Dominoes

When important parts of the cryptosphere collapse, such as Terra/Luna or FTX/Alameda, people often ask "is this the end of crypto?". The answer so far is no. But as the "crypto winter" continues, and contagion spreads from exchanges to miners and their financiers, the number of important parts still standing is decreasing.

Below the fold I explain why crypto will effectively end when there are no large, liquid exchanges, and look at the possibility that failures of major exchanges might happen.

In my view there are two key dominoes still to fall, Coinbase as the largest and most credible regulated exchange, and Binance as the overwhelmingly dominant (and unregulated) exchange. Because Coinbase is regulated it is the most important exchange for retail traders, and because Binance is unregulated it is the most important exchange for professional traders and criminals.

One of the many ironies about "decentralized, trustless" cryptocurrencies is that they are neither decentralized nor trustless. There are three main reasons:

• Since in practice you can neither buy nor sell real goods using them, you need to trust an exchange to convert fiat to cryptocurrency and vice versa.
• The decision to cash out and buy the Lamborghini is driven by the "price" you expect to get for your HODL-ings. When does this "price" come from? It comes from recent trades on exchanges, typically of your favorite coin against USDT. Unless these exchanges have much greater volume than a Lamborghini per day, the "price" quoted will be meaningless. Getting an adequate volume requires attracting enough active traders to a single marketplace. Traders are used to centralized, fast, secure exchanges, so that is where they congregate.
• While it is true that transactions between holders of the same cryptocurrency can take place on a peer-to-peer basis using its native blockchain, the user experience is too difficult for ordinary mortals to perform safely, slow and subject to fee spikes. To transact between different cryptocurrencies without using a centralized exchange involves using a "DeFi" exchange; Defi, where code is law and law has vulnerabilities, which result in the money being stolen.

If you look at the cryptocurrency ecosystem as a black box, nothing inside the box can create fiat currency. Some of the fiat currency flowing in from the buyers ends up with the miners, the remainder ends up with the sellers. The professionals are not in the business of losing money, so they expect to take out more than they put in. This would represent not paying the miners, and a disproportionate share of what is left after that. So everyone else has to both pay the miners and take out less than their share of what is left. The criminals using cryptocurrencies for money laundering are doing so because it is cheaper than other laundries; they expect to lose some on the deal. The retail traders have to lose the rest.

A rough estimate of the total amount of fiat currency that could be extracted from the black box can be made by taking the "attestations" of the major stablecoins at face value and summing them; there are unlikely to be large stores of fiat in the box that haven't been converted to stablecoins. This gets us $66.2B (USDT) + $44.2B (USDC) + $17.4B (BUSD) + $0.7B (USDD) = $128.5B, against a current total "market cap" of cryptocurrencies at around $800B. If there was a "bank run" in the cryptosphere, it is likely that the total recovery would be around the $128.5B or 16%. The costs involved in selling the non-cash securities forming part of the stablecoins' backing might be roughly matched by the fiat the estimate missed.

The connection between Binance and Coinbase is that the professionals at Binance depend in part on the retail suckers investors at Coinbase to continue to flow fiat into the ecosystem to avoid this run. How likely is it that these two important exchange dominoes will topple?

Coinbase

I wrote about Coinbase in The Exchange You Can Trust under the headings:

• Trying To Sell Unregistered Securities
• Fiasco In India
• Misleading Customers About Their Funds And Keys
• "Losing Money Running A Casino"
• NFT Marketplace Fiasco
• Tolerating Insider Trading
• Actually Selling Unregistered Securities
• Forcing Arbitration On Customers
• Staking Customer's Coins

Source

Thus it is no surprise that after hitting a high of $342.98 on 8^thNovember 2021, it currently trades 89.3% down at $35.12. Or that their bonds trade at 50c on the dollar. Or that the company has laid off at least 1160 staff this year. Their finances look shaky:

Coinbase’s SEC 10-Q filing for the second quarter of 2022 puts on a brave face — but they’re in trouble. [Coinbase 10-Q; WSJ]

Coinbase posted a $1.1 billion loss for Q2, down from $1.6 million in profit a year ago. This was Coinbase’s second consecutive quarter of losses — they lost $500 million in Q1.

Coinbase has $10 billion in cash, but $5 billion of that is customer deposits — and $4.6 billion flowed out in Q2. Coinbase needs real dollars flowing in.

