Fraud and the SEC caused crypto lending to fail

The outlook for cryptocurrency in general hinges on what occurs to the crypto lending industry over the next few weeks.  If decisive action is taken, then confidence will be restored, the bank runs will stop, and the entire market will recover in an orderly fashion.

If firms begin filing for bankruptcy, however, the outlook is bleak, with years of low prices ahead.  Failures will extend across the industry, as mining companies and large exchanges announce more mass layoffs.  People will become homeless.  The scale of losses already dwarfs the famous Panic of 1907 to which the current disaster is being compared. 

It's important for people to finally recognize that what happened in June was not a case of people making "risky investments" and those investments failing to pan out.  It was people depositing with lenders whose CEOs and managers misrepresented what they were actually doing with the money.  That is criminal fraud.  The fraud worked as long as there were an equal number of deposits and withdrawals, but the SEC's actions restricted deposits, setting the stage for what otherwise would have been an orderly drawdown.

Let's discuss what happened to figure out a way out.  The key to figuring out the ideal solution involves saving people where fraud was involved, and punishing the fraudsters.

 

Differentiating Terra from the lenders

A common refrain is that the collapse of the Terra coin was the first "institution" to fail, as if Terra were a bank or store of value.  I disagree.  TerraClassic, as it is now called, is a coin, just like dogecoin is a coin.  It's strange to state that Terra was somehow different than dogecoin, even though TerraClassic's percentage decline from its high was less than dogecoin's when I wrote this post in late June, or that Terra buyers should be viewed more sympathetically compared to buyers of many ICOs or NFTs that lost value.  Nobody should want anyone to go bankrupt, but all of these were equal tragedies and the Terra collapse was no different in its tragedy.

Buyers of Terra knew, or should have known, that they were buying a coin that could fluctuate in value, just as we know that dogecoin can do the same.  All of the information about Terra was publicly available, with a full whitepaper describing exactly how the system worked on the blockchain.  The system that was actually implemented was exactly as described in the paper.  Terra furthermore publicized exactly how many bitcoins were backing the project, and buyers of Terra could have easily searched Google to find that there weren't enough bitcoins backing Terra.  There was no fraud involved in the Terra crash, and therefore no bailout should be offered.

 

Cause #1:  3 Arrows Capital

The initial culpability for the crisis rests squarely with 3 Arrows capital, which is currently in liquidation.  As more and more information comes out, I suspect that we're going to find that 3 Arrows was simply a variant of a classic Ponzi scheme.  Perhaps 3 Arrows was more legal than a standard Ponzi scheme because the fund actually had investments, but the fund's sole action was to pay out old depositors by borrowing as much money as possible so that those irresponsible investments could continue to gain (or lose) money.  Given that people were willing to extend unsecured credit to 3 Arrows for use in risky activities like purchasing bitcoins, it was easy for them to rack up enormous debts.

3 Arrows should not be rescued from its fate.  Its wealth primarily consisted of the assets of its two founders, who will bear the brunt of their actions.  Many of the victims of its collapse are institutions, who should be addressed at a lower level individually.  3 Arrows' founders are rumored to be on the run, and they have reason to be, given the damage they have wrought. 

 

Cause #2:  The Securities and Exchange Commission and Gary Gensler

The SEC contributed to and continues to exacerbate the crisis because money can only move one direction at these firms - out.  SEC chair Gary Gensler made a catastrophic decision to pursue the one firm that has not actually failed in the crisis - BlockFi.  Instead of commencing a legal action to bring information to public light, taking action much earlier so that his concerns would be addressed before there were many US customer deposits, allowing deposits to continue while the institutions implemented the SEC requirements, or taking action to create a loan drawdown plan to return US customer money at all institutions quickly to resolve the deposit/withdrawal imbalance, his actions resulted in the worst possible outcome: making BlockFi, and only BlockFi, seem like a villain.

That caused depositor money to flow to other companies after BlockFi stopped accepting deposits from US customers.  It caused other companies to fear the SEC, shutting down deposits even though the SEC mandated no plan to actually wind down loans against those deposits.  Celsius was the last to stop accepting deposits, so it got a lot of US customer money.  It's no accident that withdrawals accelerated after US deposits were stopped.  Now, many consumers are confident that BlockFi and Ledn survived the collapse, but cannot return money to those firms.  What did Gensler expect to happen to an industry that can only process withdrawals but can't accept deposits?

Look at the current state of the surviving firms as of July 4:

• Nexo and Ledn are not based in the US, so they had fewer US deposits in the first place
• BlockFi saw a bank run after the initial SEC settlement, so it had fewer US deposits by the time June arrived
• Genesis and Gemini never stopped accepting US deposits

And look at the failed firms:

• Celsius and Voyager continued to accept US deposits after BlockFi stopped, stopped shortly before the collapse, and are now in trouble

In short, the SEC put the industry into a fragile state that it would otherwise not have been in, and the 3 Arrows crisis tipped it over the edge.

 

Lending is required for the economy to function

The economy cannot function without the ability to borrow money.  People have borrowed money since money existed.

