The End Of Ponzi Finance?

Nov 11, 2022

The End Of Ponzi Finance?

The Weekend Read

If I told you one year ago that this week the stock market would have one of its best days in history, rising more than 5% in one session because inflation was only 7.6%, you’d have thought I was crazy. While this may have seemed unfathomable then, it was predictable well before. We are in the midst of The Great Devaluation. It's an era in world history defined by Ponzi Finance.

While all eyes this past week have been peeled to our never-ending election process and the “red wave” that now looks a lot more like a “red ripple,” our capital markets have been reeling from the collapse of the cryptocurrency exchange FTX. The systemic risk revealed overnight has witnessed a massive sell-off across all cryptocurrencies. Bitcoin dropped 25% on the week and fell to lows not seen in two years. Most other coins fared even worse, some dropping 50%, while FTX coins may have no value at all and are completely illiquid.

The FTX platform, founded in 2019 by Sam Blankman-Fried and headquartered in the Bahamas, began the week with a market capitalization of $16 billion. By Friday, the Ponzi scheme was determined by Bloomberg to have a total value of $1. FTX saw more than $6 billion in withdrawals in the 72 hours leading up to Tuesday morning. This is when the run on FTX became unmanageable, forcing them to halt all redemptions. By week’s end, the market value of the exchange had crashed by 100 percent. An estimated $2 billion in investor cash has been wiped out.¹

Ponzi finance has been around for as long as human beings have been alive. It’s based on a scheme that promises rewards based on enrolling ever larger numbers of people. What’s shocking to many about the most recent edition, headlined by wunderkind Sam Blankman-Fried who goes by “SBF” and whom Fortune Magazine called “The Next Warren Buffett,” are the amount of major name institutional investors and celebrities who were a party to the sham.² Blackrock, Softbank, Tiger Global, and the Ontario Teachers Pension Plan were some of the big-name institutional investors who lost billions of dollars in equity value overnight. These institutional investors are already writing off their entire investments. Sequoia Capital, another heavyweight who had invested over $200 million at valuations between $18 billion and $25 billion, tweeted it was assuming the investment was now worthless.³

It wasn’t only “brilliant investment funds” that were duped. Superstars Tom and Giselle Brady, who were already having a rough week as they announced their divorce, may have lost as much as $600 million.⁴ The publication, Essentially Sports, reported that the famous couple had attached their entire net worth of $600 million into the FTX venture. PitchBook data also shows that San Francisco-based Iconiq Capital, which manages money for Mark Zuckerberg and Jack Dorsey on their books. This is not to mention all of the consumers whose deposits are currently unavailable for withdrawal.⁵

Mark this moment in your calendars. The FTX blowup may well go down in history as the “Lehman Moment'' of 2022. It will likely become the poster child of the “free money” mindset created by the Federal Reserve.

Lehman Brothers was once the fourth largest investment bank in the world.⁶ They filed for bankruptcy protection on September 15th, 2008. At the time of its collapse Lehman had over 25,000 employees and $26 billion more in assets than they had in liabilities. The bank’s failure has become the symbol for the excesses of the housing bubble that ultimately led to $10 trillion in global losses. When the Lehman bankruptcy occurred in ‘08, equity markets had already fallen into bear market territory over the prior six months. Much like we are seeing today, and before the Lehman collapse, bear market rallies were creating dramatic volatility. Hope was very much alive in ‘08 that markets had finally rebounded. That is until Lehman fell. The S&P 500, which closed the day of the bankruptcy at 1250 points, would fall another 37% hitting lows of 667 points just six months later in March of ‘09.⁷

The Lehman collapse was created by the Federal Reserve and their tremendously loose monetary policies. These central bank decisions incentivize leverage and risk and offer tremendous opportunities for upside gains. That is until the free money party ends. Higher interest rates destroy leveraged positions. So do dramatic overnight drops in the value of collateral. In ‘08, equity valuations simply could not endure a Fed that had raised rates from 1% to 5.25% in the two years prior. The “Lehman Moment” was the evidence that even the most long-standing and respected institutions in the world (Lehman Brothers was founded in 1850) could evaporate overnight. The excesses that had been taken on by the investment bank were not isolated. Leverage and overvaluation had become a system-wide risk and the Great Recession was born.

We would all do well to recognize the similarities between then and now.

The Fed has created a similar bubble today. We are in the midst of a bear market rally which finds the S&P 500 down about 15% from its highs. The overnight collapse of FTX, much like that of Lehman 15 years ago, is assuredly not an isolated risk. It’s only a matter of time before we learn the collateral damage already cracked underneath the surface. Nothing happens in a straight line. In the week after Lehman fell, the stock market remained elevated. The S&P 500 closed at the same level one week after Lehman.⁸ We all know what happened next.