The customer assets are flowing in the other direction. “Assets on platform” (mostly cryptos, some cash) totaled $256 billion in Q1 — but only $96 billion in Q2. $248 million in customer stablecoins was withdrawn from Coinbase just on July 15 — half the stablecoin holdings as of that day. [CryptoSlate]

9 million customers made even a single trade in Q2 2022 — down from a peak of 11.2 million in Q4 2021.

The retail crypto trade generated nearly 95% of trading fees on Coinbase in Q2.

The Q2 10Q was back in August, after Terra/Luna but before FTX/Alameda. The Q3 10Q wasn't any better:

In the third quarter of 2022, US exchange Coinbase suffered “another tough quarter.” Institutional trading was down 22% and retail volume was down 43%, compared to the previous quarter. Net revenue in Q3 was $576 million, down from $803 million in Q2, and $1.2 billion the year before. The company lost $545 million in Q3, compared to a net profit of $406 million in the same period last year.

One cannot be confident that Coinbase will outlast the "crypto winter", and it isn't flowing fiat currency from retail into the ecosystem.

Binance

Source

Except that it is seen as regulated, Coinbase is pretty insignficant against Binance. The reason is that regulation is inimical to cryptocurrencies, and Binance has been fanatical in avoiding it. What about the prospects for the 800-pound gorilla of cryptocurrency? Wikipedia introduces Binance thus (links omitted):

Binance is a cryptocurrency exchange which is the largest exchange in the world in terms of daily trading volume of cryptocurrencies. It was founded in 2017 and is registered in the Cayman Islands.

Binance was founded by Changpeng Zhao, a developer who had previously created high frequency trading software. Binance was initially based in China, but later moved its headquarters out of China shortly before the Chinese government imposed regulations on cryptocurrency trading.

In 2021, Binance was put under investigation by both the United States Department of Justice and Internal Revenue Service on allegations of money laundering and tax offenses. The UK's Financial Conduct Authority ordered Binance to stop all regulated activity in the United Kingdom in June 2021.

In 2021, Binance shared client data, including names and addresses, with the Russian government.

In 2019 Binance set up Binance.US. Tom Wilson and Angus Berwick write:

In February, a company called BAM Trading Services was incorporated in Delaware, using the same San Francisco address as Harry Zhou’s crypto trading company. BAM registered with the Treasury as a money-service business in June 2019, just as Binance said it was banning U.S.-based users from its main exchange.

Days later, Binance unveiled a “partnership” with BAM Trading, saying BAM would license Binance’s name and trading technology to launch the Binance.US exchange. Zhao said Binance.US, led by BAM, would “serve the U.S. market in full regulatory compliance” and be a “fully independent entity.”

BAM was ultimately owned by Zhao, however, regulatory filings show. Its first chief executive, Catherine Coley, reported to the Binance.US board, chaired by Zhao. Binance’s Cayman Islands holding company kept custody of Binance.US customers’ digital wallets, according to a 2019 company financial report. And a company organogram showed Binance.US as part of the Binance group.

By October 2020 Michael del Castillo was writing Leaked ‘Tai Chi’ Document Reveals Binance’s Elaborate Scheme To Evade Bitcoin Regulators:

The 2018 document details plans for a yet-unnamed U.S. company dubbed the “Tai Chi entity,” in an allusion to the Chinese martial art whose approach is built around the principle of “yield and overcome,” or using an opponent’s own weight against him. While Binance appears to have gone out of its way to submit to U.S. regulations by establishing a compliant subsidiary, Binance.US, an ulterior motive is now apparent. Unlike its creator Binance, Binance.US, which is open to American investors, does not allow highly leveraged crypto-derivatives trading, which is regulated in the U.S.

The leaked Tai Chi document, a slideshow believed to have been seen by senior Binance executives, is a strategic plan to execute a bait and switch. While the then-unnamed entity set up operations in the United States to distract regulators with feigned interest in compliance, measures would be put in place to move revenue in the form of licensing fees and more to the parent company, Binance. All the while, potential customers would be taught how to evade geographic restrictions while technological work-arounds were put in place.

