Tag: ICOs

A brief history of the stablecoin

Those of you who have been following this blog for awhile may recall my deep and enduring disdain for the “stablecoin” concept, that is, the idea that it is possible for “crypto-economic” magic and game theory to ensure that a cryptocurrency can be reliably pegged to the value of some real asset without requiring a bankruptcy-remote contractual mechanism to ensure convertibility of the crypto-asset into the real deal (something mainstream finance already does extremely efficiently).

The first of these “stablecoin” follies was the Bitshares project, back in 2014, which claimed that blockchain alchemy could create a stablecoin called BitUSD which was pegged to the dollar and indeed pegged to any other asset (gold, silver, marmots) which users of the system chose to create. I wrote at the time that the Bitshares “USD peg” system was doomed to fail, and sure enough, 100 hours after launch the thing fell flat on its face.

I had thought that would be the end of it, either because the wider community learned from this project’s mistakes, or that some government agents would take notice of the fact that people were running around selling “shares” unconnected to a prospectus or actual shares.

None of that happened. So it was not the end.

In the intervening period, the “blockchain without Bitcoin” craze came and went and then, in early 2017, Ethereum (another scheme crafted by the hands of men) shot “to the moon,” with the coins – originally valued at something like $0.30 – shooting up to $450 a pop and a $30 billion market cap. The herd took notice and ICOs began to proliferate at an alarming rate.

By the time the SEC piped up, on 25 July, the gold rush was already well underway.

The promise of overnight riches was irresistible to both startups and their venture backers alike, legal consequences be damned, and soon afterwards startups everywhere, like untrained dogs, began leaving proverbial messes all over the field of financial regulation the world over.

In October, a scheme called Basecoin claimed to have re-discovered the philosopher’s stone of finance. As with Bitshares, the scheme creates a cryptocurrency instrument that is collateralized by itself and depends on an environment of ever-rising cryptocurrency prices and never-ending cryptocurrency collateral. I wrote about it. It’s a really bad idea.

Now we stumble upon MakerDAO. I paid very little notice to MakerDAO so wasn’t going to say anything about it, but then they decided to tell a journalist that “Preston hasn’t said anything about our project because our project is amazing.”

That made me angry.

On MakerDAO

Having taken fifteen minutes to review the MakerDAO paper, the Dai system is at its core a very simple cryptocurrency-collateralised derivative contract, with a lot of intermediate steps to confuse its buyers of the facts that (a) that contract is massively overcollateralized in the underlying cryptocurrency (which is Ethereum by default) and (b) in the event of an Ethereum black swan event the value of the underlying collateral, and therefore the value of the stablecoin, will also be wiped out.

Speaking generally, the system requires someone who wishes to obtain $100 worth of Dai to post, say, $150 Ethers’ worth of collateral. This, of course, is insane, because it would be easier for the user to simply go to Coinbase and sell his Ether for actual dollars, and he’d have $50 worth of Eth left over to go spend on other things.

The system also assumes that overcollateralising will protect the value of the Dai. Not so; it simply increases a Dai holder’s exposure to the price of the underlying Ether. If Ether gets wiped out, the Dai collateral will be worthless, so the user will have lost $150 in an effort to create $100.

Put differently, this system makes zero sense and is broken to the core: it only works if the price of Ether goes up. Cognizant that the conventional wisdom is that the Ethereum “World Computer’s” price will always go up, and it has done nothing but go up for the last 18 months, I can see how this might make sense to the MakerDAO team.

Unfortunately for them, history shows that this investment thesis has been wrong 100% of the time, and Ethereum is as user-friendly and scalable as an angry rhinoceros experiencing heroin withdrawal.

Long story short

Crypto-collateralized stablecoins are the perpetual motion machines of modern finance.

I don’t blame the developers building these things; stablecoins are just a stupid meme invented by guys like Vlad and Vitalik back in the heady, schelling-point-heavy days of Ethereum Proof-of-Concept 3 et seq. that nobody in the community possessed the requisite experience or gravitas to refute.

I refute it now. It’s a terrible goddamned idea.

A stablecoin that is collateralized by itself is a complex and fragile Nakamoto Scheme doomed to fail.

A stablecoin that is collateralized by real assets and structured correctly is not a stablecoin, but a unit trust.

That’s all for now.

Postscript, 11 December 2017

I rest my case.

