Crypto crash bears all the hallmarks of classic non-bank financial crisis...

Christopher Joye

Coolabah Capital

The crypto crash has been fascinating to watch and bears the hallmarks of a standard non-bank financial crisis that inevitably arises every time there is a liquidity shock. Unfortunately, it is likely to get worse.

For years this column resisted the temptation to write about the crypto craze. There is no point expressing opinions on things you don’t understand. The spell was broken last December around bitcoin’s $US69,000 peak with a warning of an impending implosion triggered by much bigger interest rate increases than the market was expecting. The warning was reiterated with gusto in January when this column argued that crypto would become the next tulip bulb bubble to burst.

This negativity was founded on several observations. The first was that crypto is just a form of non-bank finance situated outside the regulated world. A “stablecoin”, for example, takes in your savings, pretends it is riskless and then invests that money in risky assets (eg, other cryptocurrencies), earning a return on those assets. That is a classic banking activity. Indeed, crypto was conceived as an alternative to the traditional banking system that it explicitly sought to disintermediate.

I knew loads of super-smart folks who were crypto junkies, some of whom had deep financial expertise. But I could not find anyone who really believed in crypto and who was an expert on banking systems, their history, and the web of explicit and implicit government guarantees and central bank liquidity support that ensure banks (as opposed to non-banks) can survive economic and liquidity shocks.

History shows that almost all non-banks die during liquidity crises precisely because the asset/liability mismatches that are the basis of their business models become untenable when there is a run on their funding. There is no central bank or government support to bail them out because they exist outside the prudential regulatory net that is designed to save banks during such times. Think Aussie, RAMS and Wizard during the GFC in Australia, or Lehman Brothers in the US.

And that is exactly what many crypto businesses, including exchanges and stablecoins, face right now: a failure of trust that has precipitated a run on their liquidity. It is no different to a bank run wherein droves of depositors desperately seek to withdraw cash because they fear the bank will blow up.

Key differences

There are, however, important differences between banks and non-banks. In the case of a bank, all the loans it makes with depositors’ money are subject to extreme scrutiny from a highly motivated, empowered and invasive prudential regulator, combined with regular public reporting of key financial risks. Global investors in any listed bank’s equity and debt securities furnish another layer of relentless surveillance.

Non-banks, including many crypto concerns such as exchanges and coins, have almost no regulation and/or scrutiny. And they tend to be murky private businesses, run by anonymous individuals, often located in dubious jurisdictions, that are protected from the reporting demands of public market enterprises.

Any asset/liability mismatch, where a bank or non-bank borrows short-term money from savers and uses that cash to make long-term loans, embeds enormous solvency and liquidity risks. Over centuries of experience, we have learnt that during downturns banks often go bust. Governments created “central banks” with the power to print unlimited money to in turn provide banks with infinite liquidity to ride out these shocks.

During the GFC we discovered that banks required even stronger support. Governments introduced explicit public guarantees of the banks’ biggest and most flighty source of funding – deposits. They further moved to explicitly guarantee their second-largest source of funds – senior bonds. Many countries were even forced to inject cash into their banks in exchange for ownership stakes.

Over decades of doing due diligence on both banks and non-banks, I’ve consistently found the commercial differences to be striking. Banks live in fear of political, regulatory and investor (debt and equity) oversight and normally allocate vast resources to their customer management, credit assessment, risk management and reporting processes. Non-banks, in contrast, tend to be more myopic, writing as many loans as possible to maximise their assets. Coolabah has yet to find a non-bank with remotely comparable risk management capabilities and controls to Australia’s biggest banks.

Utopian belief

The crypto crisis has been especially unusual because it has been infused with an emotive and utopian sense that these businesses were going to revolutionise, and ultimately disintermediate, the traditional financial (or “tradfi”) world. These were not just innovative and high-growth firms – they purported to provide people with a new way of life that was a threat to the old oligarchy by existing beyond the reach of governments and their stultifying regulatory controls.

Almost all crypto enthusiasts will wax lyrical about the anonymity, privacy and security afforded by crypto beyond the power of government. Crypto thus held out hope of becoming a new medium for organising our lives in a libertarian digital world without external interference.

But because almost every crypto activity relied critically on some form of trust – including the vital assumption that our savings would be secure and safe – they were predictably doomed for failure in the event of any crisis of trust, which is what a liquidity shock is.

Only two days ago a friend who is a crypto junkie had to cancel a meeting because he was desperately withdrawing $800,000 of personal savings from all his crypto exchanges and returning it to the unalloyed safety of traditional bank deposits.

Most of what we see today in the crypto universe will die. There will surely be some residual winners, and there are doubtless some impressive technological innovations that will sustain. But anything of serious value will likely be absorbed by the traditional banking system. The dominant digital currencies of the future will be those issued and guaranteed by nation states.

So where does that leave bitcoin? As this column argued last year, bitcoin has not become a medium of exchange, is not a stable store of wealth and is the opposite of an effective inflation hedge. All these Ponzi messages have been destroyed by the passage of time.

A place to hide money

This leaves one final use case, which was outlined to me last weekend by a bitcoin “maxi” – that bitcoin is a uniquely “seizure-resistant” asset. Put differently, bitcoin is a place to hide money beyond the aegis of government or other nefarious actors. This seizure-resistant quality is 100 per cent predicated on the security of the encryption technology used to mine bitcoin.

And this is where the narrative once again stumbles. Nobody knows who Satoshi Nakamoto, the person (or persons) who authored the first mysterious bitcoin white paper in 2008, and who devised the first blockchain database, actually is. Language analysis of Nakamoto’s writing comprehensively suggests that he/they wrote in both British and American English, either because Satoshi was a group of people, or one person pretending to be many people.

Bizarrely, Satoshi has also never touched his/their bitcoin wallet, which is today worth about $US18 billion, implying that his/their motives are not financial despite the rationale for creating bitcoin being monetary purity. It just makes no sense.

Significantly, the hashing algorithm used to protect the security of bitcoin, called Sha-256, was created in 2001 by the National Security Agency in the US, which is the world’s centre of excellence for cryptography.

The NSA’s sole reason for being is breaking encryption to steal global secrets: it has zero incentive to release encryption technology, like Sha-256, that the world can use to hide from the NSA’s surveillance. That would destroy its core mission.

Every single bitcoin expert I know acknowledges that bitcoin and the blockchain used to produce it could eventually be insecure. Examples include the possibility of a “51 per cent attack” on a blockchain by an entity that controls more than 50 per cent of the network’s mining hash rate, which would give them control of all bitcoin transactions.

A 51 per cent attack requires either a very large, but not impossible, investment in computing power or some disruptive competitive advantage in processing power beyond currently known technology.

The original 2008 bitcoin white paper, entitled a “peer-to-peer electronic cash system”, marketed its chief benefit as the ability to enable “online payments to be sent directly from one party to another without going through a financial institution”.

If you were an intelligence agency in 2008 watching non-democratic states and criminal actors clamouring to find anonymous payment systems to launder or hide money, it would make enormous sense to facilitate the development of digital currencies like bitcoin that you could ultimately control in the event of major power conflict between states.

We saw in the Russia/Ukraine conflict that the Russians immediately leant on crypto to protect their wealth outside the Western liberal-democratic controlled financial system.

My own view is there is no way the NSA would release the Sha-256 technology that protects bitcoin if it could not access it. The Chinese know this, which may be why they have banned bitcoin. And the day the world discovers that bitcoin is insecure is the day it is worth precisely nothing.

First published in the AFR here.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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