Justin A. Parr - Technologist

We all know (well, HOPEFULLY we ALL know) that investing in cryptocurrency is fraught with risk.  However, with the promise of privacy and decentralized banking, doesn’t crypto do more good than bad?

In short, NO.  Keep reading to find out why…

 

 

What is Money?

Conventional money consists of physical tokens, each of which represents a specific value.  These physical tokens can then be exchanged for goods and services (and other tokens) of equal value.  When you buy something that costs $10, you exchange the [something] by exchanging it for a piece of paper with $10 printed on it, issued by the United States government.

These physical tokens can be grouped in any arrangement, and their value is aggregated.  For example, to buy the [something], you can exchange a single $10 bill, or two $5 bills, or a $5 bill plus five $1 bills, or ten $1 bills, and we all agree that all of these combinations have the same value, which is $10.

Further, money is fungible, meaning that any token or group of tokens of a specific value can be exchanged for any other equal token or group of tokens.  Which means that if I borrow $1 from you, I don’t have to give you back the exact same $1, because all $1 bills have the same value.  Likewise, if I borrow $20 and you hand me a $20 bill, you won’t complain if I hand you back two $10 bills later.  Well, maybe YOU would complain, but a REASONABLE person wouldn’t.

What is money?

• Money is issued by the government
• Money has specific value
• Money can be grouped, and its value is aggregated
• Money is interchangeable with any other money of equal value

 

Where does money get its value?

All societies started with a barter economy, where goods and services are directly exchanged for other goods and services.  For example, a hunter might trade with a farmer, exchanging animal skins that he has in abundance for corn that the farmer has in abundance.  The trade is mutually-beneficial:  The hunter gets tasty corn to eat, especially if the hunting is bad and he has nothing else to eat.  Meanwhile, the farmer can make clothes, bedding, and tools from the animal skins.

We know that we can exchange corn and skins, but there is also a blacksmith who makes tools.  He has an abundance of tools, but he needs to eat, and he needs warm clothes.  Meanwhile, both the hunter’s and the farmer’s need for tools is obvious, and since they each have a surplus of their respective goods, they can each trade for tools, and the blacksmith gets skins to wear, and vegetables to eat.

However, now there is a harsh winter.  The blacksmith is doing fine, and so is the hunter, but the farmer has no crops, and he’s very cold.  The farmer can trade the tool he got from the blacksmith to the hunter in exchange for more skins so that he can at least be warm.

This all works out fine, except that the hunter, the farmer, and the blacksmith have to have a common understanding of the entire economy in order to indirectly trade goods that they themselves didn’t produce.  And, as you add more goods and services to this economy, the problem becomes exponential.

Money is something that all parties agree has value, and therefore can be traded for any goods and services within the economy.  Money also provides a way to standardize and compare costs, which is very convenient when the local hunter is asking 14 ounces of gold per skin, when you know very well that you can go to the next village, and buy the same quality of skins for only 7 ounces of gold each.

Going back hundreds and even thousands of years, the first government-issued money was made from precious metals and other materials that had intrinsic value.  For example, gold is a rare metal, scarcity creates demand, demand creates value.  Because gold has value, any coin made from gold has the equivalent value.

This gave the issuing government an easy way to:

• Standardize the value of all coins
• Standardize the cost of commodities within the economy
• Regulate and tax trade

However, people with lots of coins had the problems of how to carry them around and store them securely, which is where banks come in.

Eventually, banks allowed you to store your heavy gold in their vaults, and issued you a paper “bank note”, which was basically a certificate indicating that you have a specific amount of gold in a particular bank.  Carrying around a paper certificate was much more convenient than carrying the gold itself.  And, exchanging these certificates was just as good as exchanging gold, because anyone could go back to the bank and present the certificate in exchange for the appropriate amount of gold.

These bank notes were the first effective paper currency.  Paper is a representative currency because it has no intrinsic value, but represents some other commodity which does.

The first government-issued paper money was issued in lieu of bank notes, when bank notes were in short supply, and eventually, government-issued paper money was used as a way to regulate the banks, and protect consumers.  And, like bank notes, these were backed by a commodity.  This is known as a hard currency, because in theory, each paper note can be exchanged for the equivalent amount of gold or silver.

The problem with a hard currency is that the price of the underlying commodities can be manipulated in order to devalue the currency itself.  This happened to the US Dollar, and in 1971, US President Richard Nixon unpinned the dollar, allowing it to float against other currencies.

Today, the US dollar gets its value from the US government declaring that a dollar is worth a dollar.  This is known as a fiat currency, where money is backed by the strength of the economy and its underlying government.

 

 

Digital (Virtual) Currency and the Banking System

Digital currency is a generic term for money that uses a digital token instead of a physical one.

A primitive example of digital currency is the credit card information that you use to purchase things online.  The credit card information, in digital form, represents the physical card you carry in your wallet, and when you use it, your bank or credit card company creates a ledger entry, and when the bank posts this ledger entry, it updates your account balance.  And, of course, your account isn’t physically stuffed with paper dollars – your account balance is just a number stored and maintained by the bank, representing how many dollars you could withdraw from the bank if you wanted to do so.

In fact, most of the currency we deal with on a daily basis isn’t even physical paper money.  Rather, it’s virtual money – just numbers stored in computers within the banking system.

In that regard, most of the currency in circulation today is virtual and therefore digital.

Digital currency offers the following advantages over physical:

• Better protection against fraud and theft
• More versatile and convenient (Try buying something online with cash)
• Travelling with cash is increasingly looked upon by the government as an indication of criminal activity, and civil asset forfeiture is on the rise.

Despite the advantages, using the banking system has disadvantages as well:

• Because credit cards are fundamentally flawed, criminals tend to steal credit card information, and credit card fraud is widespread.
• Everything that flows through the banking system is tracked, and therefore not private.
• Because of money laundering regulations, it’s difficult to move money in and out of the banking system.

Because of the previous points, there are a lot of people who prefer to conduct transactions in cash.  For example, if selling a used car or other expensive equipment or valuables, requiring the buyer to present cash limits the risk of fraud, because checks and credit cards are fairly easy to fake.  Paper money can of course be faked, but it’s much more difficult.

However, cash transactions come with a lot of caveats:

• The buyer has to provide justification to the bank in order to withdraw the cash (yes, you have to ask permission to use your own money)
• The seller has to provide an explanation to their bank in order to deposit the cash
• Either the buyer or the seller could lose the cash through theft, or it could be seized by the police

In addition to eliminating geographical limitations, online marketplaces such as eBay and Amazon allow the use of digital currency while providing some level of protection for both buyer and seller.

• The buyer receives some level of guaranty about the goods or services being sold
• The seller pays a small transaction fee, and receives some level of assurance about the funds provided by the buyer

Although this protects a seller from a buyer who uses a stolen credit card, it doesn’t prevent the fraud in the first place.

Because credit card data remains static, it can be stolen and then used over and over again until either the bank detects the fraud, or the consumer reports it as stolen.

 

Prepaid Credit Cards

Prepaid credit cards (sometimes called gift cards) allow you to convert physical money in to digital money, or to partition a portion of digital money.

This is a convenient way to limit the amount of risk:

• By registering online, prepaid credit cards offer the same protections as a bank-issued credit card against theft and fraud, and you can check the balance online.
• If a prepaid credit card is compromised, the total exposure is limited to the amount of money on the card itself, rather than your credit limit, which could be significantly higher.
• A credit card is more secure than carrying cash, which can’t be tracked or recovered if stolen, and a credit card (even a prepaid card) can’t be seized by the police.
• Unlike a bank-issued card, a prepaid card isn’t tied to your name.  With a conventional credit card, your name is on the card, and the cardholder name becomes part of the information needed in order to use the card.  However, with a prepaid card, the cardholder name is ignored.  This helps protect the buyer’s identity and helps prevent identity theft.

Despite having some advantages, prepaid cards also have some drawbacks:

• When you fund and “activate” a prepaid card, there is a transaction fee, which can be a fixed amount of a few dollars, or a small percentage of the funds.  Although most prepaid cards allow you to transfer money to a bank account, the transaction fee can’t be recouped.
• Prepaid cards (in most cases) can’t be directly converted to cash.  So if you need to make a cash purchase, despite having funds in the form of a prepaid card, you need more funds in the form of cash in order to make the purchase.
• You should always use a gift card completely, but sometimes it can be tricky to figure out how to do this effectively.  For example, you might have to use two forms of payment for a single purchase – the first being the remainder of the gift card balance, and then the rest in cash.  This leads to a situation where, in most cases, gift cards are left with a small lingering balance that represents wasted money.  Most gift cards can, however, be reused by simply adding more funds, or you may be able to transfer the balance elsewhere.
• As with normal credit cards, the card information itself can be extracted and reused, making them equally-susceptible to fraud and theft.
• Because cash can be converted to digital funds, and those funds can’t be traced, prepaid cards are often used for scams and money laundering.

