Crypto Finance Is a Speculative Scam That’s Worsening the Instability of Global Capitalism

Ramaa Vasudevan

The pandemic gave a big impetus to crypto, with everyone in lockdown mode in front of their screens. Its value surged through the roof, reaching a peak with the Super Bowl ads of 2022. This bull run came to an ignoble end in May of that year.

It began with the collapse of paired crypto tokens called Terra Luna. You could think of this as a kind of “Minsky moment” for crypto — the moment when, after going strong for a long time, the bull run comes to an end. Terra was a stablecoin that was hitched to the Luna through algorithmic trading. This maintained its peg with the Luna, which was floating.

There was a nice little game at work where Luna holders made profit from their stakes in Terra while the demand for Terra was stoked through a new Terra lending platform called Anchor. This platform offered huge interest rates, in the vicinity of 20 percent, which were payable in Terra. This engine kept stoking its own demand in a way that seemed too good to be true.

Of course, it was too good to be true. The rates were unsustainable. Eventually, a pullout from Anchor began, which set off gyrations in Terra. Instead of maintaining its peg, Terra started falling and the whole Terra Luna system crumbled. Incidentally, Alameda, the venture arm of FTX, which was part of Sam Bankman-Fried’s empire, was a big Anchor depositor and one that pulled out early.

The ripples of Terra Luna spread. Celsius, a crypto lender which was offering huge interest rates, didn’t have the crypto cash to pay depositors when they started pulling out. You also had Three Arrows Capital, a crypto hedge fund that invested heavily in Terra. When asset prices fell, the fund didn’t have the value of the collateral it had put forward.

As the reverberation spread, one of the most important stablecoins, Tether, was faced with a fall in value — a moment which is like breaking the buck in a money-market fund. The nadir came with the spectacular tumble of FTX. After first emerging as a savior, injecting funds into crypto entities during the early stages of the crisis, Alameda was found to have siphoned off depositor funds from FTX to finance loans.

This unraveling reveals the fragile foundations of crypto finance. From $3 trillion, it fell to less than $1 trillion in a short period of time. What happened was very analogous to bank runs that have plagued the financial system since its inception. Traditional bank runs happen when depositors pull out their deposits.

In 2008, when Lehman Brothers collapsed, there was a different type of bank run. It was sparked by the collapse in the value of assets which were used as collateral. Those assets had pumped up the shadow banking system based on borrowing and lending through the market, rather than through loans and deposits, which is the traditional banking model. Falling collateral values decimated the basis for lending between banks and credit creation. Investors began pulling out money from money-market funds and the system came to a stop.

The crypto tumble was another form of bank run in the new, unregulated world of crypto finance. Again, collateral values played a big role. This is very important, because crypto transactions are pseudo-anonymous, so traditional forms of credit-risk assessment for the borrower are not possible. In place of risk assessment, collateral becomes important and plays an even bigger role.

Crypto transactions are generally overcollateralized and the liquidation of a transaction when collateral values fall is enforced automatically, which makes it very fragile. This fragility becomes even more severe because there is a rampant practice of using borrowed crypto collateral as collateral for further transactions. You borrow collateral and then use it to borrow even more. This is what is known as a collateral chain.

There are huge returns which can potentially be captured through this approach. This means that the initial collateral forms the foundation for a huge pile of debt. The pyramid of crypto lending is being erected on the shifting sands of volatile crypto collateral.

Another Achilles’ heel of traditional banking is the fact that you have a mismatch between your assets and your liabilities. A bank will borrow in the form of short-term deposits, but it will lend in the form of long-term loans. As depositors pull out, the bank doesn’t have the ready cash to pay, because the loans are long-term.

Crypto is subject to the same kind of mismatch. Stablecoins like Tether were issued against less liquid assets like commercial paper, which are used to fund the short-term transactions of corporations. The collapse of Terra showed that risky and volatile crypto tokens were the basis of its lending. When it had to pay out, it only had volatile crypto tokens, which had fallen in value.

Once again, we saw that crypto finance is not very different from traditional finance. It has the same tendency to fragility, and last year’s crash revealed that.