The Economist On Cryptocurrencies

The Economist edition dated August 7^th has a leader (Unstablecoins) and two articles (in the Finance section (The disaster scenario and Here comes the sheriff).

Source

The leader argues that:

Regulators must act quickly to subject stablecoins to bank-like rules for transparency, liquidity and capital. Those failing to comply should be cut off from the financial system, to stop people drifting into an unregulated crypto-ecosystem. Policymakers are right to sound the alarm, but if stablecoins continue to grow, governments will need to move faster to contain the risks.

But even The Economist gets taken in by the typical cryptocurrency hype, balancing current actual risks against future possible benefits:

Yet it is possible that regulated private-sector stablecoins will eventually bring benefits, such as making cross-border payments easier, or allowing self-executing “smart contracts”. Regulators should allow experiments whose goal is not merely to evade financial rules.

They don't seem to understand that, just as the whole point of Uber is to evade the rules for taxis, the whole point of cryptocurrency is to "evade financial rules".

Below the fold I comment on the two articles.

Here comes the sheriff

This article is fairly short and mostly describes the details of Gary Gensler's statement in three "buckets":

1. The first is about investor protection:
   

   The regulator claims jurisdiction over the crypto assets that it defines as securities; issuers of these must provide disclosures and abide by other rules. The SEC‘s definition uses a number of criteria, including the “Howey Test”, which asks whether investors have a stake in a common enterprise and are led to expect profits from the efforts of a third party. Bitcoin and ether, the two biggest cryptocurrencies, do not meet this criterion (they are commodities, under American law). But Mr Gensler thinks that ... a fair few probably count as securities—and do not follow the rules. These, he said, may include stablecoins ... some of which may represent a stake in a crypto platform. Mr Gensler asked Congress for more staff to police them.

2. The second is about new products:
   

   For months the SEC has sat on applications for bitcoin ETFs and related products, filed by big Wall Street names like Goldman Sachs and Fidelity. Mr Gensler hinted that, in order to be approved, these may have to comply with the stricter laws governing mutual funds.

3. The third is a request for new legal powers needed to pave over cracks in regulation that cryptocurrencies, whose whole point is to "evade financial rules", are exploiting:
   

   Mr Gensler is chiefly concerned with platforms engaged in crypto trading or lending as well as in decentralised finance (DeFi), where smart contracts replicate financial transactions without a trusted intermediary. Some of these, he said, may host tokens that should be regulated as securities; others could be riddled with scams.

The SEC is likely to encounter massive opposition to these ideas. How cryptocurrency became a powerful force in Washington by Todd C. Frankel et al reports on the flow of lobbying dollars from cryptocurrency insiders to Capitol Hill and how it is blocking progress on the current infrastructure bill:

And after years of debate over how to improve America’s infrastructure, and months of sensitive negotiations between the White House and lawmakers, the $1 trillion bipartisan infrastructure proposal suddenly stalled in part because of concerns about how government would regulate an industry best known for wild financial speculation, memes — and its role in ransomware attacks.
...
Regardless of the measure’s ultimate fate, the fact that crypto regulation has become one of the biggest stumbling blocks to passage of the bill underscored how the industry has become a political force in Washington — and previewed a series of looming battles over a financial technology attracting billions of dollars of interest from Wall Street, Silicon Valley and financial players around the world, but that few still understand.

It gets worse. Kate Riga reports that In Fit Of Pique, Shelby Kills Crypto Compromise:

Sen. Richard Shelby (R-AL) killed a hard-earned cryptocurrency compromise amendment to the bipartisan infrastructure bill because his own amendment, to beef up the defense budget another $50 billion, was rejected by Sen. Bernie Sanders (I-VT). Shelby had tried to tack it on to the cryptocurrency amendment.
...
So that’s basically it for the crypto amendment, which took the better part of the weekend for senators and the White House and hammer into a compromise.

The issue here was that the un-amended bill would require:

some cryptocurrency companies that provide a service “effectuating” the transfer of digital assets to report information on their users, as some other financial firms are required to do, in an effort to enforce tax compliance.

Crypto supporters said the provision’s wording would seemingly apply to companies that have no ability to collect data on users, such as cryptocurrency miners, and could push a swath of the industry overseas.

So maybe by accident Mining Is Money Transmission.