Anecdote:  I have a friend who uses prepaid cards when he goes on vacation as a way to protect himself from fraud and theft.  Unlike business travel, you’re much more likely to get ripped off in a “tourist destination” because tourists tend to be less aware of fraud and crime, and therefore criminals tend to target them.  For example, you might pay for drinks at the bar on the beach, only to find out that before you even make it back to the hotel that night, your credit card was used for a spending spree.

Criminals can make fraudulent online purchases, or simply make a new credit card, using a machine, with your name and card number on it, and then go to the local electronics store to load up.  You might think that the magnetic stripe and chip embedded in your card protect you, but the criminals have machines that can duplicate the mag stripe, and they have figured out how to defeat the chip years ago.

Stealing the credit card information and using it to duplicate a prepaid card limits the criminals to only small purchases, and they know that.  Therefore, criminals are much less likely to target them, unless they can steal the physical card itself.  If the physical card is stolen, and assuming that it was properly registered by the consumer, it can be reported lost or stolen online, and the consumer will probably get most or all of the funds back.

But worst case, losing $100 from a prepaid card is much easier to deal with than having a criminal make hundreds of purchases for thousands of dollars, having to deal with the bank, and having to get new cards issued on top of all that.  If a prepaid card is compromised, you throw it in the trash and get a new one.

 

Redemption Codes

If you’ve ever purchased software online, or maybe bought a gift card for one of the online gaming platforms such as Steam, Playstation Network, or Nintendo Online, then you probably got a redemption code consisting of some numbers and letters with dashes:

AB3AB-46XYZ-DD78D

To get a redemption code, you buy one with digital or physical currency.  Then, you go to your online gaming portal (Steam, Playstation, Nintendo, etc…) and enter the redemption code, which then adds the corresponding funds to your account (or wallet or whatever).

In most cases, that money is then “captive” to that specific marketplace, and can’t be converted back to cash, nor transferred to another bank account.  Although there are ways to get around this, for example, buying skins on Steam and then selling them on an external marketplace, the platform itself doesn’t support this, in order to avoid scams and money laundering within their marketplace.

Even though redemption codes are the least-versatile form of currency, they have some interesting qualities:

• Unlike paper money that’s serialized, and credit card numbers that are somewhat predictable, good redemption codes are generated using a cryptographic process.
• Until they are redeemed, the codes themselves have some cash-like qualities.

 

Generating Secure Redemption Codes

In it’s most basic form, a redemption code is a unique but random grouping of letters and numbers:

AB3AB-46XYZ-DD78D

Generating these codes can be tricky – each code must be unique, yet the scheme to generate them can’t be predictable.

Even using random numbers has its challenges, because most random number generation schemes aren’t truly random.  Pseudo-random number generators start with a seed value, and repeatedly iterate a mathematical operation in order to get the next number.  If the bad guys can guess the random number scheme, they can generate their own codes, which is bad.

A cryptographically-secure random number source uses an external source of entropy, such as a temperature sensor or other analog sensor, as the basis for generating random numbers.  Since they are truly random, they can’t be guessed.

The code is then checked against a database to ensure that it’s unique, and if so, it gets stored in the database until redeemed by the consumer.

I suspect that stronger schemes also use cryptographic hashing functions for better entropy and distribution.

In contrast, credit card numbers are inherently weak.

1222-2233-3333-333X  (444)

Credit card numbers consist of four groups of four digits, which is the “credit card number”, and a group of three digits which is the verification code (also known as the security code).

The first digit is the major industry identifier, which determines what kind of card it is.  The first six digits (1 + 2 above) indicate the issuer, and digits 7 through 15 (3 above) indicate the account number.  The last digit is a check digit that’s calculated from the other digits.

Therefore, in order to forge a credit card number, you start with a known-good credit card number, copy digits 1-6 (1 + 2 above), and then add or subtract a random number from digits 7 through 15 (group 3 above).  The last step is to calculate a valid check digit, which you can easily do using tools online.

Redemption codes are much harder to forge (or they should be).

 

Redemption Codes Have Similarities to Cash

• Cash can be converted to redemption codes
• Until they are “redeemed”, they can be traded for face value
• If traded, both parties have a way to verify the monetary value.  For paper money, the value is printed on the paper itself.  For redemption codes, the value can be checked online.
• Like cash, redemption codes are decentralized (until they are redeemed)
• Because they are decentralized, redemption codes are difficult, if not impossible to track until they are either registered or used.

 

The Road to Cryptocurrency

Redemption codes aren’t really designed to be used as cash, as there are opportunities for the original purchaser to commit fraud by claiming that the code was stolen when it was, in fact, traded.  Likewise, anyone who has the code and trades it for something else could simply copy the code and secretly redeem it after it has been traded, thus devaluing the code to zero before the recipient can use it.

For example, let’s consider the case of Amazon gift cards, which are in the form of redemption codes.  When you purchase one for cash, the card gets activated during the purchase process, but it’s not registered to the purchaser.  The card simply has a redemption code printed on it, and there is nothing otherwise remarkable about the card itself.  In fact, you could write down the redemption code and destroy the card.  Until it’s used, the redemption code has the same equivalent value as cash to anyone who has an Amazon account, since anyone with an Amazon account can use it to buy goods and services through Amazon.  Whoever redeems the code gets a credit added to their account, equivalent to the cash that was originally used to purchase the card.  The recipient can then make purchases against the gift card balance until it’s depleted.

Unfortunately, there’s no way to check an Amazon redemption code online without redeeming it.  However, there is no reason why Amazon couldn’t provide that service.  Let’s assume for a minute that you decide to use a redemption code in trade – If both parties can verify the code online, then in theory, you could buy something outside of the Amazon marketplace by trading just the code itself.

However, once you know the code, you could redeem it.  As it passes through multiple hands, everyone who touches it could redeem it at some point in the future, even if they no longer own it.  Whoever uses it first gets the credit, and the redemption code has no residual value for the current owner.

To fix this problem, we could simply implement a centralized system that tracks the ownership of each redemption code.  As the code passes from hand to hand, the previous owner logs in to the centralized system to relinquish control, and the new owner logs in to the centralized system to assume control.  However, this defeats the purpose, because the code itself is no longer necessary – since we’re back to a centralized system, why have the code at all?

Another approach would be to have a ledger that stays with each redemption code, where each ledger entry indicates the transaction from the previous owner to the new owner.  Further, to either transfer or redeem each specific code, you must be the current owner, as indicated in the ledger.

• The ledger prevents counterfeiting, as each redemption code can be tracked backward, all the way to its origin.
• The ledger prevents fraud, because each code can only have one owner.
• The ledger allows the codes to spend like cash, because it’s decentralized.
• The ledger prevents the code from being redeemed (and thus devalued) because only the current owner can redeem it.

But… how do we secure the ledger itself?  For example, someone could steal a redemption code and then alter the ledger to make it seem like they are the current owner.  Also, someone could simply create fake redemption codes, with completely fake ledgers.

If we were to secure these ledgers using cryptographic techniques, we have the basis of a cryptocurrency.

 

A Quick Note on Peer-to-Peer Transactions

Services such as Zelle or Venmo allow you to send money directly to another person.  The mechanism used by services such as Zelle is to link to both the sender’s and recipient’s bank accounts, where it creates a debit for the sender, and a credit for the recipient.  Some of these services use other conventional means, such as a credit transaction or a wire transfer.

Although peer-to-peer seems very “cash-like”, all of these services use conventional centralized banking systems to create the transaction.

 

 

Cryptocurrency

Cryptocurrency (also known as crypto) is a decentralized, digital currency (tokens are digital) that’s secured by cryptographic techniques.

• Users have a “wallet”, which is a cryptographic key pair.  One key is public, and the other is secret.
• Transactions are signed using the secret key, which is only known to the user of the wallet.
• Transactions are written to a public ledger called a “blockchain”, and all transactions are publicly-visible.
• Every transaction can be verified using the signature of its ledger entry and the public key of the wallet which conducted the transaction.
• Transactions are bundled in to groups called “blocks”, and blocks are “chained” to each other using a cryptographic signature, such that each block “endorses” the next block.
• New currency is created (or “minted”) by the users who perform work to maintain the block chain or perform other tasks for the network, often called “mining”.

Because only the wallet ID is listed on the blockchain, users remain more or less anonymous, with some caveats that we will discuss later.