In addition to allowing people to borrow different currencies against bitcoins to purchase personal items like homes, there are some types of borrowing that only crypto lending firms can provide.  Mining pools, for example, often need to borrow bitcoins to build up a reserve for payouts before they find blocks.  Borrowing dollars is ineffective for this purpose, as the payouts are due in bitcoins and holding dollars is too risky when bitcoins can rise in value by 15% overnight.

Without a solution to the crisis, crypto lending may cease for all but the richest institutions, and if it does, the sector will take a very long time to recover because borrowed money is used to invest in new companies.

 

The primary causes already happened

3 Arrows likely failed on June 13, even though we didn't learn about it until the following day.  Immediately thereafter, there was a cascade of failures among other platforms - Celsius was immediate (we still don't know how much Celsius was involved with 3 Arrows,) BlockFi lost some money, and Voyager was a dead man walking, eventually failing on July 1.  Several smaller lenders and exchanges also failed.  Critically, however, we haven't heard of any additional losses; all of these were involved in some way with the 3 Arrows collapse.  Furthermore, there have been no major price movements since that week to trigger massive liquidations.

By the time headlines are published, the news is already stale.  There have been a string of negative headlines over the past few weeks, but all of them are simply providing more information about events that have already happened.  Therefore, the primary remaining danger to the firms right now is simply that bank runs might sink them, or that they were lying about not losing money during the week of June 13.  It's much less likely at this point that the primary danger is unknown lenders still remaining who are unable to pay their debts. 

For example, it's unlikely that BlockFi is going to fail now that all of its liabilities are accounted for, given that the crash already happened, and people panicking withdrawing from there are needlessly doing so.  The places to worry about are those that have not disclosed what has happened.

As days go by without any rescue plan, it will cost more to effect a rescue, and the recovery of the entire cryptocurrency space will be delayed.  Every day, more and more people permanently cease lending and will never return, which will slow the entire industry's recovery.  Interest rates from remaining lenders will continue to rise, hindering investment in the space during a good time to build new products.  The existing failed firms, like Celsius, continue to pay interest on their existing DeFi loans and bleed money to lawyers.  The best talent at these companies is already looking for work elsewhere, and every day more of these people are permanently snapped up to work on web development, databases, AI, and other fields that cryptocurrency programmers can easily switch into.  Once they leave the industry, these developers' cryptocurrency knowledge grows stale and they are unlikely to return to doing something that was failing so spectacularly.

If no action is taken and almost every lender and exchange fails, then it wouldn't be unreasonable to suggest that the total losses will approach one million bitcoins in value, although much of that would be denominated in other coins and currencies, and that the next bubble will not occur until 2026, because the current amount at stake in dollar value is at least 50 times worse than that at stake at Mt. Gox.  If you don't believe my opinion there will be such a long recession in the industry, consider that the destroyed value in this collapse would be 5% of the entire bitcoin network, or as many bitcoins as Satoshi Nakamoto has.  All of this loss is unnecessary, because the continuing damage is being caused by fear rather than external causes.

 

Fraud

Before any companies can be rescued, however, it's time to say it like it is: many of the companies were based on fraud, and that fraud was the sole reason that they ended up in this situation.  The situation would not have occurred but for the companies' fraudulent statements, because depositors would have been turned away by the truth.  Here are multiple examples of what is likely outright fraud:

• Alex Mashinsky, CEO of Celsius, who repeatedly emphasized Celsius's collateralized loans while sending money to high-risk DeFi contracts
• Zac Prince, CEO of BlockFi, who the SEC found to have not updated BlockFi's website to state that only 16% of its loan portfolio was collateralized
• Stephen Ehrlich, who as the head of a public company may have even more exposure, implied Voyager's dollar balances were "FDIC insured" when he knew customers were not protected

It may not be possible to criminally prosecute these individuals for fraud, because the bar is very high to find evidence beyond a reasonable doubt.  Civil fraud will probably result in Mashinsky and Ehrlich filing personal bankruptcy, and Prince is saved only because he did the right thing to save depositors' assets and nobody actually lost any money at BlockFi.

People who deposited money at Voyager and Celsius didn't lose it because they "took a chance" on a "risky investment" and it didn't pan out.  They lost it because Mashinsky and Ehrlich made false statements or omitted critical information about how the depositors' money was being used.

 

Saving the industry

To recover from the situation without years of downturn, the following needs to happen.  These things may be impossible, but they are the only way to restore confidence and prevent the entire industry from long-term collapse.

1.  Saving everyday people

Every retail borrowing firm needs to make good on all of its depositors' assets.  That means that even the firms with the biggest holes in their balance sheets, like Celsius, need to be rescued somehow.  Because there are now multiple failed firms, it probably is no longer true that people will shift money around between them; if they all are rescued along with the other steps being taken, withdrawals will cease.

Even if "everyday people" don't compromise the largest value of losses compared to large hedge funds, the media impact of saving such people is far larger, not to mention the cost of reduced human suffering.  Imagine the people who worked for 30 years and deprived themselves of everything they wanted to buy so that they could have a good retirement, and now face the need to work for another 30.