The disaster scenario

This article is far longer and far more interesting. It takes the form of a "stress test", discussing a scenario in which Bitcoin's "price" goes to zero and asking what the consequences for the broader financial markets and investors would be. It is hard to argue with the conclusion:

Still, our extreme scenario suggests that leverage, stablecoins, and sentiment are the main channels through which any crypto-downturn, big or small, will spread more widely. And crypto is only becoming more entwined with conventional finance. Goldman Sachs plans to launch a crypto exchange-traded fund; Visa now offers a debit card that pays customer rewards in bitcoin. As the crypto-sphere expands, so too will its potential to cause wider market disruption.

The article identifies a number of channels by which a Bitcoin collapse could "cause market disruption":

• Via the direct destruction of paper wealth for HODL-ers and actual losses for more recent purchasers.
• Via the stock price of companies, including cryptocurrency exchanges, payments companies, and chip companies such as Nvidia.
• Via margin calls on leveraged investments, either direct purchases of Bitcoin or derivatives.
• Via redemptions of stablecoins causing reserves to be liquidated.
• Via investor sentiment contagion from cryptocurrencies to other high-risk assets such as meme stocks, junk bonds, and SPACs.

I agree that these are all plausible channels, but I have two main issues with the article.

Issue #1: Tether

Source

First, it fails to acknowledge that the spot market in Bitcoin is extremely thin (a sell order for 150BTC crashed the "price" by 10%), especially compared to the 10x larger market in Bitcoin derivatives, and that the "price" of Bitcoin and other cryptocurrencies is massively manipulated, probably via the "wildcat bank" of Tether. The article contains, but doesn't seem to connect, these facts:

Fully 90% of the money invested in bitcoin is spent on derivatives like “perpetual” swaps—bets on future price fluctuations that never expire. Most of these are traded on unregulated exchanges, such as FTX and Binance, from which customers borrow to make bets even bigger.
...
The extent of leverage in the system is hard to gauge; the dozen exchanges that list perpetual swaps are all unregulated. But “open interest” ... has grown from $1.6bn in March 2020 to $24bn today. This is not a perfect proxy for total leverage, as it is not clear how much collateral stands behind the various contracts. But forced liquidations of leveraged positions in past downturns give a sense of how much is at risk. On May 18th alone, as bitcoin lost nearly a third of its value, they came to $9bn.
...
Because changing dollars for bitcoin is slow and costly, traders wanting to realise gains and reinvest proceeds often transact in stablecoins, which are pegged to the dollar or the euro. Such coins, the largest of which are Tether and USD coin, are now worth more than $100bn. On some crypto platforms they are the main means of exchange.

Source

That last paragraph is misleading. Fais Kahn writes:

Binance also hosts a massive perpetual futures market, which are “cash-settled” using USDT. This allows traders to make leveraged bets of 100x margin or more...which, in laymen’s terms, is basically a speculative casino. That market alone provides around ~$27B of daily volume, where users deposit USDT to trade on margin. As a result, Binance is by far the biggest holder of USDT, with $17B sitting in its wallet.

Bernhard Meuller writes:

A more realistic estimate is that ~70% of the Tether supply (43.7B USDT) is located on centralized exchanges.

Interestingly, only a small fraction of those USDT shows up in spot order books. One likely reason is that a large share is sitting on wallets to collateralize derivative positions, in particular perpetual futures. ... It’s important to understand that USDT perpetual futures implementations are 100% USDT-based, including collateralization, funding and settlement.

So on the exchange that dominates bitcoin derivative trading, where the majority of "Fully 90% of the money invested in bitcoin" lives, USDT is the exclusive means of exchange. The entire market's connection to the underlying spot market is that:

Prices are tied to crypto asset prices via clever incentives, but in reality, USDT is the only asset that ever changes hands between traders.

Other than forced liquidations, the article does not analyze how the derivative market would respond to a massive drop in the Bitcoin "price", and whether Tether could continue to pump the "price". As money market funds did in the Global Financial Crisis, the article suggests that stablecoins would have problems:

Issuers back their stablecoins with piles of assets, rather like money-market funds. But these are not solely, or even mainly, held in cash. Tether, for instance, says 50% of its assets were held in commercial paper, 12% in secured loans and 10% in corporate bonds, funds and precious metals at the end of March. A cryptocrash could lead to a run on stablecoins, forcing issuers to dump their assets to make redemptions. In July Fitch, a rating agency, warned that a sudden mass redemption of tethers could “affect the stability of short-term credit markets”.

