Three Books To Map Crypto’s Confusing New Landscape
After Bitcoin came Ethereum, and debates over the future of cryptocurrency were not far behind.
After Bitcoin came Ethereum, and debates over the future of cryptocurrency were not far behind.
In 2013, a Russian-born and Canadian-educated computer programmer named Vitalik Buterin published a white paper describing a new cryptocurrency he thought could rival Bitcoin. Then only 19 years old, Mr. Buterin envisioned Ethereum as an “all-purpose computational platform for smart contracts and decentralized autonomous corporations.” Beyond digital money, Mr. Buterin believed cryptocurrency could be used to record wills, document insurance contracts, authenticate art ownership, even enable a new democratic governance system for companies and organizations.
He spent the next two years with a small and contentious group at a shared house in Zug, Switzerland, working to turn the vision into a reality, culminating in the official launch of the so-called genesis block of Ethereum in 2015. The first adopters of the cryptocurrency were an odd mix of libertarians and cyberpunks who dreamed of a system free from control by governments or wealthy elites. “No lawyers, no bankers, no accountants, everything is outsourced to the blockchain,” enthused one Ethereum developer, referring to one of the central innovations behind Ethereum and other cryptocurrencies.
Coders around the world have rallied to Mr. Buterin’s vision of building a new decentralized world order on the blockchain. In Laura Shin’s “The Cryptopians: Idealism, Greed, Lies, and the Making of the First Big Cryptocurrency Craze” we meet Griff Green, who was genetically engineering hamster cells in Seattle when he first heard about Ethereum. A SuperSonics fan who Ms. Shin describes as having “bleached hair . . . shaped into a mohawk” and sporting “Hulk Gloves and green-and gold-coloured plastic jewels,” Mr. Green gave up his job, moved to Ecuador, and began trading alt-coins and working on a “decentralized autonomous corporation.” He was one of many.
Bitcoin and Ethereum are both cryptocurrencies: that is, digital assets whose ownership is documented in a public transaction record known as the blockchain. A traditional financial institution keeps its own private records and uses its own servers to process new transactions. Cryptocurrency transactions, by contrast, are processed on the computers of a global network of volunteers and recorded publicly (though pseudonymously) for the entire network to see. The key innovation of cryptocurrencies lies in the way each new transaction is added to the blockchain in a secure way. This requires the application of a great deal of computing power toward solving complex mathematical problems. Anyone can participate in the network and contribute computing power; in exchange, they earn cryptocurrency, a process called mining. The shared nature of the ledger and the algorithmic process for verifying transactions ensures that a unit of currency cannot be spent more than once.
If Bitcoin is digital gold, valuable for its scarcity rather than its usefulness, Ethereum was designed by Mr. Buterin to be something much more important: A digital Lego block that could be used to build a new, decentralized world order. Ethereum functions not just as a means of exchanging currency, but as a distributed computational platform. Users can run software programs, known as smart contracts, that represent complex financial arrangements. Ethereum’s possibilities seduced programmers across the world, whose interest would help spawn the second-largest cryptocurrency after Bitcoin.
We don’t know much about the creation of Bitcoin. The cryptocurrency’s anonymous programmer, who goes by Satoshi Nakamoto, has yet to be identified. But the story of Ethereum’s creation—and the conflicts and squabbling that has occurred among its co-founders—is better known. Camila Russo’s “The Infinite Machine,” published two years ago, recounted the basic story of how Ethereum got started, while also making the complexity of cryptocurrency accessible to a broad audience. Ms. Shin’s “The Cryptopians” adds a bit more detail to understanding, though primarily this is a tell-all designed to appeal most to crypto-insiders who may want to know every detail of what happened behind the scenes. Another recent book, “DeFi and the Future of America” by Campbell R. Harvey, Ashwin Ramachandran and Joey Santoro, is a textbook that makes the bold claim that crypto will soon replace all of traditional finance. Mr. Buterin wrote the brief preface.
The first major application built on Ethereum was a “distributed autonomous corporation” known as the DAO. The DAO functioned like a venture-capital firm, putting investors’ funds into startup companies, with the important difference that every choice about what to invest was made by a vote of the owners of tokens issued by the DAO. The idea was to fund the creation of “decentralized software- as-a-service” companies that, by virtue of their decentralization would be “alegal” and could not be shut down “not by a court, not by a police-force, not by a nation-state,” in the words of Ethereum co-founder Gavin Wood.
The DAO caught on with cryptocurrency investors: The initial crowdfunding campaign raised a total of $139.4 million. But a clever programmer spotted a mistake in the DAO’s code—a mistake that allowed the coder to drain almost a third of the funds from the DAO. In a blog post, the coder claimed this action was perfectly legitimate. “I am disappointed by those who are characterizing the use of this intentional feature as ‘theft,’ ” the coder wrote in a blog post quoted in “The Cryptopians.” “I am making use of this explicitly coded feature as per the smart contract terms.” This was a philosophical dilemma, testing the crypto-community’s commitment to one of its core principles: “Code is law.”
