Imagine a world in which you did everything right, and then lost anyway. You saved money, contributing pre-tax to your employer’s 401k. You never took money out, you compounded your gains, you lived within your means. You bought index funds from Vanguard. You watched your friends buy flashy cars, take on debt, and live paycheck to paycheck. But you? No, you were playing the long game. You deferred satisfaction. You were setting yourself up for life. You did everything by the book.

Then one day, you woke up and it was all gone.

How would you feel?

The crypto equivalent of this happened to a friend of mine, and it should raise some questions about many of the core beliefs in the space.

Ideological Foundations

In the bitcoin community, one of the core principles that many hardcore bitcoiners espouse is self-custody. For those of you who are not crypto people, this is essentially “be your own custodian”, and would be the traditional financial equivalent of keeping your stock certificates locked in a safe deposit box instead of having them with your broker dealer, or maybe keeping all your cash under the mattress inside of a bank.

This is something the modern financial system mostly does not do. There will be a lot of gnashing of teeth, hissing, and screaming from some libertarians about how this is a plot to control everyone and create some sort of financial surveillance state slash techno-oligarchic feudal system, but the reality, as these things often are, is way more banal: actually people were just losing shit constantly.

If you look at the history of financial markets prior to electronification, one of the things that stands out is how big the inefficiency and deadweight loss is. You still see this today with cash. Has anyone here ever lost a stock in their brokerage account? As in, not sold it, not lost money on it, but literally misplaced it? Like one day your 100 shares of Apple stock were there, and the next day, they were not?

That happens all the time with cash. Much of the modern financial order is because of this problem, not some grand conspiracy. It turns out it’s helpful that all of the things be held in places where you can track it, it won’t be lost, and you can settle it efficiently.

However, in the bitcoin community, self-custody is often the default recommendation. Why? Because the community was founded on a deep distrust of all institutions, and a refutation that they might provide any value. In some places, this is probably correct; I am not exactly excited to leave my money in a Venezuelan bank, for instance. However, in many other places, what you are saying here is “I trust myself and my ability to assess safety more than I trust JP Morgan to treat me well”.

Is that a good bet? Many people seem to think so, despite all the evidence to the contrary.

This profile is sort of the same mental error that leads people to support communism over capitalism, despite the former dramatically underperforming the latter on both economic and human outcomes every time it has been tried. Why? The harms are easy to envision (picture a mustache twirling billionaire, and then the poor in the streets), and the gains are hard to envision (picture hundreds of millions of poor children who did not starve to death because of Archer Daniels Midland). Even so, if you take a structured utilitarian view and stack them up against each other, capitalism outperforms dramatically: it does a better job of lifting the poor out of suffering, and it does a far better job of not murdering tens of millions of people for not doing what the government says. In fact, basically no capitalist country has ever killed even 5% of the people communist countries routinely do. And yet people seem to hate capitalism and prefer communism repeatedly? Are people just stupid?

“Yes!” shouts my old behavioral economics professor.

Visibility Bias

Deep in the shadows of the past, I used to work in reinsurance, and one of my favorite behavioral economics findings comes from that industry. I got into the space because the kind of mathematics I was studying became particularly relevant in the post 9/11 era, as it turned out to be the kind of math that was being used to build terrorism risk models. Math is weird!

However, insurance is also a] hotbed of weird outcomes in behavioral finance, because of visibility bias. My favorite experiment is one where travelers were offered trip insurance, covering all sorts of outcomes that could disrupt their travel, for a fixed price. They usually declined. However, when offered the exact same price for trip disruptions due to terrorism, they would much more frequently say yes. Read that again. Terrorism is a subset of what the first policy covered; it is strictly better! You are protected from more things! For the same price!

Yet people would consistently decline that, but accept a more limited policy covering only terrorism for the exact same price? Now you see why my professor thinks people are stupid.

So what is going on here?

The people taking these outcomes are basing them on availability bias: they are scared of a thing they can easily imagine, and so protect against that. This is not a deep probabilistic analysis. You may think your brain is weighing all the possibilities in a matrix and then making a decision based on that, but unless you are quite neurodivergent, you are almost certainly not doing that. You are making a decision based on fear, and then rationalizing your way into why it “makes sense”.

Self-custody is the same thing. More people lose their bitcoin due to theft, due to hacks, or due to simply losing their private keys than lose them due to bad behavior by regulated custodians and exchanges. An important detail here: regulated. Nobody is saying to go trust FTX or some shady offshore exchange. Don’t do that! The track record there is also very bad.

However, if you think a custodian regulated by the NYDFS or JFSA is stealing all your funds, with no procedures in place, with higher probability than you just losing your own keys, you’re doing the terrorism insurance thing.

Coldcard

My friend from the introduction basically did this. The problem was knowable in advance, with certainty, and I say that because I’ve been telling him for years not to do the thing he did, which was keep almost all of his savings in bitcoin, and then keep that all on a single device.

His rationale was simple: institutions are not be trusted, because of both 2008 and the fact that the rich will steal from the poor and the political system in the United States is deeply corrupt. Therefore, his odds are much better holding his money himself than trusting a centralized entity. Decentralization, you see, was the optimal goal.

As an aside, you can tell we are in the terrorism insurance problem with that phrasing: if he truly believed that, he would have been decentralized in terms of assets and holding locations. Decentralization to him actually meant: “extremely centralized somewhere else, away from the problem I am imagining”, and the entire framework was backward rationalization to do what he wanted to do in the first place: take his money out of the US financial system.

So what happened? He did a bunch of research on this, and followed the gold standard recommendations in the Bitcoin space: a cold storage device, kept in a secure location, where it was hard even for him to access, and would likely be safe from any disaster. Only one other person, a parent, knew about the existence of this device. That device was also, unfortunately, a Coldcard device.

My friend did not do the coldly rational thing: diversify across gold, bitcoin, cash, stocks, and bonds, at a variety of institutions so even if one fails, many of the others are likely to survive. No, he was maximally centralized: one asset, one provider.

Trust Assumptions

Bitcoin is founded on being “trustless”, so the great irony of this situation is that it turns out you need a whole lot of trust to use it. In this case, my friend had placed his trust in the Coldcard device and designers, which if you have been following the news on this at all, turned out to be a terrible idea.

To paraphrase quickly, bitcoin is safe because of cryptography, and that only works if you do it properly. If you generate properly random key phrases, you’re great! But if you don’t, if they are easy to guess or replicate, someone else can steal your stuff. Guess which one of those Coldcard did, because of something that is either a bug or a deliberate insider exploit to allow theft? That’s right, the bad one.

So there has been over $100mm of BTC stolen from these devices, and more will be coming. It is the largest self-custodial hack I’m aware of at this point in time, and it raises an important point about the difficulty of actual self-custody, which is simple: unless you are doing the cryptography yourself, you are trusting someone. You’re trusting someone different than if you were trusting a regulated financial entity, but you are still trusting someone. In this case, you were trusting programmers who turned out to be some combination of incompetent or corrupt, but the outcome is the same as leaving a ton of money above the FDIC limit in a rural bank that fails: you are screwed.

The core problem with all of this is the terrorism insurance problem. That is to say, the bitcoin people were operating on religious beliefs and fear rather than deep, rigorous analysis. If you had actually been trust minimized, you would have been using open-source code, compiling it yourself, keeping it across multiple devices, and in what is probably a fatal error for the satoshi’s witness belief system, keeping it across multiple assets.

Lessons in Anti-Maximalism

I’m not writing this to dunk on these people. I’ve been warning for years that self-custody is less secure than institutional custody for most people. I’ve publicly stated the bitcoin that I own is held in ETF form, not in any personal wallet, because I trust Blackrock, Fidelity, Franklin Templeton, etc. to do a better job of this than me. Am I making a trust assumption? Yes, I 100% am. And I might make a different one if I was a political dissident in Russia, but being a college professor in the United States, I think this is probably the right call.

However, there is a bigger lesson here beyond “don’t trust a device you don’t understand”, and that is about actual trust minimization and decentralization.

Every point at which you concentrate things is a form of trust. That can produce outsized gains (if you own the one asset that goes to the moon, as many early bitcoiners did, you will be quite happy), but it also creates outsized risk. Your volatility is concentrated in both directions. So you need to understand what you are doing, and why you are doing it. You also need to step back and ask how well you understand things, which is hard. So here are some useful principles I use to troubleshoot this:

1 - If you have to assume the largest asset you hold goes to zero, what kind of shape are you in?

2 - If you have to assume the largest holding container you have is compromised, what kind of shape are you in?

3 - If you have to assume that your main form of making payments is disrupted, what kind of shape are you in?

In short, if you have a single point of failure, what happens if it fails? What is your central expectation in those cases?

As you can see from my friend, he fails on two of those (1&2). This is the folly of the bitcoin maximalist: by distrusting the system so much, you have created critical reliance on your alternative path, and if something happens, you are fucked.

If you want to make that choice with eyes wide open, I’m not going to stop you. You can. You should, if you truly understand it and think it’s the right one for you. My advice is simple: make sure you understand that.

So if you are a self-custody or bitcoin maximalist, you need to ask the three questions I said above, and you need to be comfortable with your answers. You don’t get to assume a bad thing happening is not possible. Bad things happening are always possible. Trust me, the world is endlessly creative about bad things.

Do your actual research, which means the first thing you need to research is yourself, your internal biases, the decisions you are making due to availability of mental images of risk, and the assumptions you have embedded.

Or, put in the words of my old behavioral finance professor: “Accept you are stupid, and work with that. We all are. I am. You are. Everyone is. If you deny it, you will make mistakes. If you accept it, you can begin to be less stupid.”

Harsh, but fair.

And if you know a bitcoin or self-custody maximalist still doing this stuff, send them this article and ask them to honestly answer those three questions. They probably won’t, but you will have at least made an honest effort to help.

A final note: most of my work now lives over at Zero In. You can find it here.

We are witnessing the greatest demonstration of the horseshoe theory of politics in our time. They say a picture is worth 1,000 words, and this picture has 9 words on it, so let me start with a picture worth 1,009 words:

Why am I leading with that, knowing it's going to enrage both the far left and the far right simultaneously? Well, let us talk about what a tariff is and how it works.

Definitions

First, let's all speak the same language on some things. To understand what is going on, we need to have a common understanding, so I'm going to lay down some terms to make clear what I mean. If you disagree with what these are or functionally how they work, that's a fact-based determination we can evaluate, after all.

Tariffs

A tariff is generally defined as a tax or duty imposed by a government on goods or services imported into a country. Tariffs are used to raise revenue for the government and, often, to protect domestic industries by making foreign goods more expensive compared to locally produced goods. Tariffs are typically paid by the importer (e.g. the domestic company importing the goods).

Trade Deficit or Surplus

The U.S. trade deficit is calculated by measuring the difference between the value of goods and services imported into the country and the value of goods and services it exports. Here's a simplified formula:

Trade Balance = Imports−Exports

If the value of imports exceeds the value of exports, the result is a trade deficit. Conversely, if exports exceed imports, the result is a trade surplus.

Imports and Exports

As best I can tell, import and export values themselves were likely sourced from U.S. government data, such as the trade statistics compiled by the U.S. Census Bureau and U.S. Customs Service, which track goods transactions annually via the FT-900 report etc.

These figures focus solely on physical goods (e.g., machinery, vehicles, agricultural products) and exclude services or digital trade, which are significant but harder to quantify in traditional trade balances. Those are "imports" or "exports" but not always captured. Nuance, but an important nuance.

You can check this by comparing data sources, but I'm relatively certain the figures here exclude high margin services businesses. If someone from the Trump admin would like to provide me the data they used for the calculation to confirm or refute this, please drop me a line.

Baseline Stances

The overall stance of the economics profession and most finance professionals is that tariffs are counterproductive. Essentially, blocking yourself from buying cheap goods from others is going to cause inflation without increasing net productivity. It is saying that a tiny island like Kiribati with no advanced economy producing fish for you at subsistence wages is an insult, not a good thing, and thus you should make fish massively more expensive so we can force Tom from accounting to leave the office and go out on a fishing boat to fish for us locally.

The traditional counterpoint to this comes from the national security crowd, who would state that tariffs on certain industries, while they may increase costs, are a national security imperative to make sure that we have local (both geographically and in terms of political control) industries that can produce the things we need in a time of conflict. In their world, if Kiribati sells us all our food but goes to war with us, we starve. Therefore, actually we do need Tom from accounting to leave the office and go out on a fishing boat to fish for us locally.

I would contrast these two views as the global optimization view vs. the local redundancy view. Note there is probably no correct answer and the balance lies on a continuum between those two groups. For some industries (defense manufacturing, agriculture, medicine production) the national security argument is extremely strong. For other industries (children's toy production, entertainment, luxury goods) the national security argument is much weaker.

The other element to balance between those two views is the concept of short-term vs. long-term preference in how you think about these things. It's entirely possible that the national security view does cause short-term pain, but the theoretical tradeoff is long-term defense and liberty, so the argument is that if we didn't do it, we end up worse off when the violent, aggressive, evil Kiribatians invade our country and enslave us all.

Note: I don't actually believe this about Kiribati, just to say that out loud because approximately 33% of the internet does not understand humor.

Trade Balance

Is a trade deficit a good thing or a bad thing? Is a trade surplus a good thing or a bad thing?

Is a hammer a good thing or a bad thing?

These are all related questions, in that context is required. If I use a hammer to smash your car window and then beat you in the face to steal your vehicle? Probably bad! If I use the hammer to build a house and then sell it so we have more housing? Probably good! The context is really important here.

So let us consider the case of some real world trade deficit scenarios:

First, let's go back to our lovely example of a tiny island nation. Say they have zero tariffs on the United States, but also, unfortunately for them, also pretty much zero economy. They export a bunch of fish they produce cheaply and import basically nothing, because they are super poor. In that case, they are selling us cheap food, taking nothing back, but also have no capacity to take anything back. Nobody needs a $50k SaaS package there; Marc Benioff is powerless. Second, let's consider a country rich in natural minerals and with some local economy. Here, you can think of some oil-rich nations or similarly situated. There, we could be buying a natural resource we need more cheaply than we could get it somewhere else, which necessarily pushes the jobs to produce those resources there. Here, instead of Tom from accounting going out on a boat to fish, he's working on an oil rig. Upgrade or downgrade? YMMV. Either way, he's not in accounting. In this case, these countries do have the capacity to buy things from us, just less than we buy from them, and often it will be in the form of services (they hire our oil companies to run their stuff!), which hilariously will not be included in the trade deficit calculation above. So even if they run a trade surplus, it, uh, might show a deficit if we ignore the services we provide back to them. Third, let's consider a country like China. Here, we have someone who is deliberately attempting to deflate their currency to lower labor costs so they can bring manufacturing jobs onshore. They are also stealing IP from companies whenever they bring jobs there. They have large barriers internally to outside goods but allow a much more free market in internal goods. This would be the classic example of extractive protectionist mercantile policy, and in this case, the exports back to them are artificially low because of the internal trade barriers (as opposed to for core economic reasons, like in the case of the destitute island that only has fish). Particularly, they appear to be trying to establish a near-monopoly over certain strategic industries with this approach.

So now that we have some context, let us say that we run a trade deficit with all three countries. In each case, is this trade deficit a good thing or a bad thing? My personal ranking would be good, good, possibly bad (the natsec argument carries much more weight here). Your mileage may vary on that, but it's important to expose the reasoning and the bias. If you think bad in all three cases, I think you're missing something important about core economics (specialization of labor exists for a reason and why are we upset with cheap good fish at low prices as a small part of total trade vs. making Tom from accounting take a 97% paycut to do hard manual labor), and if you think all three are good, you have completely discounted the natsec implications of outsourcing to zero. The truth is likely in the middle, if we are being fair to both sides.

If you don't agree with me on this, considering the following: as an American citizen, you personally run a trade deficit with Amazon, Walmart, Target, Costco or some combination thereof, most likely. I think we all agree there aren't really national security implications to buying a Costco hot dog. Therefore, should you tariff them if they don't buy your services in response? If I'm a hairstylist, should Amazon have to send their employees to me? If I'm a dog walker, should Costco have to buy some dogs to have me walk them? If not, should I tariff them massively?

Kind of silly when you look at it that way, huh?

Fuck the Poor

Donald Trump appears to hate the poor island nation. What I mean by this is that the way the tariffs have been implemented punish a nation like Kiribati for being poor.

The "reciprocal tariffs" are based purely on the trade deficit we have with countries. As we just discussed above, not all trade deficits are created equal. If a truly destitute island nation sells us $75mm of fish that they produced at sub-minimum wage levels, but imports nothing, Donald Trump is slapping massive tariffs on them for their "abusive" behavior towards the United States. This is true even if they have literally zero fucking tariffs on anything coming in, they just don't have any fucking money because they are destitute.

The median income in Kiribati is about ~$3400 AUD, or ~$2150 USD, just to be clear. The US median household income is roughly $80,000. We are 40x wealthier than Kirbati, and now our trade policy is essentially going to punish them for being poor. What are they supposed to do to eliminate these tariffs? Suddenly get super fucking rich so they can buy Salesforce subscriptions (oh wait, that doesn't even go into the calculation as an intangible good). Guess they have to buy... Teslas on their tiny island?

This plays out repeatedly when you look at the tariff rates for poor nations that sell us things cheaply and have limited to no capacity to buy anything from us. Essentially, Donald Trump's tariff policy says that if you are poor and all you have to sell are natural goods and cheap labor and have nothing internally to buy with, you can get fucked and die. I might not even be exaggerating there; given some of the little that these people buy from us often are goods to keep their subsistence levels of agricultural production going, we may be damning millions to hundreds of millions of people to starvation.

Back to the Mines, Tom

Now let's return to Tom from accounting. Tom previously had a job working for a company that provided accounting services to US firms, maybe somewhere boring and staid in a midwest city of <500k people, and had what could be described as a perfectly adequate life.

He had a house. It wasn't fancy. He has a car. It's a Hyundai Elantra, a few years old, not exactly a model of glamour but adequate. He's got an iPhone that is a few generations old. He's married and has one kid. They go to a perfectly adequate public school.

Guess what, Tom? You're about to get fucked.

First of all, everything Tom buys is about to go up in price dramatically. Why? Because we just banned poor nations from selling to us cheaply, meaning the $40 sneakers that Tom wears that were produced by a 50 year old woman in Vietnam working 65 hours per week in a sweatshop at <$1 per hour wages now need to be produced by shiftless, kind of annoyed they have to be there teenagers and 20-somethings in the United States, at a minimum of $15 per hour for 1/4 of the productivity of the woman in Vietnam. Oh? That doesn't work economically? Then you just have to eat the 90% tariff to Vietnam to the face, meaning Tom's $40 sneakers now cost $76, assuming no other impacts.

And there will be many, many other impacts. That Hyundai? Now 2x the cost to repair, if you can repair it at all. iPhone? 50% more expensive. The house? Yeah, that too. The next time Tom's washing machine breaks, it's not getting replaced. They are back to washing clothes by hand because everything is so expensive things have to be cut somewhere, and given how much food and basic power now cost, the cuts have to come from things they really would rather have.

Oh, and Tom is crippled because he's missing an arm and has only one eye. You think I'm joking when I say that, but I'm going to remind you that we just put Tom on a commercial fishing boat because his accounting firm closed and someone has to find us food. For those of you who have never worked on a boat like that, it's hard, dangerous, and grueling labor. There is a reason that the overwhelming supermajority of on the job fatalities are men working in blue collar industries like the one we just assigned fat, out of shape accountant Tom to. He's going to get paid less, work a far worse job where he never sees his family, lose his washing machine, get maimed in an accident, and then some bean counters in Washington are going to ask him if he's tired of all the winning.

Fetishizing Low Value Labor

I don't agree with Milton Friedman about everything, but one thing he was definitely right about is that we should not be obsessed with low value labor. The (apocryphal but directionally accurate?) parable of reducing productivity attributed to him lays that out nicely: "While traveling by car during one of his many overseas travels, Professor Milton Friedman spotted scores of road builders moving earth with shovels instead of modern machinery. When he asked why powerful equipment wasn’t used instead of so many laborers, his host told him it was to keep employment high in the construction industry. If they used tractors or modern road building equipment, fewer people would have jobs was his host’s logic.

“Then instead of shovels, why don’t you give them spoons and create even more jobs?” Friedman inquired." This is the mistake we are making with the blanket tariffs on low value production imports. If you want to know why I used the image up at the top, this is why. Fundamentally, we looked at the sweatshop in Vietnam I referenced above and instead of saying "thank fuck I work in accounting, that would suck, and I'm thankful someone is willing to do it" we instead said "actually, we want those sweatshops here".

Read that again. We want the sweatshops back.

If you believe the tariff policy is about employment and trade imbalance based on the implementation we have engaged in, you must necessarily believe that statement.

After all, if it's purely the natsec argument, we would be trying to automate the fuck out of factories to produce strategically important assets (and, to be clear, I'm sympathetic to that).

But punishing Vietnam for selling us shoes cheaply? What are we even doing here, unless we are saying that either:

1 - The US should absorb significant pain so we can exterminate the poor in other countries once and for all

or

2 - Actually we want those sweatshops back in the United States

Degrowth but Right Wing

The exceptionally strange part of this whole saga is that we just had a president lose an election over exactly this economic plan (or at least, this was a large component of the loss).

While it was expressed differently, the political goals of the Biden administration also aligned with the strange, obsessive desire to force Tom the accountant back out of the office and into manual labor.

In this case, the revitalization trade policy was based around reshoring American jobs in manufacturing, just like Trump. Through Biden, it was done with a combination of repressive antitrust (see the blocking of Nippon Steel's acquisition), using the banking regulators to crack down on both tech and crypto access that were globalizing money flows and creating alternative vectors to state-controlled economic activity, and a general animus towards the tech sector producing things that were not "real".

At the same time, the energy policy of "stop producing it here and raise prices" created a deceleration effect similar to what the Trump administration will achieve with tariffs, that is to say primarily raising the costs on American businesses while using the exact same amount of stuff as previous. In one case, it's a tariff on Vietnam, in the other case, it's blocking them from buying market rate energy to instead use "green" energy.

Also a weird refusal to build houses that drove prices up, which is related to making the cost of building houses much higher by putting tariffs on all the inputs to a house.

Both of these lead to the same place: the populist anti-elite degrowth agenda. An idealized version of happy Americans living in rural (if right wing) or walkable anti-car (if left wing) villages, where everyone does a job that involves producing goods with their hands (somehow pictured as sunny and happy instead of sweaty, injured coal miners in both cases), and nobody uses the internet (on the left, to break the tech monopoly, and on the right, because China is mind controlling us with Tik Tok).

The outcome, however, is the same, and weirdly dovetails with the Communist revolutions in Russia and China - massive regressions in quality of life combined with repression that leads to things like starvation and displacement. Decelerating the economy does not work the way you think, after all; it actually just straight up decelerates, you don't have beautiful glide paths into utopia.

Oh, and the jobs you create? Low wage, power to capital, replaceable, physically backbreaking. Sweatshops for everyone!

What Year is It!?

The current moment in American politics is a strange one. It is as if someone took parts of the French Revolution, the movie Idiocracy, and Peter Zeihan's "The End of the World is Just Beginning" and baked them all into a cake. Or maybe, given the haphazard nature of what is going on, a stew. There is less planning than a cake, to be fair.

We have the anti-elite populist moralist belief system that emerged in the French Revolution, with Elizabeth Warren on the left and Steve Bannon on the right positioning themselves as the would-be Robespierre's of our moment.