It is certainly true that the off-ramps from cryptocurrencies to fiat are constricted; that is a major reason for the existence of stablecoins. But Fais Kahn makes two points:

If there were a sudden drop in the market, and investors wanted to exchange their USDT for real dollars in Tether’s reserve, that could trigger a “bank run” where the value dropped significantly below one dollar, and suddenly everyone would want their money. That could trigger a full on collapse.

But when that might actually happen? When Bitcoin falls in the frequent crypto bloodbaths, users actually buy Tether - fleeing to the safety of the dollar. This actually drives Tether’s price up!

And:

Tether’s own Terms of Service say users may not be redeemed immediately. Forced to wait, many users would flee to Bitcoin for lack of options, driving the price up again.

It isn't just Tether that doesn't allow winnings out. Carol Alexander's Binance’s Insurance Fund is a fascinating, detailed examination of Binance's extremely convenient "outage" as BTC crashed on May 19. Her subhead reads:

How insufficient insurance funds might explain the outage of Binance’s futures platform on May 19 and the potentially toxic relationship between Binance and Tether.

I certainly don't understand all the ramifications of the "toxic relationship between Binance and Tether", but the article's implicit assumption that they, and similar market particiapants, behave like properly regulated financial institutions is implausible. Alexander's take on the relationship, on the other hand, is alarmingly plausible:

In May 2021 ... Tether reported that only 2.9% of all tokens are actually backed by cash reserves and about 50% is in commercial paper, a form of unsecured debt that is normally only issued by firms with high-quality debt ratings.

he simultaneous growth of Binance and tether begs the question whether Binance itself is the issuer of a large fraction of tether’s $30 billion commercial paper. Binance's B2B platform is the main online broker for tether. Suppose Binance is in financial difficulties (possibly precipitated by using its own money rather than insurance funds to cover payment to counterparties of liquidated positions). Then the tether it orders and gives to customers might not be paid for with dollars, or bitcoin or any other form of cash, but rather with an IOU. That is, commerical paper on which it pays tether interest, until the term of the loan expires.

No new tether has been issued since Binance's order of $3 bn [Correction 6 Aug: net $1bn transfer] was made highly visible to the public on 31 May. [Correction: 6 Aug: Another $1 bn tether was issued on 4 Aug]. Maybe this is because Tether's next audit is imminent, and the auditers may one day investigate the identity of the issuers of the 50% (or more, now) of commercial paper it has for reserves. If it were found that the main issuer was Binance (maybe followed by FTX) then the entire crypto asset market place would have been holding itself up with its own bootstraps!

This would certainly explain why Matt Levine wrote:

There is a fun game among financial journalists and other interested observers who try to find anyone who has actually traded commercial paper with Tether, or any of its actual holdings. The game is hard! As far as I know, no one has ever won it, or even scored a point; I have never seen anyone publicly identify a security that Tether holds or a counterparty that has traded commercial paper with it.

If Tether's reserves were 50% composed of unsecured debt from unregulated exchanges like Binance ...

Issue #2: Dynamic Effects

My second problem with the article is that this paragraph shows The Economist sharing two common misconceptions about blockchain technology:

A crash would puncture the crypto economy. Bitcoin miners—who compete to validate transactions and are rewarded with new coins—would have less incentive to carry on, bringing the verification process, and the supply of bitcoin, to a halt.

First, it is true that, were the "price" of Bitcoin zero, mining would stop. But if mining stops, it is transactions that stop. Bitcoin HODL-ings would be frozen in place, not just worth zero on paper but actually useless because nothing could be done with them.

Second, the idea that the goal of mining is to create new Bitcoin is simply wrong. The goal of mining is to secure the blockchain by making Sybil attacks implausibly expensive. The creation of new Bitcoin is a side-effect, intended to motivate miners to make the blockchain secure by making Sybil attacks implausibly expensive. The fact that Nakamoto intended mining to continue after the final Bitcoin had been created clearly demonstrates this.

The article is based on this scenario:

in order to grasp the growing links between the crypto-sphere and mainstream markets, imagine that the price of bitcoin crashes all the way to zero.

A rout could be triggered either by shocks originating within the system, say through a technical failure, or a serious hack of a big cryptocurrency exchange. Or they could come from outside: a clampdown by regulators, for instance, or an abrupt end to the “everything rally” in markets, say in response to central banks raising interest rates.

