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The cryptocurrency meltdown is regularly described as a liquidity crisis by industry insiders and uncritical media outlets. The story goes something like this: a downturn in crypto markets, perhaps the result of negative trends in the broader economy, triggered a liquidity crisis that led to cascading bankruptcies across the industry.
By this telling, the trouble began back in May when the Terra (UST) stablecoin began to de-peg from the dollar as its sister cryptocurrency, Luna, crashed in value. The price of both cryptocurrencies fell to practically nothing within a few days, wiping out $US45 billion in market value. The immediate fallout resulted in a loss of value of $US300 billion across cryptocurrency markets within the week. (That figure has since grown to over $US2 trillion as prices have continued to slump.) Highly leveraged cryptocurrency investment firms suffered staggering losses. In June, Three Arrows Capital, a major crypto hedge fund that had borrowed heavily to leverage their own crypto investments, could not meet margin calls and was quickly forced into liquidation.
With so many loans going into default, crypto lenders started to go under as well. At the time of liquidation, Three Arrows Capital owed lenders $US3.5 billion, with little ability to repay. Voyager Digital, a major crypto lender, was left on the hook for $US370 million in Bitcoin and another $US350 million in USDC stablecoins that they had loaned Three Arrows. Celsius Network, another major crypto lender, had loaned Three Arrows $US75 million in USDC—and that was just the beginning of their troubles. Suffering its own heavy investment losses, Celsius acknowledged a $US1.2 billion hole in its balance sheet. In truth, the hole was far larger, as their assets included billions in obscure cryptocurrencies issued by Celsius itself and similar firms, as well as almost a billion in loans to such entities. Though cryptocurrency is generally thought of as liquid—Bitcoin has been called “digital cash”—these more obscure digital assets proved illiquid and, ultimately, of little real value as the firms issuing them began to fail.
Though not regulated as such, these crypto lenders were operating as banks, offering lavish returns to depositors putting up their own cryptocurrency as collateral. Without even FDIC insurance on their settlement accounts, depositors rushed to get funds out before the firms collapsed. Without sufficient cash on hand, Voyager and Celsius paused withdrawals before filing for bankruptcy in July.
In November, FTX, a major cryptocurrency exchange branding itself as the responsible, good-faith actor in an otherwise dodgy industry, was the next domino to fall. Leaked balance sheets from FTX’s sister company, Alameda Research, revealed that the trading firm was holding most of its assets in FTX’s house “token,” FTT. This raised questions about the unusually close relationship between the two firms (it was later revealed that FTX was secretly and illicitly funneling depositors’ funds to Alameda to fund risky crypto investments), as well as their solvency. FTT, like similar assets held by recently failed crypto firms, was highly illiquid.
In response to the leak, the CEO of Binance, the largest cryptocurrency exchange by trading volume, announced that it would liquidate its entire substantial holdings in FTT, which caused the token to crash in value. Following a now-familiar arc, depositors rushed to withdraw funds from FTX, forcing the exchange to pause withdrawals for lack of liquidity. Within five days, FTX, Alameda Research, and various subsidiaries—having been recently valued at well over $US40 billion, collectively—began the bankruptcy process as well.
The industry contagion continues. Last week, Genesis, yet another leading crypto lender, also declared bankruptcy. The firm, a subsidiary of crypto venture capital firm Digital Currency Group, owes approximately $US3.5 billion to its top 50 creditors. Digital Currency Group, in addition to investing in hundreds of crypto companies, owns several other subsidiaries as well, including the major crypto asset management company Grayscale Investments, which claimed to hold over $US50 billion in digital assets as of 2021 and now, amid market uncertainty, refuses to show proof of its own reserves due to “safety and security” concerns. We can only speculate which firms go down next.
The above narrative emphasizes the liquidity crisis spreading across crypto firms at risk of overlooking their fundamental insolvency. A liquidity crisis is a cash flow problem—immediate financial obligations cannot be met as they come due. While an accounting liquidity crisis can certainly lead to defaults and bankruptcy, the term implies that the organization is otherwise solvent.
In the case of recently failed cryptocurrency firms, this was clearly not the case. During a liquidity crisis, distressed organizations seek out loans to cover immediate operating expenses. If they truly are solvent, they may well find lenders. Insolvent firms, on the other hand, usually cannot. No one wants to throw good money at organizations that are going to fail anyway—not other firms, not even central banks acting as lenders of last resort during industry-wide financial crises.