Last October in How Binance CEO and aides plotted to dodge regulators in U.S. and UK, Tom Wilson and Angus Berwick provided an even more detailed look at how Changpeng Zhao used Binance.US as a stalking horse to avoid regulation:

new reporting by Reuters reveals fresh details about Binance’s strategy for keeping regulators at arm’s length and continuing disarray in its compliance programme. The reporting includes interviews with around 30 former employees, advisers and business partners and a review of thousands of company messages, emails and documents dated between 2017 and early 2022.

It shows that in 2018, Zhao approved a plan by lieutenants to “insulate” Binance from scrutiny by U.S. authorities by setting up a new American exchange. The new exchange would draw regulators’ attention away from the main platform by serving as a “regulatory inquiry clearing house,” according to the proposal. Executives went on to set the plan in motion, company messages show.

In public, Zhao said the new U.S. exchange – called Binance.US – was a “fully independent entity.” In reality, Zhao controlled Binance.US, directing its management from abroad, according to regulatory filings from 2020, company messages and interviews with former team members. An adviser, in a message to Binance executives, described the U.S. exchange as a “de facto subsidiary.”

Dirty Bubble Media looks into the relationship between Binance and Binance.US and asks Is Binance.US a Fake Exchange?:

We can now report that based on blockchain transfers, market data, and company disclosures, it appears that there is no meaningful separation between the two firms. In fact, we show that Binance.US both transfers customer deposits to Binance and pays customer withdrawals using transfers back from the offshore exchange’s wallets. Further, we demonstrate that trades allegedly happening on Binance.US’s exchange are likely being conducted directly on the main Binance exchange.

For example:

Yesterday, Binance US temporarily halted withdrawals of the Tether stablecoin (USDT). USDT, along with other stablecoins like USDC and Binance USD (BUSD), are dollar equivalent tokens on the blockchain backed by real dollar assets (in theory). It turned out that Binance US apparently didn’t have enough USDT in its wallets to pay back customers for several hours. The USDT balance in the main Binance US wallet dropped to its lowest level ever ($197,000) during this time period.

Twitter user @jconorgrogan was one of several people live-tracking the Binance.US withdrawal freeze. He noted that withdrawals restarted after Binance.US received a single transfer of $10 million USDT from an unidentified address. In turn, those funds had been pulled from two known Binance exchange wallets:

Even early on it was obvious that Binance was playing fast and loose with regulation. In July 2019 David Gerard pointed out:

BNB is a token available on Binance. You can pay your trading fees with it — or you can trade it as if it was a crypto, like any other cryptocurrency or token listed on Binance.

BNB only imitates a crypto — it’s an entirely private token that’s traded in one venue. Binance control absolutely everything about it.

So, describing BNB as an “investment” in terms of its inner workings is like describing the inner workings of Amazon gift vouchers, or supermarket loyalty points — the answer to all such questions is: “it works however the company needs it to, at the time.”

BNB is useful if you trade a lot on Binance. But, Binance put BNB forth as being tradable — so it would almost certainly be a security in the US under the Howey test. There’s talk of BNB being listed on Binance US, their new regulated fiat (not Tether) exchange — it would definitely need to be traded like a security, for accredited investors only, and Binance had better file their Form D for exemption from registration.

It seemed to take ages for US regulators to pay attention, and when they did it wasn't the SEC. In May 2021 Tom Schoenberg reported that Binance Faces Probe by U.S. Money-Laundering and Tax Sleuths:

The firm, like the industry it operates in, has succeeded largely outside the scope of government oversight. Binance is incorporated in the Cayman Islands and has an office in Singapore but says it lacks a single corporate headquarters. Chainalysis Inc., a blockchain forensics firm whose clients include U.S. federal agencies, concluded last year that among transactions that it examined, more funds tied to criminal activity flowed through Binance than any other crypto exchange.
...
U.S. officials have expressed concerns that cryptocurrencies are being used to conceal illegal transactions, including theft and drug deals, and that Americans who’ve made windfalls betting on the market’s meteoric rise are evading taxes.

Because of its determined avoidance of regulation, Binance was always considered a hub for money laundering. In September 2021, China banned cryptocurrency transactions. Despite that, a year leter Pandaily reported that Chinese Authorities Crack Down on $5.6B Crypto-Related Money Laundering:

Police in Hengyang, a county in China’s southern province of Hunan alleged that the criminal group had been buying cryptocurrencies with illicit funds since 2018, which were then traded for US dollars at a profit. The dirty money reportedly originated from telecom scams or gambling.

