Maneuvering the Land of Crypto Investing

I am glad that we no longer carry gold or silver coins in money sacks to pay for goods and services — I am also glad that wads of cash are becoming a rarity – we can almost leave our plastic credit cards at home and rely on digital transactions. But is the world truly ready for digital currency, a simple figure displayed on a computer screen? As of December, 2022 — there are 180 currencies in the world sustaining global financial needs of about 195 countries. Typical world currencies are known as fiat currencies, issued by various governments as legal tender and not backed by physical commodities. A small number of currencies – especially in the developing countries — are known as commodity currencies, their value fluctuates based on the commodity export price.

Humans are innovative beasts capable of abstract thought – we can imagine systems that do not exist and put them into practice. Based on sheer will and confidence, we impose our abstract inventions on the natural world, fabricate our reality, and build an operational society. Our fiat monetary system is an example of an abstract structure. Historically, our monetary system was based on gold and silver but in the twentieth century the world abandoned the gold-standard in exchange for our confidence in society, government, and the rule of law. From Latin, fiat translates to “let it be done,” a very appropriate concept for our modern currency system.

In the twenty-first century with access to exponentially increasing computing power, we invented cryptocurrency, a new monetary system. Over ten thousand cryptocurrencies exit that are backed by neither a commodity nor a government. It appears that anyone can establish a cryptocurrency and such currency has value as long as there are willing buyers or investors. The best-known and most credible cryptocurrency, Bitcoin, is mined using energy intensive GPUs (graphics processing units). Bitcoin can be used to purchase goods and services including cars, jewelry, e-commerce products, news media, and insurance. The second most popular cryptocurrency is Ethereum, invented by computer programmers in 2013 — Ethereum is also accepted as a form of payment, especially in e-commerce. My personal favorite is Dogecoin, created in 2013 as a joke to poke fun at the wild speculation in cryptocurrency. Today, Dogecoin has market capitalization of about $85 Billion USD and herein lies the problem — anyone can create cryptocurrency, sometimes even as a joke, and enthusiasts also known as investors buy, sale, and trade it.

Public eagerness created a need for cryptocurrency exchanges – young entrepreneurs sensed the opportunity and filled the void — they established companies that offer trading services to the public. Fueled by entrepreneurs and every-day Joe investors, the cryptocurrency frenzy feeds on itself. Money making money is an old concept but fake money making more money is a killer-app. We all know colleagues, friends, and neighbors who own a piece of the crypto action – heck, many of us also bought into it. While we want to participate in the modern economy and make a quick buck, who truly understands the crypto-world that we are dabbling in?

Recent news about FTX, Alameda, and BlockFi filling for Chapter 11 bankruptcy sent deep tremors into the crypto world. Sam Bankman-Fried (SBF), the founder and CEO of FTX and Alameda was arrested in the Bahamas, indited on eight counts of conspiracy and fraud. As the story unfolds new information becomes available, but the larger effect on the cryptocurrency market and its investors is still unknown. One sure thing is that unsuspecting investors will lose money and hopefully financial crooks will go to prison. But how did an everyday person — an average investor got caught up in this mess?

Recently I had lunch with Frank, a former colleague of mine who is a middle aged successful professional with arguably a good head on his shoulders. Throughout his life Frank made good financial decisions – he put 15% of his earnings into a 401K account, invested into mutual and index funds — bought and sold a couple real-estate properties with reasonable gains, and as a result had some liquidity that he needed to invest. Based on complex human emotions and Frank’s limited understanding of politics and the economy, Frank judged the stock market to be a scary place for his extra dollars.
He thought, there must be somewhere else, somewhere safe to invest and enjoy reasonable financial gains. Friends and colleagues are making money in cryptocurrency but that is such an unknown and potentially volatile market — way scarier than the stock market.
Frank decided to educate himself — he researched the Internet and found encouraging articles on sites that appeared credible like Investopedia and Forbes. The articles contained a bunch of mumbo-jumbo but generally were positive with encouraging messages for the beginner investor. According to the articles, Frank can open a BlockFi Interest Earning Account (BIA), connect it to his traditional bank account, make a direct money transfer, and voila – he can earn a solid interest of about 8%
Well that is magnificent, thought Frank.
But being a cautious man, he decided to take baby steps. Frank started with a $2500 deposit that earned him a whopping 8% interest. The interest showed up as digits on the screen in his BIA account.

Frank clearly didn’t understand how his money was manipulated; but he felt secure because he read that his crypto holdings were in “stablecoin” pegged to the U.S. Dollar, and in his mind that meant “secured.” In reality, when he transferred $2500 to BlockFi, it was converted to Gemini Dollars (GUSD), advertised as a stablecoin with its value pegged to the U.S. dollar — but really a cryptocurrency issued by Gemini for the purpose of trading on their crypto-exchange platform. As long as Frank’s money stayed in GUSD he earned interest. GUSD could also be used to purchase different cryptocurrencies; but Frank shied away from that not wanting to expose himself to the cryptocurrency volatility. Frank never pondered the concept why interest rates in traditional FDIC insured banks were significantly lower than what BlockFi offered. He happily watched his assets grow and transferred more money to his BIA account. Frank ended up transferring $50 thousand U.S. dollars to his BIA.

