SBF the NFT of FTX

Frauds, Scams & Science

Every once in a while, I enjoy a little crude humor. One of my favorite genres is skateboard fails, especially when nuts get crushed by aluminum handrails. I don’t know what it is about aluminum.

In the news some dude born in 1992 figured out how to use technology to bilk a bunch of woke, green capitalists. I can’t say with any certainty that the technology worked beyond that particular end, but I can say that this dude, SBF created a company called FTX and I have seen FTX stickers on F1 cars. That means lots of moolah. At some point the full extent of the downside will be made manifest and the world. In the meantime the main trick is not to get bamboozled by people wailing about the current moment with their hair on fire.

A Brief Introduction to Crypto
Here’s what I understand about cryptocurrencies that people who are just rudely awakened to this particular scammer probably don’t understand. A cryptocurrency is a financial instrument, period. If you are smart enough to design a legitimate financial instrument then you should be called a financier. So think about a centralized financier and a decentralized financier for a moment. In the following example I’m going to use a financial instrument most people don’t consider.

Reinsurance

Reinsurance occurs when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit their own total loss in case of disaster. Described as "insurance of insurance companies" by the Reinsurance Association of America, the idea is that no insurance company has too much exposure to a particularly large event or disaster.

Since a reinsurer is a couple of steps removed from an ordinary consumer you’re going to have to think about it. Somebody had to come up with the idea that insurance companies alone, as smart as they may be, can face calamitous eventualities. So the fund that the reinsurer had to build had to be large enough to backup the failure of an insurance company so that their insurance would be inexpensive enough for ordinary consumers to afford. Makes sense?

Somewhere in the American centralized system, it comes down to USD. In the global decentralized system, let’s call it ‘RE’, a cryptocurrency that is specific to reinsurance. The only difference is that the entire fund for centralized reinsurance requires a deposit in USD whereas the entire fund for decentralized reinsurance requires a deposit in RE. Now I’m saying ‘somewhere’ because today in the actual Reinsurance Association of America, there is a treasurer whose job it is to make sure they some some fraction of cash and securities to cover insurance company failures or defaults. Let’s call that the ReInsurance Fund (RIF). At some regulatory interval, that treasurer is obliged to disclose to the members of the association what the liquidation value of that reinsurance fund is acceptable.

You and I have no freaking clue in a million years who are the people who receive those reports and what that interval is, or the proper fraction of cash to securities is to achieve the liquidity necessary for the Reinsurance Association of America to be properly responsive to a crisis. If you were the holder of the RE cryptocurrency, it would be expected for you to know. That may or may not be a reasonable expectation, but the point of a decentralized cryptocurrency is that every individual coin holder can know. Transparency is built into the code that defines the currency.

Today, let’s imagine that the RAA’s mutual holding for their RIF is somewhere between 88 and 100 billion USD. For a premium of 20 million per year per insurer, each member insurance company is therefore buys insurance for their insurance to the tune of a billion. So if your insurance company suddenly has to get $1 billion, like now, RAA has got your back, and oh by the way, if nobody made a claim against the RIF, you get a kickback of 30% of your annual premium.

So what I have just done is written a ‘smart contract’ for reinsurance. I could issue the RE coin and put all transactions on a public blockchain which will be transparent not only to the members and the regulators, but anybody on the planet who wants to see. 24/7/365. That transparency is the entire point.

Question 1: What does it take for any cryptocurrency to get 88 - 100 billion USD in value in order that this sort of permanent transparency is established that would make it suitable for the specific financial instrument of a RIF? Nobody knows.

Question 2: What kind of coding expertise does it take to establish a proper smart contract for RIFs? Thousands of software engineers around the world can do that today. That’s why there are so many cryptocurrencies (about 10,000)

The Problem With Values
So here’s our problem. We have a surfeit of people code bros who might create global transparency for financial instruments of every sort, but we have no idea how many investors it’s going to take to establish the kind of stability required of some of them. So this has generated, predictably, a class of hawkers and maximalists who are breaking common sense and reason to get the maximum number of investors to get on board decentralized finance. This is understandable. Where are all of these investors going to come from? Will they be retail investors or institutional or government investors?

Meanwhile as I have complained about a thousand times, the net worth of Justin Bieber is north of $250 million USD. What fraction of the USD is used for very narrow, very constructive purposes? Hmm, like tax dollars? Or how about health insurance dollars? How do we make it so every USD billionaire cannot just take over any industry and squeeze everybody else out? That’s the point of building purpose-built cryptocurrencies in the first place. Get it?

