The Breakdown - Crypto Credit Isn’t Dead

Episode Date: July 31, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US.   On this week’s “Long Reads Sunday,” NLW reads Nic Carter’s “The Credit Crunch Is Not the End of Crypto Lending.” - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company safeguards your crypto by relying on five key fundamentals including real-time auditing and insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsors is “The Now” by Aaron Sprinkle. Image credit: PM Images/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, July 31st, almost August. And that means it's time for Long Reads Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dig deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to

bit.ly slash breakdown pod. For what it's worth, Longreads Sunday's post are some of the best to go debate in the context of a community like the Breakers Discord, so I hope I see you there. Lastly, a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. Right, so to Long Read Sunday, and look, if you are a long-term listener of the show, you will know that there aren't too many rules when it comes to what I focus on read for LRS. But one of those rules is that when Nick Carter writes a new essay, especially a bare market essay, which just has such a different feel and flavor than the bull market, we read it here. That's a rule. And so who am I to deny that? Nick published a piece on July 20th on CoinDest called The Credit Crunch is Not the End of Crypto Lending. Subheader, it is a mistake to view Bitcoin's success as a trade-off against the creation of credit. Its future depends on it. With that,

intro, let's dive in. Tell me if you've heard this story before. A vast new market opens up, and an investment and credit boom soon follows. Real wealth is created alongside a speculative excess. Banks spring up all over to extend credit to market participants. New financial instruments are created. Trading firms start trading these instruments on margin. A massive firm blows up with a series of leveraged trades causing losses to its creditors. The main partners at the firm flee the country. Panic follows, kicking off a liquidity crisis and a wave of bank runs. Major lending institutions go bankrupt and credit contracts rapidly. Sounds like the crypto market in 2022?

It also describes the European credit crisis of 1772 to 1773. That particular banking panic is one of the lesser-known crises of the 18th century. After the Treaty of Paris in 1763 ended the French and Indian War, Great Britain gained a stable claim on territories in North America. That made it safe to invest in the new territories, and bankers in Europe obliged with enthusiasm. Colonial planters needed credit, and British merchants wanted commodities to sell to more markets. A credit boom resulted, as did a speculative fervor among traders in London and Europe. Shares in the British East India Company rallied sharply in 1772 as traders heaped on margin to trade with.

In mid-1772, events came to a head as the London Bank, Neal, James, Fortis, and Downs, failed, having shorted East India Company shares with leverage. Among its major creditors was the Scottish Bank, Douglas Heron & Co, also known as the Iyer Bank. Scotland was operating on a lazi fair or free, as in speech, banking period, at the time, and largely unregulated, startup banks were the norm. The Iyer Bank had been formed just three years prior by major landowning families in Scotland. It was intended to serve as a kind of private Scottish central bank. Iyer was a full liability institution, with deposits guaranteed by the land holdings of its shareholders. In its short existence, it eagerly issued credit in banknotes, quickly becoming one of the largest banks in Scotland.

It had a reputation for extending credit on loose terms to close affiliates. When the Fortis Bank blew up on leverage, it took down the Iyer Bank as well. Fortis himself fled to France. It later emerged that he had been temporarily covering losses with inflows from customer funds. A credit crunch developed in the following weeks, hitting London. Edinburgh, Amsterdam, and bringing down dozens of financial institutions. Credit conditions froze up. As for the Iyer Bank, its liquidation ended up taking decades, bringing down some of the largest landowning families in Scotland. A material fraction of Scottish lands was sold off to make depositors whole. Lessons learned. You might think that, post-crisis, Scotland would have reconsidered its Lazyfaire banking

system. Quite the contrary. The IRA bank is remembered as the major failure of the Scottish free banking era, which lasted from 1714 to 1844, and was a model of stability, all without any central administration. Other Scottish banks did fairly well throughout the crisis, as they were able to redeem IRA banknotes for underlying reserves. And the lessons of the IRA collapse, chronicled by none other than Adam Smith at the time, were successfully internalized by the market. Today, Bitcoiners are gleeful about the collapse of credit in the crypto industry. As I write, a few high-profile bitcoins are gathered in a Twitter space entitled RIP Celsius Long Live Bitcoin. To be clear, I've never been a fan of Celsius Network, and I have long been skeptical of its approach.

