued by the firm itself or other companies and projects with close ties to FTX or its disgraced CEO Sam Bankman-Fried.

Crypto firms issue these obscure cryptocurrencies, which we can refer to collectively as “house” tokens for convenience, to facilitate trades, settle debts, issue loans, post collateral, and conduct other financial transactions while remaining in the insular and poorly regulated cryptocurrency space. These tokens allow firms, as well as their customers, to transact without having to involve traditional financial institutions, at least until someone wants to cash out of the crypto space.

Some of these house tokens are stablecoins pegged to a fixed amount (usually the dollar), but many fluctuate in price on markets, just like any other financial asset. Such house tokens may be branded as “security tokens,” when they are supposed to explicitly confer ownership of assets or debt, “governance tokens,” if they are intended to confer a kind of “voting share” to be executed on the blockchain, or simply a “utility token” when primarily intended to be used on a native platform. But no matter what their originally intended or ostensible use case, these tokens are often traded between firms as payment, loans, or collateral. When used in this manner, they all function as unregulated securities. (This is arguably true of stablecoins, too, which are also used for loans and collateral, as their value depends upon the health and survival of the issuing company defending the peg.)

Many big crypto firms issue such house tokens. FTX had their FTT tokens, Voyager Digital the Voyager Token, and Celsius their CEL tokens. Unlike Bitcoin, or even Ethereum and Dogecoin, these tokens are not well known outside of cryptocurrency spaces and have little appeal to the masses. As such, cryptocurrency firms often generate retail demand for house tokens—which helps confer at least some level of liquidity and market valuation—by offering users various rewards. FTX gave traders discounts for using FTT. Crypto lenders, including Celsius and Voyager, have offered depositors what are effectively crypto “savings accounts” with annual percentage yields as high as 20 percent or more, an obscene return unseen in regulated financial markets.

Similar offerings can be found in the world of decentralized finance, or “DeFi” for short. Terraform Labs, creator of Terra and Luna, created demand for their tokens by offering depositors similarly too-good-to-be-true returns through an automated lending program, the Anchor Protocol. But whether these programs are executed automatically “on the blockchain” or managed by a boring old spreadsheet in an accounting office, they serve an identical purpose: generating retail demand by offering returns that are only sustainable as long as new money keeps…



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