There are two ways to obtain crypto tokens:

1. “Mine” for new tokens by performing work for the network
2. Trade something of value in exchange for existing tokens

Crypto “exchanges” are quasi-legal entities that allow you to convert dollars or other money to crypto, or vice-versa.  I use the term “quasi-legal” because these entities exist outside of government regulation, and exchanges all over the world get shut down by various governments all the time.  Reasons include:

• Issuing an alternative currency – this is a huge no-no for most governments, who need to control and regulate their own money.
• Lack of proper documentation for financial transactions.  Any government that participates in the international banking system is required to have laws in place to enforce the documentation of certain financial transactions, and these laws are intended to prevent money laundering.  This includes verifying the identity of the person conducting the transaction, and verifying the purpose and source of funds being transferred, all of which is difficult if not impossible on an anonymous network.
• Money laundering – under certain conditions, the owner of the exchange might be directly accused of money laundering.
• Fraud – especially if an exchange runs out of fiat money, or is holding funds in escrow.
• Funding terrorism – if money or other funds are diverted to a blacklisted person or entity.

Because of these issues, and because most governments view crypto exchanges as sketchy at best, most of them are hosted offshore.  This means that the individual user has to decide based on reputation, which exchanges to trust, making it potentially very difficult to convert between fiat money and crypto, especially when “cashing out”.  For this reason, a person can be “crypto rich” – possessing tokens that have a large theoretical cash value, but unable to convert a significant quantity to cash.

The blockchain, or chaining blocks of transactions is a shortcut for tracing the legitimacy of each token from its minting through its latest transaction.  If all blocks prior to the current transaction are signed, and have been confirmed to be legitimate, then any subsequent transaction can use the last block as its starting point.  Without block chaining, each new transaction would depend upon going back to the beginning of the entire network.

A “fork” is a divergence in the blockchain, where two legitimate, but alternate blockchains exist subsequent to that point.  This is often used as an easy way to create new cryptocurrencies.

 

Where Does Cryptocurrency Get Its Value?

The first component is scarcity.

• Various cryptocurrencies are designed with a fixed, maximum number of tokens.  For example, Bitcoin, by far the most popular cryptocurrency, was designed with a maximum size of around 21 million coins, and the final coin will be mined in or around the year 2140.
• Various cryptocurrencies are designed using a function that exponentially increases the amount of work required to mint new tokens.  This makes new tokens increasingly rare, and thus more valuable, due to the cost of the underlying work performed during the minting process.

The second component is demand, which is created by users who either trade or mine for crypto.

In the case of mining, the user believes that the value of newly-minted coins will exceed the investment of time, and the cost of electricity and specialized hardware used during the mining process.  Miners believe they will build a revenue stream by continuing to mine for new tokens, whose value exceeds the recurring cost of mining.  If not, then there would be no financial incentive, and no one would mine.

In the case of a user trading to obtain crypto, the user believes that the value of the crypto tokens they are exchanging for money, goods, or services equals or exceeds the value of what they are trading, and will continue to equal or exceed that value.  Assuming that the user isn’t being tricked or defrauded, nor acting out of desperation, if the exchange is unequal in favor of the other party, then the user has no incentive to trade.  Further, if they believe the tokens have value at the time of the trade, but will shortly drop in value, then they would have no interest to trade.

Therefore, the user receiving crypto from mining or trading believes these things:

• The tokens have value
• The value is equal or greater than the money, goods, or services (mining is a service) they are exchanging
• The tokens will maintain or increase in value

In order to create demand, beyond simply being willing to use it, users must prefer to conduct transactions in crypto because of its advantages:

• Speculation – many people want to invest in crypto in the hopes of becoming “crypto rich”.
• Security – only the wallet-holder’s secret key can unlock the funds held in the wallet.  Unlike a credit card number, even if a thief knows the wallet ID, they can’t use it without the secret key.
• Privacy – the blockchain is completely anonymous, because ledger entries only contain wallet IDs, not actual names nor any other identifying information.

And, users have to prefer crypto despite its flaws:

• Unlike a credit card transaction that takes seconds, crypto transactions can take minutes and even up to hours to be confirmed, especially if the network is busy.  This makes crypto impractical for casual purchases, such as buying gas, buying groceries, or eating at a restaurant.  This makes crypto better suited to larger transactions that don’t require timeliness.
• Peer-to-peer transactions (non-marketplace transactions) require trust by one or both parties, due to the timeliness problem.  For example, if you buy a tool from someone off of Craigslist, either the buyer has to commit the funds in advance of the transaction (setting the buyer up for fraud), the seller has to allow the buyer to take the tool without public confirmation of the transaction (setting the seller up for fraud), or they both have to wait around until the transaction is publicly confirmed.  None of these options is as easy or convenient as simply buying the tool with cash.
• Transactions require an internet connection.  Although technologies such as smart phones, ubiquitous WiFi, and 5G cellular networks make internet access common, there are still plenty of places without internet access, especially in rural areas.  So if you buy and sell used farm equipment using crypto, you’ll need a satellite or line-of-site connection.  Although this is a niche use case, there are plenty of other situations where one of the two parties might not have the signal bars needed in order to commit and then verify the transaction.
• Although various cryptos are often billed as “stable” and “a safe place to park your money”, they are anything but stable.  Actually, the markets are quite volatile.  If you sell something in exchange for crypto, it could easily either double or halve in value before you can even spend it.

Unfortunately, without any government regulation, new cryptos pop up all the time, and their creators boldly advertise the possibility of gaining wealth by investing.  Therefore demand is mostly created by new users who buy in to the market under one of two assumptions:

• Crypto is a way to get rich quick because of its volatility.
• Crypto is a safe place to park “real” money as a long-term investment opportunity, and to protect against inflation.

To recap:

• Crypto is not tied to a commodity
• Crypto is not tied to fiat money
• Crypto’s value is based solely on the perceived value of the user, in terms of both scarcity and demand

In short, the more you want crypto, the more it’s worth.

 

Pegged Currency

Some crypto gets its value by being “pegged” to another currency.

For each token issued, a token of some other currency is added to a “Liquidity Pool” (LP), which serves to valuate the crypto.

This all works great, except:

• If the Liquidity Pool is funded by fiat currency, it can be raided
• If the LP is funded by some other crypto, this multiplies the risk

There are all sorts of crypto schemes, including schemes that use multiple LPs in an attempt to distribute risk.

However, every attempt to stabilize the target currency simply leads to more risk.

 

 

Why Cryptocurrency Should Be Banned

Crypto is touted as a way to provide financial services to people who wouldn’t normally be eligible or have access to traditional banks.  It’s touted as a way to empower people all over the world, and a way to prevent government overreach as well as interference by the international banking system.

But… All cryptocurrency should be banned.

 

Reason 1:  ALL Cryptocurrency Is A Scam

Early Adopters Are Disproportionately Rewarded, While Late Adopters Are Disproportionately Penalized

All cryptocurrencies have a scarcity function that has the effect over time of increasing the amount of work required to mine new tokens, and eventually (over decades) it becomes impossible to mint new tokens, making the economy fixed in size.

This only works if the miners are incentivized to continue mining, and they are only incentivized if the value increases exponentially over time.  Thus the users who enter the market late pay exponentially more.

For example, let’s say you start a new crypto called “poopcoin”.  Early poopcoin miners will accumulate poopcoins quickly.  As discussed, the total amount of poopcoins they mine must be of equal or greater value than the time, effort, and equipment used to mine them.  As mining progresses, exponentially-increasing effort is required per poopcoin, and the increasing effort must be rewarded with equal or greater value, despite the fact that fewer poopcoins are rewarded.

In concrete terms, let’s say that on day 1 you are able to mine 24 poopcoins.  Two years later, you can only mine about 6 poopcoins per day, and in year 5, only 1.  On day 1, if 1 poopcoin was appropriate compensation for 1 hour of effort, then in year 3, one poopcoin must be enough compensation for 4 hours of work, and only two years later (year 5), one poopcoin must be enough compensation for an entire day – 24 hours worth of work.

Because poopcoin is easier to obtain in year 1, if you’re a diligent miner, you probably have about 8,000 poopcoins by year 5, where it’s now worth 24 times its original value (hey… that sounds exactly like what happened to Bitcoin).  If you compare your poopcoin position to a person who begins mining poopcoin in year 5, the value of those 8,000 tokens is now worth 8,000 times what the new miner is going to mine today.  If the new miner were to cash out his 1 measly poopcoin that he was able to mine, it must have the dollar equivalent of a day’s worth of work – let’s call that $200, which equates to about $73k per year.  However, if YOU were to cash out your approximately 8,000 tokens at $200 each, you would make $1,600,000 (congrats! you’re now crypto rich).