A lot of folks have been panicking since an article in BTCmanager described some proposed new legislation working its way through the U.S. Senate using the words “criminal” and “bitcoin” in the same sentence.

This immediately launched thousands of screaming cryptocurrency enthusiasts, now armed with the mistaken impression that Bitcoin is about to be criminalized in the U.S., into the stratosphere.

Later in the day, I stumbled across this article by @Beautyon_, “Senate Bill 1241 is a Threat to America,” on Twitter:

What the hell is this all really about, you ask?

In a line, the US Senate is moving a bill to move digital currency transactions clearly within the usual KYC/AML reporting frameworks already in place. Presumably this is being done to both bring digital currency regulation clearly in line with all other forms of money transfer business, and add another arrow into the quiver of prosecutors looking to take down the sophisticated criminal enterprises which use digital currency to stay out of sight and frustrate attempts to build cases.

@Beautyon_ argues that this attempted legislation is “unconstitutional and bad for America” on First Amendment (freedom of speech etc.) and Fourth Amendment (freedom from unreasonable searches and seizures, etc.) grounds.

Although eloquently written, it strikes me that this argument is… how shall I say it? Completely wrong.

Subject to the usual caveat that I’m an English lawyer and not yet US-qualified, three points:

This is not “Bitcoin Criminalization” or a “Bitcoin Ban.”

 Senate Bill 1241 puts cryptocurrency business on a level footing with existing money transmitting business by dropping cryptocurrencies into the already-existing reporting framework for monetary transactions. The main thing to look out for, on my quick reading, is that it reclassifies cryptocurrency exchanges and anyone “issu(ing), redeem(ing) or cash(ing)” cryptocurrency as a “financial institution” under the existing law. They will therefore be required to, among other things, (a) keep records, (b) conduct enhanced due diligence designed to detect money laundering, and (c) not permit structuring of transactions to evade reporting if the law passes.

Unless I’m reading this incorrectly, Bitcoin would remain perfectly legal. Merely holding a balance would not trigger a reporting obligation. Failing to report certain kinds of Bitcoin transactions is what becomes a crime.

This will remove much of the edge cryptocurrencies currently enjoy in the form of regulatory arbitrage. It will make operating a cryptocurrency exchange a far more labor-intensive and tedious proposition. That said, the existing framework is presumptively constitutional so it should be well within the province of Congress to extend it in this way.

The First Amendment is irrelevant

…although I recommend reading Beaut’s argument anyway from the standpoint of working through a well-written a priori logical argument.

This Senate bill is an amendment to an existing federal law which seems to have ample constitutional justification under the Commerce Clause.

Beaut argues that software, being plaintext, attracts First Amendment protection as “speech” and therefore cannot be regulated.

He points us to the example of the encryption program PGP, which the U.S. government had banned from export in binary form (which it was able to do as any encryption program larger than 40 bytes was classified as a “munition”). The PGP team instead published the source code as a plaintext document in a book, which attracted 1st Amendment protection, and shipped the book abroad; recipients abroad then recompiled it and could use PGP themselves.

This argument does not work for the current situation with Bitcoin as nothing in the proposed amendment suggests that the publication of Bitcoin software is regulated in any way, shape or form, nor that people will be restrained from publishing on the Bitcoin network in any way they choose (unless that use is in furtherance of a crime).

A Bitcoin transaction is capable of being a monetary transaction. If it meets certain threshold criteria (size and whether it forms part of a series of transactions) it ought to be reportable. And that is indeed what the new Senate bill says. Not that the system can’t be used, but simply that transactions on it of substantial value by persons engaging in certain types of business will need to be reported. 

The fact that Bitcoin or any other software is, at the end of the day, just a bunch of text constituting executables, as with PGP, doesn’t exempt these programs from the entirely constitutional regime that governs money transfer when these programs are used to facilitate money transfer.

Beautyon’s thinking about the First Amendment ignores/eviscerates the Congressional power granted by the Commerce Clause, which applies to business conducted with software. If the First Amendment overrode the Commerce Clause, 1A could be used as a bludgeon to exempt all online transactions from legal oversight, as anything online is necessarily software-driven (and therefore text-driven). For this reason the probability of the courts adopting that position is zero.

The 4th Amendment isn’t relevant either…

…because the blockchain is a public file, readable by all.

Beaut argues that if Bitcoin is subject to a disclosure regulation, so is all software; thus, he says, the Fourth Amendment to the US Constitution is under threat by the proposed amendment, because e-mail is also software and if they mandate disclosure of your Bitcoin without a warrant, they can also mandate disclosure of your e-mail without a warrant.