Since central banks would not be bailing out unregulated cryptocurrency firms, they had only one another to turn to. Early in the crisis, FTX was known for shoring up or acquiring smaller crypto firms in financial trouble. They bailed out crypto lender BlockFi over the summer by offering a $US400 million lifeline of credit, which kept that firm alive until FTX also collapsed. With much of the cryptocurrency industry melting down, FTX had fewer places to turn, especially for a firm their size. Binance was the only cryptocurrency exchange doing more volume than FTX. But while Binance announced plans to save FTX through an acquisition and merger, they backed out the next day after a peek at their financials.
A leaked balance sheet gives some insight into why. FTX was claiming $US9 billion in liabilities but only $US900 million in liquid assets. Most of their assets were marked either “less liquid” or “illiquid.” As with other failed crypto firms, FTX was holding the lion’s share of their assets in obscure cryptocurrencies issued by the firm itself or other companies and projects with close ties to FTX or its disgraced CEO Sam Bankman-Fried.
Crypto firms issue these obscure cryptocurrencies, which we can refer to collectively as “house” tokens for convenience, to facilitate trades, settle debts, issue loans, post collateral, and conduct other financial transactions while remaining in the insular and poorly regulated cryptocurrency space. These tokens allow firms, as well as their customers, to transact without having to involve traditional financial institutions, at least until someone wants to cash out of the crypto space.
Some of these house tokens are stablecoins pegged to a fixed amount (usually the dollar), but many fluctuate in price on markets, just like any other financial asset. Such house tokens may be branded as “security tokens,” when they are supposed to explicitly confer ownership of assets or debt, “governance tokens,” if they are intended to confer a kind of “voting share” to be executed on the blockchain, or simply a “utility token” when primarily intended to be used on a native platform. But no matter what their originally intended or ostensible use case, these tokens are often traded between firms as payment, loans, or collateral. When used in this manner, they all function as unregulated securities. (This is arguably true of stablecoins, too, which are also used for loans and collateral, as their value depends upon the health and survival of the issuing company defending the peg.)
Many big crypto firms issue such house tokens. FTX had their FTT tokens, Voyager Digital the Voyager Token, and Celsius their CEL tokens. Unlike Bitcoin, or even Ethereum and Dogecoin, these tokens are not well known outside of cryptocurrency spaces and have little appeal to the masses. As such, cryptocurrency firms often generate retail demand for house tokens—which helps confer at least some level of liquidity and market valuation—by offering users various rewards. FTX gave traders discounts for using FTT. Crypto lenders, including Celsius and Voyager, have offered depositors what are effectively crypto “savings accounts” with annual percentage yields as high as 20 percent or more, an obscene return unseen in regulated financial markets.
Similar offerings can be found in the world of decentralized finance, or “DeFi” for short. Terraform Labs, creator of Terra and Luna, created demand for their tokens by offering depositors similarly too-good-to-be-true returns through an automated lending program, the Anchor Protocol. But whether these programs are executed automatically “on the blockchain” or managed by a boring old spreadsheet in an accounting office, they serve an identical purpose: generating retail demand by offering returns that are only sustainable as long as new money keeps coming into the system. Critics, as well as regulators, have described these digital assets and projects as rather obvious Ponzi schemes.
Despite choosing not to acquire FTX, Binance CEO and cofounder Changpeng “CZ” Zhao cannot have been too surprised by what he saw on their balance sheet. His cryptocurrency exchange has its own platform-specific utility token—the Binance Token (BNB), as well as a native stablecoin, BUSD. Binance appears to operate in much the same way as other troubled and failed cryptocurrency projects and firms.
Unsurprisingly, Binance also appears headed in much the same direction. The exchange has suffered $US12 billion in outflows in recent months, at one point temporarily pausing some withdrawals, though the company contends this is all business as usual. (This may well be true, but other troubled crypto firms offered similar assurances only to announce bankruptcy shortly thereafter.) To shore up confidence, Binance released limited internal reviews—particularly uncharacteristic for a notoriously secretive firm—though their internal finances remain a “black box.” BNB has shed significant value in recent weeks due to investor concerns, and, while the company hasn’t entered collapse yet—at least not publicly—reasonable observers may get the feeling that we have seen this one before.
The prototype for house tokens is the controversial stablecoin Tether (USDT), which originally launched in 2014 (under the name Realcoin). The various companies and shell companies responsible for issuing USDT (hereinafter referred to in this article as “Tether” for simplicity) share ownership and executive leadership with the Bitfinex cryptocurrency exchange, a relationship the firms sought to obscure and deny until it was confirmed by the Paradise Papers in 2017. Bitfinex has long struggled to maintain stable banking partnerships, but tethers—functioning as little $US1 IOUs—allow trades to be settled on blockchain, which also offers interoperability across crypto markets. Within the world of cryptocurrency, tethers have been just as good as dollars for almost a decade now. Many amateur traders and investors may not even be aware that settlement accounts on many crypto exchanges are denominated in tethers, not actual dollars.