Police have arrested 93 related suspects across the country, frozen about 300 million yuan involved in the case, and recovered financial losses of 7.8 million yuan for the victim. The case is still undergoing further developments.

According to Chinese media outlet Blue Whale Finance, a large number of Binance accounts that were frozen in August are connected to the recent Hunan case.

Despite all the public evidence that Binance is violating regulations to which it should be subject, Angus Berwick, Dan Levine and Tom Wilson report that U.S. Justice Dept is split over charging Binance as crypto world falters:

Splits between U.S. Department of Justice prosecutors are delaying the conclusion of a long-running criminal investigation into the world's largest cryptocurrency exchange Binance, four people familiar with the matter have told Reuters.

The investigation began in 2018 and is focused on Binance's compliance with U.S. anti-money laundering laws and sanctions, these people said. Some of the at least half dozen federal prosecutors involved in the case believe the evidence already gathered justifies moving aggressively against the exchange and filing criminal charges against individual executives including founder Changpeng Zhao, said two of the sources. Others have argued taking time to review more evidence, the sources said.
...
Reuters has investigated Binance's financial crime compliance over the course of 2022. The reporting showed that Binance kept weak anti-money laundering controls, processed over $10 billion in payments for criminals and companies seeking to evade U.S. sanctions, and plotted to evade regulators in the United States and elsewhere.

Note the 2018 start date, but note also the Binance's argument:

Binance's defense attorneys at U.S. law firm Gibson Dunn have held meetings in recent months with Justice Department officials, the four people said. Among Binance's arguments: A criminal prosecution would wreak havoc on a crypto market already in a prolonged downturn. The discussions included potential plea deals, according to three of the sources.

When did it become the US Dept. of Justice's job to protect the cryptocurrency industry?

Some of the difficulties prosecutors face are the state of Binance's records:

Zhao became concerned about U.S. authorities gaining access to Binance's internal records, company messages show.

A guide issued to employees for one encrypted messaging service listed its "automatic self-erasing messages" as a benefit. ...
Binance was struggling to respond to the DOJ because many of the records relevant to the Department's request had already been erased due to Zhao's secrecy rules. This extended, ... to Zhao's approvals for financial decisions at Binance.US, the separate American exchange which publicly says it is "fully independent" of the main Binance platform.

Tom Wilson, Angus Berwick and Elizabeth Howcroft reported that Binance's books are a black box, filings show, as it tries to rally confidence:

After the collapse of rival exchange FTX last month, Binance's founder Changpeng Zhao promised his company would "lead by example" in embracing transparency.

Yet a Reuters analysis of Binance's corporate filings shows that the core of the business – the giant Binance.com exchange that has processed trades worth over $22 trillion this year – remains mostly hidden from public view.

Binance declines to say where Binance.com is based. It doesn't disclose basic financial information such as revenue, profit and cash reserves. The company has its own crypto coin, but doesn't reveal what role it plays on its balance sheet. It lends customers money against their crypto assets and lets them trade on margin, with borrowed funds. But it doesn't detail how big those bets are, how exposed Binance is to that risk, or the full extent of its reserves to finance withdrawals.

They tried whatever they could:

In an effort to look inside Binance's books, Reuters reviewed filings by Binance units in 14 jurisdictions where the exchange on its website says it has "regulatory licenses, registrations, authorisations and approvals." These locations include several European Union states, Dubai and Canada. Zhao has described the authorisations as milestones in Binance's "journey to being fully licensed and regulated around the world."

The filings show that these units appear to have submitted scant information about Binance's business to authorities. The public filings do not show, for example, how much money flows between the units and the main Binance.com exchange. The Reuters analysis also found that several of the units appear to have little activity.

Former regulators and ex-Binance executives say these local businesses serve as window dressing for the main unregulated exchange.

This reinforces Dirty Bubble Media's conclusion.

As far as the holding company is concerned, they had to take this on trust:

As part of a "commitment to transparency," Binance last month published on its website a "snapshot" of its holdings of six major tokens and promised to share a complete set of data at an unspecified future date.