This is, to put it lightly, a stretch. The 4A states the right of the people to be free from unreasonable searches and seizures of their “persons, houses, papers and effects” and prevents the fruits of any such unlawful search or seizure from being introduced against that person in court.

I struggle to see how a write permission on a publicly-available blockchain balance is a “paper or effect.” Public keys are pure information. When we have possession of one, we can learn a great deal without needing to also know the associated private key; we know, for example, the transaction inputs and outputs associated with a given address. The Senate bill asks us to put a name to that already-public information if and only if we engage in the specified regulated activity.

Even if this information were an effect, the last time I looked, Bitcoin was 100% publicly readable by anyone, anywhere, at any time. This means, as far as my understanding of the Fourth Amendment goes, one does not really have a reasonable expectation of privacy on the blockchain any more than one has a reasonable expectation of privacy in a pile of garbage you leave out on a street corner. Thus a 4A violation is difficult to make out. (Admittedly the Monero/ZCash situation, where information that would be public on Bitcoin is encrypted, is a little different, but not much – so I’ll leave that aside for today.)

Chill out

In most cases, then, telling the government which bit of the blockchain is yours, whilst annoying, does not act as a prior restraint on speech, does not implicate a privacy concern protected by the Fourth Amendment, does not materially change an already-constitutional regulatory framework and therefore does not undermine the foundations of the Republic.

Which is not to say that crypto-systems don’t implicate speech and privacy issues from time to time. They can and they do. They just don’t here.

Anyway. It’s a Sunday night, so I’m signing off. My tip to the Bitcoin community would be to chill out and don’t embarrass yourself by sounding off some total nonsense to your Congressman about how their “Bitcoin Ban is unconstitutional under the Fourth Amendment.”

If you are really that concerned, you’ll want to chat with a US-qualified public law lawyer or financial regulatory lawyer first.

This is the latest installment in my series of posts about ICO Mania.

A question of liquidity

On Sunday,  I pointed out that Bitcoin, by setting itself up as a sort of decentralized bank, was also creating an unreasonable expectation to its new “depositors” that they will always be able to redeem their assets at par, given a wild mismatch between its $200 billion “market cap” and the quite clearly lower levels of dollar liquidity on the markets – not all of it “new” and some of it of questionable provenance.

This expectation is dangerous as it means, in the event of a liquidity crunch, people will behave not as people necessarily behave when there’s a sharp sell-off in a stock, but more along the lines of when their bank’s solvency is being called into question. Remember bank runs?

Recent news stories make it pretty clear that the new people clearly have no idea what they’ve gotten themselves into.

In case you didn’t know, Bitcoin is the Gom Jabbar of high finance. Cypherpunks who have populated the space to date hold the line because they do not care about money, and therefore do not know fear.

These new people are different. The only reason they are here is the money.

They reek of fear.

When we consider that fresh, naive amateurs are (and their money is) flowing into the sector at a rate of millions of people per month, we should also understand that these amateurs are more susceptible to the animal spirits than their stoic, abrasive, less-socially-adept, battle-hardened forebears. They will be prone to cut and run. As such, a shock to the system, such as an exchange being taken down in a necessary and overdue enforcement action, could lead to a loss in confidence in the entire cryptocurrency ecosystem as a whole and a stampede for the exits the likes of which Bitcoin has not seen to date.

As Bitcoin qua decentralized bank is running a fractional reserve with a chronic shortage of dollars, a shock therefore has the potential to not just drive the price of Bitcoin down a little bit, but also lead to a major liquidity crunch and abject panic.

Credit comes to crypto – aka “Bitprime”

So, on Sunday, I wrote:

In the current environment, there are a number of ways such a shock could arise. To begin with, I seriously question the intermediaries’ and traders’ ability to top up their USD holdings quickly enough to catch up with their depositors’ and counterparties’ paper gains in Bitcoin. There is also the possibility that, in the event of a correction or an enforcement action, a risk-averse bank to a major service provider withdraws either credit or banking services to that provider, compromising that service provider’s ability to convert BTC into dollars, provide margin lending, or even to hold fiat deposits at all.

I had a hunch people were lending into the sector. I just didn’t know the degree of alacrity with which this lending was taking place. Fortunately, I was reading CoinDesk this afternoon and their reporting from the Consensus:Invest conference delivered:

Dan Matuszewski, the head of trading at Circle Internet Financial, said during a morning panel that there is a “real strong need” for the ability to borrow in this market.