There are currently over 66 billion tethers in circulation, down from a high of over 83 billion last year. Tether initially lied about the stablecoin being backed one-for-one by cash—for which it paid $US41 million in fines in 2021—and has repeatedly changed or walked back claims about their reserves. Tether claimed to hold a large amount of “commercial paper”—essentially corporate IOUs—until the collapse of other crypto firms holding illiquid assets created enough fear around Tether for it to slip five percent off its peg in May. Presumably in response, Tether announced that their reserves no longer held commercial paper. Their latest attestation claims that their reserves are “extremely liquid” and include almost $US40 billion in US Treasury bills, but given their history of misrepresentation and refusal to undergo a real third-party audit, such claims should be taken with a whole shaker of salt.
Tether’s reserves matter because, unlike Bitcoin, there is no hard limit on how much Tether can go into circulation. Tether routinely mints the stablecoin by the billions and sends them off to cryptocurrency exchanges and firms around the world. (Prior to its collapse, FTX was Tether’s biggest customer.) If these tokens are insufficiently collateralized, then Tether is basically printing “money” from thin air. While the company works to defend the peg and claims it can redeem tethers at face value, its terms of service make it clear they are under no obligation to do so.
Critics, as well as litigants, have accused the company of using (apparently largely unbacked) Tether tokens to manipulate the price of cryptocurrency assets. John M. Griffin at the University of Texas, and Amin Shams at Ohio State University found that half of the rise in the price of Bitcoin during the 2017–2018 bubble was the result of price manipulation using Tether on the Bitfinex exchange. They concluded that the perpetrator was a single entity that was almost certainly the exchange or an accomplice. The allegations are certainly plausible. With limitless tethers at their disposal and a major crypto exchange in their possession, they could easily buy up Bitcoin and other cryptocurrencies to drive up the spot price.
Is Bitcoin Really Un-Tethered?
This paper investigates whether Tether, a digital currency pegged to the U.S. dollar, influenced Bitcoin and other cryptocurrency prices during the 2017 boom. U
I have argued elsewhere that this kind of price manipulation renders cryptocurrency as a whole a giant decentralized Ponzi scheme and that a full ban on cryptocurrency is the best, and probably only, solution. Cryptocurrency markets are global. There is no realistic way for regulators to stop foreign entities from manipulating cryptocurrency prices with unbacked stablecoins.
However, there are limits to how high Bitcoin prices can be artificially manipulated in this way. Most popular cryptocurrencies, including Bitcoin, employ a “proof of work” consensus mechanism for verifying updates to the blockchain. Critics sometimes mock this process as “proof of waste.” Cryptocurrency “miners,” which are simply network participants competing to solve pointless cryptographic puzzles for the right to approve transactions and collect a reward of cryptocurrency (a “block reward”), now waste unfathomable amounts of electricity. This waste is by design. The difficulty of the puzzles scales with the amount of total processing power thrown at the network—known as the “hash rate”—so that the cost of tampering with the network scales with the hypothetical reward for doing so, thus helping to ensure the integrity and security of the blockchain.
But proof-of-work blockchains are only prohibitively expensive to attack because they are so expensive to run and maintain. This is precisely why mining difficulty scales with cryptocurrency prices. Crypto miners are locked in a perpetual arms race upon which the only hard cap is the price of the cryptocurrency being mined. The system incentivizes miners to add more and more processing capacity until mining costs exceed the profits from collecting block rewards.
If stablecoin issuers are artificially inflating cryptocurrency prices, they are also necessarily driving up mining costs. But miners cannot pay utility bills with stablecoins. They need real cash to avoid shutting down or going into debt. Higher prices thus force miners to convert more of their earnings into actual cash. This places some limit on how high unbacked stablecoins can pump cryptocurrency prices without making the whole operation—including crypto miners—insolvent. At some point, using stablecoins to artificially inflate crypto prices will eat up all of the real cash liquidity coming into the cryptocurrency space, and the result will be a liquidity crisis that more stablecoins cannot fix.
The limits that mining costs place on this kind of artificial price inflation are not just financial but also physical. Bitcoin mining alone—to say nothing of other proof-of-work coins—was using half of a percent of the world’s entire electricity consumption in 2022. Some reports have estimated that aggregate cryptocurrency mining activities in 2022 could have totaled almost one percent of global electricity production.