We have people like Lutnick making fabulous claims about the efficacy of tariffs that fly in the face of reality but are nonetheless believed by the masses and create an anchor point that drags us down to the bottom of the ocean, just like Jacques Necker and his cooking of the books in the Compte rendu with ordinary vs. extraordinary expenses.

We have a previous economic regime collapsing under its own weight an inefficiency, just like the Ancien régime, only just like the French instead of a considered, clear effort at reform we're just descending into chaos as we see what sticks to the popular conscious at any point in time.

Against that backdrop, we are rapidly deglobalizing the world in a way that will break supply chains, decrease aggregate productivity, and drop standards of living, similar to the descent into the dark ages in Western Europe when the Roman Empire collapsed. This was Zeihan's core prediction in his book, and whatever you think about his call on Bitcoin (wrong), his call on geopolitics has been much better.

In short, all of the signs point towards chaos, displacement, and economic and political suffering.

Now What

The way out of these moments is not easy, but I think it starts here:

We have to reject incompetence. This is the Idiocracy component I mentioned above. If we want a well thought out tariff strategy in the interests of national security, I am not opposed to that (I might even be for it). But if we want a president vibe-prompting AI models to give him tariff strategies where he's shooting from the hip while not understanding what a trade deficit is where the end goal is the destruction of poor countries globally, we should reject that in full. Not gently. Not partially. In full. This is why I am writing this; now is not a moment to fall into tribalism (left or right - notice Biden was doing this same dumb shit in a different way). Now is not a moment to shy away in the face of history.

Rather, we must insist and demand that any of the leaders running our country have a clear, positive, coherent, and functional vision for the future. We need way less reality TV star and way more Paul Ryan energy (yes, he's boring, but he was right). And if we can't bring ourselves, as Americans, to do this, we're going to be tumbling down the hill into some mix of Idiocracy and deglobalized cyberpunk dystopia with only ourselves to blame.

This topic has come up repeatedly in the past few days, with two founders I really respect, with C-level executives and senior managers at major companies, with a VC who I think highly of, in group chats, and now this whole founder mode discussion.

Something is in the air about this. So I want to start with describing the problem that motivated some of these discussions from founders/owners/management down and then explore why I think the discourse around this is so profoundly broken from both sides.

First, what's the problem? I see posts circulating like the alleged Amazon engineer who has done zero work for years, I see things like Elon Musk taking over Twitter and massively downsizing the company without much impact, and I hear complaints of employees quiet quitting.

I also have managers telling me they cannot staff up effectively with good talent. That their best people are constantly on the move and tenure is now averaging less than 2 years for many hires. That it creates a constant treadmill meaning people spend more time onboarding and getting up to speed than working, and that they are increasingly unwilling to spend time training or investing in employees because the turnover rate is getting so high. Lastly, this drives things like RTO initiatives and paralyzes hiring managers, and everything freezes.

Second, let's do something important that doesn't happen enough, which is to look at the other side. Why do employees feel this way? The average millenial / gen z'er watched the paradigm shift from their grandparents having stable jobs for decades to their parents slowly tumbling down the hill, being laid off, bouncing around, and many of their older siblings, friends, or family members being unceremoniously fired in the financial crisis and then repeatedly switching jobs afterwards. 

Employers have been extremely clear, in the past 40 years, that employment is at will and can be terminated at any time, that the company owes you nothing, and that if they want to let you go to make the quarter's results look good, they will. More so, these decisions have not been remotely based on merit or efficiency, but rather internal politics, dysfunction, external signaling value, or honestly, just apparently random! The message is clear: you're expendable. This means there's no longer community, shared purpose, or meaning at work for a lot of these people. If you ask why they do their job for reasons other than the paycheck, here's the most common answer: no, it's just for the paycheck.

If you are an employer, stop right here. Pause. Go back and reread all of that. Really think about it.

This is where almost 100% of people who work for you are at.

Third, how did we get here? I'll start with a quote:

“Show me the incentive, and I’ll show you the outcome.” - Charlie Munger

Let's step back and dispassionately look at the incentive structure in which most employees operate, and I'm going to talk about a few frameworks so that we don't just over-focus on big tech or something.

One: most people get a salary. Sometimes these are quite good. But importantly, there is either no or very slow upside to salary. What this means is that while people need it, salary makes people risk-averse. You can lose it, but you can't really gain from it.

Two: some employees get a bonus, but outside of finance front office roles and execs (where bonuses are often several times larger than salary in many cases), that basically means salary dwarfs the impact of a bonus.

Three: public company employees are often paid in stock. Now, if these employees were long-term employees who felt a connection to said company and invested / involved in the results, this would align incentives well. However, in a world where the average tenure is below five years, this basically functions as just more cash. 

The fundamental structure of tying employees to a company and the results long-term does not exist because they are not long-term holders and, more so, a lot of the future comp can also be clawed back or voided if they are fired. Which I will remind you, companies can do for any reason. Or no reason! So employees naturally value this at zero until it is received.

Private company employees, not to leave them out, who are not early-round often view their small equity shares the same way.

And reminder, again: they can be fired at any time for no reason.

Fourth, where does that incentive structure leave most employees? If you are perceptive, you can already see the problem. Simply put, employees believe they have no personal control over upside (so the stock / equity is a lottery ticket), have a huge amount of downside from rocking the boat or trying to make changes (because political managers can eliminate them), and have no long-term ties to the company they work for because they can be eliminated at any time.  If this is the position you are in, and you are rational, you are going to do one of the following:

One: check out and quiet quit while collecting that salary for as long as possible. This is the nihilism position. None of this matters, you're just there for the salary, so the goal is keep up appearances, do minimum work, cut the check, go home.

Two: use it as a platform for your future. By which I mean try to get on notable projects, talk to the press, write a blog, or use the corporate platform as a vessel for personal reputation, and use that to leapfrog to the next job where you can rinse and repeat to move up.  It’s usually your best performers who can do this, too.

That tactic does have a shelf life (the 10th time you do this well into your 40s people are wise to it), but it's a powerful way to get from junior to mid/senior management very quickly in many cases. That's where the effect usually slows down. But in the interim, they have created a ton of value for themselves but often not much for the companies on the way. These people are returning the favor, so to speak, of corporate disloyalty.

Three: active hijacking is a third. This is when employees have a mission other than the corporate mission (political causes, pet projects, etc.) and they essentially use the company as a vessel to support these things. There's no meaning in the company itself, so they create that meaning by hijacking it for personal goals.

So employers, do any of those sound like your employees? Actually, multiple of them probably sound like your employees, right? Here's the problem: all of those are perfectly rational responses to the situations many employees find themselves in. If you want to be angry about that, you're being angry that the sky is blue or that the sun comes up every day. It's reality. And in this case, you helped create that reality, so you really, really don't get to be mad about it. It is what it is.

Fifth, these same poor incentives are also part of the problem with management. When you have that set of employees, it's easy to view them as costs to be minimized. Your high performers seem to constantly use you as a stepping stone and everyone else is slacking or hijacking. That’s not a healthy group, and they are annoying and troublesome to deal with, and getting more so by the day. Wow, these younger generations are terrible, aren’t they!? you think to yourself, angrily.

This sort of thing also just increases the problem, as now companies are more apt to treat employees like a cost to be minimized. It also leads managers to being scared of employees taking risks to change or improve things, because they don’t stick around and just create chaos and the manager will be left holding the bag. Also, when there’s a lot of hijacking, it’s hard to tell genuine requests for change from “hmm, is this really good” type nonsense. Essentially, this paradigm raises the effort level for good management and requires even more work from managers, or they can just fall into the same paradigm and start risk minimizing themselves which often means cutting the loudest employees down by laying them off or getting them to move on, and then managing large teams of quiet quitters and focusing on metrics that make you look good and are performative rather than actual indicators of quality. I guarantee you, if you are a c-level executive or founder at a company with 100+ people, you have managers doing this with near-certainty. I’m sorry. It is what it is.

This creates a vicious cycle between employees and employers, where everyone has essentially defected in the style of the Prisoner’s Dilemma, and thus everyone ends up worse off. I want to point out that while the PD is often over-cited, here we really do see that problem playing out in real time: if an employee commits to a company and makes sacrifices to make it better, then gets laid off with no concern by the company, that’s essentially the betrayal option in the classic dilemma. The rational response to that is to also betray, and thus we end up where we currently are. I say that to remind people again not to be angry about this. Given the current incentive structure, everyone is (unfortunately) behaving rationally and you would do the same thing in the other position.

Sixth, so what are solutions to this? I’m going to start by, if you were already angry and upset by reading about this, making you even more angry and upset because I’m probably about to call out some of the things you have thought about as a manager or leader as bad ideas. Luckily for you, I have never given a flying fuck at a rolling donut1 about being popular or being yelled at in public, so I’m actually going to tell the truth here instead of enabling you. Let’s do this:

One: return to office. Listen, there may be legitimate reasons for wanting some groups to be in an office, but often this comes down to lazy managers wanting to exert control over employees so they aren’t quiet quitting. I have bad news. They are going to quiet quit anyways. They just do it differently in the office, scheduling fake meetings, surfing the web on their machine, chatting with people at the water cooler, or starting useless projects that have nothing to do with reality to waste time. It just changes the shape of the behavior. As an additional benefit, you now make people waste 30-120 minutes per day commuting (while you don’t compensate them for this), shrink your potential talent pool from nationwide or global to only people who happen to live around whatever city or suburb you are in, and you piss off every single introvert who works for you who didn’t want to deal with all of this shit anyways.

For those of you about to say “Yeah, okay Austin, but we really did this because we needed to lay people off and we knew a bunch would quit”, I will point out to you there is literally a name for this problem in the business literature and it is called the Deadwood problem. You’re going to lose your best performers most capable of getting other jobs and keep the people without better options. Golf clap. 

Additionally, unless your employees are literal retards, they know you did this to lay people off, and now they trust you even less. So unless you employ complete idiots, you’ve kept your worst people and degraded trust. And if you do employ complete idiots, I have even deeper questions.

So this is not a statement that RTO is not valuable in some cases, but it is a statement that RTO to solve this particular set of problems I am laying out is likely counterproductive (and even if you have good reasons for RTO, you need to consider these downsides).

Two: emphasis on culture or the company as family. 

Bad news: most of you don’t have a culture, and if you do, it probably sucks. Again, people don’t like to hear this, but it’s true. I have worked at six different significant companies in my life, and only one of them had a culture that was worth saying anything about. Five out of the six thought they had a meaningful culture though (and props to the sixth who actually knew they didn’t).

If you are going to develop and maintain a corporate culture, that takes a huge amount of work and has to come from the top. There are entire books about this, but fundamentally, it’s exceptionally hard, gets exponentially harder with scale, and can only be set at the CEO level on down. This basically becomes your full time job as a CEO. More so, you have to live it, walk the walk and not just talk the talk, and make some hard decisions based on this to convince people you mean it. Constantly, not once. Forever. If you’re not doing this (and be honest about it), stop talking about culture as a selling point.

Also, companies are not a family. You don’t have at-will employment with your parents or siblings or children. You don’t get to fire them because of a bad quarter. You don’t put them on performance improvement plans. You don’t have 360 evals with your 3 year old. Employment is a job, and there is a performance bar, and people need to work. It’s not a family. If you try to act like it is, you’re both going to make dumb decisions and come across as a hypocrite. Unless you truly would keep an employee on staff who was a drug addict making terrible decisions and maybe going to jail, and let them drag the rest of the team down while supporting them to try to get them right, stop talking about your place of employment like you’re a family. 

Put differently: if you fire people for any reason short of a felony, you’re not a family, and don’t act like it. The better analogy is a sports team. Again, your younger employees are so attuned to and sick of this duplicitous bullshit that saying nothing is significantly better than lying to them.

Three: non-competes and other restrictive covenants to impede changing jobs. Note I’m not talking about trade secrets or IP here (those are fine to protect), but if you have non-competes for all your line workers, in addition to the FTC coming for your head and the story not being fully written there, understand that comes across to your employees as indentured servitude. If you want to maintain it’s at-will employment and you can fire them anytime you want, but also if they quit you can stop them from working, there’s a word for that: hypocrisy.

This stuff massively damages trust and creates an adversarial relationship from day one. More so, if you actually enforce this against people, you end up in one of two positions. One is that you make enemies for life and scare everyone else away from working for you as the stories get out there. Two is that the employees who remain feel trapped and do even more to quiet quit or get laid off so they can go get new jobs.

As a general rule, don’t have these for anyone other than your c-level execs and maybe one level down from them.

Four: outdated management practices as “improvements” for worker engagement. Guys, nobody wants that office pizza party, I’m sorry. You know they make fun of you for it, right? Likewise, you need to meet younger employees where they are. The number of companies demanding people use things like Microsoft Teams (I apologize for nothing, Microsoft) while being absolutely fucking skewered for being out of touch boomers is unbelievable. Essentially, forcing employees to conform to the 1990s ideas of good communication and management is going to come across as incredibly tone deaf. Since a picture is worth 1,000 words, let me give you a visual of how you look to your employees doing this stuff:

Okay, so I’ve just angered almost everyone in management. Now let’s talk about what could actually work to get out of this situation. The good news is that there are genuinely meaningful solutions here that could massively improve things, but the bad news is that they are hard, and potentially disruptive, and likely going to give a lot of people heartburn to even read about these things. 

I will remind you that the goal is having a highly engaged, loyal, high-performing, high-trust group of employees overall. This is not a statement that those things should be blind (there will be bad apples and you will have to fire people for cause), but it is a statement that all is not lost. I’m also going to draw on some positive experiences I have had or know about, and reference something that a VC said to me describing his perspective (that they have a hard time hiring, but have a ton of exceptionally high performing partners… there’s a lesson in there).

Change how you compensate people. This means higher comp, but over longer timeframes, and equally important, it doesn’t go away (or only goes away in part) if people quit or get laid off. It can completely go away if people get fired for cause.

How does this look? If you’re a public company it means more equity, but over a longer timeframe. If you gave employees a five year vest but on twice the amount, and then keep a significant amount of that even if they leave (we can talk vesting, minimum tenure, etc. but the point is if someone who worked for you for five years leaves and you yoink every cent of remaining equity that didn’t already fully vest, they will always always think of themselves as a mercenary because you need that equity price to be in the future, not the past, for them to be aligned), you’re going to be surprised at what might start happening. 

Suddenly the long-term corporate results matter a lot more to people because it’s where all their money is, and if you aren’t saying “LOL JK” the moment they consider another job or you lay them off, that’s also pretty notable. This behavior is why some forms of partnerships outperform (see: GS historically), because everyone is aligned. Importantly, this works even better if you pay dividends or distribute cash or do buybacks on your stock because then employees double dip on good results between the dividend/etc. and the stock itself. 

This essentially solves for both the timeframe problem and the capital outperforming labor problem by aligning timeframes and turning labor into capital. You are co-opting the issue.

Guaranteed employment contracts. Employers are really not going to like this one, but here’s the punch line: if you want employees not to act like mercenaries who might be cut loose at any time, the number one way to achieve this is to not treat them like mercenaries who might be cut loose at any time. Giving people guaranteed contracts is a great way to do this. Put differently, would most employees be looking over their shoulder if they had three years of guaranteed work in front of them absent a fire for cause? Would that lead people to be more mission committed? Would it lead to more loyalty? More willingness to take risks or deliver hard messages to managers?

There’s also creative ways to do this to minimize the problem of freeloaders or people who are just not constructive to have around (how you structure length, when it extends, probation periods, etc.) that can be managed effectively, but what this essentially does is creates a bilateral bond between employer and employee in a way that is legally enforceable. I know most employers immediately look at that and start hissing, spitting, and freaking out, but if the thought of making that kind of commitment to your employees (or at least the better performers) scares you that much, I have to once again ask: why should they be committed to you?

This is also probably more plausible at large companies, as small ones (especially growing ones) simply might not know what they need or how many people they need. So be it. But it’s a tool that most employers never consider, which is ironic given it’s a way out of the prisoner’s dilemma. But this is the nature of said dilemma: everyone is too busy betraying each other right now to consider cooperating.

Effective management through trust and accountability. Have we stopped to consider just being good at managing, and only having managers you actually need and eliminating layers when you don’t? That maybe coming up with sound measures for evaluating both productivity and collegiality, enforcing them across the board, and then relentlessly rewarding the high achievers while relentlessly eliminating the poor performers (and being honest with everyone why they are being eliminated) might work?

This is hard. It takes work. And it will have to start at the top, where you’re going to have to make tough decisions, fire friends here and there, and generally run a tight ship. But on the other hand, if you tell people things like “work whatever hours you want, but get things done, be there for key meetings, and be responsive to key folks” and then actually live that life, you could do really well. To use a precise example, I know of a company that will remain nameless where one of my favorite people basically doesn’t work on Wednesday most weeks and goes golfing instead. This is the complete, god-honest truth. He’s also one of the best performers at the company. Why? He’s a developer who likes to work at night. If you had a standard manager heckling this dude to be in the office, he’d have been gone years ago. Instead, you have a guy who relentlessly delivers quality work, at hours he wants, who gets the hobby he wants.

Obviously this wouldn’t work for a trading desk (you can’t skip market hours), but the point is that good management is doing effective work through others and maximizing productivity. That is not maximizing hours spent fucking around on reddit pretending to work in the office, importantly. If it was, Japan would rule the world (again, sorry not sorry). It means actually evaluating competence effectively and then solving for it. Most companies could probably benefit hugely from having a hard look at themselves on this basis. Almost nobody will take this advice, though. Partially because a lot of senior managers would have to start by firing themselves under this framework if you understand the Peter principle.

Honesty. You know what else is weirdly refreshing? Just being honest about things. Don’t gaslight your employees. Tell them that yeah, the corporate world is stupid and unfair and you might get fired. That it’s okay to look for external jobs if they improve. That quiet quitting is pretty negative for everyone so if things are that bad, maybe we can find you a different job or help you transition out.

That if you can’t or won’t pay them more or extend loyalty, you can do things to at least make your company an excellent incubator for talent, with a good alumni network, and lots of good people, and you won’t be weird or stupid or hypocritical or strange when people leave for other opportunities.

This level of refreshing honesty about the reality of work, and asking everyone to treat it like a local optimization problem while they are there but not being upset when they leave, tends to help with both performance and the hijacking problem (much easier to call these people out).

So if nothing else is going to work, at least consider being realistic about the situation. Employees will respect you for that, which is a step up from the current situation for most.

Finally, if you want to talk about this, reach out. I have (unexpectedly) found myself in the situation of having to help people with and talk through a lot of these problems. I’m sure this thread is likely to provoke some thoughts, piss some people off, resonate with some folks, and be roundly rejected by others. Such is the nature of life. But if you want help and to actually start making things better (or, if you can’t, at least understanding why and what to do), reach out.

Good luck out there.

Enjoy!

0/ So @GaryWinslett recently asked for a defense of crypto and why he, as a well-situated middle class American who largely thinks our system works, should believe in it or support it. I think that’s a totally legitimate question to ask, and one that cuts to the heart of why the debate has been so broken.

I think it was also asked in good faith, so I believe it deserves a real answer. One of my criticisms of the crypto space is that CT has a bad habit of just screaming at people instead of actually debating real concerns and questions, and I don't want to behave like that myself. Thus, I am going to endeavor to answer Gary in a few parts, and specifically point to some things I think align with the worldview of many antitrust folks, YIMBYs, classic liberals, and those who care about financial inclusion.

In other words, good question Gary, and I am glad you asked.

1/ One important thing to remember is that the starting point here is not neutral. The current position of the American government with regard to crypto is hysterically against. @SGJohnsson has a good thread on the receipts that I will put in the appendix of this post1, so without turning this into a very long post about the wrongdoing of the Obama administration with regard to crypto, it’s important to understand that the current position of the administration is this:

If you have a token, you are a security, and there is no functional way to register or trade tokens as security, so your only recourse is to shut down. This is both unsupported by law (and if you don’t believe me, please read @NYcryptolawyer's2 scholarship on this issue) and a backdoor ban by the SEC without any legislative or commercial purpose behind it.

Also you’re not allowed to have a bank account. No, literally, the FDIC went around pressuring banks to close the accounts of almost all crypto companies in the wake of the 2022 events (and if you don’t believe me, read @nic__carter's piece on Operation Chokepoint 2.03, the details of which will shock you). This is the equivalent behavior to, when Bernie Madoff turned out to be a giant fraud, running around to all American banks to have them shut down the accounts of asset managers.

Additionally, Biden has been actively blocking all attempts to unwind what is, essentially, an extra-judicial blockade against the space. Biden vetoed the SAB-121 repeal, a custody rule promulgated by the SEC that bans people from doing crypto custody and, to make it even better, puts the assets of customers of crypto custodians at risk during a bankruptcy by making it entirely possible they are not bankruptcy remote. This is an anti-secure custody rule! And the Biden administration blocked the repeal, which was bipartisan!

Finally, if you look at the enforcement actions in the space, there have been a number of massive frauds: 3 Arrows Capital, Celsius, Terraform Labs, FTX, etc. How many of those were enforced against? Zero, until very far after the fact in a few lagging cases, and those mostly by the DoJ! Who did they enforce against? Coinbase, Kraken, Consensus, etc. Can anyone tell me what the logic is of an executive effort that specifically lets criminals go free until it blows up so much it hits the press, but attempts to prosecute those trying to obey the law and treat customers well? It’s hard to perceive that as legitimate.

In some cases, the administration itself is the criminal. The SEC was sanctioned for committing perjury in the Debt Box case, both forcing a whole project offshore and damaging the participants while lying to a Federal judge in such spectacular fashion that the entire Salt Lake City office of the SEC has been shut down after sanctions being levied against them. Again, none of that is hyperbole. This happened.

So my first point to people with the same question as Gary would be this: you may think your default stance is not caring, but your default stance is actually a complete disregard of constitutional rights and instead support for an extrajudicial, highly illegal, and incredibly stupid (if you don’t believe me, and you are a Democrat, imagine the Trump administration about to run this playbook against green energy, abortion providers, public sector unions, etc. and pointing at literally what Biden did as precedent) campaign against the industry.

TL;DR: we are not starting from zero. You’re actually on the side of a jihad against this technology, with the base assumption that it’s not just silly and useless, but evil on par with North Korea.

2/ Do you believe you should have to lend money to a real estate billionaire at below market rates to buy a coffee?

If you didn’t answer yes to that, you are actually opposed to the current structure of the financial system. When I say that kind of thing, most people look at me like I’ve grown a second head. However, this is precisely how the current system works, and reveals a point that I think most people don’t understand: our current banking structure is set up to hide the volatility and cost from the average user, so that you are the frog being slowly boiled and you don’t realize what is happening until it is too late.

This is such a long topic I’m writing a book that has multiple chapters about it (spoiler alert), but let me try to hit some key points here.

The first is that money in a bank is not safe.

I know I’m going to get a small army of objections about how as long as you are under $250k the FDIC will save you, but I’m going to raise two points in response to that. One is that for many small to medium businesses, this is simply not possible, and it’s not that they are rich - if you are in a high turnover, low margin business like a supermarket, you probably blow through that limit regularly but your actual net profit is far below it. So what’s the solution for you? There is none. Two is that the FDIC itself is not infinite and the insurance fund is certainly not sufficient to cover all, most, or even some of the deposits on an aggregate basis in the financial system. This means the FDIC is reliant upon good risk management at member banks, bailouts in the case of severe issues, and effective resolution of failed banks, all of which gets way harder in a crisis situation and requires some exceptional steering to survive. I’m lucky enough to know @SheilaBair2013, so let me tell you that this view does not start with me, and we still have 2008-era issues to chew on here that should be taken seriously and fixed!