 

It would not only facilitate short positions but also provide working capital for trading desks to make markets, he said.

 

During his talk, Boonen of B2C2 acknowledged the irony of the situation given that bitcoin was born as a reaction to the 2008 credit crisis.

 

“Bitcoin enthusiasts really, really do not like credit,” he said. But, he added, “for better or for worse, credit is an important part of a functioning and liquid financial market…”

 

…Even before the institutional money started flowing in, he noted, “by necessity, credit did creep back into bitcoin and crypto markets in general,” with the major exchanges offering leverage to the early retail investors.

So someone’s lending directly into the market, we just don’t know who, nor how much, nor where the liquidity for these lines of credit is ultimately coming from.

Leverage sneaks into the ecosystem in other ways, too; for example, Coinbase accepts credit cards, which is basically margin trading for Grandmas, without collateral and with 20%+ rates of annual interest. Given that rather a lot of people seem to be interested in buying Bitcoin in this way, and that platform is racking up a few hundred thousand new users a week, there’s undoubtedly systemic risk building up there.

Then there’s Bitfinex and Tether, which I do not intend to discuss save to share this passage of Nathaniel Popper’s in the New York Times:

“One persistent online critic, going by the screen name Bitfinex’ed, has written several very detailed essays on Medium arguing that Bitfinex appears to be creating Tether coins out of thin air and then using them to buy Bitcoin and push the price up.”

Long story short, the neophyte Bitbro masters of the universe, too young (or too busy working as a dev in California) to know what a financial crisis feels like, and too dilettantish to find out, are successfully (a) getting buyers to leverage themselves to buy coins, in some cases probably up to the hilt, or (b) convincing institutions to lend into this titanic, one-way, unhedged, $200 billion insanity trade, and trying to convince more of them to do so in greater amounts.

This could get serious

There are two, not necessarily mutually exclusive ways people are responding to the Great Bubble of 2017: anticipatory schadenfreude on the one hand, abject horror on the other.

So far the response from mainstream finance has been the former, with the WSJ’s treatment of the subject being more or less a long-form joke.

But while there is something ineffably twee about a retiree trying to show how they’re hip and “down with the kids” thanks to their position in “big coin,” the fact that they are doing so raises very serious questions about bubble-driven risk (and attendant negative externalities to society) which merits closer attention.

As of right now, the notional value of the cryptocurrency sector is roughly 1/3rd the size of Long-Term Capital Management  (“LTCM”) at its peak.

Cryptocurrency is, admittedly, much smaller than the subprime bubble, which was roughly 2 orders of magnitude larger than Bitcoin today. But Bitcoin has shown, on several occasions, a persistent ability to defy detractors like me to grow an order of magnitude in less than 12 months; if it does so again, it will be 3x larger than LTCM. LTCM on its own very nearly ruined the world in 1998.

If we aren’t careful this is the kind of market where a financial institution can get in serious trouble extremely quickly (imagine the damage a character like Nick Leeson or Kweku Adoboli could have done trading Bitcoin contracts – which are coming soon to both the CME and, reportedly, Nasdaq as well).

We know that cryptocurrency marketing is writing checks the technology can’t cash; most of these systems are unusable as backbones for global finance. It is a matter of time before the punter on the street becomes as disillusioned as I, an irascible blockchain software entrepreneur, have become. It’s just that none of the newcomers know what they’re doing, and most of the old-timers who have figured this out are keeping their mouths shut out of self-interest.

Put another way, this is a disaster waiting to happen. Fortunately for us, 2008 is not ancient history, and the fact that Bitcoin is a classic, manic bubble is so transparently obvious that it should be impossible for thinking people to deal with it otherwise. There are no excuses for not doing right by the societies and taxpayers who had to bail out the financial services industry last time around.

Just say no

So, banks, shadow banks, and anyone else of systemic importance, I implore you: for the good of everyone, by which I mean for the good of the human species, keep this garbage, and anything connected to it, the hell off of your balance sheets. For once, please have the good sense to not load up on frothy bubble-driven financial assets, which you have done hitherto with such predictable regularity that the ECB can model it and write a 52-page paper on the subject which is actually fun to read.

That way, when regulators finally bring this party to the bitter end it so richly deserves, the rest of the ship won’t go down with it.