 

2.  Investors lose money

Shareholders - but not depositors - in all of the failed firms need to lose almost all of their investment.  A fire sale to a larger firm for almost zero cost, where the larger firm takes on the debt, would accomplish goals #1, 2, and 3 in this list.  FTX already acquired BlockFi in such a sale, with Prince and other shareholders learning a lesson that misleading investors has serious consequences.  

These investors' loss of funds also prevents them from becoming shareholders in another firm and leading it down the wrong path again, because they don't have any money left.

 

3.  Replacement of management

Management at every rescued company must be fired and replaced with competent leadership.  If someone were to purchase Voyager, Ehrlich is hardly the person to continue leading the company.  Unfortunately, this replacement is likely to result in golden parachute clauses being triggered, but depositors won't trust the institutions if the same people are running them.  Hopefully, the money can be clawed back in personal civil actions against the CEOs and other principals of the companies.

 

4.  Criminal prosecution of a high-profile target

Private individuals can't pursue criminal prosecutions, but if nobody goes to jail as a result of this disaster, then CEOs will be incentivized to try it again next time.  It won't be possible to indict everyone, but there surely exists enough evidence to get a plea deal out of someone, even if the deal is only a massive fine with a few months living at a corrections camp.

 

5.  Reform at the SEC

The balance of deposits and withdrawals needs to be restored for the lenders to be able to function correctly.  While Mashinsky should not be excused for his misleading statements, part of Celsius's troubles likely resulted because it calculated that inflows and outflows for ETH would be equal to the current market, so it could stake a specific amount.  The SEC's actions suddenly put Celsius in an impossible situation because the stETH locked up was larger than all the ETH held by non-US customers.  And while Prince should not be excused for his excessive investments in the Grayscale Bitcoin Trust, the SEC's unequal treatment of futures and spot ETFs caused the Trust's value to decline to 35% below net asset value while money flows into foreign funds that the SEC will not approve in the US.

It's hard to see how this roadblock can be gotten around, as the 2024 Presidential election (which will decide who is appointed to the SEC) is too long from now.  No matter how much faith customers have in these companies, they are simply prohibited from depositing money back into them.  The companies could operate well if they could somehow operate only internationally, but they've already lended the US customer money out and can't simply return it until those loans come due.

 

The situation

Someone has to come forward to bail out the crypto lending companies, or every retail lending firm will either fail or close and return depositors' assets.  If the companies are allowed to fail, then the lending market will be gone and the industry can't grow without the ability to borrow money.

For firms like Voyager, who were involved in making bad loans and misleading depositors, a large exchange could accomplish the task of buying it in a fire sale and firing management.  The major roadblock is that the CEOs of these companies are blinded by greed, believe they can somehow continue operating their companies, and worry more about themselves than about the lives of their depositors and employees.  Ehrlich could unilaterally decide to file bankruptcy instead of taking a bailout, because there is no difference in consequences to him - both result in his termination and a zero value of his stock.

For Celsius, I argue that the most sensible outcome is a public-private partnership, because the SEC was partially responsible for causing Celsius's problems.  Of course, the government getting involved in Celsius will never happen, and Celsius's debt is too great to see how a private  company could afford to save the firm and turn a profit.

For other firms, simply bailing out the larger companies will have a ripple effect that saves them.  Companies that had deposited money at Celsius can reopen withdrawals if Celsius is saved, for example.  A "haircut" doesn't assist the solvency issues for these other firms, however, which is why an all-or-nothing approach is needed.

 

Conclusion

There are few people with enough money to rescue the crypto lending industry, and the SEC's ban on the US market is likely the key factor preventing a rescue from those who have enough.  The 1.7 million Celsius "customers" include many US customers who are prohibited from dealing with Celsius, so anyone acquiring these firms for their customer lists is actually considering only a subset of customers.

Relaxing the SEC's limitations on the rescued firms so that they can transition their offerings slowly to whatever the regulatory body requires is critical to any attempt to execute a bailout, but Gensler is unlikely to play ball.  Nexo, Ledn, FTX, and other survivors are stuck in a position where their businesses will continue to wither away due to a toxic association with the failed firms unless they do something, but the firms they would be buying are unprofitable with the SEC restrictions because the deposit/withdrawal demand imbalance remains.

People didn't make "bad investments" in the failed companies.  They deposited to institutions that were led by managers that probably committed fraud by providing unsecured loans while misleading depositors that most or all loans were collateralized, and the FDIC promise at Voyager was particularly egregious and should result in jail time.  Because of the actions of these alleged fraudsters, combined with consequences of the restrictions placed by the SEC, depositors have become victims.

The only solution may be what Rockefeller did in 1907: to pledge half his net worth to save the US economy, at great cost to himself and J.D. Morgan.  The two bankers knew they would lose a lot of money, but that nobody would deposit money in their own banks ever again if they failed to act.  Similarly, a person with many bitcoins might decide that the benefit of increasing the price of bitcoin a few years earlier outweighs the immediate cost.  Since it would be against depositors' interests for the only lender big enough to do it - Genesis - to step up, the mandate comes down to an exchange or private individual, most likely a non-US person.  Will anyone step forward, or are we doomed to years of despair?