The Great Devaluation

The modern-day version of The Great Devaluation began in earnest in February of 2019, when Fed Chair Jerome Powell threw in the towel on monetary discipline and pivoted entirely from what had been an attempt to normalize monetary policy. That precise moment in time inspired me personally to begin putting every investable dollar I had into physical gold. It sparked my determination to share the story of what I believed would be the next epic superbubble that would ultimately end in tears.

What’s happening today, while a new chapter, is the tale of a story that has been around since the beginning of man. It is unfolding before our eyes.

All one needs to understand the story is a basic understanding of how the price of money drives incentives. Powell’s decision to give up on “normalization” over three years ago was the mindset shift that then permitted the decision to pump trillions of dollars of new money into the system in response to COVID-19. Powell’s reversal on sound money policy in February of ‘19 fueled an epic debt expansion that has taken our country's national debt from $22 trillion dollars to now over $30 trillion and rapidly rising.⁹ His move also signaled a checkmate for the U.S Dollar, the end result of which can only end in a controlled devaluation of the currency.

It’s no coincidence that at the same time that Powell’s decision opened the door to an avalanche of free money, a young tech guru was seeing ways in which to game the system utilizing the free money party our central bank had created. Sam Bankman-Fried focused his efforts on a cryptocurrency he understood more than most: Bitcoin.

Bitcoin, which had hit all-time highs of nearly $20,000 in ‘17, had fallen to $3,500 by January of ‘19. The collapse, much like the collapse in cryptocurrencies this year, occurred while our Federal Reserve was tightening monetary policy and reducing their balance sheet. As Powell pivoted in February of ‘19, bitcoin exploded higher allowing SBF to seize his opportunity. The digital currency soared nearly three times from $3,500 hitting highs of over $11,000 by July.

This is when the billionaire, SBF, noticed an out-of-the-box opportunity where the price of bitcoin on the American exchange was trading at a different price than on a Japanese exchange.¹⁰ SBF collected $10 million, purchased bitcoin from the American exchange at $10,000, and then sold it on the Japanese exchange for $11,000, gathering an instant profit of $1 million per transaction. He did this every weekday to make $20 million with this simple arbitrage.

Bankman-Fried took this initial windfall and founded the FTX cryptocurrency exchange. Before founding FTX, Bankman-Fried had traded international ETFs at Jane Street Capital, a proprietary trading firm. This experience, and his newfound fortune, helped him to open Alameda Research, a quantitative trading firm. Soon Binance, the largest cryptocurrency exchange in the world, a firm that had also booked dramatic profits on cryptocurrencies shooting stars, purchased a 20% stake in FTX.¹¹

The FTX exchange enabled customers to trade digital currencies for other digital currencies or traditional money. The exchange made money by making a small fee on every transaction. However, this is not how SBF came to be on the cover of Fortune Magazine and labeled the next Warren Buffett. SBF recognized the power of adoption and momentum. He described FTX in an episode of Odd Lots where he admitted that the core business at FTX was based on something called “yield farming.”

Yield farming is a method of earning rewards or interest by depositing your cryptocurrency into a pool with other users. The pooled funds are used to carry out smart contracts such as cryptocurrency lending that generates interest in return. According to Google, “FTX.US offered up to 8% in interest on both fiat currency and crypto held on its mobile app, and this feature is relatively simple to use if you opt in. Rewards compound hourly, and you can withdraw your tokens at any time.” ¹²

Bankman-Fried described yield farming the following way in his April interview with Mark Levine and Joe Wiesenthal. We include portions of the interview taken directly from the Bloomberg article posted on April 25th: ¹³

Matt Levine: (21:17)

Can you give me an intuitive understanding of farming? I mean, like to me, farming is like you sell some structured puts and collect a premium, but perhaps there's a more sophisticated understanding than that.

Sam Bankman-Fried: (21:28)

Let me give you sort of like a really toy model of it, which I actually think has a surprising amount of legitimacy for what farming could mean. You know, where do you start? You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It's just a box. So what this protocol is, it's called ‘Protocol X,’ it's a box, and you take a token. You can take ethereum, you can put it in the box and you take it out of the box. Alright so, you put it into the box and you get like, you know, an IOU for having put it in the box and then you can redeem that IOU back out for the token. So far what we've described is the world's dumbest ETF or ADR or something like that. It doesn't do anything but let you put things in it if you so choose. And then this protocol issues a token, we'll call it whatever, ‘X token.’ And X token promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens. They can vote on what to do with any proceeds or other cool things that happen from this box. And of course, so far, we haven't exactly given a compelling reason for why there ever would be any proceeds from this box, but I don't know, you know, maybe there will be, so that's sort of where you start.And then you say, alright, well, you’ve got this box and you’ve got X token and the box protocol declares, or maybe votes by on-chain governance, or, you know, something like that, that what they're gonna do is they are going to take half of all the X tokens that were re-minted. Maybe two thirds will, two thirds will offer X tokens, and they're going to give them away for free to whoever uses the box. So anyone who goes, takes some money, puts in the box, each day they're gonna airdrop, you know, 1% of the X token pro rata amongst everyone who's put money in the box. That's for now, what X token does, it gets given away to the box people. And now what happens? Well, X token has some market cap, right? It's probably not zero. Let say it's, you know, a $20 million market …

Matt Levine: (23:56)

Wait, wait, wait, from first principles, it should be zero, but okay.

