Crypto scams and modern capitalism are long lost siblings

by Arthur · March 29, 2023

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Charting the massive waste from last year’s cryptocurrency collapse – trillions in nominal market capitalization evaporating in months; allegations that the founder of bankrupt crypto exchange FTX bribed Chinese officials; and a punitive lawsuit by US regulators against rival exchange Binance Holdings Ltd. this week — it’s tempting to think that nothing like this has happened before.

Thank goodness the domineering heights of our financial system are run on the most sane principles, rather than the kind of delusions that drove self-absorbed millennials to pay $3.4 million for a cartoon of a monkey.

In truth, however, crypto-land is not so much a parody of the modern financial system as its sibling.

Part of that comes down to the fact that many of the participants cut their teeth in traditional capital markets, replicating their structures in the institutional architecture of decentralized finance. However, there is a deeper similarity.

Conventional finance is no different from Bitcoin, Ethereum and their ilk because the founders were fundamentally wiser and more sensible than Changpeng Zhao, Sam Bankman-Fried, Do Kwon and Caroline Ellison. Go back to its origins, and the real difference is that modern capitalism got away with it, becoming institutionalized in the process.

It’s a lesson not just for this bubble, but for others that will burst in the coming years.

A certain degree of chaos comes with finance, an industry based on predictions about a future whose uncertainty increases over time. The invention of paper money in the Song and Yuan dynasties of medieval China led to repeated bouts of hyperinflation as the government used note printing to finance its deficits, eventually leading people to abandon the monetary system altogether and return to the relative stability of barter. before the empire reverted to a silver standard.

Yet it is the turmoil of the financial revolution in early modern Europe that most closely resembles the Wild West of crypto.

In an infamous episode of Bloomberg’s Odd Lots podcast last year, Bankman-Fried explained “yield farming” – a dubious process of creating investable crypto-assets out of thin air. People can put their digital savings into a “box,” he said, receive an IOU in return, and then get paid interest on the assumption that the code in the box will be a “world-changing protocol that will replace all the big banks. .”

Whether the echo is conscious or not, his account is curiously similar to the way 17th-century goldsmiths in Amsterdam and London developed fractional reserve banking. Investors who deposited precious metals in their vaults would receive an IOU in return, negotiable as a form of quasi-money – what we now call a note. As soon as the goldsmiths realized they could get away with issuing more notes than they had gold in the vaults to back them—a practice that some heterodox economists still consider little better than fraud—they also began paying interest. That innovation turned out to be a world-changing protocol.

In the 1690s, the devastating costs of the Nine Years’ War against France led England to seek more and more ingenious ways of raising government funds. Financial innovation went into overdrive.

State lotteries attracted thousands of gamblers who established a vibrant secondary market for tickets, which paid interest and were traded in the same coffee house where the London Stock Exchange was born. The government sold annuities to the public, borrowed money from the East India Company, and even created a new East India Company backed by a rival faction in Parliament and raised a separate loan from it.

A Scottish slave trader named William Paterson had a better idea, suggesting in a 1694 treaty not much longer than a Substack record that a Bank of England should be set up to lend £1.2 million to the government at 8% interest . Once established, the new national lender found itself in bitter competition with the goldsmiths, who conspired to engineer a banking operation two years later.

Never short of ideas, Paterson persuaded Edinburgh’s trading monopoly, the Company of Scotland, to establish a colony in Panama to control Atlantic-Pacific trade. Supported by about a fifth of Scotland’s national wealth, the so-called Darien scheme was abandoned within nine months as the colonists fell victim to hunger, thirst, disease, shipwreck, a Spanish blockade and English obstruction. Scotland’s economy came close to collapse, hastening union with England nine years later.

Paterson then proposed to restructure England’s own national debt by exchanging it for equity in a new business with a royal monopoly on trade with Spain’s American colonies, mostly the slave trade. Backed by a shadow bank posing as a sword maker’s shop and with minimal revenue or prospects of earnings, the so-called South Sea Company bribed MPs and sold shares on margin to investors who borrowed from the Bank of England, sending shares soaring. and then plunge into one of the first real stock market bubbles.

If you can see any traces in these frauds of the polite modern financial industry which employs only clean, respectable types with an ingrained sense of prudence and fiduciary duty, you have a better eye than I.

And yet, there is one thing that the financial fraudsters for the restoration of London have fundamentally right, and crypto is fundamentally wrong. When the chips were down in the casino of early modern capitalism, the early investors could count on the government to bail them out. It is far from the situation now. When US regulators have bailed out banks popular with the crypto crowd, such as SVB Financial Group and Signature Bank, it has been to maintain the stability of the conventional financial system, not the alternative, digital one.

Britain’s victory in continental wars was all the evidence needed in the 18th century to show that the new innovations, for all their chaotic effects, were socially useful. The government introduced new taxes on land, imports, key goods and even windows to ensure that creditors were made whole. Public confidence in the government’s ability to raise revenue meant that credit was believed to be as safe as – well, the Bank of England.

The rejection of that lesson was the fatal flaw of crypto. The original white paper outlining the theory behind Bitcoin was written within weeks of the collapse of Lehman Brothers Holdings Inc. in 2008. For libertarians, the crisis had revealed how the alliance between the financial system and the state was little more than a confidence trick. along with insurance policies that can evaporate within hours. Bitcoin was built on cryptographic proof, rather than what it called “the inherent weaknesses of the trust-based model.”

However, trust is still important. That we have a society at all testifies to the ability of trust to extend bonds of obligation and commitment between millions of people, across time and geography. This power is only enhanced by the state’s amazing ability to harness and organize our interdependence to achieve common goals. By rejecting trust and rejecting any social purpose beyond personal enrichment, crypto doomed itself from the start.

Can crypto, like early modern capitalism, be reborn from its ashes? It’s hard to be optimistic. There have been many proposals to harness the blockchain to a cause as existential as the continental wars of the early modern period – climate change. The World Bank is trying to use technology to clean up the emissions reporting mess. Carbon offsetting and ESG investing, two fast-growing fields rich in both investor interest and self-promotional shenanigans, are in dire need of standardization.

However, making this proposal work will be challenging, especially as many blockchain innovations appear to be running into the ground. The world’s largest container shipping company AP Møller-Maersk A/S and Australia’s stock exchange owner ASX Ltd. both abandoned plans to use blockchain in their business last year.

If this technology is to be harnessed for the public good, it must find a way to use it to increase levels of trust, rather than avoid the problem or, worse, treat trust itself as harmful. That’s going to be hard to do in the wake of a multi-billion market collapse and a flurry of lawsuits. Still, it’s probably crypto’s last chance to turn itself into something lasting, rather than a bubble that sparkled for a moment but was forgotten as soon as it popped.