However, if the new miner continues to mine crypto for the next 5 years, they will only accrue about 80 tokens.  Again, we can assume that the miner is still making $200 per day, or it wouldn’t be worth it to continue mining.  Therefore, those 80 tokens are now worth $365,000 or about $4,500 per poopcoin – not bad for 5 years.  In comparison, you’ve now been mining for 10 years, and you’ve managed to accrue 8,080 poopcoin, worth $36.3M.  You’ve earned 22 times your year 5 wealth, while the new miner (now mining for 5 years) only accrued 3 times their original wealth.  In fact, you can just stop mining, because each new poopcoin requires weeks of effort, and will barely increase your overall wealth.

The reality is that poopcoin is never going to be worth $4,500 per token.  So the later users actually put in disproportionate effort relative to their compensation.  For example, if poopcoin is only worth $2,250 per token, which is a more realistic value, then current poopcoin miners are only making $100 per day, or about $36k per year.  Meanwhile, your crypto nest egg is still worth a whopping $18M.

New miners hoping to get rich will never get rich.

 

Cryptocurrency is a Bubble

Touted as a currency, cryptocurrency behaves more like a valueless cryptocommodity.

Where currency gets its value from the confidence in its economy, we’ve established that cryptocurrency gets its value based on scarcity, which is the hallmark of a commodity, despite the fact that it has no intrinsic value.

How do we reconcile the two?

Let’s look at three case studies.

 

Case Study 1:  The 1634 Dutch Tulip Crisis

In 1634, in what is now the Netherlands, tulips were a novelty.  Tulips reproduce through bulbs, which is essentially a tulip root that grows in to a tulip the following year.  After the tulip flower dies, the bulb fractures in to “daughter bulbs”, each of which is a potentially viable bulb for the next cycle.  I’m not a botanist, so if I got that wrong, I apologize, but the specifics are immaterial to this narrative.

• Tulips are popular in 1634 Netherlands, thus increasing demand
• A tulip bulb is a future tulip
• Tulip bulbs take a while to replicate, thus limiting supply

People who wanted tulips would contract a tulip… uhhh…. farmer? for tulip bulbs.  They would pay the farmer in advance to grow a specific number of tulip bulbs, which would then be sold to the contract holder at a specific price.  Because of high demand and limited supply, people who wanted tulips more than average would pay more than average for a contract, which had the cumulative effect of inflating the price of tulip bulbs.  After three years of ever-increasing tulip bulb prices, in 1637, the contracts for tulip bulbs were considered better than cash!  Almost everyone was eager to receive one in trade, because the value was “guaranteed” (by which, we mean “predicted”) to increase, versus the native currency whose value was more or less constant.

This made tulips one of the first futures markets, because both parties were speculating on the future value of the contract.

At the time of purchase, the contract holder paid much less than market value, because the time involved in producing the bulbs allowed the price to significantly increase from when they purchased the original contract.  So most bulbs were sold at a loss.  The purchaser could then sell the bulbs at auction, and make a significant profit in the process.

This came to a crashing end when, in Feb, 1637,  and for the first time in thee years, no one showed up for the auction.  Now, the sellers had a surplus of bulbs, and no demand, which forced the prices down sharply.  To nearly zero, in fact.  Worse, as prices dropped, the farmers could enforce their contracts at the now-above-market prices, forcing contract holders to pay significantly for nearly worthless bulbs.

This was the first, documented financial bubble.

• Tulip bulbs have no intrinsic value other than entertainment.  You can’t breathe, drink, eat, build with, or use tulips.
• When demand was high due to their novelty, supply was short due to the long incubation cycle, driving up perceived value.
• When demand dropped, value dropped.  As demand plummeted, value plummeted.
• The perceived value ultimately dropped to the intrinsic value, which is nearly zero because you can’t breathe, drink, eat, build with, or use them.

People went bankrupt over tulip bulbs, and no one saw it coming, because no one predicted the possibility that tulip bulbs would be worth less in the future than they were at the time of purchase.

 

Case Study 2:  The Toilet Paper Crisis of 2020

For no known reason, people began hoarding toilet paper in the first days of the COVID pandemic, in early 2020.

Personally, I think it was all caused by the manipulation of social media by Chinese government-sponsored hackers, as an ironic dry run for testing their level of control over the US presidential elections later that fall.  Or do I?  No one knows…

The crisis came in five waves:

• In wave 1, there was irrational demand from just a few people, but the supply was virtually unlimited, and the cost was low.  These “early investors” were able to obtain indecent amounts of toilet paper for very little money or effort.
• In wave 2, the irrational hoarding became infectious, but even with an uptick in demand, there was so much supply that prices were unaffected.
• Wave 3 was fueled by the media and social media, and caused an exponential rise in demand.  This is the point where stores began running out of toilet paper, which fueled even more panic-buying.  Because the supply dried up so quickly, there still wasn’t an uptick in price.
• In wave 4, most of the toilet paper was gone from store shelves, demand was still high, and people started buying whatever toilet paper they could find.  Profiteers began hoarding in order to speculate, draining the remaining supply.  As people who DIDN’T hoard (late adopters) actually started running out of toilet paper, there was no supply, and no choice but to buy toilet paper online from the hoarding profiteers who were now charging ten times its shelf cost. There were reports of toilet paper selling for $10 per roll or more!
  
  Of course, rational people knew this was simply just a supply chain bubble caused by the magnitude of the short-term spike in demand.  However, whether you’re rational or not, if you have no toilet paper and you can’t buy toilet paper, you suddenly become willing to pay more money for toilet paper.  Either that, or you have to be willing to go REALLY REALLY green. 
  
  Once supply was depleted, the cost shot up exponentially, but only for a short time, and the hoarders became temporarily “toilet paper rich”, whether they were profiteering or not.
• In wave 5, the stores were re-stocked a few weeks later, and rationing was in effect (which should have been in effect since wave 2), but the “survivors” continued to buy as much as they could, in fear of another bubble, thus continuing the hoarding and extending the strain on supply.  Fortunately, in spite of wave 5 hoarding, prices returned to normal levels, and the whole thing blew over after a couple of months.

Once supply returned to normal, the value of the hoarded toilet paper dropped back down to its intrinsic value.  Who wants to buy “technically-used” toilet paper from a hoarder, when they can buy new toilet paper from the store for nearly the same price?  Presumably, the hoarders were stuck with a closet or garage full of toilet paper that they would have to either use over time or liquidate at a loss.

Thus, the only people who were able to profit were the hoarders from waves 1 through 3, who purchased at a low price, had excess supply, and were in a position to sell at inflated prices during the short-term spike in demand.  Meanwhile, the wave 4 hoarders maybe broke even – they had to expend extra time, money, and resources to accumulate enough toilet paper to resell, and the “survivors” in wave 5 came out of it with a loss.

In summary, early adopters either profited or were in a position to profit, while late adopters suffered shortages and paid the high prices demanded by profiteers.

 

Case Study 3:  POGs (1990’s Milk Cap Game)

There have been many “toy-driven” bubbles for popular toys throughout the 80’s and 90’s, where popularity drove a short-term strain on supply, especially around Christmas, when doting parents all over the country jumped through hoops to get their child the “had to have” toy that year.  Although stories of scarcity, hoarding, and high prices for toys such as Cabage Patch Kids and Tickle Me Elmo fit the model of a bubble, it’s actually the fad toy POGs from the 1990’s that presents an interesting case study.

What differentiates POGs is that, unlike Elmo dolls of the same era, POGs varied in rarity, and rarity drove up value.  Kids would trade POGs for other POGs, but also for other goods and services, which made POGs a commodity currency that lasted a few years.  Eventually, even adults were willing to trade real-world money for POGs that were perceived to be rare or otherwise valuable.

At the height of the POG craze, they inflated in price to a degree that sparked serious speculation – people were investing in POGs as a way to make a short-term profit.

POGs were like the NFTs of the 1990’s.

As popularity declined, and as with all bubbles, the POG bubble eventually burst.

At the beginning, when kids were trading POGs on the school bus, they paid little to nothing, even for rare POGs.  Later, as POGs began to rise in real-world value, speculators were able to profit by buying early and selling later at higher prices.  As popularity dropped, even “rare” POGs significantly diminished in value because they were no longer in demand.  So later investors paid higher prices, and perhaps even cashed out at a loss.

Like the tulip bulbs, the value of POGs was highly speculative, but everyone generally agreed that it would keep going up, despite the fact that a POG is only a printed piece of cardboard or plastic.

Today, however, except for a few extremely rare POGs that are collectible and therefore valuable, so many were made that even so-called “rare” POGs and even entire collections of “rare” POGs have no monetary value.

…sort of like NFTs.

 

NFTs Are a Scam

NFTs, or “Non-Fungible Tokens”, are unique tokens that exist on the blockchain.

As we discussed:

• Money is a set of tokens, each of which has a specific value, either because the government says it has value (fiat currency) or because it can be exchanged for a commodity (commodity currency)
• Money is fungible, meaning that a token is interchangeable with any other token or group of tokens with the same combined value.