In this case, it turns out, the law needed interpretation. And Mr. Buterin and his co-developers turned out to be more Earl Warren than Antonin Scalia. What they decided to do was create a “hard fork” in the Ethereum code, beginning a new blockchain whose ledger of historical transactions was identical to the original . . . right up until the point when the hack occurred. After that, the fork diverted as if the hack had never happened.
In effect, the founders rewrote the history of Ethereum. This raised concerns about Ethereum as a cryptocurrency. “If you rewrite the Ethereum consensus rules to recover the coins,” one prominent Bitcoin developer wrote to Mr. Buterin in protest, “you show that the system is really controlled by political whim, in particular via you.” The DAO attack showed the limits of the “code is law” approach, and the immaturity of Mr. Buterin’s crypto-utopian vision.
In the preface to “DeFi and the Future of Finance,” Mr. Buterin describes the benefits of his decentralized approach as “censorship resistance, self-sovereignty . . . instant global accessibility . . . [and] the purchasing power stability of the dollar.” In the slim and credulous book that follows, the normally skeptical academic Campbell R. Harvey and his coauthors argue that decentralized finance will “replace all meaningful centralized financial infrastructure in the future.” Perhaps. Or perhaps Mr. Campbell and his colleagues have fallen into the trap of thinking that, to quote a satirical aside that Ms. Russo makes in “The Infinite Machine”: “If you picked any business idea and somehow added blockchain technology, it would be an instant success.”
So far, the decentralized solutions promised by Ethereum’s developers make the cures seem worse than the disease. Ethereum is supposed to be more accessible and less opaque than traditional finance. Yet how accessible and transparent is a system that requires a 15-page glossary of terms (including concepts like hexadecimals, impermanent losses, nonces, oracles and vertical scaling) in order for readers to properly understand it? Marketers might struggle to identify the consumer segment for whom “self-sovereignty” is the determining factor in choosing a credit card. Not everyone would prefer to trust the anonymous servers of the cryptocurrency world with their finances, rather than large financial institutions that are answerable to shareholders and, yes, government regulators.
In her book, Ms. Russo argues that fundraising has been the only “killer app” to emerge on Ethereum—first, “initial coin offerings” of speculative alt-coins that have now provoked a crackdown by the SEC, and later so-called nonfungible tokens like Crypto Kitties and Bored Apes. Mr. Buterin himself has expressed frustration with how his creation has been used. “Need to differentiate between getting hundreds of billions of dollars of digital paper wealth sloshing around and actually achieving something meaningful for society,” he wrote.
Believers in Ethereum argue that the cryptocurrency can solve many problems faced by society. In Ms. Russo’s telling, Ethereum co-founder Gavin Wood believes “the world is ruled by elites who will seek to maximize their own profit at the expense of others.” Thanks to Ethereum, Mr. Wood is now one of the richest people in the cryptoworld, with an estimated net worth in the hundreds of millions of dollars. Creating Ethereum might not have ended elite control of wealth, but the cryptocurrency did turn Mr. Wood and several of his fellow developers into new members of the financial elite.
These books on Ethereum, particularly Ms. Shin’s “The Cryptopians,” don’t portray the new elite as any better than the old elite. Her book is seamy, full of score-settling, gossip and backstabbing. Readers might share the exasperated view of one programmer who posts on Reddit: “Stop acting like bickering 5 year olds.” Ms. Shin covers the bickering in detail, and there are few likable people in “The Cryptopians.” Ms. Russo’s book, by contrast, spends less time on infighting and more time making Ethereum comprehensible to the lay reader. “The Infinite Machine” is well-organized, easy to follow and serves as the best introduction to the world of Ethereum.
But both these books reveal the messiness behind crypto. Code may be law, but code is written by people. Crypto may be decentralized, but servers are still bought and run by people. Ethereum may be both “immutable” and “self-governing,” but when the code was hacked, history proved plenty mutable and the developers who created the currency were the ones who made the ultimate decisions. Using cryptocurrency rather than the traditional financial system simply trades the abstract problems of monetary debasement and elite manipulation for the very concrete problems of rampant theft and fraud in the cryptoworld.
Are works like “The Cryptopians” and “The Infinite Machine” accounts of a world-changing new technology? Or histories of a utopian experiment that turned into a financial bubble? Only time will tell, and readers won’t miss much by waiting a few years for a work that reveals, with the benefit of hindsight, how the story turned out.
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Crypto’s lack of connections with traditional finance means its problems haven’t spilled over to the economy
This year’s crypto collapse has all the hallmarks of a classic banking crisis: runs, fire sales, contagion.
What it doesn’t have are banks.
Check out the bankruptcy filings of crypto platforms Voyager Digital Holdings Inc., Celsius Network LLC and FTX Trading Ltd. and hedge fund Three Arrows Capital, and you won’t find any banks listed among their largest creditors.