So long as more energy remains available to miners, energy consumption will continue to scale linearly with price, according to economist Alex de Vries, who has been tracking cryptocurrency energy consumption since 2014. Bitcoin investors have become accustomed to bull runs that bring tenfold returns, maybe more. But Bitcoin prices 10 times the previous high would incentivize miners to use 10 times the energy—five percent of global electricity production. A subsequent bull run of the same magnitude would require half of the world’s current electricity production. I would say “and so on and so forth,” but you see the problem here.
Of course, crypto miners cannot use electricity capacity that doesn’t exist, nor would most operate at a loss. The likely result of “overinflating” Bitcoin prices is that some miners would halt operations and the hash rate would fall until mining again became profitable. However, with Bitcoin prices still high, this would leave the network more vulnerable to a devastating “51% attack”—the very thing the system is designed to prevent.
Manipulating cryptocurrency prices to a high-enough level to keep luring in new money without breaking the whole system is likely a careful balancing act that gets harder with each successive bull run. This helps explain the reduced returns. For years, crypto boosters pointed to the fact that Bitcoin had never crashed below the previous cycle’s all-time high as proof that it never would. But Bitcoin prices have spent much of the last six months well under the almost $US20,000 highs of the previous bubble set back in 2017. Though the current lows may represent an inflection point, the trend isn’t new. Bitcoin’s annual ROI has been trending down since its inception. Despite growing media coverage and hype, every bull run since at least 2013 has produced lower returns than the previous one.
Stablecoins, artificial liquidity, and market manipulation cannot solve this problem. Proof-of-work blockchains simply require too much energy to operate at scale. Market manipulation has helped sustain interest in what is essentially a negative-sum investment for probably at least a decade now. But luring in new investors requires ever-higher prices, and ever-higher prices are creating ever-higher mining costs. The scheme is even less sustainable than traditional Ponzi schemes, which don’t require dedicating a growing share of new investors’ money toward massive processing centers that now rival the size of the entire world’s traditional data centers.
Financial and resource limits place some theoretical hard limitations on growing the cryptocurrency ecosystem. But, ultimately, de Vries told me, the real limit on cryptocurrency mining—and, by extension, cryptocurrency itself—is likely to be political. Diverting so much energy toward crypto mining activity is neither tenable nor sustainable. Policymakers will eventually have to step in before miners consume anywhere near the entirety of global energy production.
This is already happening. China banned cryptocurrency mining in 2021, which sent miners underground or fleeing to more permissive locales. The European Union is again considering a mining ban as the European energy crisis worsens. In the United States, where crypto mining already gobbles up as much as 1.7 percent of the nation’s electrical output, New York placed a moratorium on new cryptocurrency mining permits at fossil fuel plants. In Texas, where favorable regulatory conditions attracted more mining activity than any other state, the state’s grid operator has slowed the issuance of new permits due to added stress on an already-strained power grid. Nationally, the Biden administration is exploring cryptocurrency regulations, such as tighter controls on stablecoins and other digital assets and a possible ban on some crypto mining.
The inability of stablecoins to manipulate the price of Bitcoin and other cryptocurrencies ever higher helps explain the emergence of increasingly complex financial schemes built atop crypto markets. Initial coin offerings (ICOs), undercollateralized security tokens, the Ponzi-like financial offerings of crypto lenders—these new digital assets are more easily managed and manipulated than the lumbering Bitcoin blockchain with its massive overhead. Such schemes are perhaps the only path forward for crypto in the face of diminishing returns from proof-of-work cryptocurrencies and the inability to manipulate their prices higher.
Unfortunately for those orchestrating these projects, they are much more recognizable as Ponzi schemes and far easier to prosecute. Tether, and other such bad actors, allegedly conducted their fraud on shadowy foreign exchanges beyond the reach of regulators. They did so off the Bitcoin blockchain, which offers plausible deniability to “legitimate” regulated companies benefiting from artificially inflated cryptocurrency prices.
By comparison, crypto firms issuing and artificially inflating the value of their house tokens are just plain old Ponzi schemes. They have proven much easier to identify and prosecute as such. Sam Bankman-Fried was indicted and arrested for, among other charges, his role in orchestrating securities and commodities fraud at FTX and Alameda Research. Voyager Digital is under investigation, as is Celsius Network. Do Kwon, CEO of Terraform Labs, is on the run after a South Korean court issued an arrest warrant for him on fraud and other charges. The Commodity Futures Trading Commission is suing Gemini—a prominent US-based crypto exchange operated by the Winklevoss twins—for misleading regulators about the workings of a Bitcoin futures product. In addition to charges against a mounting number of individuals running various crypto token Ponzi schemes too numerous to list here, the US Securities and Exchange Commission (SEC) just charged both Gemini and Genesis with selling unregistered securities. At this point, pretty much every major player in the industry appears to be under investigation, and the future of crypto looks bleak.