You also often hear the cry of “well, you should due diligence your bank to make sure it is safe”, and I am here to tell you that is pants-on-head level crazy. Most people are just completely flying blind on this. I’ll remind the crowd that long, long before I was ever in crypto I traded one of the most bank capital focused trading books in the entire world (Bank Owned Life Insurance wraps, if we want to really go into the dark forest of finance), and I spent roughly 80-100 hours a week thinking about this problem and still couldn’t fully figure out the capital position and solvency of many banks. Did I have a decent guess? In many, but not all cases. Did I know for sure? No.

Thus, unless you genuinely believe that, in order to be allowed to have a bank account, the guy running the aforementioned supermarket should also have to become a bank capital expert solid enough to compete with psychopaths like me running trading books on the street, this is a complete lunatic position to hold (also where are they getting the time to run their actual business?). Don’t believe me? I dare you to go read some 10-Ks and Qs for banks. Let me know who YOU think the 5 most at-risk banks are for collapse in the next three months. Let’s see how good your results are and how long it takes you to figure that out. And if you don’t want to or don’t think you can, I actually agree that’s the smart thing to do. For anyone who doesn’t have this as a full time job, it’s a waste of time for nearly zero return.

Here’s the problem: our system is also based on the idea that you have to do this! Our regulators, in their wisdom, have decided to shut down better options within the banking sector itself for safe banking, as we can see from the sad story of things like the Narrow Bank or @CaitlinLong_'s Custodia. As a result, we have some hybrid solutions (like being able to pay for things with a money market fund through a debit card - Fidelity has a good solution for this that will be in a future article I’m writing about financial market structure), but currently, this brings us back to the first question I asked here: when you leave money in a bank, they make risky loans with it, often in the real estate space. This is the price of admission. You are exposed to that risk, the bank pays you 0% for it in most cases, but if the bank fails, you lose your money. Is that a fair trade? No. Oh, and the executives largely keep their giant bonuses at your expense.

It happens because we have given banks a monopoly on the payments system. Why did we do that?

That’s a great question. I'm not sure there is a good answer.

3/ Change will have to come from the outside. Asking the banking cartel who have created this setup where they get to sweep up deposits, not pay people for taking risk, and lend cheaply to billionaires to politely stop is not going to work. Instead, it’s going to take people creating competitive products that can break down what is essentially the extreme anti-competitive framework that exists around the current financial system to undo it.

It’s not clear to me specifically which one of these efforts will ultimately be successful, but we should be supporting all of them. My personal guess is that dollar stablecoins (more later on this) are going to slowly erode the monopoly moat of the banking system until it collapses and is forced to restructure itself in a way where it’s not just straight up stealing cents at a time, day after day, adding up to trillions but unnoticed due to it happening one penny at a time (Office Space predicts all).

This is a sort of antitrust problem where what we need is just a fair playing field. This is something that most antitrust fighters are familiar with (ht: @musharbash_b ), and simply having our regulators and legislators force fair competition is the core issue. The problem is our banking regulators only want that competition within a very specific type of bank, risk managed in a very specific way, that is coincidentally somehow hugely to the advantage of rich donors err borrowers and bank executives, and at the expense of the common customer in this arrangement. In many ways, I don’t think it’s even deliberate. I think it is what happens when there is a slow march through institutions over time tweaking things by 1 degree for 100 years.

This is before we get to the point that someone like @RitchieTorres has eloquently spoken about, which is that often certain disfavored groups can’t even get (or maintain) bank accounts. Anyone remember redlining? How quickly our memory fades. If only there was an open access solution where people could control their own money without needing permission from a racist 65 year old at a bank!

Funnily enough, crypto has an answer to all of this. What is it? Stablecoins.

What if I told you that you could have a product where you can custody your own money, or if you don’t, you can have a securities-style custodian who is not allowed to lend your money out and it belongs to you, where the only loans in the reserve behind this money are t-bills rather than risky loans to billionaires, and where transaction costs are less than a penny, rather than the percentage points currently charged to merchants and retail customers for their purchases?

Sounds like a pretty good deal for consumers (and a real competitive threat to banks), right?

Please go look at #PYUSD on @solana. I literally built the back end for this thing when I was at Paxos. It exists. It’s real. You can use it right now. Most of what is stopping you is what I discussed in point 1.

This is not a screed in favor of some random shitcoin, or even bitcoin. The value of crypto to the average American is a dramatic restructuring of the financial system that puts power back into the hands of the average consumer and trust in a global consortium of neutral actors, rather than letting Citi unilaterally decide your fate based on their whims (and then having to be bailed out with public money when they fuck it up for the 19th straight time).

TLDR, if you’re not strongly in favor of the public massively subsidizing bank executive compensation and rich billionaires borrowing money, you’re pro-stablecoin (at least, properly constructed ones - my critique of the bullshit we call “stablecoins” is a whole different topic and I’ll link to my congressional testimony4 at the end describing what I think works). You just don’t realize it.

4/ Let us, for the purposes of this discussion, concede that you either support bank executives and billionaires controlling the financial system at the expense of the average person or, if not that, you disbelieve everything I said and believe that the current financial system in the US is perfect with no incentive problems and competition should not be allowed (you may think this is a jest, but again, go back to point 1 on what is actually happening here).

Let me then ask a different question: do you believe women in Afghanistan should be allowed to have money? At all?

A stat that I often mention from my time at Paxos is that we believed about 95% of the holders of #BUSD were non-US persons, and that the only country where I am close to certain they did not have any of the stablecoin was North Korea.

Why is that? A dollar stablecoin is something you can purchase on an open-access network so long as the following two conditions are met:

You have the internet

You have something you can exchange for it (local currency? Bitcoin? Eth? Sol? Doge? Doesn’t matter, anything, really)

Congratulations. If you meet those two conditions, you can now opt out of your local financial system and into the US dollar system. You can do this with a private wallet, meaning that your (potentially exceptionally corrupt) local system cannot expropriate you. You can do this in dollars, meaning that your (potentially exceptionally corrupt) local central bank cannot inflate the value of your money to zero. You can do this without needing anyone’s permission (except, ironically, the stablecoin issuer not confiscating your money, meaning you are probably subject to dollar norms, so don’t try this if you are the North Korean government, we will totally seize your money).

I think people in the United States, because our system largely works, do not understand how massive this is for human rights. When you look at most of the world, the financial systems are coercive, abusive, and corrupt towards various groups (sometimes basically all groups). Are you a religious minority in a theocratic state? Are you a woman in a hardline muslim country? Are you a political dissident in mainland China? Are you guilty of the crime of not supporting the current regime in some of the basket cases in Central and South America? Did you just not pay a bribe to the right person in about 50% of the world?

These are all right now, today, current year things that happen to the majority of people in financial systems globally. It’s part of why the value of crypto was seen much earlier in Asia than it was in the United States. When you have at least somewhat secure property rights, it’s easy to believe the government won’t just lie in court to steal your bank account (unless you work in crypto, ironically). But this happens all the time, all over the world, to all kinds of people.

And now they have another option. The ability to call bullshit on your local system and hold dollars in secure fashion with respect to the local system is earth-shattering for many of these regimes. It will be an existential threat to autocratic and corrupt governments globally, and we are already starting to see the freakout begin in Nigeria over crypto, where they have kidnapped anti-financial crime people from Binance because people keep ditching the Naira due to local corruption to buy bitcoin, but also more so, USD stablecoins.

So let me ask this: do you hate religious minorities? Disfavored political groups in third world nations? Women? Gays? Anyone who speaks up against the government?

Unless your answer is yes, you are also pro-crypto. You probably just didn’t know that until now.

5/ None of what I just said should be read as an endorsement of a specific product in crypto (other than well-constructed USD stablecoins, I’m totally endorsing those, to be clear).

Do I think #BTC will hold up as a long-term store of value? Maybe!

Do I think ETH will become the main transaction layer globally? Probably not, actually, unless there is a lot of improvement.

Do I think the majority of the current crypto projects have long-term value? Unlikely!

Do I think the scammers and bad actors in the space should just be allowed to do whatever they want? No, and they belong in jail in many cases!

None of this, however, is an attack on the technology. Here is where we have really tied ourselves into knots. Just like Bernie Madoff was not an argument against asset management, Lehman was not an argument against banking, AIG was not an argument against insurance, and the S&L crisis was not an argument against mortgages, the actions of bad actors in the space is not an argument against crypto.

It is an argument in favor of smart, well-crafted regulation (like the @PatrickMcHenry and @MaxineWaters led effort on stablecoins) that improves safety while preventing monopolistic concentration, and it is an argument that our law enforcement and regulatory agencies really need to up their game and start executing better.

But the core value of the technology is very real, and if you aren’t convinced it has any value, I would also bring you back to point one: are you so convinced that we should destroy it, vs. letting it compete and just lose in an open market (as if you are right about it being useless, it will just go away when you force it to compete on equal terms)?

Unless you believe the former, which is that a top-down state-sponsored ban on the technology (not just bad actors) is appropriate, you actually disagree with the current political situation in the United States.

Finally - thank you. I appreciate you taking the time to read and consider this. I'm happy to discuss with anyone who wants to engage in good faith, so all questions welcome.

There will be a hearing in the Senate about crypto and illicit financial activity this Tuesday, where Wally Adeyemo from the Treasury goes to ask for additional powers to combat this alleged scourge. I have written about this before, but because this is essentially catnip to me by mixing together multiple strong interest I have (blockchain, market structure, financial crime, stablecoins, geopolitics, etc.) I cannot resist writing about it again.

More so, this hearing is overwhelmingly likely to be an absolute tire fire and clown show when it comes to accuracy and framing, as all sides will be pushing a political agenda to maximize their narrow concerns. This sort of thing is how you end up with huge amounts of theater that increase, not decrease, the confusion around an issue.

However, I think that’s an exceptionally dangerous thing right now, as I personally believe we stand at a critical point and we are rapidly running out of time to make a decision between two paths.

First, let’s talk about goals. One of the problems with this debate is that people are not being clear about what their goals are, so I am going to set and example by defining what my goals are in making policy recommendations for what the United States should do here. They are:

1. Minimizing the amount of illicit financial transactions in the world, and

2. Maximizing the amount of privacy we can have while achieving the first goal, and

3. Create a system where the United States has primary regulatory control of dollars moving on blockchains

I lay these out because I know there are those in both the regulatory and crypto spaces who may disagree with some of these goals, but I propose that this is the best minimum set of guidelines to actually guide the preferences of US policymakers and legislators as we look at the blockchain space, both domestically and globally.

To that end, I’m going to lay out what I mean, briefly, for each one of these, and then we can talk about how they each relate to the hearing we are about to have.

Minimizing the amount of illicit financial transactions in the world

My friend Adam Zarazinski has spoken about this previously when he testified, but the punch line is that bad actors just want money. Cash? Traditional system? Blockchains? Literally teleporting gold into their house? They don’t care. Anything that works, they will do it. Each illicit financial transaction is just a tool, and these organizations are like bodies with a gravitational pull for illicit funds regardless of the rails. If you shut down one set of rails, they will pivot to another. Therefore, looking at things in isolation is a lot like trying to stop a river by just putting a rock in the middle. It goes around it. You need to build a dam, which is to say we need a comprehensive, platform agnostic solution to the whole problem if we want to achieve anything other than just grandstanding.

Maximizing the amount of privacy we have while achieving the first goal

I am not an absolute privacy maximalist because I understand there are bad people in the world, and if the entire system is in shadow, it gives them a large scope to operate. I don’t think that is a good thing, and my personal view of true privacy maximalists (e.g. all transactions should be private) is that they suffer from the same naivete as many libertarians about what that freedom will actually be used for (Hint: often, not good stuff!) in the real world.

With that said, I also don’t think it should be trivial for the government to get their hands on private transaction data. I think it should be possible in many cases, when there is a legitimate need to investigate criminal acts, but that the current dragnet we have of scooping up huge amounts of financial data from innocent people through third parties is deeply harmful in the long run.

As much as many people don’t like it, how you spend your money is often a form of speech, and there are legitimate reasons to want some of those to be private1.

Therefore, my goal is a system where that information should be available when there is a true need, but getting that information should be difficult and there should be the ability to disclose what happened after the fact so it can be monitored2.

Create a system where the United States has primary regulatory control of dollars moving on blockchains

Note that I do not say the United States has primary regulatory control of blockchains. Why do I not say that? Why, in fact, do I also not include the possibility that we could just outlaw blockchains to stop this whole thing?

The simple fact is that the horse is out of the barn. Standing in front of technological progress and screaming STOP has been an excellent way to get completely run over, historically. Sometimes figuratively, such as when your economy ceases to be competitive, and sometimes literally, such as if you had tried this with a train or automobile.

Blockchains are not going away. There are many non-US jurisdictions3 actively embracing them as the future rails of financial technology to build faster, safer, more transparent platforms.

Secondarily, a goal to have primary US regulation of all blockchains is probably out of reach given how we have already lagged in this space. Had we acted aggressively, during the first Trump administration or the second Obama administration, I think this might have been possible. But instead, we sat on our hands and catered to the same class of incumbents who had caused our problems in 2008 (and used the same regulatory playbook) and as a result, we are where we are now.

There’s too many things outside the United States. Only one of the top 5 or so crypto exchanges by trading volume globally is even located in the United States, thanks to the efforts of the SEC in scaring everyone offshore and ensuring we do not have US regulatory control of the space4.

The good news is that in a global sense, it’s still early. We’ve probably lost the chance to dominate blockchains as we do securities trading, but it’s not too late to have an oligopoly on blockchain regulation where we also primarily control dollar stablecoins.

Therefore, given I believe blockchains are here to stay, I’m falling back on what I think our best achievable option is right now. If you think we can do better and regulate it all, more power to you, but I think we are too late.

Thus, with those goals stated, let’s move on to this hearing.

Nocoiner Arguments Building Bridges Leading to Nowhere

The crypto-skeptics are likely to lead with some combination of the following arguments at the hearing:

1. Bad people have used blockchains to do bad things, therefore blockchains are bad

2. We need unique powers to sanction and control blockchains because they present a unique threat

3. Blockchain entities don’t follow the same rules as banks, and therefore that’s bad and we should make them

All of these are likely to be marshalled for one of the following purposes: either banning blockchains entirely (as Warren’s bill in the Senate essentially does by placing impossible requirements on the technology, similar to saying cars must be made of cheese but also survive a 100mph collision with no damage), or asking for massive increases in power and control that are basically unprecedented in our times.

Let me take a moment to address each of these in turn as well.

Bad people have used blockchains to do bad things, therefore blockchains are bad

This point has been effectively addressed previously in hearings5, but it will be brought up again, so I want to directly take it apart here.

If our standard for something being bad is that even $1 of illicit finance is too much, the first thing we should do is shut6 down7 the legacy banking8 system immediately. Using blockchains as a distraction because they have better detection when 99% plus of the illicit flows are cash or the traditional system would be a little bit like New York City pursuing their Vision Zero traffic safety strategy by banning unicycles. That is not the problem, people! Scapegoating blockchains for the problems of the traditional system is the tactic of someone who wants to misdirect from the failures, either out of shame or to perpetuate them. It is not the tactic of someone serious about solving the actual problem.

Likewise, if our standard is that the current amount of bad activity on blockchains is too much bad activity, wow do we have a lot of things we need to shut down. On the list would be:

1. Fedwire

2. ACH

3. PayPal

4. Venmo

5. Cash App

6. Literally cash itself

7. All of correspondent banking

etc.

Essentially, any system where money is used will have some degree of wrongdoing. This is the nature of people - some people are bad, and bad people, just like average, mediocre, and good people, use money. The only way to stop that is, ultimately, to ban money.

That’s silly. We need to focus, instead, on hardening our systems. If someone is doing the latter, you may disagree with them but they are being intellectually honest. If they are throwing one specific set of rails under the bus without first describing the magnitude of problems across all rails to demonstrate this one type is actually the nexus of bad activity (spoiler alert: it’s cash), you should have some very deep and serious doubts about their motives and/or capability.

We need unique powers to sanction and control blockchains because they present a unique threat

One of my favorite podcasts is the Dunker Spot9. Why? Because I am a basketball fan, but also someone obsessed with process, and Nekias and Steve are deep thinkers on the process part of basketball. A bit like finance, basketball is a complex system with interdependent parts that are not all stable over time, and interestingly, thinking about basketball can provide a useful mental framework for thinking about other systems.

In specific, when a team loses and Steve and Nekias are dissecting what happened, one of the main questions that is often asked is a version of this:

Do they need to change something, or do they just need to execute the current plan properly?

More than once this has jokingly been called the “do better” adjustment after a bad game.

I would suggest this is where we stand with our current crop of regulators. It is not so much that they need new powers10, but rather, they need to use the powers they already have effectively (especially before being given new ones).

So why do I say this?

First, there is a huge amount of information in the hands of crypto analytics companies, and almost none of it is being effectively used at the Federal level or the state level. I have a client who is working with an independent law firm to start filing civil suits against crypto scammers so they can get court orders to freeze blockchain wallet addresses containing stablecoins because the FBI and DOJ have fumbled it so badly for years they literally gave up.

Second, we have very good information almost instantly on many of the hacks in crypto, yet a shocking number of them remain both completely unprosecuted and more so, freeze or seize orders were never even asked for by US regulators. All the data is there, but here is a visualization of what is being done with it:

Third, we have entire analytics companies devoted to understanding this space, but the amount of airtime they get within the gov’t itself is extremely limited; the combined number of people in the US law enforcement space who are familiar with any of Inca Digital, TRM Labs, or Chainalysis is probably less than 1%, which does not scan if you look at the amount of FUD they continue to spread about bad activity on a blockchain. Focusing on crypto crime in a hearing in that context would be like becoming an expert on crippling inner-city violence and drug problems in inner city Baltimore or Memphis, but also being unaware police departments exist.

Thus, one of the things I truly hope for in this hearing is that people press Treasury on exactly what they (and related Federal agencies) are doing to combat illicit finance. Not just in crypto, but in general. In concrete terms, how many people are working on it, who are they working with in industry, what is the success and failure rate, what tools are they using, and do they need more help, more training, or more compensation for staff?

As coming in, without having made serious efforts to do anything other than a niche office or two, and then asking for sweeping powers is poor conduct. “We can’t do anything (also we never tried)” is not the same as “We tried very hard, here are the exact problems, we need these specific powers”. I am very sympathetic to the latter, to be clear.

But we appear to be doing the former, which is simply not good enough. Right now, I am not of the belief we need new powers for most agencies, because they aren’t even using the current powers to do anything.

If anyone doubts that, please reach out. Happy to put you in touch with people.

Blockchain entities don’t follow the same rules as banks, and therefore that’s bad and we should make them

You get this one a lot from people who believe they are KYC/AML experts, but are often academics in practice. JP Koenig is someone who has espoused this belief, for instance, and it’s one of the best instances of saying technically correct but also completely misleading and actively harmful to discourse.

So what do I mean by this?

One of the arguments you will often hear from skeptics is that blockchain participants don’t follow the same rules as banks and financial services providers, and that especially stablecoins don’t.

To tackle the first part first, that’s often a mistake of classification. If you believe that miners and validators are primarily in the business of providing financial services directly to participants, you would hold this belief about them not fulfilling similar obligations. However, if you look more closely at the role they play, which is basically providing communications infrastructure, you might also realize you’d then have to apply this duty, in traditional markets, to Bloomberg, to internet providers, and perhaps even to the phone company.

I am not sure this is working as intended. Suffice to say, the whole “just make validators collect KYC data” is not a policy that is technologically sound, and that there are parties that should have to collect this data, but all of them are parties that, you know, have a direct relationship with the client. This is not how a validator works.

The second part I find more interesting, because here we run face first into the complexity of the solution.

Specifically, we often hear “same activity, same rules” as something banking regulators want to apply to blockchains, and when they talk about stablecoins, they mean this: because banks KYC everyone who touches a bank deposit, stablecoins should have to KYC everyone who touches a stablecoin.

In a literal sense, it is true that if this analogy holds between stablecoins and bank deposits, Circle (to pick one issuer as an example) should have to KYC everyone who touches USDC.

On the other hand, the analogy does not hold. And this is where things get interesting, and where I am going to segue from this specific point to the greater problem we are facing in this space and why I have said elsewhere that blockchains are the solution to financial crime11, not the source of it.

So why aren’t stablecoins just bank deposits? To understand this, we have to understand how the current system works.

I’ve described this elsewhere, so apologies to those reading it again, but let us take a transaction that goes like this:

Person P sends money to Relative R who spends money at Business B who pays out that money to Owner O who sends that money to Hamas, which we will denote as H.

Using Banks

In the current system, let’s say P uses a bank to send to R, R uses a card to pay at B, B uses a bank to send to O, and O uses a bank or cash to send to H.

In fact, let’s get slightly more provocative by saying that Person P used Chase as a bank to send to Relative R using Standard Chartered, both institutions with very solid KYC/AML procedures according to banking regulators compared to some peers.

So, with that said, can this chain happen? Totally. In fact, I’m almost 100% sure it has. Why? How? If banks are obeying the rules that we just described, what the hell just happened here?

It has to do with the definition of bank deposits, and how we think about the reach of an institution. Namely, when JPM sends the money to Standard Chartered, that’s it. It’s no longer a JPM bank deposit, it’s now a Standard Chartered bank deposit.

When StanChart has the money spent from an account and goes through a card processor, it stops being their problem as well. If nobody knows that business is a conduit for money to Hamas, because the last bank in the chain is an evil bank, then nobody upstream has visibility and it’s not their product. Importantly, in this chain, Chase has absolutely zero idea that money that originated with Chase ended at Hamas.

Using Stablecoins

Now, let’s make this Circle’s problem so we can draw the contrast. The transaction is exactly the same as above, only in this case, the sole customer of Circle who does mint/burn is P.

Then, P sends to R, who spends at B, who sends to O, who sends to H. Only, let’s say they use stablecoins, and in fact, the same stablecoin at every step. This reveals a couple of things that work differently than the banking system immediately.

One, Circle can see every step. In fact, if Circle knows the last wallet is Hamas, they can see the entire chain that lead to money that originated in the system with Circle ending up with Hamas! Second, everyone else can see it too. It’s a public blockchain. Third, because Circle has freeze and seize capability, they could in theory stop the money at the final point, and certainly, they would refuse to onboard Hamas and redeem them back into the traditional financial system.

So this is a bit different. We have far more visibility (remember, in the other system, only participants one hop away see the transaction), and while Circle is “involved” at every step because it’s a stablecoin in a literal sense, their involvement is no more than the banks in the same way. Even so, at the final step, unlike the banks in situation one, they can stop the funds.

Same Activity, Same Rules

What does this mean? Once you zoom out to the system level, this means we have one of two options if we want to go with same activity, same rules.

Option 1, which is what most of the stablecoin world is asking for, is that they not have to chase a chain of transactions just like banks don’t do this, and what they want is just that as long as they keep a hard perimeter around mint/redeem and freeze and seize when asked by the government, they are seen as in compliance.

My personal view is this is a good option, but we should additionally add the requirement for monitoring of transactions on-chain by third party wallets so they have to make good faith efforts to interdict bad actors.

Option 2, which nobody discusses but I think is the significantly more hilarious and revealing options, is that JPM should be liable for the money going to Hamas in the first example and should pay a huge fine and have people go to jail over it. Why? If you introduce the money to the system, and then it travels through the system and gets to a bad guy, that’s your responsibility. After all, that’s what we are saying in the stablecoin example if Circle is responsible for this entire chain despite facing only the initial customer. Banks should have the same responsibility! They started it. Here is where banks will tell you this is unreasonable, they don’t have control or visibility over their competitors, this is not a fair interpretation, etc… which, when you pause, sounds a lot like what crypto is being criticized for saying right now, doesn’t it?

