The Big Crypto Struggles with Basic Accounting and Economics - by Martin Walker - 50 Foot Blockchain Attack


guest post by martin walker

The leaders of “Big Crypto” seem to have a big problem understanding the basics of conventional finance – such as balance sheets, auditing and cash flows.

Changpeng Zhao, also known as “CZ” from cryptocurrency exchange Binance, newly described how they managed over $580M worth of FTT crypto tokens: “We never touched on it, actually kind of forgot about it.” Sam Bankman-Fried has expressed endless confusion about asset management by cryptocurrency exchange FTX and hedge fund Alameda.

Even before the FTX collapse, Sam had some unusual ideas about the methods the crypto industry uses to generate value:

… the smart money is like, oh wow, this thing is now yielding about 60% a year on X tokens. Sure, I’ll take my 60% yield, right? So they put another $300 million in the box and you get a psycho and then it goes to infinity. And then everyone makes money.

Cynics such as most of the mainstream media and the Securities and Exchange Commission (SEC) have finally started to buy into the idea that much of Big Crypto is run by recklessly incompetent and/or criminal people. Maybe some of them are. But it’s worth trying to understand how billionaires (and recently ex-billionaires) developed their ideas about the financial world.

In 2016, I co-wrote an article that pointed out that cryptocurrencies like Bitcoin are “an asset without a liability”. In other words, “created out of thin air, defying the laws of double entry accounting”. Financial assets are always someone else’s responsibility. If they are not liabilities to another party, who is going to pay the returns on the asset that ultimately gives it value? No one, therefore, they have no core value.

The big crypto companies have been buying and selling “nothing” for so long, mostly in exchange for different pieces of “nothing”, that many actually believe that taking nothing, giving it a name – and sometimes a history – combined with a one little trading with friends, gives “nothing” enormous value.

Regardless of whether large valuations for “nothing” tokens have simply driven up the market price of old-school cryptocurrencies or the creation of complex DeFi (Decentralized Finance) structures, the belief in the value of nothing makes it easy to lose sight of the fact that nothing exists. Underlying Reality: It is the real money inflow rather than “the technology”, “the community”, “the network” or “freedom” that gives value to crypto assets.

A crypto enthusiast who struggles with the idea that financial assets have corresponding liabilities should find the concept of a balance sheet quite impressive. Unfortunately, the basic accounting misunderstanding is reinforced by fundamental misunderstandings about banking and economics.

Big Crypto leaders, including those regularly interviewed on shows like CNBC, seem to have learned about banking and finance by repeating fairy tales to each other in tweets and old blogs based ultimately on Austrian economics. Most of them seem to genuinely believe that banks “create money out of thin air”, selfishly enriching themselves and defrauding the public by creating inflation. If they had some understanding of balance sheets, they might understand how making a loan creates an asset for the bank (the loan) and a liability (the funds placed in the borrower’s account) and that the bank is not creating money for itself. out of nowhere, even with credit creation controlled by the requirement to have sufficient capital.

Oddly, given the contempt for inflation that spawns fiat money, Big Crypto actually creates “money” out of thin air. Their preferred way of dealing with the resulting dissonance is based on further misunderstanding. They believe that having a fixed supply of any given token – representing “nothing” – protects against inflation. Even though some of the top cryptocurrencies like Ethereum and Dogecoin don’t have a fixed supply.

Perhaps if they studied some basic monetary economics and learned all four letters of the Quantitative Theory of Money equation:

In plain English, the price level (P) is kept constant only – that is, no inflation — if the speed at which money (V) is spent is constant and there are real expenditures on goods and services (Q). Since there is no actual crypto spending on goods and services, it really doesn’t matter if the money supply is fixed.

Which brings us to the crypto industry’s struggle with the concept of auditing. CZ said about audit firms that “Many of them don’t know how to audit cryptocurrency exchanges.” With the crypto industry largely living outside the fundamental laws of finance and economics, what hope do auditors have of applying their antiquated ideas about assets, liabilities and balance sheets? Very little – but not just because of the crypto industry’s struggle to understand the basics.

One of the tenets of the Crypto faith is that everything is transparent “because it’s on the blockchain”. Audits are not really necessary and, if they have to be done, they involve complex mathematical analysis. Unfortunately, blockchains don’t make things transparent in the old-fashioned way that auditors like. A certain amount of cryptography can be held at a given address on the blockchain – but that doesn’t mean it’s under the control of the party being audited. An auditor cannot simply see an asset in the accounts and reconcile it with a bank statement.

In the crypto world, the best guarantee that you own the cryptocurrency you claim is to move some cryptocurrency from one address to another and hopefully back again – as Craig Wright famously failed to do. Unfortunately, even this gives limited warranty. A conventional audit can verify who is authorized to move funds from a bank account. In the crypto world, anyone who has seen the private keys related to crypto funds can pick them up, and there is no central part to ask if they are authorized or even reverse the transaction.

Hopefully now the reader has a little more sympathy for the poor confused Big Crypto leaders. If any of them end up sadly in prison, the least society can do for them is provide them with some basic accounting and economics courses. Something sure to help with rehabilitation. Perhaps taking the right courses could be a condition of probation to encourage more diligent study.