Still that doesn’t change the fact that right now, the very same population of people code bros are generating capital in the crypto markets. It’s marginally less difficult to understand what purposes are behind them.

According to (randomly selected currency dot com) there are seven kinds:

• Payment-focused digital assets such as bitcoin, litecoin and ethereum

• Stablecoins such as tether, which have value pegged to an underlying asset such as the US dollar

• Central bank digital currencies, a digitised version of fiat money that has been embraced by the likes of Sweden

• Privacy coins, which are designed to deliver anonymity to senders and receivers

• Governance tokens, which give owners the right to vote in decisions affecting a blockchain’s future development

• Utility tokens, which unlock access to particular services

• Non-fungible tokens, where each token has unique characteristics that separates them from all others.

NFTs are the bête noire of the day, and at the moment of populist hype it should come as no surprise that they have so much viral attention. But that’s kind of the point. It’s like a piece of art you buy, sell and trade having nothing to do with any relationship to anything but what people emotionally feel it’s worth. That’s a crappy way to define ‘value’ because of course human beings can decide to value anything, and really what is the ‘value’ of a nation’s currency? Getting into the nuts and bolts of that question is what the code bros are doing.

The Fiat Hedge
In case you still have a problem understanding or accepting that there is some possibility for decentralized finance (DeFi) to have any lasting value, remember coin type two, stablecoins. There are clever ways to insure that, as with the RIF, some fraction of a crypto asset is pegged to USD or some national currency. So while some of PT Barnum’s best customers are throwing good money after bad and being bilked like the marks they are, there are smarter ways to assure stability and fungibility, much of what is needed for certain financial instruments to flourish.

On the other hand, public crypto enemy number one managed to motor up the value of his empire, which in turn funded his investments in another basket of startup collections of code bros. OK now I’m going to stop using that term. Because I know that there are some genuinely low-scam individuals out there. We’re going to have to depend on some good meta-analysis and criticism. Unfortunately a lot of this commentary is taking place on Twitter of all places. Sheesh. But let me name Silvio Micali. I tend to trust him. He’s the founder of Algorand, which I hold. I’m not exactly sure how much I hold because I’m not generally day-trading, but I’m fairly sure I have between 200 and 1000 coins. I bought Algorand and Solano around the same time a year or so ago.

I’m personally not in a hurry to completely understand a whole lot about crypto, but I get the basics. Furthermore, the moment I heard that we were heading toward inflation, I moved a significant amount of my money to the care of Berkshire Hathaway. At any rate, lots of gadflies are throwing all crypto under the bus without explaining stuff underneath the covers. So we are all challenged to discover code bros worth trusting. There’s no easy way around it. It’s finance science.

In Summary
There is a deep irony in all of this, which is the fact that the entirety of the modern finance industry was indeed built by coders who built a digital infrastructure for banks, insurance companies, exchanges, brokerages, etc. I’m old enough to remember when micropayments and video on demand were considered practically impossible. It takes more patience and wisdom than code bros are demonstrating.

We have demonstrated our ability to build things, monetize things and distribute things. By ‘we’ I mean code bros. But we’re still patting ourselves on the back about email. Email destroyed the interoffice memo. We’re still jazzed about Kayak, Priceline and Expedia. Those destroyed travel agents, and Yelp crowdsourced most food critics out of newspapers and magazines. Yet newspapers and magazines are still around. Just because you can build, monetize and distribute digital paragraphs doesn’t mean social media is automatically going to be better than newspapers and magazines. They can be, but it doesn’t mean they will be. So the new Genius class of software developers have demonstrated a capacity, but not an excellence.

I should say the same thing counts on the other side, the consumption side. Half of the value of a city’s pride in its symphony orchestra is that it doesn’t attract hooligans who desire to rush the stage, say ‘ho!’ or flick their cigarette lighters. An investment’s value also depends on the character of the investors. This is also part of the Twitter problem, especially as regards the shallow reasons Elon Musk is being cynically criticized. Social media is an oligarchic industry. There’s a lot of headroom for evolution of the industries IT seeks to disintermediate. It will require time, competition and excellence of both supply and demand for this industry to mature and be properly regulated.

Niches will be filled one niche at a time. It’s not going to be a revolution.