While bankruptcy filings aren’t entirely clear, they describe many of the largest creditors as customers or other crypto-related companies. Crypto companies, in other words, operate in a closed loop, deeply interconnected within that loop but with few apparent connections of significance to traditional finance. This explains how an asset class once worth roughly $3 trillion could lose 72% of its value, and prominent intermediaries could go bust, with no discernible spillovers to the financial system.
“Crypto space…is largely circular,” Yale University economist Gary Gorton and University of Michigan law professor Jeffery Zhang write in a forthcoming paper. “Once crypto banks obtain deposits from investors, these firms borrow, lend, and trade with themselves. They do not interact with firms connected to the real economy.”
A few years from now, things might have been different, given the intensifying pressure on regulators and bankers to embrace crypto. The crypto meltdown may have prevented that—and a much wider crisis.
Crypto has long been marketed as an unregulated, anonymous, frictionless, more accessible alternative to traditional banks and currencies. Yet its mushrooming ecosystem looks a lot like the banking system, accepting deposits and making loans. Messrs. Gorton and Zhang write, “Crypto lending platforms recreated banking all over again… if an entity engages in borrowing and lending, it is economically equivalent to a bank even if it’s not labeled as one.”
And just like the banking system, crypto is leveraged and interconnected, and thus vulnerable to debilitating runs and contagion. This year’s crisis began in May when TerraUSD, a purported stablecoin—i.e., a cryptocurrency that aimed to sustain a constant value against the dollar—collapsed as investors lost faith in its backing asset, a token called Luna. Rumours that Celsius had lost money on Terra and Luna led to a run on its deposits and in July Celsius filed for bankruptcy protection.
Three Arrows, a crypto hedge fund that had invested in Luna, had to liquidate. Losses on a loan to Three Arrows and contagion from Celsius forced Voyager into bankruptcy protection.
Meanwhile FTX’s trading affiliate Alameda Research and Voyager had lent to each other, and Alameda and Celsius also had exposure to each other. But it was the linkages between FTX and Alameda that were the two companies’ undoing. Like many platforms, FTX issued its own cryptocurrency, FTT. After this was revealed to be Alameda’s main asset, Binance, another major platform, said it would dump its own FTT holdings, setting off the run that triggered FTX’s collapse.
Genesis Global Capital, another crypto lender, had exposure to both Three Arrows and Alameda. It has suspended withdrawals and sought outside cash in the wake of FTX’s demise. BlockFi, another crypto lender with exposure to FTX and Alameda, is preparing a bankruptcy filing, the Journal has reported.
The density of connections between these players is nicely illustrated with a sprawling diagram in an October report by the Financial Stability Oversight Council, which brings together federal financial regulators.
To historians, this litany of contagion and collapse is reminiscent of the free banking era from 1837 to 1863 when banks issued their own bank notes, fraud proliferated, and runs, suspensions of withdrawals, and panics occurred regularly. Yet while those crises routinely walloped business activity, crypto’s has largely passed the economy by.
Some investors, from unsophisticated individuals to big venture-capital and pension funds, have sustained losses, some life-changing. But these are qualitatively different from the sorts of losses that threaten the solvency of major lending institutions and the broader financial system’s stability.
To be sure, some loan or investment losses by banks can’t be ruled out. Banks also supply crypto companies with custodial and payment services and hold their cash, such as to back stablecoins. Some small banks that cater to crypto companies have been buffeted by large outflows of deposits.
Traditional finance had little incentive to build connections to crypto because, unlike government bonds or mortgages or commercial loans or even derivatives, crypto played no role in the real economy. It’s largely been shunned as a means of payment except where untraceability is paramount, such as money laundering and ransomware. Much-hyped crypto innovations such as stablecoins and DeFi, a sort of automated exchange, mostly facilitate speculation in crypto rather than useful economic activity.
Crypto’s grubby reputation repelled mainstream financiers like Warren Buffett and JPMorgan Chase & Co. Chief Executive Jamie Dimon, and made regulators deeply skittish about bank involvement. In time this was bound to change, not because crypto was becoming useful but because it was generating so much profit for speculators and their supporting ecosystem.
Several banks have made private-equity investments in crypto companies and many including J.P. Morgan are investing in blockchain, the distributed ledger technology underlying cryptocurrencies. A flood of crypto lobbying money was prodding Congress to create a regulatory framework under which crypto, having failed as an alternative to the dollar, could become a riskier, less regulated alternative to equities.
Now, stained by bankruptcy and scandal, cryptocurrency will have to wait longer—perhaps forever—to be fully embraced by traditional banking. An end to banking crises required the replacement of private currencies with a single national dollar, the creation of the Federal Reserve as lender of last resort, deposit insurance and comprehensive regulation.
It isn’t clear, though, that the same recipe should be applied to crypto: Effective regulation would eliminate much of the efficiency and anonymity that explain its appeal. And while the U.S. economy clearly needed a stable banking system and currency, it will do just fine without crypto.
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