But the failure of that institution and many of its peers, alongside a new spate of consolidation in the lending sector, doesn't make crypto credit obsolete. It simply ensures that the sector will reemerge invigorated, reformed, and more prudently managed. Bitcoiners attacking lending institutions are undermining their own interests. Many adherence to the Bitcoin maximalist doctrine maintain a curious disdain for credit. They often follow a Rothbardian ideal, believing fractional reserve banking to be fraud, even though the idealized full reserve banking generally never emerges in free market conditions. During Scottish free banking, a fully lazai fair market space system, reserve ratios were commonly 2 to 5 percent, and the system works swimmingly.

Full reserve banks wouldn't be able to extend credit or transform maturity. They can scarcely be described as banks at all. A world with no credit is a dismal one. Credit, responsibly extended, is the cornerstone of civilization. It unleashes savings and puts the money to work in productive areas of the economy. A world without credit is a sterile, stagnant one. In times like these, security of your assets should be your number one priority. If you want to offset risk as much as possible and still stay in

crypto, you need a trusted partner by your side. Nexo is a security first company that manages risk by relying on mechanisms such as over-collateralization, real-time auditing, and insurance on custodial assets. Learn more about Nexo's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more informed, decisions around crypto, Chainalysis is here to help. Chainalysis demystifies cryptocurrency by providing industry-leading compliance, market intelligence, and investigations support for all crypto assets. For organizations like Gemini, Crypto.com, and BlockFi, gain unparalleled visibility and maximize your potential with the leading blockchain data platform by visiting

us now at Chainalysis.com slash CoinDesk. The breakdown is sponsored by FTX US. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets, with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show.

Bitcoin maximalists. In case you think I'm making this anti-credit crusade up, just read the words of self-described maximalist Stefan Levera, under the heading what do Bitcoin maximalists actually believe? In practice, most of the maximalists I know are simply not interested in non-monetary uses and are more interested in distinguishing Bitcoin from all of the crypto garbage out there. And at times like these, with so many crypto lenders stopping withdrawals, Celsius, Vauled, Voyager, filing for Chapter 11 bankruptcy, Voyager, or taking bailout deals,

BlockFi, Voyager, there's a strong case to say the maximalists were right. But were they? If their victory condition is no credit is ever extended based on a crypto asset ever again, they guarantee a loss. Yes, the lending industry has taken a hit, but it certainly won't cease to exist. The desire for leverage and a lower cost of capital on one hand, and yield on the other, is inherent to free capitalist enterprise, and that urge will never disappear. Bitcoiners who ostensibly believe in free markets should recognize that this necessarily includes the market for money as well. Bitcoiners embracing the Rothbardian view cannot reconcile the demonstrated history of fractional reserve credit extension under totally free market

conditions, free of state interference. Consumers throughout history have preferred banknotes to hauling species around. Businesses and individuals have desired leverage. and banks have been happy to give it to them. Even in the most radically unencumbered conditions, free of state influence, full reserve banking doesn't emerge naturally. Just look to lazifere banking regimes in Scotland, Sweden or Canada in the 18th and 19th centuries. In defense of credit, in a 2020 defense of crypto credit creation, I wrote the following on Coin desk. By no means is the state of credit in the crypto industry perfect. I expect many more failures from those depository institutions. But with each failure, depositors will gain an appreciation for the merit of diligence

and will start to scrutinize these institutions more carefully. And each failure is evidence that financial institutions can indeed fail without the state stepping in. These painful lessons will force the industry to adopt best practices around transparency, depository assurances, and reserve ratios. Lacking a paternalistic state to backstop credit and bailout excessive risk-taking, the industry can benefit from negative feedback. Well, here we are. We have suffered our first true systemic credit crisis. Virtually no lender has been unaffected. We got no government-led bailouts. The bailouts Bitcoiners derisively refer to

are simply private markets distressed asset transactions, normal in any market, no state intervention, and yet the credit markets will recover from here. The dust still hasn't settled, but it's clear that we already have the tools to build a more robust lending system. As it happens, Bitcoin is the perfect form of collateral upon which to build banks. as a cryptographically auditable, digital-bearer instrument with cheap physical delivery, it vastly outperforms gold species as a collateral type. The problem with gold is it's costly to verify, meaning it ends up in walled gardens,

and consumers rarely want to redeem notes of specie, so the gold-based system empowered banking institutions at the expense of depositors. An opaque market. The problem with the 1.0 version of crypto-credit markets was the opacity of the system. its dependence on artificial defy yields and a general undercurrent of fraud facilitated by the loosest financial conditions in living memory. This can obviously be improved upon.