However, if stablecoins have this liability, banks should not be able to ditch liability by just having someone swap to a different product at each step, otherwise Circle, Tether, First Digital, PayPal, etc. can just get together to make sure customers swap coins at every step and achieve the same broken outcome.

Either we care about a good system and consistent rules, or we don’t. To be clear, I’m not arguing for the second outcome, but if you believe that’s the correct standard for the stablecoin issuers but not the banks, I have to ask you this question:

Why is it okay for banks to engage in terrorism financing?

Now we will return to where we began, with the hearing. Here is what my hopes would be for an outcome:

1. We realize that the fact that we can clearly see all of this bad activity on a blockchain actually means it’s a superior, not inferior, tool for detecting illicit finance.

2. There is a real discussion about what efforts the US gov’t needs to start undertaking to police this activity.

3. There is also a discussion about how our single most urgent need is legislation, because the way you end up with zero say at this table is forcing every company offshore because you can’t get over yourself and make it impossible to do business onshore. In this outcome, we end up with everyone else controlling the future system, not us.

4. Finally, we end up with legislation that actually puts crypto and banks on equal footing, meaning they are responsible for bad activity in their space, have to meaningfully interdict it, and over time, flows should be pushed to the system that does a better job of allowing this.

What I am worried about is that we will instead have three hours of grandstanding and furiously distracting from the failings of the current system and the actual problem of terrorism financing in favor of attacking a pet peeve of some senators.

Am I hoping in vain for legislators to return to focusing on good governance, instead of theater and social media hot takes?

Probably.

Here are the core policy recommendations I would make, as a result:

Monitor the System

Affirmative monitoring obligations should be handed to centralized blockchain firms, so that they can use the capabilities they have to freeze funds at the point of entry and exit more effectively. And on-shore firms should not be able to interact with offshore firms not doing this, if we want to build a good web.

Compare the Systems

Treasury should be required to put together reporting on the amount of illicit finance in traditional vs. blockchain systems, and share that data. Both on a total $ value basis, but also % of activity basis. If they can’t get that data, they should be clear about where blind spots are and what we don’t know. We need to know this to do a good job. It’s done partially now but could be much better.

Legalize Stablecoins

We need to pass legislation so that onshore stablecoins are a thing. As soon as possible. As fast as possible. Our worst case scenario is that eurodollar stablecoins or non-dollar stablecoins become the default money, as in that case our tools for addressing financial crime on blockchains will become much weaker, and we’ll have shot ourselves in the foot.

Reward Visibility

Finding illicit crime should be rewarded, not punished. We should have bounties for people to find crime in both traditional and blockchain systems, and then we should mandate more usage of the system where it’s easier to find the crime.

If we do these things, which are quite simple, in the end, we will win. I’m also open to being wrong that blockchains are a better tool for fighting crime, and only by actually testing and monitoring will we be able to determine that.

We should do it, if we care about doing the right thing.

“Even $1 of funding to Hamas is too much,” I was told, in a private meeting with a good friend, to explain the antipathy of some US politicians towards crypto.

This was after my previous tweet taking apart the Treasury request for additional authority, and was in the context of trying to understand why I opposed the majority of those proposals and, it was implied, stopping terrorism financing. When I explained that I opposed the majority of the Treasury proposal because my goal was stopping terrorism financing, they got very, very confused, as this was not the rejoinder they expected.

Using that as a starting point, I wanted to take the time to post a detailed explanation of why I believe public blockchains are a better, not worse, method of detecting illicit finance. To cover that, we need to plant a few seeds first.

One, what is the substantive transaction, with no specification of the rails?

In this case, we are going to start with American A, who is an otherwise law-abiding citizen who is going to send a transaction that ultimately reaches Hamas. This happens because American A sends money to Relative R, in another jurisdiction. Relative R then sends their money to Business B, either in a valid appearing transaction that is “overpriced”, or simply in a fake transaction where no value is actually exchanged. Unfortunately, to make this somewhat more complicated, Business B is the sort of hard to detect hybrid business that does have legitimate business operations, just not all legitimate business, so it’s a mix of bad stuff and legitimate stuff; maybe it’s a charity, maybe it’s a dog-walking service, maybe it’s an FX broker, maybe they make furniture. Sometimes they do sell you a chair! But sometimes they just launder money. Sometimes they sell you a chair but at a huge markup. Problematic to untangle from the outside. Lastly, Business B pays a dividend out to Owner O, who is actually a member of Hamas, and Owner O sends the money to Hamas.

Therefore, our total chain is A -> R -> B -> O -> H, meaning that the money went through five entities and passed through a combination of legal, semi-legal, and definitely not legal steps in order to reach the final resting point.

Two, what is our goal?

This one is important, because mis-definition of goals is part of how we got here. Importantly, is our goal to interdict as much terrorism financing to Hamas as possible, or is our goal to shut down all of the platforms where we can easily detect terrorism financing, so we just don't see it, even if lots of it happens?

The former is likely to materially improve the situation, if done properly. Legislation that would facilitate effective enforcement, monitoring, and interdiction of bad actors while preserving privacy for the majority of law-abiding folks is absolutely key. However, the latter option is likely to do a lot of collateral damage without improving anything (unless all avenues were easy to detect), as all you are doing there is forcing the activity out of the light. This is a bit like the Streetlight Effect problem, where we are searching for something not where the problem occurred, but rather where the light is, because it’s easier.

In short, we need to focus on actual security, not security theater.

TradFi

Now, having laid all of this out, let’s talk about how the transaction we designed above moves through the snake in the traditional financial system.

Step one would be the transaction to the relative. This could be done via a bank transfer (wire, ACH, etc.), this could be done via cash, check, or via a payment app (PayPal/Venmo, etc.). Regardless of which one of these is done, here is what happens: the company, if any, processing the payment knows about it, and the two people know they transferred money between each other. It could be companies in the case of an international bank transfer, as this probably moves through correspondent banks, and they would all know American A and Relative R, in theory. It could be a payment company to a bank if Relative R receives the money via PayPal and transfers locally.

Step two is the transaction between the relative and the business. What is this in? Cash. Credit Card or bank payment, payment app. Roughly the same stack of possible ways to send money. Here is what is interesting, though: does the originating company for American A know about this step? Probably not, unless it’s the same institution. If, for example, American A banked at Citi but the money ended up at HSBC (to pick two large international banks) then Citi won’t know about the next step, where money goes from HSBC to a local bank when a payment is made to Business B. Potentially nobody will really be connecting the dots if it was cash. If it’s a card payment, then the card networks might see something between these two, but unclear if they saw the first step. Here’s the point: we’re only on the second hop, and it’s already incredibly fragmented and we have no way to assume the institution involved in step 1 knows what is going on here, much less American A.

Step three, which is the business to the owner, often is going to be completely impenetrable to outside persons. Why? Because often they bank at the same institution and it’s an internal transfer. Literally only one company knows about it, and the question about if this is understood or reported outwardly is going to be a very difficult one to answer. Depending on the jurisdiction , the rules may vary, and certainly, no external entity will know about this happening. If they bank at different banks, then at least those two banks know about it, but again, what do they see about the rest of the chain of events? Also, if this was a cash transfer, even more difficult. Again, we have a break in the chain of events. It’s quite possible the sender in the previous transaction is in the dark here, much less the long chain back to the originator, American A. Even more interesting is the fact that we are dealing with a partially legitimate business. Those are usually the hardest to trace for the financial entities. Even if Relative R is knowingly giving money to terrorism finance, would any of the entities in this chain understand that without a complete picture of the books on all sides?

Step four, finally, is Owner O sending money to Hamas. This part is definitely bad! However, depending on the method used, unless it’s all going through the same bank, here’s the interesting part: none of the previous entities really understand this happened. If a well-known US bank like Citibank or Bank of America was the sender in the first case, do they know anything about what is happening this far down the chain? Almost certainly no (otherwise they would not have sent the first payment and would have been filing SARs about it). Instead, we are three levels down through multiple layers of other entities, and there’s just not much to be done here. Especially if funds moved through cash or local banks that don’t follow sanctions regimes.

This reveals the problem with the traditional financial system: it is fragmented, it is opaque, and it’s not particularly good at knowing what the other parts are doing. The majority of the activity is only in silos, the interior of which is dark to outsiders, and they can only see one door of many doors.

Put differently, let me ask a question that tradfi folks will find truly wild: After a dollar was first deposited for the first time at a bank, can you tell me every single transaction involving that dollar from that point forward? Go ask someone at a bank that. They will tell you to stop being stupid. Guess what?

You can do that with a blockchain.

Blockchain

Let's shift to a blockchain.

Now, American A sends money to Relative R. These are two wallet addresses. The world as a whole may not know who owns the wallets, but obviously they know each other. Importantly, everyone can see this (and all subsequent) transfers.

The next step is the same: Relative R sends money to Business B. However, because it’s on a blockchain, this is still visible to everyone. Again, publicly, we do not know who R is and we do not know who B is (unless the wallets have been doxxed), but we can see the time, amount, and wallets involved in the transfer. In this case, very much unlike the Tradfi system, American A can see their money passed through R and to B.

After that, B sends their money to O. Again, we’re still using a blockchain. Same rules apply to yet another on-chain transfer. Therefore, again, nobody knows the exact owners, but we can see the addresses that were involved.

The final step remains that O sends the money to Hamas. Once again, the path is clear. If, at the time, we don’t know that wallet belonged to Hamas, then it does become clear when and if we find out who it was. Public blockchains are public records!

In this case, using public blockchains, we have strictly more information than the previous case. If they wanted to, American A could figure out where the money went. Proving intent or knowledge at each step is harder, but unlike in the first case, they can see their money eventually went to the final wallet.

Second, once we know the bad wallet, it’s easy to map the ecosystem around it. Here, the pathway of the money starts to become much more clear once these elements are known.

Interdiction

Now, let’s go back to the original point of this post. I said that I was pro-blockchain because I was anti-terrorism financing. To really have that be a credible stance, I need to believe two things based on the cases that we’ve laid out above:

1: just because blockchains are transparent doesn’t mean the wallets are, so can we identify the wallets?

2: just because we have identified the wallets doesn’t mean we can stop the funds, so can we stop the funds? If we can do those things, then I think it becomes trivial to see that blockchains are likely to be more effective than traditional finance at stopping illicit activity (in addition to just detecting it).

Can we?

Identifying Wallets

I have good news on this front: it’s shockingly easy.

By requiring KYC at the point of initial introduction of funds (e.g. where dollars turn into crypto), you can have a good idea of the starting point of most transactions. In our terms, this means we can know who American A is, and who their first bank-equivalent entity is (usually an exchange, currently) in each case. This also becomes true for every other user who exists in a cooperating jurisdiction, meaning that in this case, we probably also knew Relative R and maybe even Business B from a surveillance standpoint. Did we know Hamas? Probably not initially, but it’s pretty quick to find them when you can triangulate funds being sent from all over and you know a some of the network.

Why else? Well, people are really stupid. And by really stupid, I mean they publicly post their wallet addresses all the time, or people adjacent to them do it. There are very few wallets out there which are completely unknown, and you are not solely reliant on blockchain analytics to find them. There are many other tools. Suffice to say, we know a shocking number of wallets associated with Hamas, or sanctioned Iranians, or Russians, or North Korea, etc. Combining listening operations of various sorts with the KYC data above, you can find almost all the wallets with enough effort.

Are you a crypto skeptic at a regulator, in law enforcement, or with a financial institution and you don’t believe me? Go talk to my friends at Inca Digital. No, seriously, go do this. You’ll be shocked.

Confiscating Funds

Here, the picture is a bit more convoluted. In traditional finance, to seize funds, you usually need to know where the holding entity of those funds is, and then give them a judicial order and have them be in a jurisdiction where they will cooperate with you (e.g. you can probably get BofA to do that in the US, but you can’t easily get an Iranian bank to do that if you are the US). This works in crypto as well: if you are dealing with an exchange or custodian in a jurisdiction that cooperates, you can usually get the funds just like in TradFi.

However, the real magic bullet in TradFi would be if you could identify the funds and then, if they were in dollars, just magically teleport them back out of the account of the bad guy and confiscate them. This isn’t how that system works (and the fear of this kind of behavior is one of the things often raised with CBDCs). Obviously, if that was going to be allowed, there would also need to be some incredibly strong legal and judicial guard rails around the process or it’s going to be abused, as has recently happened in Canada in their banking space, for instance.

So what if I told you that’s possible in crypto?

It’s not for the crypto-native tokens that power blockchains (unless you controlled the entire blockchain, which is a discussion beyond the scope of this post). For BTC? For ETH? This capability does not exist.

However, for a significant subset of token standards, there exists a capability called freeze and seize. This allows the issuer of a token to, without the private key of the wallet holding the tokens, freeze the tokens in a wallet so they cannot be transferred or, more interestingly, remove them entirely (and possibly burn them). The main tokens that have this capability? Fiat-backed stablecoins. Tether can do this. PayPal can do this. Circle can do this.

So going back to our transaction from above, at that final step, where Hamas has the funds: if they are in dollars or other currency at an institution that won’t comply with our sanctions regime, we can’t do much. If they are in BTC and in a Hamas wallet or at an exchange that is non-compliant, we can’t do much. But if they are in a fiat-backed stablecoin that complies with the US sanctions regime?

Yoink!

Building A Better System

Once you understand these tools, if your goal is the effective interdiction of illicit finance without massively compromising privacy, here is what you would actually want as a US legislator, regulator, or prosecutor:

As many regulated crypto companies doing business in the United States or a friendly jurisdiction as humanly possible. The more people who are onshore or in cooperating jurisdictions, the more KYC information we have to know the chain of transactions and persons sending money to bad wallets, and the more opportunity we will have to seize tokens at exchanges, custodians, and so on.

As many people using properly designed dollar-backed stablecoins as humanly possible in friendly jurisdictions. As I said, these things have a superpower: freeze and seize. If the standard currency of blockchains is a dollar with these features, it becomes increasingly easy to choke out bad actors as you identify them, because the money itself can be taken from them.

Effective ecosystem monitoring, with information sharing agreements, so that firms doing intelligence operations on-chain can quickly identify the wallets of bad actors and then pass this information along so they can be interdicted.

Importantly, if you are going to do this, you also need a strong civil rights regime backing to these operations, where they can only be used against people who are actually engaged in suitably illicit activities and there is due process around them that will necessarily have to be transparent and public in the end (if not at the beginning, to avoid compromising an investigation). Why do I say this? Because if you want people to use money with these properties and you just randomly take it from people and don’t explain why (which is what this will look like if you don’t explain), they won’t trust it and won’t use it. And nor should they, I would add. You’ll shoot yourself in the foot before you start if the bar for using freeze and seize is not much higher than the current bar we use for things like civil asset forfeiture in the United States. People have to be able to trust that if they are not literally terrorists or murderers, you won’t just steal their shit because they said mean things about you or something. Rule of law matters.

This also does reveal the objection to Tornado Cash as being at least partially legitimate; tools that obscure the transaction chain, primarily being used by illicit actors? That's a problem. I am for privacy and I am for stopping crime. We have to have a careful discussion about a fair balance.

How Close Are We?

Right now? I give it a solid D-. We are often doing the exact opposite of what we should, though to our credit, we haven’t been good enough at doing that to really break things completely.

First, we have refused to license stablecoins at the federal level, and they are largely moving offshore as a result. This is definitely bad, given the framework I laid out for success. We want those here! There’s a lot more on how to do stablecoins well that is beyond the scope of this post, but as a starting point, it doesn’t matter how well one is done if it’s also done out of Russia and won’t comply with our legal system for the purposes of this exercise.

Second, we are driving exchanges offshore as well. The SEC in particular has been a huge driver here, and ironically, they are probably a major contributor to the ability of the North Koreans, Hamas, etc. to make money in crypto, because there are major exchanges outside the US that will tolerate their presence. Ooops!

Third, we don’t have a good conduit for our regulators and law enforcement to work with the best blockchain intel folks, and to be honest, the government has done a very poor job of execution here. The DoJ, Treasury, etc. need to do better, more than they need new powers. This is an area where the chickens are coming home to roost for not investing more heavily in technological transformation in the United States, especially in the government arena and at various regulatory agencies. A heavy lift, but one we have to get right if we want to do better.

Fourth, we’re doing a really bad job of understanding the problem. Right now, because crime can be observed in crypto, we assume it is bad. However, something like 1% of Hamas’ total funding comes from crypto, which as both a professor and math major I can tell you means that something like 99% of it comes from the traditional system. This means there are 99 times the problems in the traditional system than in crypto, but because we can’t easily see them, we freak out about crypto. This is the classic fallacy of only caring about crime under streetlamps at night (because you can see it there); that’s not where most of the crime is! We have to stop mistaking visibility for severity. After all, how much of Hamas’ funding could we detect if we could force all banks,FX brokers, and hawaladars to use public blockchains for their activities, instead of their fragmented private systems? Probably close to 100%.

Why Has This Been Hard?

I’ll end with a final note on why we’ve been stumbling so hard on this:

Banks hate it. It will force them to expose how much bad activity there is and how ineffective their controls are. Plus they have to upgrade their tech stack to use blockchains.

Regulators hate it. It forces them to actually grapple with new ideas instead of falling back on the old methods, and it will also expose how wildly ineffective some of the current regimes are by bringing information into the light. Plus, being blunt, there is a significant technophobia problem at many US regulators.

Crypto hates it. Why? A lot of hardcore libertarians in that space think such a system will inevitably be used for extreme control and evil (ignoring that the current system often already is), and nobody wants to add cost and effort to do these things.

Everyone will agree with the thrust of the goals, but the reality is local short-term concerns that damage long-term aggregate better outcomes dominate right now. It is, in short, the Prisoner’s Dilemma writ large. Which is why, ironically, we need Congress to act more than ever. You unlock a lot of game theoretical problems with collective action and rules changes, not individual movement. We can, and should, do better.

TL;DR

Crypto reveals far more bad actors than the traditional system. If we truly want to stop terrorism finance, corruption, and more, we should not ban public blockchains. Instead we should force banks to use them!

American Regulators Have a Hard Job

I’ve made some comments critical of regulators in the past, as I think it’s important to be intellectually honest. Despite this, I have some people I am privileged and honored to call friends at places like the Federal Reserve, CFTC, JFSA, MAS, and NYDFS, among others. They aren’t perfect (who is — certainly not me!), but I think they genuinely care about trying to get things right. They don’t always achieve that, but I want to be clear I’m not a conspiracy theorist who thinks the entire regulatory space is motivated by animus against humanity1.

That’s not to say everything is perfect (quite the reverse, in some ways). I don’t want people to miss the fact that there are some underlying structural problems facing both US regulators and, to be blunt, the entire US financial system that ultimately require a bit of thought. But we also need to be fair about what is going on here.

I want to start with three key points about the position that most regulators are in to help educate the crypto community about why things are going the way they are. Then I want to give some updated commentary on my views about the space moving forward, and which regulators are performing well and why.

Regulators are Underpaid and Understaffed

Do you know people at the CFTC are paid? Hint: it’s not a lot relative to financial services or law in general. How about the SEC? Hint: it’s also not a lot relative to financial services or law in general.

Put differently: there’s likely at least one second year analyst or something at a combination of JPM / Goldman Sachs / Morgan Stanley who made more money than the highest paid person at any of the agencies I just referenced.

Think about that for a moment. Some 20-year-old kid, who has one year of experience and was trading Pokémon cards or something before showing up at a bank, earns more than our highest paid civil servants.

This creates some problems: talent retention and attraction are difficult, morale often sucks, and the people you get either are there for non-monetary forms of compensation (status, prestige, profile, or just caring about doing the right thing), or you get low performers who are lazy. That’s not a specific comment about any agency, that’s a statement about what that kind of pay disparity does. I would take a step further and say this is also systemic across the entire span of US regulatory agencies, not just the financial regulators, and it’s probably one of the most infuriating things about our government at times.

Also, you don’t have nearly enough people to compete with the small army of snakes and sharks2 at all the banks and hedge funds. This is before we throw the live grenade that is crypto into this mix.

Regulators Get All the Blame and None of the Credit

This is something we are terrible about as a society. The problem extends to journalists, to academics, to politicians, and to the general public. It has to do with the way the human brain works, and how we are wired to over-index on concrete bad things that happened while lacking that awareness about bad things that were avoided. Don’t believe me?

When was the last time someone said “fuck yeah” to the CFTC for implementing the tremendous hairball that was Dodd-Frank without breaking the derivatives markets and (mostly) moving everything to collateralized and cleared? Anyone? Anybody?

Okay, so maybe that was a hard one. How about the SEC? Has anyone actually had something nice to say about the agency’s efforts to overhaul money market fund structure and the changes to rules post-crisis that have, it seems, actually pretty dramatically improved the functioning of that space and forced people out of somewhat broken prime funds and into much more functional government money market funds?

Still tumbleweed and empty roads, huh?

Okay, rough. Then let me give you a super easy one: I’m sure that the Basel 3 reforms that the Federal Reserve has been championing are obviously, transparently, and globally popular, the subject of glowing press coverage and consistent and loud praise for everyone at the banking regulators working on extremely granular and specific details like specific risk add-ons for full look through methods for off-balance sheet insurance vehicles held by banks, right?

Fuck. Does nobody pay attention to any of this shit?

This is the problem regulators face. When they do good things, they get no praise and usually industry insiders bitch to them constantly because it erodes “competitiveness” or “profitability”. Worse, because they say that every single time (like the Italian footballer who falls down anytime gets within 5' of them), it’s hard to determine the noise from the signal of when a proposed change is actually bad enough that people will pull back from legitimate economic activity3.

You know what does get regulators lots of attention, though? When things go wrong. And it’s not the good kind of attention. They get blamed for everything. Sometimes justifiably, but often not justifiably, and the refrain of both “WHY DID YOU NOT DO SOMETHING” and “DON’T YOU CARE ABOUT THE CHILDREN” will be loud, constant, and worst of all, in all caps.

What this leads to is a very risk-averse decision-making framework, because all of the feedback they are receiving from the outside world point in one direction. Regulators have virtually no personal upside for allowing innovation, for championing transformation and the improvement of financial systems in terms of access, quality, and reliability (so long as the baseline system functions already, even if poorly), and certainly don’t get bonus points for making hard decisions in the face of pressure that yield long-term benefits.

But everyone will always yell at them when stuff breaks.

Regulators Don’t Have the Reps or Information

When you are a regulator, there’s a few things that are necessarily true of your job:

1. You are something of a generalist, as nobody regulates like just money market funds and thinks about nothing else (and if you do, please message me, I promise I will send help because nobody deserves that). You know who does think about almost nothing but money market funds? All the people managing money market funds. Thus, you are always outclassed in terms of subject matter knowledge and reps by the opposition.

2. You don’t have day-to-day knowledge. You don’t have to close your books and deal with breaks. You aren’t having irrational clients scream at you about market activity on a daily basis. You aren’t making mistakes and troubleshooting things and fucking up and losing money in ways that make you learn to perform or get fired. In short, you don’t have the scars and the lessons that you only get by doing in markets.

3. You don’t have the budget or resources of your opponents. I know people believe the government has infinite money (and in a technical sense, this may be true), but this does not mean it’s specifically the regulators who have that money. In fact, I can assure you that it is not. They don’t have infinite staffing. They don’t have super expensive consultants everywhere. And they sure as hell don’t have the ability to win a war of attrition with the industries they regulate, thanks to how the court system works in America4).

