Tag Archives: Bitcoin

Flywheel investments, an anatomy of most crypto scams

FTX is in the news for both the enormity of its bankruptcy and the moral bankruptcy of its founder, Sam Bankman-Fried. Before even reading the news I knew in general how FTX went bankrupt, because it’s the same way every crypto ponzi scheme, sorry crypto “exchange” goes bankrupt. Here’s how it always happens.

Someone creates a whole bunch of magic beans, a billion in fact, then sells one of the beans to a sucker for a dollar. Their billion beans are now worth 1 billion dollars, because the most recent sale multiplied by the total number of items must be the fair value of them all, right? With net assets of 1 billion dollars, you can start doing some real financial malfeasance. You can take out big loans (using beans as collateral) or trade your beans for someone else’s beans, since you’re both playing a game where you pretend these beans have value. This gives you cashflow (although most of your “cash” is just other people’s beans) and the ability to pretend you’re running a business.

Once you’re trading beans, you tell suckers (retail investors) that your business is profitable and they should invest. Not by buying stocks in your company on the stock market, that’s a mug’s game. Stocks actually have value and are regulated by the government, no we’re in the business of beans. You tell people that to invest in your beans they just have to hand you over some of their dollars and in exchange you’ll give them beans. You tell them that the beans are interest payments on the dollars they’ve deposited with you, and since you’re still claiming the beans have value these suckers can then trade the beans amongst themselves. You then take those dollars they deposited and gamble them away on over-leveraged stock and crypto bets, all while pretending you’re the Wolf of Wall Street.

As long as people keep giving you dollars in exchange for beans, the scheme is solvent. The beans cost you nothing and you can print as many as you like. If a few people want to exchange their beans for dollars again, well that’s OK too because you’ve still got a big pot of dollars that you haven’t lost yet, so you can give them back their dollars and take back your beans to maintain the illusion of solvency. Your beans are your main asset remember, they’re what you are selling to raise money, they’re what is underwriting all your loans, so people need to believe that the beans have value and the best way to maintain that lie is to always be willing to buy back beans at the current market price.

It seems like the magic of a flywheel, once you spin it up it keeps going and going forever. As more and more people see your company as being profitable, more and more will want to buy your beans to “invest” in you. And when they invest, you give them all the beans they could ever ask for. As long as you keep buying back beans, fear of missing out (FOMO) will drive many investors to throw more and more money at you, driving up the price of your beans and making your company seem like a can’t lose bet. But nothing lasts forever, entropy will eventually slow down a flywheel and risky bets will eventually end a crypto exchange. There’s always some trigger, whether it be too many bad bets, a collapse in the price of bitcoin (which is probably one of your main “assets” after your magic beans) or you or an employee just steals everything and runs. But eventually people will start to catch on that you’re probably insolvent, and they’ll want their money back.

The reason FTX was insolvent is the same reason every crypto “exchange” is insolvent, there is absolutely no profit to be made in doing what they claim to do which is hold people’s money and always be willing to give it back. There is zero profit in doing this, banks write loans using depositor’s funds because that’s the only way to make a profit, and for the same reason exchanges gamble with depositor’s money because that’s the only way they make a profit. But banks are highly regulated to prevent insolvency and stupid bets, whereas crypto exchanges just aren’t. So eventually all exchanges make stupid bets and go insolvent, while most banks don’t.

So insolvency, it’s just a fancy word meaning people want their money back and you don’t have it. You gambled it all away and now all you have are magic beans, magic beans which only have value because you’ve been claiming you’d always buy them back at the market price. So the price of your beans collapse once people learn what’s up and that you no longer have the money to support your beans. Everyone tries to get their money out but you’re broke and can’t give it to them, then the people you took loans from realize you can’t pay them back either. As long as the numbers were going up, people kept buying beans from you and you could use more and more deposits to pay back your loans and keep up the fascade, now you can’t so you’ve got no choice but to default on those loans. And those loans and other obligations were underwritten with beans, which are now worthless as you won’t buy them back from anybody.