A major development came about in July, 2022, when the U.S. Security and Exchange Commission (SEC) investigated BlockFi and charged it with failing to register the offers and sales of retail cryptocurrency lending product. The ruling was followed by a $100 million dollars settlement, and an order to cease and desist to engage new U.S. based customers. Moreover, BlockFi could not accept any more incoming deposits from their existing U.S. based customers and had to establish an electronic wallet, an on-line service for the purpose of holding currency which then could be transferred to BIA and converted into altcoins. Altcoins (alternative coins) are digital assets other than Bitcoin. Frank didn’t interpret the SEC actions as a warning; he considered himself fortunate to be grandfathered into a closed fund. Frank was glad that he got his $50 thousand in and happily watched the interest in the BIA grow. Somehow, there was $1508 dollars sitting in his digital wallet, whatever — not important, though Frank.

In the meantime a lot of funny money business deals took place in the cryptocurrency world. Sam Bankman-Fried (SBF) was firing on all cylinders promoting cryptocurrency in Washington D.C. — he contributed about $40 million dollars to both the Democratic and the Republican parties while running his Bahamian cryptocurrency company FTX into the ground. FTX issued its own version of altcoin called FTT and its partner company (also founded by SBF) owned a large number of FTT. When information became public and with an involvement of a competitor, there was a run on FTX which could not sustain the demand of customer withdrawals. FTX made false claims that their customer deposits were FDIC insured, but they were not; these statements had to be withdrawn. FTX accounting practices were an absolute mess — millions of dollars were mis-accounted for. FTX, Alameda, and BlockFi were tied up together in bad financing. Alameda defaulted on a $680 million loan to BlockFi, but BlockFi had a $400 million line of credit that FTX provided as a life-line when another stablecoin, TerraUSD, collapsed. TerraUSD was pegged to the U.S. dollar via an algorithm but it was not actually backed by the U.S. dollar — holy-mackerel – how to decipher these financial deals?

As a result of the interconnected collapse Frank’s BlockFi account was frozen and he received a nice message from corporate, “We are shocked and dismayed by the news regarding FTX and Alameda …. We are not able to operate business as usual.”
OMG! Thought Frank, over $60 thousand frozen in BIA (still earning interest).
Frank learned that BlockFi intends to seek a court ruling to release assets frozen in digital wallets to the customers, so he quickly went into his account to move funds from his BIA to his digital wallet, but it was impossible to move the assets – he only had $1508 in his digital wallet. From Client Services Frank received BlockFi’s petition filling for Chapter 11 where he learned of the fifty largest creditors who have unsecured claims, including $30 million unpaid settlement to the SEC; $275 million loan to FTX (part of the $400 million line of credit during the collapse of TerraUSD); $729 million in obligations to Ankura Trust and Indenture claim (Ankura Trust was assigned by SEC to act on behalf of about 100 thousand investors with balances in BIA). BlockFi entered bankruptcy with $256.6 million in fiat USD cash and was allowed to continue paying obligations such as employee salaries to maintain business operations.

The largest unnamed individual investor had $48.5 million in BIA and the list continued down to a one-million-dollar investor. Frank did a little research and learned that in thirteen rounds of funding, BlockFi raised $1.4 billion dollars from 56 investors – Silicon Valley must have been hungry for investments and full of people with more money than brains. Reading further, Frank learned that BlockFi was a Seed and Round-A investor in other ventures to an order of about $270 million. This puzzled him, a company that raises money to grow its business and operations acts as a venture capital fund? Frank was curious but didn’t have time to investigate these companies to see if there were any incestuous relations like the one between FTX and Alameda. Frank concluded that he will probably recover monies from his digital wallet but everything else will vanish into the ether – he will write it off as a lesson in investing and hope that the people who defrauded the customers will end up in prison. But what about the politicians?

Frank failed to acknowledge red-flags on the field and bought himself an expensive lesson in digital currency investing: don’t invest in anything that you do not understand. Yet, this is not the end for crypto-currency but rather the new beginning which will hopefully force the issue of regulation. Financial institutions and politicians alike will need to put their minds together to enforce order in the chaotic world of cryptocurrency. Investors need to get educated, exercise caution, stop speculating and go back to a solid analysis and understanding of the fundamentals prior to investing. Humans have come a long way from trading furs for grain, then grain for salt, salt for silver coins, and silver coins for colorful pieces of paper – time has come to trade colorful pieces of paper for digits on a screen.