This is a difficult position to be in, as you can imagine. And you know what doesn’t help? When an industry is a wildly incoherent shitshow that mainly expresses itself through mutually contradictory tweets, wildly inaccurate marketing materials riddled with basic factual errors on day 1 things like FDIC coverage, and scam artists and self-promoters pushing any narrative they can for clicks.

You know, not to call out a specific industry or anything.

Now, Add Insanity

So what happens when you have all of these elements, and along comes a brash, chaotic, wild new form of technology that essentially does the following:

1. Insist it’s better and it’s going to destroy the legacy system

2. Do a huge amount of PR, raise a bunch of money in non-traditional ways, and completely fail to explain itself along the way

3. Lose most of that money to hacks, or just straight up steal it

Seriously. What did people think was going to happen? It should not be shocking that regulators are going to have a hysterically negative reaction to it. It’s mostly deserved.

When the number one priority is protecting main street investors, this sort of conduct is radioactive levels of toxic, after all. The active defiance of basic financial hygiene like operational controls, audits, multiple redundant systems, and even lip service to things like KYC is just absolutely wild to me.

In many ways, I’m surprised the regulatory reaction has been as positive as it has been in much of the world (though this is perhaps driven by the global macro view of taking economic share from the US).

As a result, we end up where we are in the United States: our banking regulators think that crypto is an existential threat to the financial system (as opposed to identifying there were multiple bad actors and the problem is not with the underlying technology), the SEC remains on the warpath, and the political will to do productive things is mixed at best.

What Should Crypto People Do?

I’m not often in the business of straight up giving advice to strangers, but here I’m going to do that and suggest the following.

One, have a little humility. One advantage regulators often have is that they’ve seen some shit. Listen to the concerns. Try to understand why they have them. Study financial history, especially financial crises. If you can speak their language and understand what they are worried about, you’re going to have a much better dialogue with them. Failing that, at least hire some consultants to get you up to speed here.

Two, those who are building compliance, risk, and security tools need to do a lot more education and outreach. If you run an exchange that is continually being accused of money laundering, you might want to instead show you are taking serious efforts to combat that and helping regulators catch the bad guys, as blockchain technology can be surprisingly good for that, as one example.

Three, call out bad rules when you see them, and don’t just give things away to regulators. However, the other side of this is that you need to call out bad actions in the crypto space and clearly identify them, and sometimes, you need to tell the truth and not narrowly talk your commercial interests. Rather, take your business hat off, put your consumer protection and citizen hat on, and get people up to speed even where it might not be in your favor.

Four, do the right thing yourself. If you don’t know how to build institutional grade, safe, secure, and robust financial operations (if you are ever handling customer money) or crypto operations, get help.

Simple, I know, but I think it would go a long way with at least some of the people in the regulatory world (who are genuinely good people, but just don’t have much tolerance for nonsense that harms consumers). You won’t win over everyone, and some of them are people on political power trips or with uninformed agendas, but… crypto has a fair share of crazies as well.

If you are in the space, you are reading this, and you care about what I just said but don’t know how to do this, I literally started a consulting firm for exactly this reason. Feel free to reach out. If I can’t help you, I can probably at least give you some thoughts and maybe point you at some people who can.

What Should Regulators Do?

My advice to most regulators would be the flip side of the coin, which is to do the following:

One, try to find trusted people in the industry that you can get in contact with so that you can accelerate your learning curve. One of the nice things about crypto is that a lot of people will just straight up talk to you. Those who run around the industry not giving a fuck about being judged by certain ivory tower types and instead learning everything they can as fast as possible will massively outperform here5.

Two, don’t buy the claims of crypto people without skepticism. There’s a lot of ideologically motivated folks who are light on facts. If you don’t get good answers to questions or they constantly talk about reinventing the financial system without knowing what maker checker controls around trades are, you are probably right to doubt. Get some second opinions. The tech being good doesn’t mean specific actors are good.

Three, also don’t buy the claims of financial institutions without skepticism6. This is the flip side of the coin: most of them would prefer crypto go away because it competes with them and might stop them from charging egregious fees due to their near-monopoly status to consumers. Don’t be part of screwing over the little guy to make sure a bank CEO gets their second yacht, either. These folks totally have an agenda and anything said to you by this crowd about crypto should be met with extreme skepticism, as most of them know very little.

Four, actually do the homework to know the facts. The next time a regulator tells me crypto is rife with money laundering without knowing the DoJ itself believes that there is more money laundering by percentage and amount in the traditional financial system, I’m going to throw something. More to the point, the structure of public blockchains and the tools emerging mean that over time, it’s probably a better system for interdicting illicit finance than opaque private bank transfers with limited information. Technophobia is one of the greatest long-term dangers to our financial system; don’t fall for it!

The best regulators in this space, like the CFTC, NYDFS, and JFSA, have struck a very strong balance between all of these forces by understanding the core mission: put consumer safety and fair conduct first, understand the market and the participants, insist on best practices, and work to create a level playing field.

To that end, if you’re a regulator reading all of this and have questions or need help, also feel free to reach out. I know how hard your job is already.

Do you believe that, in order to make an electronic payment in the United States, first you should have to loan money at 0% to a venture capital firm, a billionaire real estate mogul, or a rich law partner looking to buy a second vacation home?

Most people would answer “no” to this question.

So if I told you that the answer to this question in the current American financial system is actually “yes”, how would you feel about that? What if I also told you the current rules mean you are not allowed to have another option, and you are trapped?

How Things Work Part 1: Banks, Simplified

The starting point for most payments in the United States is a bank account. While there are rare exceptions to that system, for the overwhelming majority of retail payments (and many corporate payments), the starting point is the humble checking account.

So what happens with that thing? From the perspective of the customer, it’s simple: you give money to your bank to put it in that account, it’s there, and when you need to pay bills or buy stuff, you spend it. How? Debit card, check, cash at an ATM, having your credit card paid off by the funds, etc. It’s all pretty simple. If you want to be simultaneously fancy and live in like 1948, you can send a wire.

Now, that is the customer perspective, so here is the more interesting question. What happens on the bank side when you deposit money into your checking account?

Banks receive deposits, and they become liabilities of the bank. This is important to understand, as it is very much not the case that the bank just keeps that money, set aside, segregated, as purely the property of the person who gave that to them. That is a custodian. The bank, more specifically, is taking your money and can do whatever they want with it1. What do they pay you for that privilege?

As of August, 2023, the national average is 0.42%2.

That is not a typo. In an environment where the Federal Funds target rate is 5.25%-5.5%3, banks are paying through an average of 0.42% on your checking account, meaning even if they lend risk-free to the government, they are pocketing 5% for letting you give them money, and then giving you a tiny amount. If they lend that onwards to billionaires and venture capital firms, they keep even more of the spread, and still pay you the same amount.

So let us pause for a moment and ask a simple question: is that a fair price to be granted the privilege of being allowed to pay people for things?

How Things Work Part 2: When Things Break

If the story ended there, it would be a simple conversation about what the price of access should be. There are many viable answers to that question: zero, some small amount, or several percentage points of your money every year, such as in the current system4. The story does not end there, however.

Remember that part where you deposited money to the bank and they start doing things with it? Those things typically involve taking credit risk to people they have lent money to, and also taking duration risk5 to the term of those loans if rates rise. Let us just say that banks have a history of getting themselves into trouble with those kinds of risks6, to put it gently.

This means that, for the average person, you are putting money into a black box7, and then praying the box does not explode and you lose all your money. We have the FDIC in the United States precisely because of this problem, but that covers you up to $250k. More than enough for a small individual account, but what about a regular business just taking payments? Is that enough for, say, a grocery store? How about a Best Buy location? Do we really expect Wal-Mart to have 54,1828 bank accounts just to avoid credit risk? At that point, Wal-Mart should literally just start their own bank (some companies have done this!).

In short, once you incorporate credit risk, now you are essentially both paying a huge subsidy to rich borrowers who are the borrowing from a bank and essentially selling the bank CDS protection for free9 on all funds over $250k, just to be allowed to use the payments system.

Yikes.

How Things Work Part 3: Timing and Tracking

Another problem with the current banking system is that it is (unnecessarily) slow10.

Electronic signals move very quickly, yet somehow wiring money around the world takes 4+ days and is subject to the whims of banks and completely non-transparent. If you send money from the United States to a relative in Hong Kong, what is the pathway the money takes to get there? You don’t know, do you?

This is completely unnecessary. Many of these delays are due to regulatory compliance, but many of them are also simply due to oligopoly power of banks and delaying things so they can make extra money on the friction.

What this does do is create a web of confusion and opacity for the average user. Sending money to a relative overseas (or even just at another domestic bank!) currently means you are going to not exactly know where your money is for an unclear amount of time with no real understanding of if/how/when errors occur. Also, you’re not earning any interest (not that most banks are paying you anyways) on that money while it is in flight.

Does this seem fair?

What is a Stablecoin?

For those who have read my work elsewhere, we are going to come back to a familiar definition that I have used repeatedly.

A Stablecoin is a unit of fiat currency represented on a blockchain.

For such a simple statement, there is a lot that is said. Ignoring the issues of designing a stablecoin properly11 for now, let us just simply say this is a US dollar stablecoin backed only with transparently disclosed reserves of very short dated t-bills. That’s something that almost everyone (banking regulators, the SEC, FASB, etc.) agrees trades at $1. So what happens when that thing exists?

First, it removes the problem of subsidizing risky borrowers. Depending on the design of the stablecoin, and whether it is interest paying or not, you may be subsidizing the government. However, what you are not doing is lending that money to the usual suspects that banks lend it to. Lending solely to the US Treasury, while still perhaps something that could end badly, is at least within the realm of basic expectations for holding money. People will not be surprised when their US dollar stablecoin is impacted if there are stability problems for the dollar itself.

Second, it removes the black box problem of bank solvency. In addition to not subsidizing risky borrowers, now you are not also staring at a horrible black box that contains a mix of mortgage lending, corporate lending, underwriting and issuance, prop trading12, asset management, prime brokerage, and who knows what else just to use the payments system. A very vanilla, narrowly designed stablecoin means solvency comes down to two simple factors: one, is the stablecoin company run by idiots who make catastrophic operational errors (no escaping this one for any company) and two, is the US government itself solvent? This, I might suggest, is at least something you can try to reasonably assess from the outside. If your stablecoin holds reserves bankruptcy remote13, even the first issue isn’t fatal to you, just annoying.

Third, you have solved the transfer problem. Sending money on a blockchain is near instantaneous. In fact, it’s downright miraculous compared to the four day journey of my friend Omid’s international wire. Similarly, it’s quite cheap, if you use the right chains. This means that you know where your money is up until the point that it vanishes from your wallet and appears in that of the recipient, at which case you can see it has been delivered. You know what this doesn’t allow for? Four days of delays, games, and correspondents fighting with each other at your expense to scrape basis points of interest.

So we’ve gone from subsidizing billionaires building commercial real-estate, expecting plumbers, nurses, schoolteachers, and grocery store chains to perform their own due diligence on global megabanks to ensure their funds are safe, and allowing intermediaries to deliberately gum up the system or just refuse to innovate to delay payments for their own benefit and/or laziness, to a system that is instant, transparent, and puts people in control of their own money.

Is it any wonder that the entire financial system fucking hates it?

Competition

There is nothing that incumbents with special privileges hate more than fair competition. Certainly, this is part of the hysterical reaction to blockchain technology and the driver of banks and certain bank advocates and regulators14 to the innovation. From the perspective of banks, this is an existential threat to their business: zero cost, instant transactions without the need for an intermediary would wipe out entire (very profitable, because they have a monopoly of economic force) business lines. More so, it would have a fundamental impact on the profitability of the entire industry. Multi-million dollar bonuses are at stake, you see.

In short, stablecoins represent a full front assault on the traditional arrangement that even something like the Narrow Bank15 could not quite achieve, because it did not have the connection to a blockchain and the many-to-many payments network attached.

At the core, this represents a complete re-negotiation of the financial structure of our payment system. A system based on stablecoins of this sort means:

1. Users of the payment system do not subsidize borrowers implicitly16

2. Users of the payment system do not have to understand or try to evaluate black-box complex financial entities just to make electronic payments

3. Legacy payments systems built on intermediaries and delays cease to exist

Is this not a strictly better system for the average user?

Yes, large borrowers will pay higher costs for debt (is this bad?). Yes, many large banks will become significantly less profitable (is this bad?). However, the average person takes less credit risk, has more control of their funds, and can send their money when they want, to who they want, for virtually zero.

More so, customers of this sort are much cheaper to deal with. The entire cost burden of banks is virtually gone with regard to payments. Now, anyone who can create an electronic wallet and deposit funds is formally part of the system. From a financial inclusion perspective, you don’t have to worry about their credit, you don’t have to worry about compliance17 to the same degree. The entire cost structure is, well, deconstructed.

What does this mean? The kinds of customers that are unprofitable and get terrible service or worse, no service at all from banks? Now they can also be fully integrated into the system.

I suggest this is important.

Time Ends All Monopolies

This progress is inexorable. Forty years from now, we will not be transacting with an opaque, highly centralized, extremely expensive system when the technology and economic incentives to do better exist. However, one prediction I will make is that the places that will embrace this first are actually the ones who are the furthest behind now. Just like Africa, in many cases, went straight to mobile phones and skipped the landline, payments systems will likely evolve in areas with rickety or poorly run financial systems first.

Yes, the marginal benefit of this system in the United States is real, but it’s marginal. This benefit in Argentina, where you could get on a global, fast, secure, peer to peer omni-ledger and use dollars to avoid the local inflation of 100% per annum that has been running for decades? I’m no rocket scientist, but that seems pretty compelling.

Once that happens, then technology will begin to bleed backwards. If you trade with people who are doing that, why stay on the old system? It begins to flow downstream to the places that were slower to adopt. Right now, most Western nations face the nation-state equivalent of the innovator’s dilemma with regard to this, so they may very well go last. Just like the disrupted companies often move last and get run over as a result.

But it will happen, eventually.

The question is just if someone else will go first, and seize an outsized share of the economic pie as a result.

Stablecoins are coming

This is something that I have been saying for a while. Stablecoins are inevitable1.

Our choice is not to prohibit stablecoins or allow them, it is to allow them elsewhere and out of our control, or to allow them here, under our control. This “here” applies to basically ever major nation where people want to use or implement stablecoins, as the horse is already out of the barn and has been for a long time.

For truly small nations2, I would also add that my personal belief is the stablecoin may be the end of local currencies, either completely or for use as anything other than mechanisms to pay the government required amounts of money in that currency.

Why is this happening now?

Blockchains Create Options

Fundamentally, one of the most important impacts of public blockchains is that they will erode monopolies over time. My friend and crypto co-conspirator Omid Malekan has written about how crypto will lead to a re-imagining of the current highly centralized, highly opaque, very consumer unfriendly world of global value exchange, and I’m going to attempt to summarize the parts of his argument that I agree with here.

Platform Incentives Suck in Web2 and for Banks

Within a corporation, the first duty of management is to the owners. Be those shareholders, for public companies, or the partners and private owners, for private companies, these vehicles exist to generate a profit for their owners. This means that when walled gardens emerge, the natural tendency is to treat the customers within that walled garden like livestock: fatten them up (build the network effect) and then harvest them (charge as large fees as possible that don’t totally destroy your network effect). It is, essentially, an abusive relationship: they hook you in, and then they don’t let you leave. Consumers know this, and don’t like it. Most of the tech monopolies are not popular, and banks are especially not popular. Nobody wants to be lending to risky VC companies and funding commercial real estate for the rich just to use the payments system, and nobody wants to pay 30% for a privilege of buying an app on a phone you already paid $1,000 to own, but this is how walled gardens work.

Enter blockchains. Suddenly, there is an open-source, interoperable tool for communication, storage of data, and transfer of value. Where is the wall? Now the garden has escaped and it’s in the wild. Everything is the garden, so to speak. When users have the option of having their own control, they are likely to prefer this over time3.

Interoperability Matters

Part of the reason these walled gardens exist is that people build things to keep others out. Want to be in the app store for the iPhone? Pay your tax to Apple, go through their rules and procedures (which they can change whenever they want), and bow down to your corporate fruit-adorned overlord. Don’t want to? They kick you off the platform, or don’t let you on in the first place.

I want to be clear: I don’t think there’s anything illegal about that (so long as they aren’t engaging in some monopolistic practices), but I don’t think it has a right to exist or be profitable, either. I believe in markets solving these problems.

One of the big solves with blockchain is the interoperability. Companies that embrace the technology and allow it to work that way will now have the ability to be composed with apps from other companies, or find use cases they never expected. Settling invoices between Finland-based merchants with Afghanistan-based vendors using USDC on Sui? This is possible now.

Before, that would have taken a bunch of hops through banks, if any bank would even process that (and if they don’t, they won’t tell you why or let you appeal, mostly).

Why can this happen in this way? You now have a wallet provider (built anywhere) and a stablecoin issued from the United States that, thanks to the architecture of the system, can all be used for a peer-to-peer transaction to settle that can then be brought back into the local system through a stablecoin or exchange4.

Trust Assumptions

Another important feature is that trust no longer works the same way. With a blockchain, you don’t have to trust some nameless or faceless institution to handle your money properly. Instead, code is law. Now, this obviously has downsides, but the upside is very simple: if you use the blockchain in a valid fashion5, you know what is going to happen and your things work. The good news about this is you can be in control of your own tokens with self-custody, you can choose when and how things are sent out, and you can, in general, build a system that is not reliant on others6 to work properly. The bad news about this is you don’t have centralized entities to run to if there are screwups, so there is a balancing act between error rates in the crypto system vs. failure rates in the traditional system that is under-discussed.

However, as tooling and the user experience improves, reducing this error rate and complexity means that the crypto system should, in theory, be strictly better once fully developed. Again, I don’t think we are anywhere close to that, though we are moving in that direction.

PYUSD

This brings me back to PYUSD7. One of the ways that progress emerges is early adopters will become increasingly scaled, formal, and understand their use cases for which they are adopting the technology.

I believe this is the case with PayPal. The first thing to understand is that this is a remarkably forward-looking move for a company. Most firms, when faced with disruptive innovation, adopt the emu strategy of burying their head in the sand and pretending there is not a problem. PayPal, instead, has taken the challenge of technological evolution head on, which is good, because their old business model was going to have problems if the world went to an open-source framework.

You’d always rather disrupt yourself on your terms than have someone else do it to you on theirs.

The other point here is that this has massive ramifications for everyone else in the payments space. If you are at Visa, Mastercard, Amex, Stripe, or any number of large banks, today marks the start of a very important moment in time for you.

Do you follow PayPal quickly, attempting to learn from any mistakes they make and overtake them after drafting in their wake (fast follower)?

Do you think deeply about what they have done and reject it in favor of a different path, which may be a correct or incorrect decision, but is at least decisive (regime shift and/or building up the current moat)?

Do you get paralyzed trying to figure out what the right path is and really do nothing while slowly being eroded by your competitors because you don’t want to give up your current position (the classic innovator’s dilemma problem)?

This is a critical decision point that is going to lead to massive success or massive failure for all of the companies that need to react to what PayPal has done, and all of them are now playing from behind in this game.

So what do I think the impacts here will be?

Legislative Action

This sort of thing is what spurs people to act. There is clearly a (narrow) path for non-bank but professional issuers to do stablecoins right now. Having them be the only ones who can do this is fundamentally weird, and the fact that a company as large and important as PayPal pulled it off means that Congress will probably realize this issue is not going away.

They should act. This is not to say they will (nothing in Washington is certain), but the odds are likely growing by the day.

Regulators Asking Questions

Prior to legislation, our regulators are now in a particularly challenging position. The banking regulators have largely been anti-stablecoin or, at best, stablecoin tolerant, with the exception of a few notable states (NY, Wyoming, Nebraska, in particular). However, now you have to confront this issue. PayPal is simply too big to simply tell people not to do business with them, and attempting to that will make the political football far more toxic and dangerous to the regulators themselves. Instead, the regulators that have been pushing this away now probably have to ask themselves how they are going to start to manage it and live with this situation, because it’s clearly not going away in the United States, nor is it going away abroad, as if you think PYUSD is the only thing coming…

Talent Wars

As this starts to take hold, one of the realizations that a lot of people are going to have is that there’s not a huge body of people who understand how to do these things well. New technologies are disruptive by nature, and small groups of people with direct experience are usually the ones who drive adoption across a series of firms over time8.

Basically, stablecoins are a somewhat unique problem, and just like with other emerging technologies, those with specific expertise in the space are going to drive it forward. The team at PayPal, former Circle, Paxos, and Tether employees, and even those at some more normal fintechs or more crypto-native implementations will be in high demand as the space expands9.

Obviously, one angle is issuing stablecoins, but there are many others: integration, usage, risk management, vendor evaluation, business strategy, and so on.

I mean, I literally started a consulting firm10 to help people with these kinds of problems.

Dollar Expansion

Most important is the expansion of the reach of the dollar. Now, anyone with a PayPal account can get their hands on this token. That is not a small thing. Giving people, globally, the ability to opt out of their local system and into another system is incredibly valuable. I think this is one of the most understated impacts of stablecoins, and one of the most important in the long-run. Having global on ramps and off ramps with a trusted, battle tested platform like PayPal means people can use this, and they aren’t going to be subject to the whims of banks doing things like closing accounts because people dared to leave their walled garden and use crypto instead. Just send money to your PayPal account now.

Conclusion

This is a long-term positive for the space. A player like PayPal entering the field is material, for credibility, for access, for public education, and to force everyone else to start grappling with the reality of blockchains and the types of commercial applications they enable.

I predict we’re going to look back on this as a turning point in five years, for PayPal, but also for the usage of blockchains globally.

Today, the SEC disclosed their latest broadside against the crypto space, and there have been a number of takes flying around with regard to it. Despite the fact that my writing is dire enough to convince some, I am not a lawyer myself, so I wanted to read the entire thing and then respond with thoughts on how this impacts the business of exchanges, crypto, and what the long-term effects will be for the space.

Let there also be this important caveat: everything here is based only on allegations from the SEC. We have not seen a response from Binance and they have not yet had a chance to defend themselves. Neither party in a lawsuit deserves unconditional belief or the ability to make facts up that are not true, so please take everything here as a hypothetical possibility until more facts emerge. They are, for now, just allegations.

Also, perhaps, why I think the effects will be long-term given the current political situation in the United States.

Summary of Claims

There’s a lot going on inside this document, so I’m going to try to summarize in a way that is understandable to a normal two-legged human being.

First, in terms of allegations, the SEC is stating the following:

1. Binance operated in the United States as an exchange, clearing agency, and broker dealer with regard to their exchange operations.

2. Binance has directly acted as the issuer / in a material partnership regarding securities with thinly disguised language around BNB and BUSD1.

3. Binance has facilitated trading of other crypto assets on their platform

4. Binance has lied, misrepresented, and obfuscated the actual activities of their legal entities such that they were:

   1. Faking volumes on some exchanges

   2. Engaging in trading against their own customers

   3. Lying about / fabricating controls

   4. Faking the independence of Binance.US

Note that the SEC having authority over these things is predicated upon them being securities. The S in SEC stands for the Securities and Exchange Commission, after all. With that said, even if the assets are determined not to be securities and that the SEC does not have authority (a thing that is going to take years to determine, and also one where the collateral damage in the meantime is going to be significant - more on this later), the conduct in bullet number four is clearly impermissible if true and the structural issues in bullet one are something that I have talked about before in the crypto markets.

Put differently, even if I have harsh words for the SEC at times and think they are being profoundly damaging in their approach, that does not mean that everything they say is incorrect or that there is no merit to various accusations. It can be the case that both things are true at once.

To that end, let us go through these in order.

