Post invited by Martin Walker
“Big Crypto” executives seem to have a huge problem understanding basic concepts of conventional finance – such as balance sheets, auditing and cash flow.
Changpeng Zhao, a.k.a CZ, from the Binance cryptocurrency exchange, recently described how they managed over $580 million worth of FTT crypto tokens: “We never touched it, we kind of forgot about it.” Sam Bankman-Fried has expressed endless confusion over asset management by cryptocurrency exchange FTX and hedge fund Alameda.
Even before the collapse of FTX, Sam had some unusual ideas on the methods used by the crypto industry to generate value:
…smart money is like, oh, wow, this thing now makes about 60% a year in X tokens. Sure, I’ll take my 60% return, right? So they’re going to pour another $300 million into the box and you get a shrink, and then it goes on and on. And then everyone makes money.
Cynics, like most of the mainstream media and the Securities and Exchange Commission (SEC), have finally started to get used to the idea that much of Big Crypto is run by recklessly incompetent and/or criminal people. . Some of them might be. But it is worth trying to understand how billionaires (and more recently ex-billionaires) have developed their ideas about the financial world.
In 2016 I have co-wrote an article who pointed out that cryptocurrencies such as Bitcoin are “an asset without a liability”. In other words, “created from scratch defying the laws of double-entry accounting”. Financial assets are always someone else’s responsibility. If they are not the responsibility of another party, who is going to pay for the returns on the asset that ultimately gives it value? No one, so they have no core value.
Major crypto companies have been buy and sell “nothing” for so long, mostly in exchange for different bits of “nothing”, that many have sincerely come to believe that taking nothing, giving it a name – and sometimes a story – combined with a bit of back and forth with friends, gives “nothing” huge value.
Whether the huge valuations of “nothing” tokens come simply from the rising price of the old-school cryptocurrency market or the creation of complex DeFi (decentralized finance) structures, belief in the value of nothing makes it easy to lose. view the fact of the underlying reality. : it is the influx of real money rather than “the technology”, “the community”, “the network” or “freedom” that gives value to crypto assets.
A crypto enthusiast struggling with the idea that financial assets have corresponding liabilities must find the concept of a balance sheet quite mind-boggling. Unfortunately, the misunderstanding of basic accounting is reinforced by fundamental misunderstandings about banking and economics.
Big Crypto executives, including those regularly polled on sites like CNBC, mostly seem to have learned banking and finance by repeating fairy tales and old tweets and blogs about the Austrian economy. Most of them sincerely seem to believe that banks “create money out of thin air”, selfishly enriching themselves and defrauding the public by creating inflation. If they had some understanding of balance sheets, they could understand how making a loan creates both an asset for the bank (the loan) and a liability (the funds placed in the borrower’s account) and that the bank does not not create money for itself out of thin air, with even the amount of credit creation controlled by the requirement of having sufficient equity.
Strangely, given the disregard for inflation and the generation of fiat money, Big Crypto is truly creating “currency” out of thin air. Their preferred way of dealing with the resulting dissonance is based on further misunderstanding. They believe that having a fixed supply of a given token – representing “nothing” – protects against inflation. Even though some major cryptocurrencies such as Ethereum and Dogecoin do not have a fixed supply.
Maybe if they studied some basic money economics and learned the four letters of Quantity theory of the monetary equation:
Clearly, the price level (P) is only kept constant — that is to say. no inflation – if the rate at which money (V) is spent is constant and there are actual expenditures on goods and services (Q). Since there is no true spending of crypto on goods and services, it does not matter if the money supply is fixed.
Which brings us to the crypto industry’s struggle with the concept of auditing. CZ said about the audit firms that “A lot of them don’t know how to audit crypto exchanges.” With the crypto industry largely living outside the fundamental laws of finance and economics, what hope do auditors have of applying their old-fashioned ideas of assets, liabilities, and balance sheets? Very little – but not just because of the crypto industry’s struggle to understand the basics.
One of the tenets of the Crypto faith is that everything is transparent “because it’s on the blockchain”. Audits are not really necessary and, if they must be carried out, they involve complex mathematical analysis. Unfortunately, blockchains don’t make things transparent in the traditional way of auditors. A certain amount of crypto may be held at a particular address on the blockchain – but that does not mean it is under the control of the audited party. An auditor cannot simply see an asset in the accounts and reconcile it to a bank statement.
In the world of crypto, the best guarantee that you own the crypto you’re talking about is to move crypto from one address to another and hopefully back again – like Craig Wright has notoriously failed to. Unfortunately, even that gives limited assurance. A typical audit can verify who has permission to move funds from a bank account. In the crypto world, anyone who has seen the private keys related to crypto funds can take them, and there is no central party to ask if they are authorized or even reverse the transaction.
Hopefully now the reader has a little more sympathy for the poor confused rulers of Big Crypto. If one of them unfortunately ends up in jail, the least society can do for them is provide them with basic accounting and economics lessons. Something safe to help with rehabilitation. Perhaps taking the right courses could become a condition of parole to encourage more diligent study.
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