SBF: (23:59)

Uh, sure. Okay. Completely reasonable comments.

Matt Levine: (24:04)

I mean, that's not quite true, but, like, when you describe it in this totally cynical way, it sounds like it should be zero, but go on.

SBF: (24:10)

Describe it this way, you might think, for instance, that in like five minutes with an internet connection, you could create such a box and such a token, and that it should reflect like, you know, it should be worth like $180 or something market cap for like that, you know, that effort that you put into it. In the world that we're in, if you do this, everyone's gonna be like, ‘Ooh, box token. Maybe it's cool. If you buy in box token,’ you know, that's gonna appear on Twitter and it’ll have a $20 million market cap. And of course, one thing that you could do is you could like make the float very low and whatever, you know, maybe there haven't been $20 million dollars that have flowed into it yet. Maybe that's sort of like, is it, you know, mark to market fully diluted valuation or something, but I acknowledge that it's not totally clear that this thing should have market cap, but empirically I claim it would have market cap.

Joe Weisenthal: (24:59)

It shouldn't have any market cap in theory, but it practice, they always do. Okay.

SBF: (25:03)

That's right. So, and obviously already we're sort of hiding some of the magic impact, right? Like some of the magic is in like, how do you get that market cap to start with, but, you know, whatever we're gonna move on from that for a second. So, you know, X tokens [are] being given out each day, all these like sophisticated firms are like, huh, that's interesting. Like if the total amount of money in the box is a hundred million dollars, then it's going to yield $16 million this year in X tokens being given out for it. That's a 16% return. That's pretty good. We'll put a little bit more in, right? And maybe that happens until there are $200 million dollars in the box. So, you know, sophisticated traders and/or people on Crypto Twitter, or other sort of similar parties, go and put $200 million in the box collectively and they start getting these X tokens for it. And now all of a sudden everyone's like, wow, people just decide to put $200 million in the box. This is a pretty cool box, right? Like this is a valuable box as demonstrated by all the money that people have apparently decided should be in the box. And who are we to say that they're wrong about that? Like, you know, this is, I mean boxes can be great. Look, I love boxes as much as the next guy. And so what happens now? All of a sudden people are kind of recalibrating like, well, $20 million, that's it? Like that market cap for this box? And it's been like 48 hours and it already is $200 million, including from like sophisticated players in it. They're like, come on, that's too low. And they look at these ratios, TVL, total value locked in the box, you know, as a ratio to market cap of the box’s token. And they’re like ‘10X’ that's insane. 1X is the norm.’ And so then, you know, X token price goes way up. And now it's $130 million market cap token because of, you know, the bullishness of people's usage of the box. And now all of a sudden of course, the smart money's like, oh, wow, this thing's now yielding like 60% a year in X tokens. Of course I'll take my 60% yield, right? So they go and pour another $300 million in the box and you get a psych and then it goes to infinity. And then everyone makes money.

Matt Levine: (27:13)

I think of myself as a fairly cynical person. And that was so much more cynical than how I would've described farming. You're just like, well, I'm in the Ponzi business and it's pretty good.

Joe Weisenthal: (27:27)

At no point did any of this require any sort of like economic case, it’s just like other people put money in the box. And so I'm going to too, and then it's more valuable. So they're gonna put more money in, and at no point in the cycle, did it seem to like, describe any sort of like economic purpose?

SBF: (27:42)

So on the one hand, I think that’s a pretty reasonable response, but let me play around with this a little bit. Because that's one framing of this. And I think there's like a sort of depressing amount of validity…

Matt Levine: (27:53)

Can you comment on like the sustainability of that? Because, you know, on the one hand you're like, well, a trillion dollars of institutional money is going to come into Bitcoin. And on the other hand you're like basically there are a lot of Ponzis that have done really well.