In June 2015, YouTube user Alex Millar uploaded a video, now lore in cryptocurrency circles, recounting Bitcoin’s many boom-and-bust cycles. Tongue planted in cheek throughout the video, he warns viewers not to buy Bitcoin since “you know it’s gonna crash.” The video does the rounds on online crypto spaces whenever prices tumble. “Zoom out,” crypto boosters remind would-be new investors and “weak hands” considering selling out to stop losses. The implication is that, since Bitcoin has always recovered to new highs after every crash, so it shall again.
These boom–bust cycles have become so routine that even mainstream media outlets now speak of “crypto winter” without reflection. The implication, again, is that no matter how bad things look now, someday the season will turn. So far, it always has, so I court an army of laser-eyed trolls merely suggesting that this time might be different.
Forecasting speculative markets is always fraught, to say nothing of those so poorly regulated and highly manipulated as cryptocurrency markets. Those calling the end of Bitcoin or crypto have so far been proven wrong or—more likely—simply premature, so pardon me for hedging my bets, but I won’t go that far. Fraud, like life, finds a way. But if the price manipulation driving recent crypto bubbles is no longer financially viable or politically tenable, then crypto may well have entered a new era of diminished future prospects.
Ethereum, a blockchain platform home to the second most popular cryptocurrency (Ether), may be charting a new path forward. In September 2022, after years of delay, Ethereum finally completed a software upgrade known as “the Merge” that moved the platform away from a proof-of-work consensus mechanism to a much less energy-intensive “proof-of-stake” system. The new system replaces crypto miners with validators who “stake” their own cryptocurrency in exchange for a yield. The switch has successfully reduced the energy consumption of the Ethereum blockchain by over 99.99 percent by doing away with mining entirely. Though the change has been years in the making, the timing of the Merge may not be so coincidental if rising mining costs are hamstringing crypto markets.
While post-Merge Ethereum is far more environmentally friendly than its previous incarnation, the switch to proof-of-stake has caught the attention of regulators. Though the SEC has previously deemed Ether (and other proof-of-work cryptocurrencies) not to be securities, they may be reversing course after the Merge. SEC Chair Gary Gensler recently suggested that cryptocurrency exchanges offering staking—which is inherent to the proof-of-stake system—look “very similar” to crypto lenders. The SEC forced crypto lenders to register with the agency last year and fined BlockFi $US100 million for failing to do so. And, as we know, crypto lenders aren’t doing so well under increased regulatory scrutiny.
Ethereum helped popularize “smart contracts” and became a foundation for DeFi and the broader crypto finance sector. Various ICOs, stablecoins, and other security tokens were built on Ethereum, many of which have been revealed as Ponzi schemes, big and small. Following the move to proof-of-stake, Ethereum now more clearly resembles the Ponzi schemes and sketchy firms using crypto to sidestep financial regulations that the platform hosts. It’s Ponzis all the way down, and always has been, but proof-of-work mining once helped obscure that fundamental truth. After the Merge, Ethereum is a more efficient Ponzi scheme at the cost of being a more transparent one.
In the end, the greatest innovation of cryptocurrency may have been its ability to evade regulatory scrutiny. Blockchain—which is essentially just distributed append-only spreadsheets—was a remarkable mystifier when it involved proof-of-work. But the novelty and tangibility of crypto mining appear to have been indispensable to blockchain’s ability to confuse and obfuscate. Proof-of-stake projects are simply much easier to recognize as the Ponzi schemes they are. Now that excessive energy consumption has curtailed the expansion of the proof-of-work cryptocurrencies upon which the crypto industry has been built, the jig—it appears—is finally up.
The scorched-earth behavior of some of the biggest players in the cryptocurrency space suggests they know the walls are finally coming down. The falling valuation of better-regulated crypto companies apparently operating mostly within the bounds of the law—Coinbase stock has been down as much as 90 percent from its 2021 IPO in recent weeks—suggests a poor outlook for even the “legitimate” firms operating in a sector driven by fraud once that fraud is excised. When your house is a Ponzi scheme built atop Ponzi schemes atop a Ponzi scheme, everything starts to come down when the base buckles.
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