Cryptocurrency consists of fungible tokens, just like money.

However, some blockchains also support NON-fungible tokens that are unique on the blockchain.  Because they are unique, they are usually used to represent something specific – either a digital or real-world asset.

A good example of a real-world, non-fungible token is a concert ticket.  It allows you to enter a specific location at a specific date and time, and sit in a specific seat.  Every concert ticket is unique, because of specific seating – the concert experience could change significantly based on how far left or right of center, or how close or far you are from the stage,  Thus, there are “better” tickets that command a higher value because the experience will be better, and “worse” tickets that are less valuable, because they won’t provide the same level of experience.  Because of the range of values, you would only be inclined to trade YOUR ticket for another ticket of GREATER value – one that would provide a better experience, and thus concert tickets are non-fungible.

In the crypto world, the concert ticket would exist on the blockchain as a NFT.  The concert producer would create a NFT for each seat, and its ownership would be tracked on the blockchain until redeemed at the time of the concert.

Just like a tulip contract, the NFT represents an entitlement, where the holder is entitled to enter the concert venue at the specified future date and time, and then entitled to sit in the specified seat.  From a commodity perspective, the ticket might go up in value as hype about the concert builds, or down in value if something bad happens, for example, if one of the bands cancels.  This means that, just like tulip futures, you can speculate on concert tickets.  If you buy a concert ticket, you’re speculating that you can’t get one at a lower price later on.  If you sell a concert ticket, you’re speculating that you can’t sell it for more money at a later time.

And, NFTs are also a good way to track ownership of real-world assets – things like cars and property, where the NFT is an entitlement to the ownership of the asset.  In the real world, ownership would be tracked with a title document, but these are also good use cases for crypto NFTs, where the entitlement (or ownership) is tracked on the blockchain.

So how did we end up with pixel art animals wearing hats?

A NFT on the blockchain is a pointer which points to something via a URL.

Let’s say that you made a picture of a duck wearing socks, and you want to turn it in to a NFT.  First, you have to put “ducksox” somewhere that other people can access it – this is called “hosting”.  Once “ducksox” is hosted, it has a URL, and then you register that URL on the blockchain as a NFT, and once “mined” or “minted”, the blockchain now indicates that YOUR wallet contains the “ducksox” NFT.  When you sell “ducksox”, the NFT moves from your wallet to someone else’s wallet via a transaction that eventually gets mined and ends up on the blockchain, which now indicates that the buyer’s wallet contains the “ducksox” NFT.

If you buy the ducksox NFT, what are you really buying?

• The NFT sits in your wallet
• The NFT has a URL
• The URL is the location where the ducksox picture is hosted

We can analyze this point by point.

Because of the blockchain, there is no debate about who owns the NFT.

However, the NFT points to a URL, which is a specific location on the internet.

• Who pays for the hosting?
• What if the host goes down?
• Who has access to modify the content?

There are stories of NFTs “disappearing” because the URL no longer works, or of scammers who replace the picture you THOUGHT you bought with a picture of a penis, or maybe a sign saying “you’ve been scammed”.

Further, what supposedly makes a NFT valuable is the scarcity created by its uniqueness.  But, as the original creator of the “duck in socks” image, I own the copyright.  Legally, there is nothing preventing me from minting multiple copies of the same image as NFTs, selling each one as “unique”, but diluting the value by having multiple copies on the same market.

As a buyer, you THINK you’re buying the exclusive rights to some unique asset, like a piece of real-world artwork.  However, what you’re really buying is a pointer to a copy of a digital image, and unless otherwise specified, you don’t even own the rights to publish or reproduce the image.

If they have no value, why do NFTs sell for such a high price?

In short, because some dumbass paid way too much money for one, leading others to mint more NFTs in the hopes of selling them at inflated prices, while spurring speculation from buyers hoping to get rich quick.

Like every good bubble, the market supports the price… until it doesn’t.

 

The Cryptocurrency Concept is Dangerously Close to a Ponzi Scheme

In a Ponzi scheme, later investors fund a fictitious enterprise, where their money is funneled to earlier investors in the form of profit.

We’ve already shown that because cryptocurrency has no intrinsic value, it behaves like an economic bubble, and an economic bubble is simply a decentralized Ponzi scheme.

Comparing the two, a Ponzi scheme implies intent to defraud, and a bubble implies collective stupidity.

Crypto sits somewhere between the two.

Although it’s decentralized, it’s also not free from the intent to defraud, because the very existence of crypto depends on demand from later investors, as well as the continued work of miners, who all believe that crypto will continue to significantly appreciate in value.  Unlike tulip bulbs or POGs that at least continued to exist after they lost their value, crypto is created for the purpose of holding value, and if its value drops to zero, it has no purpose.  So there is a tremendous incentive, especially for early adopters, to maintain a crypto’s value at any cost, which is an incentive for collusion and fraud.

And, crypto is also rife with intentional fraud.  Given the fact that literally anyone can create a new crypto through an “initial coin offering”, this is now a standard tool used by scammers, who offer the benefit of healthy returns combined with the “safety and security” of crypto as a way to protect against fiat inflation, or against the variability of another crypto market.  They do this by maintaining a pool of “real” money (called a Liquidity Pool, or LP), funded by investors, and the crypto gets its value from that pool.  The scammers operate the market normally for a while, but when they get enough “investors” and the LP is large enough, the scammers either steal the funds (explicit fraud) or “cash out”.  Remember, early users are rewarded with exponentially more tokens, and cashing out an early investor drains the LP, thus devaluing the crypto.  In fact, both of these cases happen so often that there is a term for it, known as a “rug pull”.

 

Actual Ponzi Schemes

In addition to rug pulls, there are explicit Ponzi schemes that capitalize on public ignorance of crypto.  There are many examples:

• Bitconnect – A crypto that operated from 2016 through 2019, Bitconnect is a poster child for crypto scams.  Bitconnect purported to be a legitimate crypto, while offering investors high rates of return by “reinvesting” their crypto tokens back in to the infrastructure, promising amazing rates of return.  Even in the face of evidence that Bitconnect was a fraudulent enterprise, investors continued to throw BILLIONS of dollars at it.
  • Early investors were disproportionately rewarded
  • No external governance, auditing, or regulation
  • Investors were strongly encouraged to “reinvest” their profits
  • Investors were issued “paper only” statements showing vast profits and healthy account balances
  • The mechanism for driving profit involved an arbitrage process “too complicated to explain”
  • The executives and directors lived a lavish lifestyle by diverting funds
  • Some missing assets have yet to be discovered
• Onecoin – A “centralized” (captive) currency that existed only on OneCoin’s servers, OneCoin operated from 2014 through 2017.  Purporting to be a multi-level marketing enterprise, where members would sell “educational packages”, and the profits were “reinvested” in to a fake mining process.
  • As a captive currency, there was never any mining, and never any currency.  The executives could fraudulently report an entire fake market, with fake profits and fake account balances.
  • Although everyone was scammed, early early investors were given the illusion that they profited disproportionately.
  • No external governance, auditing, or regulation
  • Investors were required to reinvest their profits
  • Account balances and profit statements were completely fraudulent
  • The fake mining process created new, fake tokens, which was the basis for the scam
  • The “inner circle” lived a lavish lifestyle by diverting funds
• Gainbitcoin – a “cloud mining” venture operated from 2016 through 2018.  Mining is complicated, and requires an investment in specialized hardware.  Also, the rewards for mining are more or less proportional to the amount of computing power you control, so theoretically, if you have a couple of computers in your basement, you will be rewarded much less frequently than one of the many consortiums that have entire datacenters dedicated to mining.  “Cloud mining” is ostensibly a good idea – rather than invest in expensive hardware, you run the mining software on cloud computing resources that scale as needed.  The more people invest, the more cloud resources you can afford, and you scale up the computing accordingly.  More computing = more tokens = more profit.  Unless, of course, you’re just stealing people’s money…

And there are many others.

 

 

Reason 2:  Cryptocurrency Facilitates Fraud and Scams

No Regulation, No Governance, No Accountability

We already mentioned “initial coin offerings” (ICOs) and rug pulls:

• Anyone can make a new crypto
• Early investors benefit disproportionately by having more tokens
• Later investors fund a Liquidity Pool of real money that valuates the crypto
• Early investors cash out a large number of tokens, drain the LP, and devalue the crypto

The current trend is “celebrity crypto”, where someone of notoriety lends their celebrity status as a measure of credibility for an ICO, which is so much more stable, safe, and lucrative than all of the dozens of other celebrity ICOs that offer the exact same thing.

Unfortunately, most of these end in a rug pull.  Of course, the celebrities in question insist that they had no ill intent, had to protect their investment, etc, etc, etc, but it doesn’t give back the hundreds of thousands of dollars that their respective investors lost when their ICOs collapsed.