This above scenario is more or less how every crypto collapse has operated, plus or minus a few cases of an insider just taking all the money and leaving. They always issue their own coin because it’s an easy way to create the illusion of assets, they always take deposits and gamble them because it’s the only way to make money, and their balance sheet is always nothing but crypto so when the price of crypto goes down, they collapse under the weight of their own coins. Sam Bankman-Fried isn’t the first crypto scammer (although he does have the most appropriate name for one), he’s just the biggest one so far.

I don’t think people understand stocks or what gives stocks value, and I think that’s why some people fall headlong into Bitcoin

Let me get one thing clear: Bitcoin is a ponzi scheme and Bitcoin “exchanges” are rugpulls waiting to happen.  There is no value in Bitcoin as an asset; anything it can do, everything else can do better.  But it’s clear that Bitcoin has a hold on people and I’ve seen many try to defend Bitcoin by comparing it to stocks.  Once you accept that Bitcoin is terrible and has no use cases, the only thing left is to claim that everything else in the world is even worse.  I’ve seen the argument made that the stock market is a legalized ponzi scheme taking money from individuals and giving it to corporations, but that argument clearly comes from a place of ignorance. Stocks are a legitimate investment vehicle, unlike Bitcoin, and I’d like to explain why.

First, why does a stock have value at all?  Two big reasons cited are ownership and dividends.  When you own a stock, you have real *ownership* of a small percentage of the company with all the property rights that come with that.  In a very real sense the stockholders can plutocratically vote (plutocracy in this case means 1 share = 1 vote) on the direction of the company. The stockholders have a sort of representative plutocracy in which they vote for the Board of Directors, who then act as the stockholders’ representatives guiding the direction of the company through their chosen CEO.  In 2021 for example, ExxonMobil stockholders led by a group called “Engine No 1” fought to make ExxonMobil commit to new environmental standards and a sustainable energy future.  There have also been cases in which stockholders such as private equity will put up a proposal to replace the board of directors and management staff with someone else in order to turn around the company and bring it back into profitability.  All these things are possible only if you can get the stockholders to agree, and this is the value that owning a share of stock has.

Another reason shares of stock have value is dividends, and here ownership comes into play as well.  If a plutocratic majority of the stockholders want it, they can demand that the company give them more and more of the company’s money in the form of dividends.  The value of the stock therefore is the value of all future dividends, divided by the uncertainty the company will stay in business, multiplied by the fact that money now is better than money later.  Say I hold a corporate stock that gives a yearly 1$ in dividend. I think the dividend is stable, so I expect to receive 1$ per year every year.  So the price of the stock is infinity because I expect to receive infinity dollars?  Well no because there is market uncertainty, I could be wrong about the company for instance, and it goes bankrupt next year. Or the market could change in ways I can’t predict and the company goes bankrupt, there’s no certainty about how long this company will stay in business.  Also, money now is always worth more than money later (even if inflation is zero, I’ll talk about that some time), so the dollars I expect to get 10 or 20 years from now are worth less than and less then the dollar I will get this year.  And so despite seeming infinite, the stock value can converge to a finite amount because there’s no guarantee I get all those future dividends. And of course different people can value a stock more or less based on their own personal appetite for risk.

So the value of a stock is based on real value.  A company has value just as much as say a factory does.  People want to buy the things that come out of it, so owning it gives you something that makes money and therefore has value.  Likewise a company gives money back to its stockholders in the form of dividends.  Now there are many reasons a company would want to give dividends, and likewise reasons stockholders would be OK with not having dividends, but going back to shares being ownership, remember that the shareholders can always demand the company give them dividends if there is a plutocratic majority in favor of it.  So dividends are demanded by the stockholders, given by the company, and the value of all future dividends plus the value of owning a part of the company itself is what gives a stock value for a stockholder.

Bitcoin does not have this value.  There is no dividend, there is no underlying thing of value that you “own” when you own a Bitcoin.  All Bitcoin has is the greater fool theory, the idea that somehow you’ll find someone to buy your Bitcoin for more than what you bought it for.  Greater fool theory isn’t unique to Bitcoin, and at least some percentage of stock market daytraders are only buying in order to sell to a greater fool, but as I said stocks have more than greater fool theory underpinning their value.  Bitcoin only has greater fools, and that’s what makes it a ponzi scheme.