Binance operated in the United States as an exchange, clearing agency, and broker dealer with regard to their exchange operations.

What does this actually mean? In a normal financial arrangement, when you have an exchange, that exchange does not do everything. They are not typically the custodian, they do not typically clear or settle the trades, and they are not the brokers going out and facing customers (as the usual path is customer to broker to exchange; you don’t directly transact with the exchange as a retail trader in the US).

Now, ignoring the broker dealer part (as with crypto, it is possible and feasible to deal directly with the exchange), this does raise an important structural point:

The fact that exchanges are the exchange, the custodian, and the clearing agency all at once is a bit uncool. What this means is that centralized exchanges (CEXs) in the crypto space are among the most centralized financial entities in all of existence. They take many things that are done independently elsewhere, with checks and balances through the fact that they have different responsibilities, and glue them together into a single horrifying Frankenstein. Note that this has absolutely nothing to do with crypto or blockchain. The fact that we operate this way is a structural choice that has nothing to do with the chain itself; this is off-chain activity.

Is this good? I would suggest no. This sort of centralization is part of what allowed FTX to persist for as long as it did. There are better structures where these things can be separated and crypto would do well to adopt them.

However, is this something the SEC should police? Only if these things are securities, and even then, there will need to be rulemaking and guidance because the current acts the SEC authority is based upon, which are very old2, don’t exactly work with how this would be done on a blockchain. Much better would be legislative clarity, which is what the original acts creating the SEC were written for.

Binance has directly acted as the issuer / in a material partnership regarding securities with thinly disguised language around BNB and BUSD

This one is a bit more interesting to me. First, to dispense with the ICO point, it is entirely possible to me that depending on the terms and conditions of the original distribution of BNB, it could have been a securities offering.

However, if so, in their own complaint, the SEC points out that the offering price was $0.15 and it has traded as high as >$300. I’m going to have a hard time finding some theory of damages here that is going to be particularly persuasive to a judge. If anyone damaged investors, it was the SEC nuking BNB prices today with this filing, but even then, if you were in the ICO, you are way, way, way up.

Now, as a matter of conduct, should people not be doing unregistered securities filings? Yes. I do agree with that. But when we get to the section on relief being asked for, let us remember this: they are upset paperwork wasn’t filed when investors clearly got rich.

A secondary point, one which my friend Lewis Cohen has spoken about far more eloquently than I ever could, is if BNB is still a security even if there was an initial securities offering. Here, my answer is “…uh, maybe?”, but we would have to see a lot more facts than what are in this filing for there to be a clear answer on that.

Now let us move onto BNB. The relevant section there is as follows:

First of all, to give readers a tenor of how petty and tenuous elements of this filing by the SEC are, let’s first start with the “purportedly” backed part.

BUSD, to be clear, is issued by Paxos Trust Company3, which is an NYDFS regulated trust company that has pretty strict rules around the management of reserves, replete with risk and controls requirements as well as disclosure requirements. In my time at Paxos, we moved to absolute best-in-class reporting on the assets backing the stablecoin.

In different words, the “purportedly” there is accusing Paxos of fraud and accusing the NYDFS of failing to regulate the reserve. To the best of my knowledge, and with certainty for my time at Paxos, not only was all the money there, it’s actually the only one of the major three stablecoins (along with USDC and USDT) that has had zero doubts about the reserve and been at the forefront of both disclosure and safety.

For the SEC to come out and make a statement essentially falsely accusing another US regulator of malfeasance is pretty beyond the pale. If they meant something else, they should have said it.

Second, the argument for why BUSD is a security is quite expansive. The theory that all it takes is a commercial arrangement where there is profit and an intent to distribute is extremely broad. Agreeing to help with listing and distribution, and profiting from that, is basically how… things work?

I’m going to be interested to see how the rubber meets the road on this one with a judge. I do agree it’s possible there could be some sort of investment contract, but for that to make BUSD the security itself is pretty much the exact opposite of the original finding in Howey (spoiler alert: the oranges are not securities). For something to be the product of an investment contract does not make it investment contracts all the way down4.

This is one area where I will be watching the result very closely, as a finding that this sort of arrangement is specifically a security could implicate all kinds of things that we are not currently thinking about as securities in the United States, and also puts the SEC perilously close to stepping onto the turf of banking regulators if they push the money angle of this argument.

If nothing else, it’s a previously undisclosed view that a specific type of activity engaged in by many parties (for example, almost the exact fact pattern alleged here would also apply to Starbucks profiting off user funds for Starbucks gift cards or their app) that magically sprung up through an enforcement action rather than any rules making.

With that said, like the previous point, are there specific activities that were taken with BUSD that could be a securities offering? Yes. I think that’s possible. See my previous comments on BNB. However, does that make BUSD itself a security? Likely no.

Binance has facilitated trading of other crypto assets on their platform

The SEC specifically calls these crypto asset securities, a term that is not actually a legal term but just a way of saying it’s a security. What confuses me about this is the list of assets they picked to target, other than the aforementioned BNB (maybe) and BUSD (…sigh).

They are:

SOL, ADA, MATIC, FIL, ATOM, SAND, MANA, ALGO, AXS, and COTI

I genuinely have no idea what is going on with this list. It’s like a robot randomly generated a list of tokens and decided to go after them. There are some of the layer 1’s on the list (SOL, ADA, MATIC, ALGO, ATOM), but… FTM is not on there, AVAX is not on there, and more notably, LUNA is not on there. Yet some of those have the exact same characteristics and arguments as the things listed?

Did they just do a few and stop? Were they not aware of the existence of other tokens? Do they inexplicably think that FTM is not a security but ALGO is? Do they think some of them lack a US nexus? Did they just forget to include, oh I don’t know, the one where investors and consumers were actually badly damaged and they would have the best claims!?

This is the work of a madman.

Do you know why this is also so inexplicable?

Because it is 2023, and the SEC has still not publicly written a clear statement or made rules on what makes a token a security or not. They do not tell people what features they use to determine them. They do not explain how they are making determinations that seemingly apply to many tokens but are only naming a few. They don’t tell you how to register (everyone that has tried has failed, either by registering in a way that makes them illegal and thus shutting down, or failing to register).

It is, to say the least, confounding. Certainly, for a regulator charged with investor protection, consumer protection, and capital formation, it’s a path to likely achieve literally none of those goals.

Binance has lied, misrepresented, and obfuscated the actual activities of their legal entities such that they were…

So I want to be clear on this list of things: if there is truth to the allegations being made here, then whether the SEC is the correct regulator or enforcement authority for this action or not, these are bad.

Some of them are very bad.

I would say the minor ones are commingling if it was purely operational mistakes, and the whole issue of independence of people when you report up a chain to ultimately the same executive as other entities.

The medium ones would be the wash trading (not actively harmful, but clearly deceitful market conduct and something that should not be occurring), commingling of funds out of laziness or convenience, and if the independence was fake and a shield to block things out of paranoia they would be unfairly targeted in the United States.

The very bad ones would be the whole lying about controls that did not exist (inexcusable in any context), commingling funds to specifically engage in activities that you had said you were not engaging in, or if the independence was always fake and these were known puppets where even the employees were deceived.

In no context would these things be acceptable, it’s just varying degrees of bad. To that end, I do want to hear the Binance side of the story, and the fact that I have some very pointed criticism for the SEC’s approach does not necessarily mean the other side is a good guy.

If two hardcore criminals shoot each other simultaneously in cold blood, there’s no good guy in that engagement. It’s possible that is the case here. I’m not rushing to judgment because I believe we have the legal process for a reason, and I’m still not convinced the SEC is the right regulator, but I do want to be clear that if the conduct here is as alleged, it’s somewhere between bad and very, very bad. It should not be allowed to continue or ignored.

What Does the SEC Want?

So based on that, let’s look at what the SEC is asking for in terms of preliminary and final relief.

Let’s be very clear about what this means:

They want Binance to be bankrupted and shut down as part of the temporary and preliminary relief. This is the kind of thing you ask for when the conduct is so bad that it’s a clear and present danger to everyone involved for it to continue for even one more second, and the collateral damage doesn’t matter.

Why do I say that? Note the part about asset freezes, repatriation of assets, and the appointment of a receiver.

That is what you do when you kill a financial institution. None of that, I repeat none, is about anything other than putting something to death. This is a bald-faced ask that, as a temporary injunction before any real activities have occurred, a court shut down Binance purely on the speculative say-so of the SEC.

This seems inappropriate. If they have cards that show Binance is actually a ponzi scheme actively damaging customers right now in the sense of FTX5, or that there is a clear and present danger that Binance has misappropriated all the user funds in a way that would justify this action, they need to say that in a filing. They have not.

Without that, killing Binance or crippling it in this way would, with certainty, damage investors, damage customers, and benefit basically nobody. They are basically threatening companies with death for not bowing down to regulation by enforcement.

Gary Gensler: (Michael Palin) (looking round office casually) You've... you've got a nice army base crypto exchange here, Colonel Brian.

Brian: Yes.

Gary Gensler: We wouldn't want anything to happen to it.

Brian: What?

Dan: No, what my brother chair means is it would be a shame if... (he knocks something off the mantel listing page)

This is how you know how extreme the position is: the people that the SEC is purporting to protect with this action are the ones who would actually be harmed the most as their assets collapse in value because the SEC itself killed the value.

“Pay up or we destroy you” is the conduct of thugs and criminals, not legitimate regulators.

The other relief they ask for, which are at least not insane, basically involve kicking Binance and CZ out of the US and never letting them operate here, as well as civil penalties for the misconduct and lying. These I agree with - if they are guilty as charged, then these are fitting penalties.

That first part, though.

Implications for the Space, Customers and Investors

What do I take from this as a businessperson, as ultimately, that’s what I care about?

I would say the following:

First, don’t assume the SEC intends to make rules or act openly until they sue. If you operate in the United States, they will take insanely broad maximalist stances (see the BUSD as security argument), and if you don’t play ball with them, they will file things like this about your business. Here, there are also allegations of very real misconduct, but this has not always been true elsewhere (LBRY anyone?).

Second, given the US political stasis, the only fix for this currently is the courts. If 2024 is a landslide for the Republicans (or a very different Democratic president), then maybe we get a change a full year after that. So at the earliest, we are talking roughly 2.5 years of continued litigation and enforcement by regulation. The only path to clarity will be through the courts, and that is also a path where one has to be aware judges do what they think the law says and permits6. It’s entirely possible you get a very left field ruling on crypto that is crippling to both the SEC and the sector if you push your luck.

Third, given the lack of compliant trading venues in the United States if the SEC’s theory is true, we could be in a world of hurt for retail crypto traders. Nothing would be more devastating to the investors that the SEC is purporting to protect than if they actually forced all the US exchanges to shut down and people could not trade their crypto. However, given the path they are proceeding down is one where it does not appear to be functionally possible to trade crypto (there are zero clearing agencies, for instance, who can touch it based on current rules, and they just said people have to “register” as one), the SEC’s current theory of crypto amounts to a complete ban in the United States and people should be aware of that.

To that end, note that the market for non-security crypto assets (even those the SEC has not called securities, like BTC and ETH) are down significantly on this news. If you believe that information is priced in, the market seems to understand better than the SEC itself that the current SEC path damages, not protects, investors.

I continually advise my clients in this space to avoid the United States for now. Things like this are why; when you don’t have to take on this kind of risk, why would you? The loser will be the United States.

With that said, there is very little new in this filing. It’s just a continuation of themes the SEC has been banging on about for three years: everything is a security, you have to come in and register, but also our requirements are that to register, you have to stop doing crypto and just do traditional securities. And if you don’t, we’re going to burn your house down.

Legitimate vs. Illegitimate

So why am I writing this post, and why is my reaction to this filing so negative?

The core problem here is one of legitimacy.

Again, I want to re-iterate the point that I am not necessarily supporting Binance. If some of the actions are as alleged, they should not be permitted and there should be consequences.

What I am against is the following:

Regulators making up the rules as they go and refusing to provide clear notice for people to understand what they are. Legitimate rules are transparent and understandable. If I park where I am not supposed to and it was clearly marked, I deserve the ticket. If there is no signage, no way to know, and it depends on a subjective determination by a parking officer, that’s not legitimate and is a pathway to corruption and collapse of rule of law.

I am against regulators going rogue. Unless you are okay with operation chokepoint 3.0 under the a future extreme administration targeting immigration attorneys, abortion providers, liberal media organizations, public sector unions, and electric vehicle manufacturers because they are high risk activities, you should not support the SEC’s conduct here. Unless you are okay with a future administration doxing every single vendor or counterparty of a financial product to intimidate them without any legal process, you should not support the SEC’s conduct here. Unless you are onboard with extending legal theories to what is convenient so that any company in America can be a target at any time for enforcement based purely on the whim of an unelected bureaucrat, you should not support the SEC’s conduct here.

Lastly, when you ask for relief, clearly state the claims and have that basis be grounded in reality and based on your mandate. If you are charged with investor and customer protection, don’t ask for relief where the primary effect of the relief is to nuke investors and customers from orbit while you cackle maniacally and tell people you are protecting them. This is Bond villain level conduct.

There could have been a more narrow complaint against Binance for basic consumer protection issues that could have been filed. Maybe that would not be the SEC alone, or maybe they would have had to cooperate with another federal agency (like the DoJ) in order to do this effectively. They did not. They went big, with novel theories previously undisclosed or stated (see the token list, again) and enforcement actions designed to intimidate. This is not doing the right thing.

This filing is not about consumer protection.

This filing is not about investor protection.

This filing is about power.

Austin Campbell is the founder and managing partner of Zero Knowledge Consulting, as well as an adjunct professor at Columbia Business School. He has previously run the stablecoin platform at Paxos, run trading desks at JP Morgan and Citi, and been a portfolio manager at Stone Ridge, the parent of NYDIG. Austin has been in crypto since 2018 and has been trading and structuring profoundly weird financial instruments for decades.

This morning, I am seeing an awful lot of angst about the latest proposal from New York State about crypto regulation, up to and including tweets about how this will be the end of crypto in New York.

I think all of this is profoundly misguided.

I want to start with a quick breakdown of what this proposed framework is actually calling for:

Eliminating Conflicts of Interest

Specifically, the bill says the following about interconnected activities:

• Preventing common ownership of crypto issuers, marketplaces, brokers, and investment advisers and preventing any participant from engaging in more than one of those activities;

• Preventing crypto brokers and marketplaces from trading for their own accounts;

• Prohibiting marketplaces and investment advisers from keeping custody of customer funds;

• Prohibiting brokers from borrowing or lending customer assets; and

• Prohibiting referrals from marketplaces to investment services for compensation.

I am going to be blunt for the crypto crowd: this is all extremely normal in traditional finance.

It should be standard practice that exchanges and brokers do not trade against their customers with knowledge of order flow. It should be standard practice that centralized marketplaces aren’t also the custodian (this is how FTX happens!). It should be the case that brokers can’t lend out customers assets (or at least not without express permission and a better regulatory structure than just being a broker). Undisclosed referral payments or those with inherent conflicts of interest should be prohibited.

This is all very normal and reasonable. There’s no good reason that the exchange should get to issue tokens that they trade on the exchange with insider knowledge; there’s no good reason for exchanges to trade against their own customers; there’s no good reason not to use an external custodian with verifiable balances so you know your exchange isn’t selling all the BTC and yolo’ing into shitcoins.

The last one is a step beyond so-called “proof of reserves1”, in that it actually creates a binding legal structure where the customer assets belong to the customers, at a totally different firm with a fiduciary duty and legal requirement to return those assets.

One of the big problems with crypto is how we currently structure exchanges. First, in traditional finance, this is basically how things work:

What this means is that there is separation of duties and legal responsibilities, and it’s quite hard for the exchange to abscond with people’s money (because you’d need to compromise the custodian and the clearing agent as well!). Also, notice the exchange is not trading against its own customers (another big no-no).

So how does it work in crypto?

And we wonder why regulators have a problem with the space?

Seriously, look at those two diagrams and think, for a moment, about what we have done. Crypto, a space ostensibly founded on decentralization, self-custody, and breaking away from the legacy system, is somehow responsible for the creation of the most centralized, trust-dependent financial entities on the entire planet (outside of possibly central banks), and is now defending them from a regulatory proposal that would make them more decentralized?

Mandatory Auditing and Financial Statement Disclosure

Again, this is pretty normal stuff. Here, there is going to be something of a bar that favors incumbents with some degree of scale. On that front, I could make the argument that these requirements should either be lighter or perhaps dependent on time in operation / scale of assets so that you don’t capture startups on day one into a system that requires huge spend with a big 4 auditor.

On the other hand, once you have some degree of scale, shouldn’t there be some independent oversight? “Hey we are totally not ripping you off, trust us” is not a system that anyone should rely upon. It was a problem for FTX. It was a problem for most of the lenders. It will be a problem again in the future.

If you want to handle other people’s money, but you also don’t want anyone able to monitor your behavior with other people’s money, some questions should probably be asked.

The complete aversion of some exchanges to this is likely indicative of problems, I would add. Given my background in financial risk, where there is smoke, there is often fire. If an exchange stridently won’t comply or their compliance is facial at best while hiding the key details, you should be exceptionally skeptical of them.

Financial Controls and Investor Protections

There is another large segment of this bill around these issues, and it basically works as follows:

• Enacting and codifying “know-your-customer” provisions, meaning brokers would have to know essential facts about their customers, and requiring crypto brokers and marketplaces to only conduct business with firms that comply with KYC provisions;

• Banning the use of the term “stablecoin” to describe or market digital assets unless they are backed 1:1 with U.S. currency or high-quality liquid assets as defined in federal regulations; and

• Requiring platforms to reimburse customers who are the victims of unauthorized asset transfers and transfers resulting from fraud.

Again, pretty normal financial stuff. Most places should have KYC/AML for dealing with clients in a centralized fashion. Having your stablecoins actually be stable would be great. In traditional markets, most platforms do retain liability for fraud and other financial misdeeds, so that they can’t just punt on controls and then pass the damage on to their clients when bad things happen.

This is also very normal.

Problems With the Bill

So with that said, I see a number of problems here, but they are mostly not the problems I see being raised (with one exception, in the case of fellow professor Drew Hinkes, who sees some of the same problems I do) in public right now, where people are acting like causing an exchange to break apart is some kind of heresy and extreme centralization is a natural right.

So what are those?

First, we need to be careful about who these provisions apply to. NY state will need to be exceptionally clear when crafting this, as this legislation should 100% apply to Coinbase, Gemini, Binance.US, etc., but it should 100% not apply to Metamask, Uniswap, or so on. People who are providing a centralized service in the regular way and handling the customer funds are precisely those who should be bound by the kinds of controls we need for trusted, centralized intermediaries.

Those are not the kinds of things we need to apply to actually decentralized software deployments, especially those which are immutable2. Drafting this will be key to avoid breaking a bunch of things that are not actually in scope from a first principles perspective.

Second, we need to make sure these services can actually be provided. In the case of audit and accounting, what are the standards they are being held to and how are those services to be provided? If you tell all the exchanges you must be audited, and then all the audit firms turn around and say no thanks because there are not AICPA standards or some such and refuse to audit due to lack of clarity, do you know what this bill actually is? A ban! To that end, all of the requirements should have feasibility attached to them, such that if an exchange attempts to retain auditors in good faith and the audit community will not do so, then the exchange is allowed to be out of compliance because the services literally cannot be provided. When that market matures, they should have to do it. Similarly, it would probably be a good idea for NY to spell out some standards they expect here so people have something to point to and build around.

Third, we need to make sure this is not accidentally a financial death penalty. A good example there is in the case of covering acts of fraud. Most firms have insurance for this, but guess what? The crypto insurance market basically doesn’t exist. Now, maybe this will help create it because people will be forced buyers, but again, one should make sure this works properly. With no insurance, you don’t want exchanges going to bankruptcy every time there is a hiccup in this space, because that helps nobody. Properly regulating custodians would help, but also important here is the knowledge that the OCC is currently blocking custodians in this space (see none of the custodial banks nor private entrants having any success), so mandating a thing has to be used and then banning the creation of the thing is again a ban. NY basically needs to have their own custodial legislation with a mandate for the NYDFS to get moving and approve some of those post-haste if they want to pass this and require custodians. Again, a phase-in approach is probably the key to this kind of requirement as well. Doing it with immediate effect would, actually, kill crypto in NYC.

Conclusions

Overall, I think this is a good starting effort by NY state on some financial market standards, with the caveats that they need to apply it to the right players, they need to make sure the services required can actually be offered, and that they give adequate time for implementation.

I think the most important part is the ban on certain types of commingled services (we have known for a long time these are problems in traditional finance). Let’s not beat around the bush - this is a dramatic restructuring of the industry and will take a lot of work. However, I think it’s a necessary restructuring, as this sort of change is how you prevent another FTX situation. Financial conglomerates that control all of the levers of a system are invariably used to abuse people over time, either in overt ways (FTX) or less obvious ones (extremely high transfer pricing, etc.). If we care about decentralization and reducing monopoly power, we should be supporting this kind of implementation as an industry.

Therefore, I view this as a surprisingly constructive starting point. I think the key will be engaging with NY to discuss actual feasibility, as a jump-to-compliance before services exist and transition plans can be created would be catastrophically dumb, but equally bad would be just acting like the problem will magically go away on its own and that insanely centralized exchanges are an acceptable financial structure in this space.

Austin Campbell is the founder and managing partner of Zero Knowledge Consulting, as well as an adjunct professor at Columbia Business School. He has previously run the stablecoin platform at Paxos, run trading desks at JP Morgan and Citi, and been a portfolio manager at Stone Ridge, the parent of NYDIG. Austin has been in crypto since 2018 and has been trading and structuring profoundly weird financial instruments for decades.

As one might imagine, I’ve been getting a lot of questions over the past 24 hours. More than usual. We have several critical events moving in parallel, so this is going to be a long one. I’ve broken it up into sections and subsections for those who want to read each part, or for the real wild people among us, just start rolling and do the whole thing.

I normally say this only at the end, but my contact info is at the bottom. If you need my services, or you are a regulator/legislator and just need help (free, for you guys), reach out.

So what am I going to address today?

1. What happened with SVB?

2. What is the localized impact of SVB failing?

3. Are there going to be runs on other banks, and are we about to have another 2008 or S&L crisis?

4. Circle and the topic of “stablecoins”

Let’s do this.

What Happened With SVB?

The Rise

As you may have heard, we just had the 2nd largest bank failure in the history of the United States on Friday (March 10, 2023, RIP Silicon Valley Bank). Suffice to say this is not news that can really have much of a positive spin put on it.

The SVB story is, unfortunately, very similar to the issues at Silvergate. To avoid re-hashing a lot of the same material in anything other than summary form, if you haven’t read my post on Silvergate, go read that.

To give the brief background, Silicon Valley Bank was founded in 1983, and fundamentally specializes in providing banking services to technology and life sciences companies. It is based in, unsurprisingly, Santa Clara, and has long been a bastion of the tech community and has linkages to many of the major tech, venture capital, and adjacent firms in the ecosystem.

SVB had a reputation for being front-footed on technological risk, solid understanding of the tech ecosystem, their own ventures arm, and was, in general, not considered to be particularly remarkable from the core banking side of things.

So how did a bank like this blow itself up in spectacular fashion, such that the demise of SVB was basically the fastest bank run in American history and it went from semi-operational to literally dead in under 48 hours?