Data firm Nansen said the holdings, worth around $70 billion at the time of the Nov. 10 snapshot, had fallen to $54.7 billion by Dec. 17 after withdrawals and price fluctuations. Two "stablecoins" that are pegged to the dollar – Binance's BUSD and market leader Tether – accounted for almost half of its holdings. Around 9% of the assets were in BNB, its in-house token which Binance itself has issued, the Nansen data showed.

Another part of Binance's obscurity relates to BUSD, their stablecoin. Amy Castor and David Gerard noted:

BUSD is a Paxos-administered dollar stablecoin. Each BUSD is backed by an alleged actual dollar in Silvergate Bank, and attested by auditors. (If not actually audited as such).

That’s true of BUSD on the Ethereum blockchain. It’s not true of BUSD on Binance.

BUSD on Binance is on their internal BNB (formerly BSC) blockchain, bridged from Ethereum. It’s a stablecoin of a stablecoin. Binance makes a point of noting that Binance-BUSD is not subject to the legal controls that Paxos BUSD is under.

They based this on Binance's own Web site:

New York state regulators have enforced particular measures on Paxos, Binance, and how the stablecoin must operate. Along with making sure the token is fully collateralized, Paxos must carefully control the creation and burning of BUSD tokens. Paxos also has the right to freeze accounts and remove funds if needed due to illegal activity. These principles all adhere to the Trust Charter and New York banking laws applicable to the stablecoin.

Inbuilt within the smart contracts of the token is a new function that reflects the regulation of the stablecoin: SetLawEnforcementRole. This small piece of code allows Paxos to use the powers mentioned previously in upholding NYDFS regulations.

As noted above, these features apply to the Paxos-issued BUSD on Ethereum. Binance-Peg BUSD, issued by Binance on BNB Chain (formerly Binance Chain and BNB Smart Chain), operates pursuant to different procedures and is not issued by Paxos or regulated by the NYDFS.

Nidhi Pandurangi's Read the full memo the CEO of Binance sent to staffers after the exchange was hit by more than $1 billion of withdrawals in a day amid the FTX fiasco reported outflows from Binance:

On Tuesday, jittery investors withdrew more than $1 billion from Binance, the world's largest crypto exchange. Hours later, the company's CEO, Changpeng "CZ" Zhao, sent a memo to staffers where he seemed to try to assuage market fears in the aftermath of the implosion of crypto peer FTX.
...
Phil Rosen reported on Wednesday that Binance has seen about $3.66 billion in net outflows in the seven days preceding December 13

The article quoted CZ thus:

With regard to questions on the temporary halt of withdrawals of USDC, because we auto convert USDC to BUSD in order to retain large liquidity pools, we generally retain USDC deposits for future withdrawals. In today's case, many people deposited BUSD or USDT to withdraw USDC. When this happens, we need to convert. Our current conversion channels are clunky. We have to go through a bank in NY in USD, which is slow.

Presumably, when Binance converts USDC to BUSD, the result is BUSD-on-BNB. More was revealed in this thread by DataFinnovation (unroll) in response to this tweet from @cryptohippo65:

I'm calling on onchain analysis twitter sleuths to look at this, to see if they can shed light on how a wallet can contain 22M BNB without a record of a deposit.

Datafinnovation's thread is too detailed to excerpt, but as I understand it the gist is that the implementation of BNB Chain is complex, opaque and does not conform to the definition of a blockchain. Transactions are not fully visible and auditable. Datafinnovation believes that, because BUSD-on-BNB are created and destroyed via a bridge from BUSD-on-Ethereum, the total amount of "dollars" in the system matches the number reported by Paxos. But what is happening to them on BNB Chain is opaque. The result is a system credibly backed one-for-one by USD but where transactions cannot be effectively traced. This could greatly assist Binance in laundering money.

In summary, what we have in Binance is:

• Fanatical efforts to avoid regulation, including establishing "fake exchanges" that deflect regulators while serving only as channels to and from the unregulated exchange.
• An established history of laundering billions of dollars.
• An exchange banned from operating in many jurisdictions.
• Completely opaque finances, including reserves and profit/loss.
• Substantial outflows after the collapse of FTX.
• A "blockchain" which is un-auditable and whose implementation is opaque.
• A long-standing criminal investigation by the US Dept. of Justice.
• An exchange run on "self-erasing messages".

None of these tend to reassure observers as to the survivability of Binance. So there are different but dark clouds hovering over both the most important dominoes left standing.