What makes this possible is that most crypto is completely unregulated.  Without government oversight, the legitimacy of each of these endeavors depends on their internal controls, which is dictated by organizational governance.  Most of these organizations simply have no governance, because they are intentionally fraudulent.  Governance consists of four major principles:

• Executives set direction – organizations depend on the fact that executives will define policies that are consistent with the organization’s purpose.  For example, an organization that makes widgets depends on having policies which are conducive to creating widgets as efficiently as possible.  In a fraudulent organization, the purpose of executive direction is to misdirect the efforts of the organization so that no one detects the fraud.
• Controls – At a high level, controls ensure that policies are followed.  Controls are like rules that the organization must follow, and include requirements and procedures for things like obtaining approval for financial transactions and then making sure they are appropriately documented.
• Compliance – ensures that the organization follows executive direction.  The organization must follow policies set by executive management, and adhere to controls which dictate how that’s accomplished.  In a legitimate organization, workers follow procedures and adhere to policies, seek executive approval when required, document transactions, and document all work performed.  In a fraudulent organization, workers have much less autonomy, but are discouraged from maintaining a documentation trail.
• Audit ensures that the governance model is adequate, and that controls are operating effectively through compliance.  Audit ensures that executives set direction which is consistent with the organization’s objectives, and that the organization faithfully follows that direction.  A legitimate organization will hire internal and external auditors, and “findings” (gaps in policy and deviations from policy) result in action plans to correct internal issues, as well as transparency about documenting and communicating issues when they are discovered.  A fraudulent corporation hides internal inconsistencies, because they don’t want their fraud to be discovered.  They might even hire fake auditors in order to convince investors that everything is legitimate.  Audits should be conducted frequently, especially for an organization that handles money, and most especially for an organization that deals with volatile markets.  An audit measures two things:
  • Do baseline controls exist (gaps in policy)
  • Are existing internal controls effective (deviation from policy)

Without government regulation, there are no laws and no penalties.  With no laws, there is little or no driver for internal governance, and an investor is left to depend on the organization’s ethical leadership, which tends to change once huge sums of money are involved.

Further, when something bad does happen, crypto executives tend to cash out and then disappear, accelerating the collapse of a house of cards.  In doing so, they may or may not even be breaking any laws, and they have sufficient funds to disappear forever.

To underline the lack of government regulation, most of these scams and schemes operate offshore, outside the reach of major governments, where regulation is weak at best.

Thus, there is insufficient negative incentive in order to prevent crypto fraud in the first place.

 

Case Study:  Madoff Ponzi Scheme

In 2009, Bernie Madoff was arrested for running one of the most infamous, longest-lived, and largest Ponzi schemes in history.  Running from the late 1980’s through 2009, it’s estimated that he stole approximately $62 billion from investors, claiming to have a proprietary electronic trading algorithm that was “too complicated to explain”.

He installed family, relatives, and close friends in executive positions, and his company’s external auditor was a close friend and investor.  This created a situation called “conflict of interest”, where all of the people who were charged with protecting the investors didn’t have enough motivation to dig too deeply.

Appearing as a legitimate company, people worked there every day without suspecting that a massive fraud operation was taking place on a secured floor that was restricted to only a few people in Madoff’s inner circle.  Anyone who asked about it was told not to ask about it.  Any time auditors or regulators asked about it, they were told about a super-secret, proprietary algorithm that was completely off limits, and somehow, even the government accepted this as a completely legitimate reason not to dig too deeply.

Instead of a highly-secret, proprietary algorithm running on state-of-the art hardware, the secured floor actually contained antiquated computers that were simply printing fake account statements for the “investors”.

After years of scamming, Madoff was brought down by his own sons, just as his scheme was on the verge of collapse.  Despite ignoring multiple whistle blowers who warned the SEC for the better part of a decade that Madoff had to be running a scam, they finally managed to arrest him in 2009.

He was sentenced to 150 years in prison, and died there in 2021.

Of course, if he was crypto scamming, he could have stolen the same amount of money in much less time, and he might not have even been committing a crime.  And, if convicted, he probably would have had a trivial prison sentence.

However, we can see that the Madoff scam and crypto scams follow the same blueprint:

• Appears as a legitimate enterprise
• Uses a “complicated process” that “can’t be easily explained” to generate steady returns
• Investors are encouraged to re-invest
• Employees and auditors are discouraged from asking questions
• Executives live a lavish lifestyle
• Little or no internal governance
• Inadequate government regulation – in the case of Madoff, the government regulation existed, but was ineffective

 

Case Study: Celsius Network

Celsius Network claimed to be a decentralized token that could be used as an alternative to traditional banking.

Its users could “park” Bitcoin and other crypto in a Celsius wallet, which would be exchanged for CEL coins.  The underlying crypto would then be used to lend money, and users would receive premiums on the interest.

Started in 2018 with venture capital, Celsius took in multiple rounds of funding before completely crashing in June, 2022, where it blocked withdrawals, and eventually declared bankruptcy in July, 2022.

Although Celsius started as a legitimate venture, it recklessly gambled with users’ assets.  To cover its losses, it decided to start paying its users in CEL tokens rather than “real” funds, thus doubling-down on the lie that they remained profitable.

Celsius was rife with insider rumors of executive incompetence, indicative of a lack of governance and audit.

• Governance provides assurance that the organization follows executive direction.
• Audit ensures that there are no gaps in the governance model.

 

Crypto is Potentially Lucrative, But Complicated

It’s difficult for the general public to understand crypto, or even conceptualize how it works, yet the media is quick to create hype about people who are continuously getting rich by investing in it.

This creates a situation where there is an eagerness to invest from people who are very vulnerable to being defrauded.

Almost everyone understands how money works, because it’s been around for thousands of years.

If someone asked you to invest money that you DO understand, in [something] you DON’T understand, and so complicated that they can barely describe how it works, you would be hesitant.  However, if there was constant media attention about how people were getting rich by investing in [something], you would be much less hesitant, despite the fact that you have no idea how it works.

“I want to get in on this!”, you’d say.  “Take my money!”, you’d say.  This is called “Fear Of Missing Out” or FOMO, a term you’ll hear often when discussing crypto.  Hype builds FOMO, and FOMO leads to bad decisions.

How do you get in to crypto?

• Make a wallet.  How do you do that?  What software do you use?  How do you know that the software, which has access to your wallet, won’t steal your crypto?  Worse, some wallet apps have access to a normal debit or credit account, which means that malicious software could steal your “real” money, also.
• Which crypto do you invest in?  Bitcoin is the most popular, but there are literally thousands of them out there.  Which ones are scams?  Which ones are going to eventually dwindle to nothing, with your investment along with it?
• Which exchange do you use?  The exchange allows you to convert between cash and crypto, but these are largely unregulated.  Which ones are trustworthy?  Which ones charge too many fees?  Which ones will protect you from fraud?  Which ones are scams?
• If you do manage to get crypto rich, how do you cash out safely and document everything properly to avoid getting accused of money laundering?

If you make a bad decision at any of these points, each of which is inherently susceptible to fraud, you risk losing your “investment” and maybe more.

To illustrate the problem, this fake news story was widely circulated by the real media in 2017:

Marlon Jensen, 36, was arrested a Sunday morning when NYPD stormed his home. NYPD received calls from the fraud victims that someone had sold them “Bitcoins”, only to find out there actually was no tangible bitcoin currency available. NYPD found $1.1 Million of cash inside Marlons home. According to police, Marlon had scratched off most of the Chuck E. Cheese engravements on the coins, and would write “B” on each coin with permanent marker.

Although the story was fake, it was believable enough to get picked up by the mainstream media, because people intuit that crypto is confusing.

 

Pay for Play / Regressive Tax

Crypto users must pay a transaction fee, which funds the work done by miners.

When the network is busy, users are expected to pay more in order to expedite their transactions.  Miners will select higher-paying transactions over lower-paying ones, which makes the entire network pay-for-play.

So, the technology that’s supposed to “liberate people from centralized banking” and “bring financial services to people all over the world” is actually better when used by people with more money who can pay to expedite their transactions, and people with less money pay disproportionate fees, making the use of crypto a regressive tax on the use of their own money.

Maybe a better way to state the worldwide “benefit” of crypto, is that the few people who control the network are now able to “exploit people all over the world” by avoiding the regulation that exists within the central banking system for a reason.  Yep, that’s more accurate.  You’re welcome!

 

Derivative Currencies and Ignoring Risk

The Global Financial Crisis of 2008 was brought about by reckless speculation, where risk was simply eliminated from the equation by clever accounting.  Except, it wasn’t.

Unlike tulip bulbs that are basically worthless, the underlying speculation was based on houses, or rather, the mortgages created when people borrowed the money to buy houses.