But, as the article admits, a discontinuous change from $44K or so to $0 is implausible. A rapid but continuous drop over, say, a month is more plausible, and it could bring issues that the article understandably fails to address.

Source

As the "price" drops two effects take place. First, the value of the mining reward in fiat currency decreases. The least efficient and least profitable miners become uneconomic and drop out, decreasing the hash rate and thus increasing the block time and reducing the rate at which transactions can be processed:

Typically, it takes about 10 minutes to complete a block, but Feinstein told CNBC the bitcoin network has slowed down to 14- to 19-minute block times.

This effect occurred during the Chinese government's crackdown, as shown in the graph of hash rate.

Source

Second, every 2016 blocks (about two weeks) the algorithm adjusts, in this case decreases, the difficulty and thus the cost of mining the next 2016 blocks. The idea is to restore the block time to about 10 minutes despite the reduction in the hash rate. When the Chinese crackdown took 52.2% of Bitcoin's hash power off-line, the algorithm made the biggest reduction in difficulty in Bitcoin's history.

In our scenario, Bitcoin plunges over a month. Lets assume it starts just after a difficulty adjustment. The month is divided into two parts, with the initial difficulty for the first part, and a much reduced difficulty for the second part.

In the first part the rapid "price" decrease makes all but the most efficient miners uneconomic, so the hash rate decreases rapidly and block production slows rapidly. Producing the 2016-th block takes a lot more than two weeks. This is a time when the demand for transactions will be extreme, but during this part the supply of transactions is increasingly restricted. This, as has happened in other periods of high transaction demand, causes transaction fees to spike to extraordinary levels. In normal times fees are less than 10% of miner income, but it is plausible that they would spike an order of magnitude or more, counteracting the drop in the economics of mining. But median fees of say $200 would increase the sense of panic in the spot market.

Lets assume that, by the 2016-th block, that more than half the mining power has been rendered uneconomic, so that the block time is around 20 minutes. Thus the adjustment comes after three weeks. When it happens, the adjustment, being based on the total time taken in the first part, will be large but inadequate to correct for the reduced hash rate at the end of the first part. With our assumptions the adjustment will be for a 25% drop in hash power, but the actual drop will have been 50%. Block production will speed up, but only to about 15 minutes/block. Given the panic, fees will drop somewhat but remain high.

As the adjustment appraoches there are a lot of disgruntled miners, whose investment in ASIC mining rigs has been rendered uneconomic. The rigs can't be repurposed for anything but other Proof-of-Work cryptocurrencies, which have all crashed because, as the article notes:

Investors would probably also dump other cryptocurrencies. Recent tantrums have shown that where bitcoin goes, other digital monies follow, says Philip Gradwell of Chainalysis, a data firm.

Recall that what the mining power is doing is securing the blockchain against attack. Once it became possible to rent large amounts of mining power, 51% attacks on minor alt-coins became endemic. For example, there were three successful attacks on Ethereum Classic in a single month. Before the adjustment, some fraction of the now-uneconomic Bitcoin mining power has migrated to the rental market. Even a small fraction can overwhelm other cryptocurrencies. As I write, the Bitcoin hash rate is around 110M TH/s. Dogecoin is the next largest "market cap" coin using Bitcoin-like Proof-of-Work. Its hash rate is around 230 TH/s, or 500,000 times smaller. Thus during the first part there was a tidal wave of attacks against every other Proof-of-Work cryptocurrency.

It has never been possible to rent enugh mining power to attack a major cryptocurrency. But now we have more than 50% of the Bitcoin mining power sitting idle on the sidelines desperate for income. These miners have choices:

• They can resume mining Bitcoin. The more efficient of them can do so and still make a profit, but if they all do most will find it uneconomic.
• They can mine other Proof-of-Work cryptocurrencies. But even if only a tiny fraction of them do so, it will be uneconomic. And trust in the alt-coins has been destroyed by the wave of attacks.
• They can collaborate to mount double-spend attacks against Bitcoin, since they have more than half the mining power.
• They can collaborate to mount the kind of sabotage attack described by Eric Budish in The Economic Limits Of Bitcoin And The Blockchain, aiming to profit by shorting Bitcoin in the derivative market and destroying confidence in the asset's security.

The security of Proof-of-Work blockchains depends upon the unavailability of enough mining power to mount an attack. A massive, sustained drop in the value of Bitcoin would free up enormous amounts of mining power, far more than enough to destroy any smaller cryptocurrency, and probably enough to destroy Bitcoin.