First, we have to start with COVID. During the pandemic, there was a very dramatic expansion of money supply in order to offset the effects of everything shutting down. A large beneficiary of this situation was the tech sector, as everyone was stuck at home and all-virtual forever all-everything became the investment thesis at the time. VC funds, tech unicorns, and the valley in general had a massive boom in terms of cash and funding. As a result, this happened to SVB’s balance sheet:

That’s a big increase! And as you can see, most of that increase did not go into loans, but rather, into investment securities. Notably, the fact that their balance sheet almost tripled in size directly concurrent with the pandemic meant that when the tide went back out on the stimulus, it was entirely possible that the deposits would go out with them.

As a treasury and risk person at a bank, when you have that kind of deposit inflow, you have to make a judgment call. Your options are essentially the following:

1. Refuse the deposits, either explicitly or by making the economic terms so poor people move them elsewhere.

2. Take the deposits, but expect them to be hot money and leave quickly, and thus invest them very conservatively in things like t-bills, ON reverse repo, or other such highly liquid and easy to unwind instruments.

3. Take the deposits, and assume that we are in a new paradigm where this time is different and thus go invest them in long-dated things to earn “more”1 to juice your profits.

Obviously, #1 is not going to make your management or your customers happy. This is genuinely hard to do. I’ve seen very few banks that have the stomach to just tell potential customers to go away. It does happen once in a while, but it takes above average management with significant confidence to run this playbook.

#2 is probably the smartest move overall, if you can make the economics work. This gives you maximum optionality. It is more work to onboard a bunch of people who might just rampage right back out the door, but the reality is that other than the work and the effort to make sure the risk is managed, there’s little downside here. If both SVB & SI had done this, they’d both still be standing. Even so, there’s inexplicably a severe allergic reaction to the idea of “how about we not lend all this money out in risky ways” at a bank. I can’t explain why. Sometimes it even rests on management misunderstanding of economics2, as shockingly few people truly understand how fixed income works.

#3 is, unfortunately, what most people do. I find it personally confounding every single time this happens, but it’s also the most common thing to happen, so maybe I am the problem here for thinking people should do something else? Either way, this path obviously ends in disaster if things don’t break exactly the way you planned for. If rates go up instead of down, and deposits leave, you are now a forced seller at a loss. Do you know what that means for a bank?

The Fall

At the same time SVB was experiencing those massive gains in deposits, they decided to run play number 3 from the list above. To the best of my knowledge, SVB had an average duration of roughly 4 years for their securities portfolio, and those securities consisted of things like Agency MBS, not just US Treasuries.

For those uninitiated in the complete and total nonsense that is fixed income pricing, here are some basic rules of thumb so you know what happened to the balance sheet at SVB:

1. Rates and bond prices move in opposite directions. If rates go up, bond prices go down. If rates go down, bond prices go up.

2. Bond prices change in response to rates by a percentage equal to duration * change in rates, as a rule of thumb3

So with those rules in mind, here is what SVB did: they bought bonds back when interest rates were about 4% lower than they are now, and they bought bonds with about a 4 year-ish duration. What this means is that as the Fed raised rates, SVB lost money on those bonds. In this example, they lost about 16% on those bonds (approximate at best), so if they had bought, oh, $100B of bonds for the deposit growth, they are now down $16B on that.

Which is more than the equity of SVB was worth.

Now I am going to tell you something that is probably going to surprise many of my readers: this happens all the time in banking. Why are banks not constantly dying because of it, then?

First, banks have two forms of accounting they can elect for assets. One is called Held-to-Maturity (HTM), which means you don’t account for gains or losses and just hold the thing as though you will, with certainty, hold it until it matures. This one doesn’t require any change in value unless there is an impairment. The other option is Mark-to-Market (MTM) accounting, which means that you have to price your securities and loans at the price you could sell them for in the open market as of that day.

Which one of these is correct?

That actually depends on the funding base of the bank. If you have long-term funding and can match your obligations with the tenor of your assets, HTM accounting is actually pretty appropriate. If I have a 4yr bond and a 4yr loan against that bond, that’s great! If you have short-term funding that can depart at any time, then MTM is much more appropriate, as you can’t count on holding to maturity.

So how did things go wrong at SVB? They assumed their long-term bonds were matched by long-term deposits, but as it turns out, those were short-term deposits. This is the essence of many bank runs, and is exactly what happened here.

As depositors left, they were forced to sell what had been HTM positions, which crystallized losses, which makes more people worried, which causes more withdrawals, which causes more deposits to leave… you see where this is going:

What is the Impact of SVB Failing?

Here is where things get interesting. I’m going to start by explaining the common narrative that I am seeing on Twitter and in the popular discourse, and then I’m going to explain what is actually going on.

Popular Narrative

“Wait a minute, SVB is just a bank for rich venture capital folks. If you had over $250k of money there, you can take a loss. Why should we bail out rich bankers!?”

This is basically almost every variety of take that I have seen about SVB, and it relies upon two fundamental misunderstandings of the structure of a bank.

The first is that somehow depositors are always rich and/or investors in the bank. The second is that plugging the deposit hole is somehow bailing out the bankers.

In this scenario, where we would end up is a slow or semi-functional resolution for the bank, in which large amounts of deposits are locked up for an indefinite period of time, and when they are released, might be worth 50-80 cents on the dollar.

We can call this scenario 1.

What’s Actually Happening

Now, let’s talk about how FDIC coverage at a bank works, and how the capital stack of a bank works.

First, FDIC coverage applies to single persons4 up to $250k of deposits. This means that if you had money at SVB, and it fails, and that money is less than $250k, you are almost certainly fine. That money will leave first, and everyone else gets to fight over the scraps. Now, if the FDIC itself fails, that coverage isn't worth much, but that's a true end-game scenario as that didn't even happen in 2008. Also important to know is that that is $250k per bank, meaning if you have multiple accounts at one bank that add up to more than $250k, you have a problem! However, if you have over $250k, but it's at like six different banks and they are all below $250k, that's good.

Why does it work this way? I don’t make the rules.

Second, we need to talk about the kinds of accounts that you find at these banks. The natural tendency of humans is to generalize from their individual situation, so a common refrain is “well, anyone with over $250k should have spread out their money!”. To that I say this:

Well, duh.

If you were a person in the sense we mean, like a two-legged human being.

But what if you were not? What if you were a legal person? What if that legal person is a corporation that needs to make payroll? A local grocery store chain taking payments and then paying for inventory? The donation account for a charity?

There are many kinds of “persons” at a bank, and most of the ones that are over FDIC limits are typically not what we mean when we say “Joe is a person” but rather what lawyers mean when they say “Santa Clara Firefighters Pension Fund is a person”.

Capital Stack

Let’s also take a moment to talk about the typical capital stack of a bank. By this, I mean money that has been “invested” in a bank in various ways, and as you can see, I am going to use invested pretty loosely here. These are the major components:

Equity, which is actual money invested by (hopefully) sophisticated investors. Here, they know their money is at risk, as they take the first losses when things go wrong. As a result, they also get an outsized share of the gains. For a company like SVB which is public, this is a combination of active fund managers, passive index funds, hedge funds, and private investors who all can purchase shares. In general, these people are supposed to be informed, do their own research, and understand the risks that they are taking when they invest in this thing. I would suggest that when a bank fails, unless it failed because management perpetrated a massive fraud on these people, you shouldn’t have much sympathy for them. Why? Failure was literally the risk they were being paid to take.

Bondholders, which are people who lent money to SVB and were senior5 to the equity holders. These people typically lend an amount of money, to be repaid at a specific later date, and are paid interest along the way. That kind of thing is called a bond. There's a lot of them out there in the world, and you've probably heard of Treasury Bills, Bonds, or Notes before6. These people also tend to be sophisticated investors, just like the equity holders.

Deposits, which are the deposits of people at the bank. Most people don’t realize this, but technically when you deposit at a bank, you are lending that bank money! Yes! I mean it! I know that sounds crazy, but it is true. However, this is not where the sophisticated investors are. Most people don’t go to the bank and go “ah, yes, [Insert local community bank here], I will lend you money expressly for you to make loans because I want to make a profit”. They give money to banks because they want someone to hold it for them and connect it to a banking system so they can later pay for things, not lose it, and generally treat it like money locked in a box. Thus, these people are fundamentally different in their sophistication about evaluating bank balance sheets (none) and their purpose for being there (they are using the product, not making a profit).

Why did I explain all this? It will become important when we discuss fallout, which we will do now.

Fallout Directly Related to SVB

We defined scenario 1 above, so let’s talk about that now: in scenario 1, when the bank fails, persons7 get $250k back, and should get that back on Monday. However, the rest becomes some kind of estimated return from the FDIC and then an unsecured creditor thing that can best be described as an IOU of somewhere between real and highly dubious value. In the case of IndyMac, this was 50% or so.

So to talk about our capital stack above, equity is gone, bonds are gone, but deposits? Also kind of gone.

In this case, you’re going to have complete fucking chaos. Multiple firms likely cannot make payroll, pay vendors, or function appropriately come next week as their cash on hand is wiped out. This is less of a problem, in some ways, for companies that were hoarding cash and it was their runway (so VC-style companies) but way more of a problem for operating companies because if that was your operating capital, then…?

Yeah.

The other problem is that SVB served as a bank for several payments and payroll processors, so all of that stuff is likely fucked beyond all recognition if there are major haircuts for anyone who was using them at scale. Again, this is not what people typically think of for banks, but it is actually the stuff more likely to break and more contagious, because what you could have is massive layoffs, disruptions, failure to pay vendors, and more for a lot of businesses in the tech space and local California space.

Now let us consider the other option, which we are going to call Scenario 2, which is going to be derided in the popular press (or at least some economically illiterate quarters of it) as a bank bailout.

In this case, where the “rich bankers” are being “bailed out”, here is what the recoveries are going to look like: equity is wiped, bonds are wiped, but deposits are almost entirely (if not completely) safe.

I want you to pause, consider what we said about capital stack before, and ask who got bailed out here. The investors? Toast. The employees and executives paid in stock for their giant bonuses? Toast. The venture capital and private equity funds that invested in the bank? Toast.

You know who is not toast? The depositors who were using the bank as customers. Some of those people, yes, will be rich people and some will be angry that they were “bailed out” (even though in this case, it’s unlikely those people were investing for a profit because you wouldn’t be a depositor if that were the case!). Many more of those persons will be corporations making payroll, paying vendors, and the like. A lot of them might be things like startups, partnerships, or banking-as-a-service clients for a bank like SVB. These are not typically the things you expect to be completely wiped out, and making sure your building facilities people get paid or that the non-profit donation account doesn’t get wiped out are not the “rich” we rail against in a bailout.

As a general matter, in scenario 2, contagion is very limited. Yes, there are some equity losses and a handful of unlucky people who went super big on SVB are going to end up bankrupt. Bondholders might be ticked, if there are many of them. But all of these people knew the game and this is what they signed up for. C’est la vie.

On the other hand, there is minimal disruption to the depositors and regular main street types of business. The chaos from scenario 1 is limited. Here, it’s almost… boring that the bank failed. Your bank account probably gets re-labeled as a new bank takes over and continues onwards after the equity and bondholders get wiped. So congrats, you are now customers of Goldman Sachs US Bancorp or some such.

I think it is pretty obvious one of these outcomes is both better and fairer than the other, and yet it’s the one decried for being a bailout. I hold the view that this mostly comes from a lack of understanding about how a bank is structured and the role depositors play.

Are There Going to be Runs on Other Banks?

Now here is where things get interesting. First, I need to expose an important truth about bank runs that people gloss over completely: all banks have exposure to runs.

That is to say there does not exist a type of bank that can withstand a run. The question is how much damage it will do. The other question is the network effects of the run, as a run on individual banks works very differently than a run on the entire banking system, as this is a network problem.

Let us start with the simple model that I had created in a previous post:

If that is our bank balance sheet, then one of the things you can see is that banks have some buffer of equity in normal cases, and then beyond that, they have deposits. If 100% of the deposits leave, you… don’t have a bank? This is the definition of a bank run. In a literal, functional, basic sense, if you have mass deposit flight, you stop being a bank, because you stop having depositors.

The questions that ultimately matter to the depositors are the following:

1. Is everyone else going to take their money out?

2. If everyone takes their money out, can the bank unwind this whole thing and I get my money back, or do the depositors8 get screwed?

First of all, if there is strong confident in number 2, number 1 becomes less relevant. The problem is that most people have no idea how to assess this risk. Hell, I worked at a bank, traded the Bank-Owned Life Insurance (BOLI) wrap book9, which is a key part of tier 1 capital for US banks, and I can barely assess bank solvency from the outside sometimes. Expecting normal people to do this is ridiculous, and the logical conclusion most would draw is simply either not to use banks or only use banks so big that if they fail, we know they will be bailed out (e.g. the big 4).

Thus, bank CEOs are often left playing a very dangerous confidence game. Many fail at it (see: SVB), but the best of them not just succeed but inspire confidence. The problem is to do this you need charisma, knowledge, to have actually managed risk well, and to be willing to take all sorts of slings, arrows, and daggers in public. Perhaps the best at this in recent history is Jamie Dimon, who led JPM through 2008. I can still hear him saying “fortress balance sheet” in my head, because he said it so many times he must whisper that in his sleep now.

But it worked.

Here is why that matters so much: if the answer to number 2 is that people think they will get screwed, they know that they would take their money out if they can, so the answer to number one also becomes “well, obviously”. It is the Prisoner’s Dilemma. It would be better for everyone if we don’t collectively run the bank, but if people start running the bank, you want to have gone first. Therefore, people go first.

Once that process starts, it’s over. And what determines if that starts? The public perception that the bank won’t have enough money to pay out all the deposits, either because of losses on loans due to default, or losses on loans if they are a forced seller due to interest rates going up.

That last point is very relevant right now.

Other Bank Contagion

This is the problem regulators are grappling with. The profile of a troubled bank in this environment looks like the following:

1. Underwater on a securities or loan book with long duration loans made at low rates

2. Concentrated depositor base that could rapidly engage in flight

3. Low NIM compared to competitors (which is a tell they don’t have room to move up to retain depositors)

So if you are looking for banks that would be in trouble right now, I would suggest that is the profile most similar to SVB and Silvergate. I am less concerned about the giant banks with huge deposit bases, smaller banks with low duration risk and diversified deposit bases, or specialist banks where this really isn’t how they operate (see: State Street).

If you are a banking regulator at this moment, the question you are asking yourself about SVB is that if it goes down, will people start withdrawing deposits from other banks? Here is where we get to the uncomfortable truth about uninsured deposits: mostly people don’t think deeply about counterparty credit risk to their bank, so if you make them think about it, they basically panic.

The ideal situation for a regulator is that people stay calm and don’t start stampeding away from other banks, as once that starts, the logical conclusion is a US banking system where you have 10-ish huge banks, a handful of key specialists, and everyone else is a corpse. That is not great for long-term competition or short-term stability, as one might imagine.

So how do you stop that from happening, and why would SVB not kick off a mass contagion event for the US banking system?

First, you want to resolve the SVB situation without depositors taking a haircut. Quite bluntly, recoveries for the bondholders and equity holders are simply not a priority in this situation, but depositors are. If the FDIC, who has been working quite hard over the weekend and has run this process many times since 2008, can broker a sale where the depositors are made whole, there will be much more confidence in the system overall going forward (unless this keeps happening over, and over, and over).

Second, if you can’t do that, you consider seriously backstopping the depositors. Again, not the bondholders or the equity, but if you allow SVB to open on Monday with a “yeah, um, so if you were a depositor, we just don’t know, maybe you get your money back but also maybe not and we don’t know when”, people are going to do the hyper-panicked speedrun just assume it’s all dead version of the thing I said above and runs are likely to start on many other banks. This is a bad situation. That’s why there are rumors out there of the Fed creating a facility to stop this if it starts in other places.

Third, you have to project confidence and get in front of rumors of other runs. To some extend, this is the hardest problem as you are now reliant on people from multiple agencies coordinating information and the bank executives themselves not saying dumb things. Bad outcomes here increase the reliance of solutions in the first and second point, as one can imagine.

Lastly, there is something of a network effect issue here. When people “take their money out of a bank”, that can mean one of three things:

1. They send it to another bank

2. They put it in securities or a money market fund

3. They literally ask for cash and put it in a hole in the ground or something

These all have very different implications for the system. Obviously, situation number one means your total deposits are unchanged, but the location has changed. This can lead to collapses of banks and either diversification or consolidation, depending on context. The second and third are different: now your banking system is straight up losing money and people are reducing their exposure. In those cases, things start to get systemic and failures are cascading as opposed to localized. That is the 2008 scenario that caused the government to get so scared about the system, and is the one that everyone would be wise to prevent this time around.

Predictions

So to put my money where my mouth is, what do I think will happen?

I don’t think the regulators in the United States want to risk a massive, uncontrolled tailspin. I also don’t think they want to be seen as offering an unlimited bailout to people who took significant risks and then got immolated because of it. Therefore, I am going to predict a middle road solution:

SVB is likely sold, probably but not certainly in parts, the depositors are going to make it out with a 100% (or very high 90s) recovery in short order, and the bondholders and equityholders are going to get completely wiped out. This would send the message that if you are a depositor, you don’t have to panic and we’ll take care of you, but if you are running a bank or investing in one, you’d better have your act together or if the reaper comes to your door, we’re not saving you.

Larger measures will come later, if there are bigger failures and more political will behind it. The reality is the optics of a significant “bailout” (even if people misunderstand that and it’s mainly the depositors) for a bank named Silicon Valley Bank (especially after the obnoxious bleating of the VC crowd on Twitter, which comes across as exceptionally tone-deaf) just aren’t something most politicians will go for… but neither is kicking off a chain reaction of bank failures that infects main street in shockingly short order.

So we are going to get a middle solution. Will it be enough? I actually think it might, with some important caveats that other similarly situated banks to SVB might also tank this week.

Non-Bank Collateral Damage

Now that we’ve talked about the banking angle, let’s talk about what might turn out to be the more important angle: the non-bank impact. SVB was a notable bank for VCs, supporting the startup ecosystem, and back-end functions for things like payroll processing. This is actually the mechanical stuff that matters a lot more, in some ways, and why all banks of sufficient size are at least somewhat “systemic” despite what anyone will want to say about them.

In plain English, if SVB fails in disorderly fashion, there’s a lot of firms that can’t make payroll, pay vendors, pay for inventory, etc. in the coming days, even if they eventually get a lot of that money back, and it will have knock-on effects to the real economy. In this specific case, probably primarily the California Bay Area economy, so that’s not particularly politically favorable for SVB, but that doesn’t change that people would lose jobs over this.

Even if SVB is rescued, however, I expect there will be impacts. One is going to be structural changes to how deals work. Banking diversification will be a thing, and reliance on one bank for serving a whole segment is pretty transparently dumb going forward. What that means is that competition for tech banking will increase, but as SVB was at the forefront, the shape and terms may be less favorable to the tech sector in the short and medium term. The shine is off the industry, and their biggest financial hub just imploded. It’s hard to take that as a short-term positive, even if a long-term shift in structure might be for the best.

Still, watch for the actual mainstream business impact. That is what could cause real bleeding if there is not satisfactory resolution.

Why Did USDC Break?

Speaking of stress in the market, check this out from Coinmarketcap:

I’m going to go out on a limb and say that’s not how a stablecoin is supposed to work! So what happened?

As it turns out, Circle was managing reserves for the stablecoin USDC by keeping a significant amount (allegedly about $11B) in bank deposits. Going back to what people mean when they say cash, they don’t literally mean cash in a vault, so Circle did this instead of getting much larger amounts of the reserve money into t-bills or other forms of securities.

It was revealed Friday that Circle might have exposure to SVB, and over the weekend, it became clear they held $3.3B of reserves at SVB, according to Circle themselves. That’s not great risk management about cash, but my thoughts on that are definitely too long for this blog post and I’ll be creating another one on how to manage funds for a stablecoin down the road. For now, let it just be said this meant that they had $3.3B minus $250k of FDIC coverage of exposure to SVB, potentially.

They also suspended withdrawals over the weekend (likely due to running out of cash at 24/7 fast payments rail banks, a traditional banking problem I have talked about before).

Now, is that real? There are two questions. The first is they attempted to wire money out, and allege they made the cutoff before the FDIC put the bank into receivership. If this is true (I have no personal knowledge), then they should get the money and there is not a hole. The second is even if they didn’t, are they going to recover on the deposits?

Some very rough napkin math is that if you had $3.3B of exposure against low $40B of outstanding, that’s ~8% of your total. So the point where USDC traded down below .92 either implies that people thought other banks were going to die and Circle would lose even more, that somehow the US treasury was going to default (the rest is in t-bills, remember), or that Circle had stolen the money and was off to the races. It’s indicative of a panic. There’s no fundamental reason for that. More so, if you understand recovery levels, then SVB is likely getting back at least 70% even in a very, very conservative scenario, so the actual trading level is more like 2-3% down, meaning USDC was likely a screaming buy beneath .97. Right?

Nerdy Stablecoin Mechanics

So one of the things to consider here is that we actually have to make some assumptions about how things are going, as there are well-founded reasons to believe that maybe USDC should be trading below .97. What are they?

One is how Circle redeems. If they actually had a 3% hole, and they allow 1:1 redemptions starting on Monday, what this actually means is that the first 97% of people to redeem would get $1, but the last 3% would get $0. That is definitely not .97! Neither of those numbers are! So if you believe Circle has a hole, but also is going to carry on like they don’t, and you don’t currently have a Circle account or way to redeem, you might just want to get off this train.

Two is that you might just have lost faith in Circle over this. One of the truisms of the stablecoin game is that people need to have confidence in the reserves and the mechanics of getting their hands on those reserves, but that’s fine. However, if you break that confidence either through poor management or through being in places where people doubt they can get the money out (either through lack of rule of law or through regulatory capriciousness) then you can have long-term doubts in your viability.

Three is people are actually thinking that bank run contagion will kick off and Circle’s other banks are at risk. I don’t want to discount this to zero and USDC would be an imperfect but plausible way to play that. I don’t like that trade and wouldn’t do it, but I can’t say nobody is using it this way.

So is Circle Okay?

The reality is they have most of the money, unless the US treasury nukes, in which case I don’t think the stablecoin is really our biggest problem. It may take them time to process all the withdrawals, as if market makers and hedge funds were loading up on USDC over the weekend they could see a shelf of over $10B of redemptions to close the gap. It’s entirely possible this will happen and Circle’s business is about to get absolutely wrecked.

But it’s also very unlikely they don’t have at least a large supermajority of the money. This is the nice part of a fully disclosed stablecoin. You know what is there. We should have more clarity this week, so stay tuned on this space.

Austin Campbell is the founder and managing partner of Zero Knowledge Consulting, as well as an adjunct professor at Columbia Business School. He has previously run the stablecoin platform at Paxos, run trading desks at JP Morgan and Citi, and been a portfolio manager at Stone Ridge, the parent of NYDIG. Austin has been in crypto since 2018 and has been trading and structuring profoundly weird financial instruments for decades.

Today was not a great day for the SEC. There were two major hearings, and things appear not to have gone well for the agency.

Before we begin, some meta-context is that these hearings are not necessarily final rulings (though in one case, it was). So some of this is reading tea leaves, but it’s also a useful set of insights with regard to how things are going for the SEC when, instead of just engaging in saber rattling, they have to actually meet their opponents on the field of battle (in this case, the courtroom).

Voyager

First, because it is final, let me address Voyager’s bankruptcy. For those who don’t recall, Voyager had originally struck a deal for the bankrupt crypto bank without capital or risk management (let’s call a spade a spade) to be sold to the then-golden-child of the industry: FTX.

We all know how that worked out.

With the FTX plan somewhat obviously on the rocks, Voyager was forced to find another firm to acquire them, and their savior materialized in the form of Binance.US. This was largely good for consumers, as optimistic estimates of recovery are now in the ~70% range, as opposed to the original ~50% that had been kicking around in markets.