SBF: (28:06)

Right. So let me, okay, cool. I'll stay on the cynical route, think about like cynically, what could happen here? Well, okay. So you've got this boxes and it’s kind of dumb, but like what's the end game, right? This box is worth zero obviously. And like that, you know, you can't like keep this smart cap or something. But on the other hand, if everyone kind of now thinks that this box token is worth about a billion dollar market cap, that's what people are pricing it at and sort of has that market cap. Everyone's gonna mark to market. In fact, you can even finance this, right? You put X token in a borrow lending protocol and borrow dollars with it. If you think it's worth like less than two thirds of that, you could even just like put some in there, take the dollars out. Never, you know, give the dollars back. You just get liquidated eventually. And it is sort of like real monetizable stuff in some senses. And you know, at some point if the world never decides that we are wrong about this in like a coordinated way, right? Like you're kind of the guy calling and saying, no, this thing's actually worthless, but in what sense are you right?

Tracy Alloway: (29:15)

Can I just ask on this point, I mean, so are you saying that the value has to derive from everyone agreeing that it's worth something? And I know like on the one hand, that seems like a simple point about crypto, but on the other hand, throughout crypto's history, there have been these different arguments about how it actually gets value, you know, use cases for the underlying technology — for blockchain. Everyone's gonna start migrating stuff on blockchain, and then you're gonna have a real economic use attached to these assets. And that's where the value's gonna come from. But are you saying that it depends more on everyone just agreeing that these are worth something?

SBF: (29:53)

So really what I'd say is that it could come in theory from either. You can sort of get a market cap either because of cash flow and then Warren Buffett's like f*ck this. Like, I'm going to buy this if it's at too cheap of a price, because I'll just buy it and own it and get cashflow from it. And that's great. Or you could see something get market cap in the way that, I don't know, Doge coin or SHIB coin have, where people are just kinda like ‘ha ha’ and then they buy it. And if you're like, that's dumb, it has no cashflow flow. I'm gonna short sell it. You lose all your money. And, you know, those like, at least like over the last few years, those have both been ways that assets have gotten market cap. And I sort of like think that this starts to hint at like, at least some interesting angles on this, because it's not just cryptocurrencies that have had this dynamic, right? How about like, you know, AMC or Hertz or GameStop or meme stocks in general have like a very similar pattern to this and the sort of concept of maybe people will pay something for it even though it doesn't seem traditionally valuable, is not a crypto specific concept…

This interview was given in April. Perhaps you find yourself as stunned as I did when I first saw it?

It’s impossible, when seeing the words directly from the mouth of the most famous and respected crypto billionaire in the world, not to lose faith entirely in the cryptocurrency universe. It reveals cryptocurrency for what many people, including myself, have continually argued it has become, a giant scam. It also reveals how long Ponzi finance can be sustained. Despite openly admitting his business was a Ponzi scheme six months ago, it was only until this week that the entire thing went belly up.

This is the unfortunate mindset that has been created by the “free money” which has been pumped into the system by our government. As a result, trillions of real dollars of real money flowed into cryptocurrencies and other inflated assets built on fake money. Most crypto coins are, simply put, a casino designed to hand out free chips. The more chips the casino hands out, the more people want to come to the casino. When enough people are playing, the value of the casino rises, then the “smart money” uses this fake value to earn a “yield.” Because that yield is much higher than any yield available anywhere else, it drives more and more people into the casino which fuels more investor momentum into the coins. Of course, it ends with real people, the little guys, holding the bag.

What’s maddening about the entire episode is the level of profile that early adopters had. These were major institutional investors and mega celebrities vouching for FTX which brought attention to the FTX and the FTX coin to begin with. Market share was accumulated because of the “trust factor.” If these major institutional investors were plowing in, if Tom and Giselle were plowing in, it must be safe, right?

It wasn't. It’s a Ponzi scheme. One that Wall Street has made fortunes on over the last several years. One that is now blowing up the balance sheets of an entire generation, all of whom “invested” real dollars in the hopes that cryptocurrencies would be their way to an easier and more wealthy life. They took the money from the handouts given by the Federal government in the form of unemployment benefits and stimulus checks, plowed it all into the crypto Ponzi universe, only to watch it all disappear.

Now ask yourself an important question. How is this any different from a Federal Reserve making its own money, handing out that money to the players at the casino, who then lend that money to earn a yield, as borrowers plow that borrowed money into stocks which are only going higher because other investors are pouring in their own fake money?

Once you get your mind around that one, ask yourself another question. If Ponzis collapse when there is more money being redeemed than there is new money going in, how long before the Ponzi of the U.S dollar is revealed? How much faster will it all unwind as the Fed raises rates and continues to reduce the money supply? Is it really any different than the “money in the black box” described by the genius SBF?

Ponzi finance is based on a scheme that promises rewards based on enrolling ever larger numbers of people. This is why the U.S dollar must forever continue to expand. It’s why markets explode higher on a lower CPI print, even though it comes in at a whopping 7.6%, because it means that the Fed may slow down on shrinking the money supply.

In the end, it’s the little guy, facing inflation far higher than his wages are increasing, holding the bag.

It’s also why I will continue to put my savings into a real box with real money.