Houses are always worth something, so at best, the bank recoups its investment:

• If the buyer defaults, the bank repossesses the house, and then resells it at market value, making back anywhere from 20% to 200% on their original investment.
• If the buyer pays the principal over the term of the loan, the bank makes back anywhere from 50% to 200% on their original investment.

This means that for a $100k loan, the bank makes $120k on the low end, up to maybe $300k by the end of the loan.  So unless the value of the house drops, the bank is guaranteed to make a profit.

But, the bank has to carry the borrower’s debt, and debt = risk, which is why banks often sell their loans.

The companies who buy the loans are speculating that they can make money, and the bank eliminates their risk, so it’s a win-win.

As long as the home buyer pays their mortgage, the company gets the steady revenue.  If they default, the loan is secured by the value of the house itself, which the company can repossess and then resell at market value.  However, the company that now holds the loan now also holds the risk.

In the late 1990’s someone came up with the idea of grouping loans together in to “Mortgage-Backed Securities” (MBSs), meaning, they could sell steady, but smaller income to long-term investors, and the potential risk along with the potential for higher rewards to speculators.

Here is an example:

• Let’s say that you have 1,000 loans, each of which is for 100,000 in principal, but the interest rate varies based on each borrower’s credit worthiness.
• A borrower with high credit is a lower risk, but pays significantly lower interest, which means less profit.
• A borrower with low credit pays significantly higher interest, which means more profit, IF the borrower doesn’t default.
• Across these loans, you might have a blended interest rate of 8%, which means that you’ll receive around $733,000 per month.
• If you pay out 2% at the top, that’s $14,000 every month, guaranteed by the low-risk loans who never miss a payment.  At the bottom end, you might pay out 10% per month, or about $73k, but ONLY if everyone pays their mortgage that month.
• Now, you sell all of this to your friends as an investment opportunity!

But…

What if there was a way to get the higher 10% return without the risk?

Welcome to the wide, weird world of Collateralized Debt Obligations (CDOs).

Mortgage-Backed Securities (MBSs) arrange mortgages in to groups based on risk, called “tranches” (‘TRAHN-chez’), where the higher tranches are more likely to have steady revenue, but the revenue is lower.  At the other end, the lower tranches are higher risk, but are paid more.

Just as a MBS groups hundreds or thousands of loans in order to obtain a reasonable and predictable rate of return, a CDO does the same thing by grouping the lower tranches from many MBSs.  CDOs use the same “layering” process, basically grouping the worst loans from SMBs in to new tranches that represent the best of the worst at the top, to the worst of the worst at the bottom.

To offset the risk that the entire CDO is crap, a second instrument is used, called a Credit Default Swap (CDS), which is basically mortgage insurance for your CDO.  You pay monthly payments on your CDS, but the much higher profits of the CDO more than offset the cost.  If your CDO crashes, the CDS holder pays you face value in exchange for the CDO.

To summarize, a CDO contains the income from the worst groups of loans within a Mortgaged Backed Security, and a CDS is insurance that the CDO won’t collapse.

But, there’s a way to make even MORE money!

We can take the lower tranches from a CDO, and make a new CDO, called a CDO-squared.  And, we can insure CDO-squared with more Credit Default Swaps.

So as long as people keep paying their mortgages, and housing prices remain level or increase, everyone makes money.

But, for the first time in over a decade, when housing prices began to fall in 2007, all of the CDOs collapsed.  Which is OK…. the risk was banished to some corner of an accounting ledger with the use of CDSs.  The CDSs cover the risk for the CDOs, right?

Except that AIG held almost two trillion dollars of Credit Default Swaps against MBS/CDOs.

If you have a decent job, you might be making $60k or $70k a year.  If you have an awesome job, you might be making $100k per year.  If you have an awesome job, and you work for 10 years without spending one cent, you’ll have a million dollars.  If you work for 10 MILLION years, you’ll have a trillion dollars.

What it boils down to, is that the risk was there all along.  The CDO doesn’t eliminate the risk.  The CDS doesn’t eliminate the risk.  Disregarding trillions of dollars of risk is psychotic behavior, simply disconnected from reality.

MBS, CDO, and CDS are what is known as “derivative instruments” – it’s a way to take a real transaction, and manipulate the risk and rate of return by aggregating it with thousands of other transactions, resulting in something that looks good on paper, until, you know… it completely flattens a 14 trillion dollar economy (circa 2008).

Unfortunately, people are doing the same thing with cryptocurrencies, today.

A “stablecoin” is a crypto that “pegs” its value to an underlying commodity or fiat currency.  By pegging crypto to large pool of fiat money, the underlying fiat money becomes the force driving the value of the crypto.  This only works if you have a large pool of fiat money.

But, you can also do this by pegging a crypto to other crypto, that itself is pegged to fiat money.  And this can be layered in to all sorts of schemes, where the underlying commodity is leveraged multiple times over without anyone even realizing it.

Further, various crypto can be packaged and sold as a commodity, very similar to Mortgage-Backed Securities.

Just as with derivative instruments, this is a psychotic way to disregard risk by shifting it to some other part of the game board.

To be clear – shifting risk is just a way to ignore it, which can lead to aggregating too much risk, which can lead to very bad things.  Like, the Global Financial Crisis.

Just think… in a couple of years, we can have Jim Cramer go on national TV again to have a meltdown about the impending collapse of the crypto market this time, and about how the American way of life will be destroyed unless the government fronts another multi-trillion dollar bailout.

 

Reason 3:  Cryptocurrency Facilitates Crime

Silk Road and Other Illegal Marketplaces

Charging a small fee for each transaction, Silk Road operated from 2011 through 2013 as an anonymous black marketplace where people could both offer and solicit illegal goods and services, paid for in Bitcoin.

The site was accessible through the anonymous network known as Tor, and brought public attention to the so-called “dark web”, which is simply a name for a website or other service that’s not reachable via search engine, or has other access limitations in place.  In the case of Silk Road, users were required to run the Tor browser, which anonymizes both the server and the client by routing traffic through other Tor users on the network, making traffic incredibly hard to trace.

After it was shut down (twice), a slew of successors popped up using the same model:

• Only available via Tor or some other anonymous “dark web” service
• All transactions are anonymous
• Charge a small transaction fee
• All transactions are conducted using crypto

A marketplace like this is only possible because crypto is largely (but not entirely) anonymous.

If you used credit or debit cards for your black market needs, there would be a money trail that includes your personal information.  It would take the authorities mere hours to find the marketplace, shut it down, analyze the transactions, find your payment information, and come knocking on your front door.  Worse, once they have your bank account information, they can look at all of your transactions, so if you’re doing anything else that’s sketchy or illegal, they will find that as well.

By using crypto, all that’s exposed is an anonymous wallet ID, tied to an anonymous user ID.

 

Money Laundering

As bad as crime itself is, money laundering can be much worse and much more insidious.  Money laundering legitimizes funds obtained from illegal activities, thereby rewarding criminals and providing funding for much larger criminal ventures.

Money laundering facilitates and funds organized crime:

• Drug cartels – Anyone who has seen the movie “Scarface” or watched a “60 minutes” documentary understands that drugs flow north, while money flows south.  Rather than risking the possibility that drug money can be seized in transit, it’s not too difficult to convert cash to crypto (for example, by using prepaid cards), where it can be converted back to cash anywhere in the world.
• Organized theft – Although a small-time crook might steal my stuff and then sell it at the local pawn shop for a hundred bucks, theft at scale requires much larger amounts of money that is difficult to move… unless you use crypto.
• Organized fraud and identity theft – When you hear about data breaches where 100,000 people’s social security numbers or credit card information were disclosed, these are traded online to criminals who use a small army of underlings to fraudulently open bank accounts, apply for credit, forge checks, or buy goods and services (both retail and online).  The proceeds are eventually converted to cash through various means.  Crypto is used both to facilitate the conversion to cash, and to launder the cash in to usable funds.

Money laundering facilitates and funds terrorism:

• Terrorists can easily bypass OFAC and other blacklists in order to engage in crypto speculation
• Funds from legitimate ventures can be diverted to OFAC restricted countries and entities via crypto
• Funds from criminal ventures can be directly transferred to restricted entities via crypto without government scrutiny

 

Tax Fraud

You might be reading this, and thinking to yourself, “Really?  You’re nit-picking”.  But, think about this:

YOU pay taxes.  I pay taxes.  Tax money funds the operation of the government.  Taxes pay for the roads we drive on, the education of our children, and the military who keeps this country safe from foreign threats.  If I pay LESS in taxes, it doesn’t reduce the need for those services, rather, it means YOU have to pay MORE in taxes in order to make up the difference.