Note that these estimates are highly variable, and there are intertwined concerns with the FTX bankruptcy where clawbacks may occur. Suffice to say, having high confidence in these numbers is probably a bad idea.

However, as the court proceedings were held about this new deal (to be clear, in bankruptcy, you typically need the approval of a judge to move forward with restructurings), a party emerged to attempt to prevent retail users and end consumers from recovering their funds and instead preferred to keep the Voyager acquisition in limbo, apparently to… protect… those consumers?

It’s hard to say what the rationale is, but obviously, this was the SEC, and as we’ll find, they had a hard time saying a lot of things today.

The judge in this case, Michael Wiles, had some harsh words for the SEC. He called them out for attempting to only discuss the concerns about tokens being securities in private (who demanded they happen in open court), he accused them of trying to “stop everybody in their tracks” without explaining how to address the SEC’s concerns, and then when the SEC could not or would not provide specific concerns or commentary, he reminded them actual creditor money was at stake on timeframes that were immediate, not glacial, with the following: "Bankruptcy code doesn't contemplate an endless period of time". The judge overall said he was “absolutely shocked” with the SEC’s conduct.

Ouch.

In the end, Voyager’s deal with Binance.US is likely to move forward, though there are conditions that must be complied with and an order to sort out. The SEC seems to have been sidelined after their showing, however.

Grayscale Bitcoin ETF

This? This went badly for the SEC. There’s simply no way around it. The three judges hearing this were Rao, Srinivasan, and Edwards. Rao was largely expected to side with Grayscale based on past jurisprudence, but I think perhaps surprising to the peanut gallery was how negative the other two judges were.

One of the main sticking points here was that Bitcoin futures ETFs have been approved by the SEC in the past. However, the judges all rightly have attached to the point that if the spot market is “manipulated”, then the futures market inherently has the same problems.

The SEC lawyer attempting to argue they were not “manipulated in the same way” drew an incredible amount of fire from Srinivasan and Edwards. Edwards in particular pushed the SEC to explain exactly what they meant, and he did not seem to be satisfied by the answers of the SEC attorney1.

Most of the legal commentators I know have moved up the chances of Grayscale winning dramatically, although it’s important to know that Grayscale winning does not necessarily mean ETF conversion will happen.

There are other issues the SEC has introduced, such as the insanity that is the new custody rule (a topic of its own) and the fact that it’s quite possible the SEC will simply withdraw approval for Bitcoin futures ETFs and require them to be unwound rather than allow spot ETFs to proceed.

It’s surprisingly hard for a judge to get an agency to do something, as it turns out. Congress, on the other hand, less so, but they seem actively disinterested in solving this problem.

So what is the endgame for the SEC?

SEC as Overseer

Ultimately, the core objection likely comes down to something the SEC appears to have made an issue of repeatedly, and as recently as the Voyager case: they view all crypto trading exchanges as unregistered securities exchanges. Their objections about manipulative trading ultimately relate to things happening outside the walls and rules of the SEC securities regime.

It is likely that the current SEC stance is simply that they don’t intend to approve anything until all the exchanges come and register with the SEC, with the small detail that it’s not entirely clear how a crypto exchange could register with the SEC and be within the rules of a 90 year old exchange act. No, that’s not a typo. The 1940 act that governs securities in the United States was written closer to the Civil War than it was to the current day, and yet we continue to use it.

To that end, despite the optimism and the courtroom smackdowns of the SEC, the reality is that until there is legislative reform, the path for crypto is very clear:

Leave the United States.

There are other regulatory regimes2 emerging that offer a much cleaner path to both legal clarity and safe operation, and the United States is taking an approach guaranteed to cause crypto firms to take a second look at all those options.

Austin Campbell is the founder and managing partner of Zero Knowledge Consulting, as well as an adjunct professor at Columbia Business School. He has previously run the stablecoin platform at Paxos, run trading desks at JP Morgan and Citi, and been a portfolio manager at Stone Ridge, the parent of NYDIG. Austin has been in crypto since 2018 and has been trading and structuring profoundly weird financial instruments for decades.

One of the more misunderstood topics in the world is banks. How they work, how they succeed, and how they fail are all things that are typically described with some mix of factual accuracy, factual inaccuracy, deliberate obfuscation, and straight up confusion so profound it is neither correct nor incorrect, but rather so incoherent it seems like it originated from another dimension.

To that end, in light of the current Silvergate situation, I am going to endeavor to do three things with this post:

1. Describe a deliberately oversimplified model of how a bank works

2. Describe how banks typically fail, in light of this model

3. Apply points one and two to the current situation at Silvergate

Hopefully, I will be able to add more detail at each step to provide some clarity. I promise we won’t do much math, either.

How Do Banks Work?

I remember vividly having a conversation with a friend of mine (who will remain nameless) that went like this:

Friend: “So you work for a bank now?”

Me: “I do.”

Friend: “Can I ask you a question?”

Me: “Sure.”

Friend: “How are banks so profitable? All they do is take people’s money and just hold onto it.”

Me: “…”

This is, shall we say, not how banks actually work. However, it’s a common misconception, and one that still shows up today:

Dollars, in our current system, are bank deposits. Which means the tweet above, which was referring to a stablecoin that was in t-bills, is arguing that it should not be in “debt” but should instead be in “dollars”. There are so many layers to how this tweet is wrong that I am going to basically have to write an entire article that also explains why Silvergate is in such a bad situation just to address it.

This is also why complex problems are awful for short form debates or Twitter: a refutation usually takes 50x as much work as the malformed question.

To understand why this is so backwards, let’s talk about what a bank actually looks like by starting with a balance sheet:

Simple Example Bank

This is pretty much the balance sheet of a bank, abstracted as far as possible. On one side, you have the assets of the bank, which are things like loans and debt. On the other side of the balance sheet, you have the liabilities of the bank, which are things like deposits. Then you have equity, which is the extra capital the bank uses for when it invariably fucks up and loses money.

I’m one paragraph in, and this is usually where I’m already getting confused looks or having people ask questions when I give talks, so I’m going to go through the parts that are likely to cause some brain damage for a normal mentally healthy person. If you already know this stuff, then you have my condolences, as that probably means you’ve worked for a bank. Sorry about that.

Wait you said loans are the… asset? Isn’t that money you owe someone?

Yes, that’s what I said.

Here’s the key: banks exist in the mirror universe compared to how you think about your own balance sheet.

Remember how you just said loans are money that you owe someone? That someone is literally the bank in this example. You owe them money, usually in the form of principal (the original amount of the loan) at some point in the future (or maybe parts of it at many points in the future, like with a mortgage), and you owe them interest.

If you had given someone money, and they were going to give that money back to you, plus extra money beyond just that money, so you made a profit… that’s an asset. It’s a loan or a bond, usually.

Okay, so I get that part now, at least kind of, but why are deposits liabilities? Isn’t a deposit where you put money in something and can take it back out when you want it?

Yes, that’s also what I said. Let’s go back to the banks existing in the mirror universe point. The thing that owes you the money when you come to get your deposit? Also the bank. That means if you gave the bank a dollar at a deposit, they have to be ready for you to burst into a branch, at any time1, and demand your money back. Usually politely, but sometimes impolitely and loudly.

What this means is that while the deposit is your asset, it’s a liability for the bank because at any time, they might have to give it back. It’s also a type of liability for the bank that simultaneously drives their profits (because they are ripping you off paying you a low rate of interest on them) and that regulators worry about constantly. The latter is because rather than just you, an angry mob might all show up at once to get their deposits back, which causes problems for the bank.

What kinds of problems you ask? You’re way ahead of me.

Great, now I’m not totally lost, but what about the capital thing?

Regulators, having decided that banks are pretty much incapable of not fucking up at least some of the time, don’t trust them to just take deposits and lend those deposits out. Instead, they require banks to hold a buffer, in the form of equity or other capital (again, we’ve simplified here), so that if the bank fucks up, the first people that is a problem for are the shareholders of the bank, not the depositors.

You can think of the equity capital a bank holds as a measure of the degree of how stupid a bank can be before the depositors are going to have a problem, in a lot of ways. Again, we’re oversimplifying, but if you want to understand the furious debate about appropriate bank capital ratios and leverage and why it matters that happened after 2008, this is why. It’s essentially an argument about how big of a margin of safety banks should be required to have.

Keep in mind this capital is not free, before someone in the peanut gallery shouts “obviously banks should hold all the capital ever”. More capital = higher costs. So while banks are safer, they are also more expensive for people to use. There is some effective balance here, and it’s neither zero nor infinity. Reasonable minds can debate it (and they do, constantly).

So with all that said, let us look at that balance sheet again, but now with more context, label it properly for a bank:

Now that we have more specific labels on things, we begin to see how a bank actually operates and makes money. There is an infamous old joke about the 3-6-3 rule in banking, which is that you borrow at 3%, lend at 6%, and are golfing by 3pm.

The last part is almost certainly not true (as anyone who works at a bank can attest to), but the first two are the core of a concept called Net Interest Margin (NIM), which is the difference between how much an entity pays in interest and how much the entity earns in interest. Thus, our 3-6-3 bank above has a NIM of 3%, which is quite simply2 6% interest earned minus 3% interest paid.

This is the core game of a simple bank: earn more on your loans and securities portfolio than you pay on your deposits and capital. If you can also sell a bunch of services that you charge for, even better!

This leads us to a couple of important points that I want to end this section with:

Dollars at a Bank Are Not Cash Like Dollar Bills

When you give money to a bank, that bank takes your money and does something with it. See that big green box up there labeled loans and securities? Yeah. They do that. The bank is not putting your money in a vault or a box, typically. They are keeping some amount of it on hand in case the depositors come back to redeem, but a lot more of it is being lent out.

Banks Engage in Credit Creation

In simple language, this means banks lend money to people. That seems like a trivial thing to say, but it’s important to remember the mechanics of it. Specifically, banks lend other people’s money to other people, for the most part. This is both credit creation and credit intermediation, where the bank is kind of acting on behalf of all the depositors.

Most Depositors Can Show Up and Ask for Their Money Back

While there are forms of term funding (CDs, etc.), for demand deposits, banks always have to have some degree of paranoia in the back of their mind that depositors are going to show up and ask for their money back. How likely is that? Well, that’s one of the main questions that keeps bank management up at night.

Remember those three points as we continue.

How Do Banks Fail?

Looking at the model above, I’m sure there are a number of people reading this who are thinking to themselves some variation of the following:

“This seems pretty simple. Why do banks fail, often in bunches, then?”

There are two ways a bank can ultimately fail: bad assets, or a run on liabilities. These are not necessarily independent, and that is most certainly not an exclusive or. Often they go together, but they don’t have to.

Let’s take them one at a time.

Bad Assets

Remember that picture from above? Well, let me paint you another picture of a bank balance sheet:

This is what happens when a bank loses money on its assets. At this point, the size of the “uh oh” is what matters: a small one can be absorbed by the capital that the bank holds as a buffer. You’re going to have some upset shareholders, you might look stupid in public, and the regulators are for sure going to ask some questions. But in the end, if the rest is well managed and you are still profitable, you will build back the capital and things will be fine. This was the exact experience of JP Morgan around the London Whale, for instance, while I was there. It’s not a great experience, but the bank will survive and the depositors won’t have a problem.

For a big enough “uh oh”, you probably have a problem, though. The exact threshold of big enough is not a fixed number, as it depends on when your depositors and/or regulator start getting quite upset (as opposed to merely annoyed with you in the example above), but when that happens, you are Fucked with a capital F. The only way out of this situation is to pray that nobody notices how big of a hole is in your balance sheet, that the depositors don’t demand their money back, and that you make enough money on the remaining assets to fill it back up over time.

In practice this rarely works, but it does explain why even the most beleaguered bank executive will express extreme confidence in public. The moment a bank CEO goes on Bloomberg and says “Actually, we’ve lost a shitload of money so if everyone showed up to get their deposits back, there’s literally zero chance we could pay them all”, you can bet every depositor will show up as quickly as possible to try to get their money back and then the game is over. Instead, that bank CEO, the one with the giant “uh oh” on the balance sheet, will go on Bloomberg and say everything is fine, the bank is profitable, operations are normal, and life is good and sunshine and beaches and nobody panic (while screaming on the inside).

So how do you lose money as a bank? There’s a lot of creative ways to do this, but I want to focus on two main ones here.

Bad Loans

This one is simple, and it happens a lot. You loaned money to the wrong people, and by wrong people, I mean people who are not going to pay you back the money that you loaned them. This is basically the TL;DR version of the entire subprime mortgage crisis in 2008. Loans were made to people who could not pay them back. Those people did not pay them back. A bunch of people lost money because of that, including banks. Some of those banks died.

Banks are typically going to call this default risk, so if you hear people talking about it, this is why. There are a lot of types of risk around loans and defaults, such as the very vanilla type we just mentioned where you loaned someone money and they didn’t pay you back. Another example is the somewhat more exciting counterparty credit risk, which is when you have a trading counterparty that fails to fulfill some obligation (usually posting margin on a derivative position, which is way beyond the scope of this exercise) and you have to close them out or do something else nasty, often at a loss. That was at the root of the problems with the CDS market and AIG in 2008.

In short, though, it’s simple in the end: someone owed you money, somehow, and they didn’t pay you. Fuck.

An important part of this type of failure, though, is that it’s usually a multi-level failure of risk management. Banks are supposed to lend at a profit, to a broad and diversified group of borrowers, with that diversification spanning things like time, types of borrower, creditworthiness, core business activity, and so on. In practice, that’s not so easy. But what it means is that either you seriously misjudged the ability of people to pay on large loans, you made a lot of concentrated loans that all went bad at once, or both. One small loan going bad won’t bring down a bank (remember that buffer?).

Duration

So many of the readers of this article, assuming you are enough of a masochist to have made it this far, will have heard the phrase “maturity transformation” before when discussing banks (as opposed to teenagers). What this ultimately means is that banks have a tendency to “borrow short, lend long”.

Or, in plain English: they have demand deposits, which depositors can come ask to get back at any time, and they use those deposits to make long-term loans, which the bank can’t just go ask someone to pay back merely because someone wants their deposits back.

Usually this works fine. When interest rates are stable and loans are performing, you can file this solidly under “who cares” in most situations.

However, there’s a specific case where this is often a problem, and that’s when interest rates are going up. Why is this a problem?

Loans and bonds are typically fixed rate (e.g. you pay 3% interest), and when interest rates go up, those bonds fall in value. I promised there would be no complex math, so we’re not going to get into why, other than to say in English words that the reason this is true is that if interest rates are now 4%, the price someone will buy your 3% bond at is a big enough discount such that they are essentially getting 4%.

So let us engage in a thought experiment.

1. Imagine a bank bought a bunch of long-dated bonds.

2. Imagine interest rates go up because Congress spent a shitload of money, and the Federal Reserve didn’t notice and left interest rates at zero and now there is a ton of inflation. The Fed suddenly realizes everything is fucked and massively increases interest rates over the course of a year.

3. The price on those long-dated bonds the bank bought go way down.

What happens to the bank?

If this isn’t a big problem and the uh-oh from this loss is less than the capital, usually they just end up getting some unfriendly phone calls from their regulator and have to chill out for a bit until they recover by earning more interest. Shareholders tend to hate this because they will have to stop paying dividends or engaging in buybacks until the capital recovers. Overall, though, this is a mild problem.

A slightly more major problem is if depositors notice and get restive, as once they come in and want their money back, you either need to be able to borrow against those securities so you aren’t a forced seller, or you are a forced seller. This is quickly bleeding into how banks die from deposit runs, and these issues are intertwined, but just know that borrow short, lend long is specifically a problem in the case where you did the lend long part into rising interest rates or credit spreads (which do the same thing as interest rates, but only for credit risky bonds, so not treasuries).

Volatile Liabilities

Let’s create a theoretical depositor for a bank. We’re going to call this depositor Omid, which is totally a coincidence and not me teasing one of my friends by naming the worst depositor ever to live in a hypothetical example after him3.

So this Omid guy? He’s awful, if you’re a bank. Why? Because his deposit behavior makes no sense, and worse, other people listen to him. What do I mean by this? One day, Omid shows up. He’s got millions of dollars, and deposits them at your bank. Congrats! That’s a bunch of funding. Sometimes, you will think you are even more lucky when a bunch of Omid’s friends show up and deposit millions of dollars as well. Look at all these deposits! Better make some loans or buy some bonds.

Everything seems great, except about four months later, Omid comes back and he wants his deposits back. Why? He doesn’t need a reason! So do his friends. All at once. And now, you have a problem: you have millions upon millions upon millions of dollars that you need to raise to pay all of these people, but you went and bought loans and bonds.

Now you have to sell them.

In normal times, where they haven’t changed much in price, this is annoying. You might end up paying bid/offer to unload some things, you might not be at the same investment targets you thought you were at, and you might have to borrow some money to pay people out and then sort things out later. Specifically, you might have to borrow money using Fed or FHLB facilities, which can be a signal to the market that you have a problem, all because this one dude started a trend of people leaving your bank. Annoying!

However, in times where those loans and bonds have lost money, you have a problem. Not the small kind of problem that will go away, but the big kind of problem that is about to kick your ass. Why? Because you are selling at a loss. If you bought $10mm of bonds that are now worth $9mm, and people come to demand $10mm of deposits back, you’re out the entire set of bonds and you need to go find another $1mm somewhere.

This is why hot deposits are a problem. Unless a bank knows in advance that those deposits are hot money, if they go and buy long-dated securities or make loans against them, it’s going to be a problem when they redeem.

Another factor about volatile deposits is that usually, the depositor is not irrational like Omid, but actually is quite unfortunately rational. Why do they want their deposits back? They probably need the money to pay for things because their industry is in trouble. Which is the same reason all the other correlated deposits are redeeming as well. This is what regulators mean when they talk about hot money and runs on the bank being caused by certain industries.

A Live Example

This all brings us to Silvergate.

For those who don’t know, Silvergate was one of the banks that was an early supporter of the crypto industry. And by supporter, I mean merely a bank that did not aggressively turn away crypto clients and was instead willing to at least consider working with them.

Considering that most of the banking industry has reacted to crypto about the same way someone would react to a person running up and shitting on their porch, this was actually quite remarkable and forward-thinking on the part of Silvergate.

Silvergate also ran something quite notable called SEN, which is important to understand insofar as it was both the main reason for all the deposits and it was just shut down this Friday, March 3, 2023.

SEN is an instant payments network. Keep in mind that normal banks are only open during weekdays, during banking hours, and use fedwire (mainly, there are other forms) to send money. That means if you want to send money and have it settle with finality at 2pm on Saturday, here’s what you do:

Wait until Monday morning.

First of all, let me say this is positively neolithic at this point. South Korea, for example, has had a real-time payments infrastructure in place since the early 2000s. For those who object to me using South Korea because they are both small and a technocratic dictatorship, some other countries that have fully deployed, fully functional 24/7 real time payments include such micronations as Brazil and India. Put differently: the US has no excuse here and this is one more example of America not being a serious country anymore.

Second of all, what this means is that if you are crypto company, weekends become death. Why? Your primary market is 24/7, that being crypto, but if you want to trade, you…

Wait until Monday?

That’s not going to work in many cases. Instead, everyone banked at Silvergate because of SEN. What that meant was that if I was at firm A, and wanted to trade with market maker B, we could trade at 2pm on Saturday and as long as the money was at Silvergate, Silvergate would move it in real time from firm A’s account to market maker B’s account at 2pm on Saturday, instead of waiting until Monday morning to open.

For those of you being like “so, seriously, the innovation here was being aware of time existing?”, my answer to you is yeah, basically that. But Silvergate did a decent job with the implementation (as did Signature, another big crypto bank, with Signet), so people used it. In size.

You’ll notice I said something interesting just above there: “as long as the money was at Silvergate”. Now let’s take that little tidbit and put it back in the language we have been using to talk about banks.

This means a customer has deposits at Silvergate, and those deposits can be used 24/7 on SEN to pay other customers of Silvergate. This creates quite the little network effect, which served as an excellent asset gathering tool for Silvergate. Silvergate’s economic terms were also terrible (0% interest, and even charged people fees to use SEN), so they were making absolute bank on these deposits4 so long as they could deploy them at any positive interest rate.

So what happened with Silvergate? Here is the timeline, as best I can reconstruct it:

1. Silvergate, with SEN, had the pole position in crypto and a deposit base that was mostly crypto companies heading into 2022.

2. Riding high on these deposits, Silvergate decided to buy longer-dated assets, which look to be some mix of treasury bonds, agency debt, and agency mortgages, exactly the kind of thing you’d expect a normal bank with a boring deposit base to have.

3. In 2022, as Terra/Luna happened, Silvergate largely appeared to be fine, but then after the FTX crash, finally began to experience large drawdowns in their deposit base. They allegedly lost approximately 70% of their crypto-related deposits in the fourth quarter of 2022, which is a lot!

4. This, back to our examples above, forced Silvergate to begin selling securities that had declined in value thanks to J.Pow & crew going fucking hard at inflation and raising rates multiple percentage points over the course of the year.

5. Silvergate had been stumbling around drunk and wounded for several months after that, having lost at least $700mm on the sale of securities to pay out the departing depositors.

6. However, this past week, they were cut off by the FHLB, appear to not be able to make a filing deadline with the SEC due to some kind of accounting or balance sheet issue, and shut SEN down after the close of fedwire on Friday.

This is the kind of thing that happens when your bank is about to die. In this case, the path is pretty simple, and it’s one of the things that was discussed above as a basic reason banks die: borrow short, lend long, lose money on duration, and then have your depositors ask for their money back.

The only part of this tale that is shocking to me is that they did it. Silvergate is the ideal bank to do nothing other than own t-bills and just rake in profits, given they were paying 0% on deposits. In that world, why take the duration risk? I’m genuinely curious as to what the thought process was behind the securities they bought. Hell, even better would be ON reverse repo with one of the big dealers or custodians, and that was paying even more than t-bills for most of the year!

There were plenty of highly profitable debt trades that would not have created a material mismatch in duration, but that doesn’t appear to be what they went with.

So what happens now? It’s unlikely that Silvergate can recover from this, in my eyes. It’s likely that someone buys them at a highly distressed price or that the FDIC puts them into receivership (which is roughly the same thing, now). Either way, you don’t create this degree of crisis of confidence and bounce back.

In terms of lessons for other banks in the space, I would suggest everyone should note the following:

1. If you don’t have a highly diversified asset base where crypto is a small part of your lending, be careful on the asset side here. I won’t say more because this is literally something I advise banks on5, but suffice to say it’s solvable.

2. In a rising interest rate environment, be very careful about extending out in duration in general, even for non-crypto exposures.

3. Don’t act like a jerk to your customers because they won’t cut you slack when things go wrong.

Full Circle

Now let’s come back to that tweet above. Remember the person who said stablecoins should be in “dollars”, which in our system are bank deposits?

When a bank fails, you might lose those deposits. In this case, Silvergate is plausibly going down, and given the FDIC6 will only cover up to $250k, I’m pretty sure that’s not going to help the major stablecoin issuers.

As a general statement, if Silvergate goes through receivership and the depositors are made whole, things could work out okay. But if they fail in less orderly fashion, or there’s not great bids in receivership, depositors could take a big ding.

In general, bank deposits work this way: you are reliant upon the risk management and credit underwriting of the bank you are depositing your money within order to get it back. Put differently: banks are credit risky!

The punch line for that tweet above is that a stablecoin invested entirely in t-bills would be fine right now, but one that had left money at Silvergate might be about to lose a bunch of money if things get worse.

“Dollars” were not the safe bet.

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