Hybrid C-fi-defi credit markets are already extending credit undercollateralized in a fully transparent manner, a massive improvement compared with the default centralized finance model. Both consumers and regulators alike will insist on transparency, and the emerging defy infrastructure is poised to give it to them. We are seeing lenders experimenting with proof of reserves. This will surely be refined and extended. Underwriting standards are being tightened, and future lenders, mindful of the rapidity of the bank runs possible with crypto assets, will have to maintain more prudent liquidity and reserve ratios. The Bitcoin are not your keys, not your coins doctrine is also ironic in this context. If Bitcoiners had spent more time building

better tools to use Bitcoin in a non-custodial manner, they wouldn't have been subject to the false binary of full custodial intermediation versus full self-custody. Intermediate models are possible. Anyone who has used blue-chip defy protocols knows that you can harmonize financial innovation and self-custodial key management. Ironically, the emergence of defy, which caused users to pull all their coins off exchanges so they could deploy them directly on chain, did far more for individual self-custody than the Bitcoin preachers ever did. Tens of millions of people use Metamask, while no widely equivalent wallet for Bitcoin even exists, as there's no defy applications to use it with. Maximilists interested in a better managed credit sector

won't achieve anything by bleeding to each other about the dangers of crypto lenders. If everything is a scam to them, their warnings contain no information. They cannot extinguish the demand for credit or yield, and entrepreneurs will always emerge to fill this need. Instead, they should start their own financial institutions, using Bitcoin as a neogold with superior collateral qualities, and setting reasonable underwriting standards. It is a mistake to view Bitcoin's success as trade-off against the creation of credit. Its future depends on it. All right, back to NLW here. And the first thing I'll say is that while I would understand if some are going to read this as the next front in Nick's ongoing war with the Bitcoin maximalists,

I think that it would be wrong to just reduce it to that. It's not untrue that Nick has now taken it upon himself to puncture holes in many tightly held mantras of that set. But that doesn't mean that there isn't something to be learned here. I think the fundamental point is that free markets proceed towards credit creation. Nick's point that credit is a way to take savings and through the auspices of financial institutions like banks, turn those reserves into new resources that can be used for productive purposes. That is the way in which new endeavors, new creation is funded. That is not some scam to be derided. That is a fundamental aspect of free and open markets. It is the genesis in Wellspring from which entrepreneurship on the smallest or biggest levels can spring.

I think further, Nick's point is that while it is completely reasonable to question, deride, and revise excesses of certain types of practices, a certain lack of expectations around transparency, or whatever hole you want to poke in the first version of some of these crypto credit platforms, crypto-based collateral offers really unique and powerful properties that make it even more interesting for some of these free market credit creation purposes. The reason I think it's important to have these conversations is that it's way too easy, especially right now in this moment, in the wake of institutional failure, for conversations to become rigid and dogmatic, unnuanced, political, and just for scoring points among an in-group of like-minded people.

Like Nick, I don't believe that that will be to the long-term success of Bitcoin. But I also think it would be a shame for Bitcoiners to not have a stake in that conversation because they've cut themselves off. In a world where everything is just reduced to a scam, what happens is people stop listening to warnings, even if they're legitimate. I think movement Bitcoiners do have a fundamentally different view of modern economics, which could be a powerful force for people revisiting and making their own decisions about how they want to structure their personal lives, how they think about their own assets and sovereignty, and has implications for society writ large and the economy writ large, but not if the conversation never even happens. I continue to believe that crypto is a cauldron of raw, unfettered capitalist experimentation. Everything that can be tried will be tried. And to the extent that one wants to have an influence on the conversation, about what should be tried or what should be stuck with over the long term, being a part of the

conversation is a lot better than standing and shouting from the outside. Thanks to Nick for another thought-provoking post, and thanks to my sponsors, nexus.com.i.o, chain aliasis and FtX for supporting the show. And of course, thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.