From a tax perspective, investing in crypto is a lot like conventional investing.  When you invest in stocks or commodities, you don’t pay taxes until you sell, and when you sell, you pay taxes on the amount you earned, meaning, the difference between the selling price and the purchase price.  For example, if you buy 20 shares of stock for $10 each, your initial investment is 10 x 20 = $200.  If you hold on to that stock for 5 years and then sell it for $100 per share, it has appreciated ten-fold.  You pay taxes on 20 shares x ($100 – $10) = 20 shares x $90, or $1,800, which is your capital gains.  The tax on these gains is some percentage of $1,800, and the percentage (tax rate) is based on your overall income and other factors.  If you buy AND sell within one year, the math is the same, but this is considered short-term capital gains, which is taxed at a much higher rate.

In legitimate markets, transactions are documented and reported to the government, and if you simply decide that you don’t have to pay taxes on your capital gains, there is still a trail of documentation to prove that you owe the money.

Whether you like paying taxes or not, everyone gets taxed equally, thus reducing the individual burden.

Unless, of course, you trade in an unregulated crypto market, where everyone is anonymous, and there is no government requirement for documentation and reporting.  Then, you can “cash out” by converting your crypto to some other crypto, such as Bitcoin.  You can then use the Bitcoin to open up a crypto-exchange account offshore, convert your Bitcoin to local currency, and then wire transfer the funds to yourself.  You then claim you already paid taxes on the money overseas, and therefore it’s not income – it’s simply your money that you have chosen to consolidate on-shore.

Most people actually lose money speculating on crypto, which means that their tax burden is zero.  Despite this fact, there are probably BILLIONS of dollars in unreported, laundered income, constituting HUNDREDS OF MILLIONS of tax dollars that go unreported and uncollected.

And because of this, whether you trade crypto or not, YOU as an individual pay more income tax than you should be paying.

 

Reason 4:  Cryptocurrency Wastes Energy

In crypto, there are two different ways to “mine”, which is the process of writing to the blockchain in order to formulate consensus.

• Proof of work (PoW) – multiple miners compete by performing the same work until specified criteria are met.
• Proof of stake (PoS) – miners have a captive “stake” in the currency, and mining activities are assigned at random.

Although Etherium has plans to move to a Proof of Stake consensus method, Bitcoin and many other cryptos still use Proof of Work.

Regardless of the fact that PoW systems are much more fair – the investment is minimal compared to PoS, the unfortunate reality is that PoW systems result in massively-duplicated effort.  Blocks are calculated over and over again by multiple miners until someone manages to calculate a block whose hash is less than the specified hash target, at which point that block becomes part of the ledger, and the miner is rewarded with a minuscule amount of crypto.

What this means is that over 99% of the work performed in a PoW system (including Bitcoin) is simply redundant – it’s just wasted computing, and wasted computing is wasted energy.

Unlike most daily computing activities, mining is very CPU-intensive.  Verifying signatures and computing hashes are just math problems, and the CPU’s job is to solve those math problems using a set of instructions that it repeats over and over for each problem.  Whoever finds the magic hash first is rewarded by newly-minted crypto, so miners want hardware that can perform these calculations as fast as possible, using as many CPUs as possible.  This gave rise to specialized mining hardware, which is tailored for that purpose.

More and faster CPUs means more energy consumption.  Although it’s estimated that crypto only consumed anywhere from 100 to 150 TWh (teraWatt-hours) of electricity in 2021 out of 23M TWh (23 petaWatt-hours) used worldwide (a small percentage), that usage is growing significantly year-over-year.

This means that 99% of conservatively 100 TWh of energy was wasted by crypto in 2021 – that’s more than ten times the combined 9.3 TWh consumed by all of the 2.32M electric vehicles on the road during the same timeframe.

This is the equivalent of 4.4M tons of Carbon Dioxide emissions, or about 900,000 gasoline-powered vehicles driven for one year, wasted by crypto, and the waste is growing exponentially.

There are entire datacenters devoted to crypto mining.  If that computing power is 99% wasted, it could be utilized for greater benefit – for example, researching a cure for cancer, or searching for alien life.

 

 

Reason 5:  Cryptocurrency Isn’t Really Anonymous

When you buy or sell crypto, your wallet ID gets written to the block chain as part of that transaction, as does a cryptographic signature created using your wallet’s secret key.  The two are tied together in such a way that anyone can take the signature of the transaction along with your wallet ID, and verify that your wallet did, in fact, create the signature, and thus confirm that the wallet’s holder did, in fact, authorize the transaction.  The record of this transaction remains on the blockchain forever.

At first, this seems anonymous, since there is nothing to tie a wallet ID back to a person, and only wallet IDs appear on the blockchain.

However, there are a number of ways that careful analysis can be used to track down a wallet-holder’s identity.

 

Direct Disclosure

“Hey, I’ll buy that widget for 1.5 poopcoin”, I say.

“OK!! That sounds good!”, you say.

Me: “Give me your wallet ID, and I’ll poop you the money”.

You: “My wallet ID is 1234567”.

A few hours later (because crypto sucks), the blockchain reflects 1.5 poopcoin transferred from wallet ID ABCDEFG to 1234567.

• The buyer and seller know each other’s wallet IDs
• Everyone who views the blockchain can see this transaction, including both wallet IDs and the transaction amount.

It doesn’t seem like much information, but wallet IDs never change.

Even if I use an intermediate wallet, which would theoretically behave like a prepaid credit card, you can see which wallet ID funded the intermediate wallet, and you can see the money flow from the intermediate wallet to the seller.  Unlike a prepaid credit card, the link to my “real” wallet (account) is visible for anyone to see.

Although it’s possible to use an anonymous marketplace to buy and sell widgets, you still have to ship me the widget, which means, at the very least, you would be able to link my wallet ID with a shipping address.

Also, we’ve traded e-mails or chatted prior to the purchase, which means that you know my alias or e-mail address, which you can link to my wallet ID.

Of course, all of these can be anonymized in a number of ways, but unless I specifically take those precautions, I risk disclosing real information that can now be linked to my wallet ID.

 

Surveillance

Assuming that I buy your widget for 1.5 poopcoin using an anonymous marketplace, the only real “trail” you can link to my wallet ID is the shipping address.

Although the transaction itself requires communication, we can assume that the marketplace allows both parties to chat anonymously.  And, I can take the further precaution of using a throwaway account.

However, when you ship me my widget, someone has to physically be at the shipping address to pick it up.  Even if I use a mail drop or a cutout, both of these services leave a money trail that leads back to me, and neither would prevent you from including a geo-tracker (such as an airtag) inside the package, or hiring a private investigator to conduct physical surveillance.

And, of course, there are many more resources and options available to law enforcement.

 

Mining… Data

Just as crypto mining mines crypto, data mining mines data.

Because every transaction and wallet ID is visible, you can analyze patterns of transactions and compare them to real-world facts and information in order to gain insight about the wallet holder(s).

For example, even though I can’t buy a mocha latte with poopcoin, maybe I have an assistant who is willing to perform that task every morning – go to Moonbucks, spend fiat money to buy a mocha latte, and then bring that mocha latte to my office, two blocks away.  For this task, I pay my assistant 0.5 poopcoin, and this happens regularly.

If you know about my coffee habit, and want to obtain my wallet ID, you could analyze the blockchain for this recurring transaction.  And, you might find several possible candidates, but by coupling blockchain analysis with careful surveillance, you can match real-world anomalies to anomalies in the blockchain.  For example, maybe my assistant took Friday off – if you suspect you have my wallet ID, you can simply look at the blockchain to verify that I didn’t pay my assistant on Friday.  If these two facts correlate, then you not only have my wallet ID, but you also have my assistant’s wallet ID.

Similarly, you can look for transactions which look like money laundering, or involve large sums of money, and perform the same kind of analysis.  Even if you can’t immediately identify the “suspicious” wallets, you can follow chains of transactions until you CAN identify a person, and like a huge jigsaw puzzle, work from the edges toward the middle until you are able to identify the target wallet holder.

And, as with surveillance, there are many more resources and options available to law enforcement.

If you plan on being able to conduct nefarious transactions without any repercussions, think again.  Or, if you plan to conduct legitimate transactions, but value your privacy from the government, think again.

 

Conclusion

All cryptocurrencies are valueless commodities that waste energy and resources, while either being explicitly fraudulent, or enabling fraud and other crime due to a lack of regulation and governance.

At best, crypto is a bubble formed by uncontrolled speculation, fueled by FOMO and a complete disregard for risk, that must eventually burst.  At worst, crypto is a Ponzi scheme perpetrated by fraudsters, waiting to collapse.

Crypto offers the promise of decentralized banking, bringing financial services to people who don’t have access to the traditional banking system, but instead, crypto is a means to exploit poor people in bulk.

Crypto is used to launder money, and to fund terrorism and organized crime.

Crypto should be banned.