Summary

Claim Steel-Manned

Opportunity for gain: Retail traders (individual, non-professional market participants)

Investing in crypto has the possibility of gaining me huge assymetric returns. I've heard other people making huge gains by investing in crypto, therefore it is possible that I can make huge gains aswell.

Opportunity for gain: Quants and hedge funds

If I'm allowed to trade products that are massively asymmetric and disadvantageous to retail traders, then I can and I will. Markets are a force akin to evolution: inefficient players will be elimated, and the strongest will be rewarded.

Even if I know it’s a greater fool asset and has no fundamental value, if I have access to non-public information and more capital I can (and should) use it and exit before the other fools.

If the market allows market manipulation (pump and dumps, insider trading, wash trading) this is public knowledge and it is reflected in the price formation of the assets. There is no non-public disclosure about the risks of these assets. Everyone is going in with their eyes open that this is the wild west.

Some people legitimately did make money trading on bubbles: South Sea Bubble, Dotcom Bubble, Tulip Mania. These booms and busts are just a natural part of market cycles.

Evidence of claim being made

Retail trader interviewd by the FT in Barrett, Claer. ‘Why Young Investors Bet the Farm on Cryptocurrencies’. Financial Times, 2021:

Sam found out his younger brother had turned a £3,000 investment into £30,000 within four years — money he now intends to use as a property deposit. "I was very surprised and it made me feel a bit stupid . . . why aren’t I doing this?... I'll either be rich or wrong".

Mann Group chief in Silverman, Gary. ‘Crypto Has “No Inherent Worth” but Is Good to Trade, Says Man Group Chief’. Financial Times, 2021:

If you look at cryptocurrencies as a whole, it is a pure trading instrument. There is no inherent worth in it whatsoever. It is a tulip bulb.

Huang, Matt. ‘Bitcoin for the Open-Minded Skeptic’. Matt Huang, May 2020:

Bitcoin offers a compelling risk/reward profile for patient, long-term investors willing to spend the time to truly understand Bitcoin.

HQ, Ikigai. ‘The Case for a Small Allocation to Bitcoin’. Kana and Katana, 1 March 2019:

Bitcoin offers a unique opportunity for a non-material exposure to produce a material outcome. It would be irresponsible to have an exposure to Bitcoin that one cannot afford to lose because the risk of losing the principal is very real. But it would be almost as irresponsible to not have any exposure at all.

Evaluation

Risk to traders

Investing in crypto assets is a negative sum game as defined in game theory and economics. Negative sum games result in a net loss across participants and multiple losers associated with every one winner.

Since crypto assets are investments the purpose of buying a crypto asset is to buy it at a lower price and sell it at a higher price to generate a return denominated in a real currency. However as an investment, crypto assets have no income-cashflows therefore the only money that exists to pay out investors is money that is brought in by later investors. This makes the entire scheme a zero sum game. All money won by speculation is ultimately money that is equally lost by another participant.

This is comparable to the analogy of a game of poker and other gambling games The only money that can be won in a poker game "pot" provided by the players of the card game. The act of playing poker does not generate any money, it simply redistributes to participants according to a game of chance. If the "house" or casino takes a percentage of the pot on every round of the game played then the size of the pot must decrease over time. This turns the zero-sum game into a negative-sum game which admits a negative expected return.

Investing in crypto assets is statistically guaranteed to lose money for almost all market participants because as investments they have no income-cashflows. This differs drastically from productive assets such as stocks, bonds and real-estate.

While there is evidence of some people making gains trading crypto, there is a strong sample bias in self-reported winnings of crypto assets: participants who make outsized returns gambling on the bubble are more likely to report these returns compared to the vast majority of those who lose money investing in crypto assets.

And in such an asymetric and "wild west" market, the chances of a minow beating out the sharks is tiny.

Everything that has been illegal for 80 years is suddenly allowed: wash trading; front running; insider trading; price manipulation and order book tampering;refusing cash withdrawels; pump and dumps. Exchanges are basically like bucket shops from the 1920s.

What we are seeing is a captive market for fictitious commodities that is controlled by opaque unregulated market making and an economic cartel. This is great if you're inside the cartel. Not so great if you aren’t. Wealth transfer from the public to insiders is all but guaranteed by the information asymmetry.

Wider risk

Crypto assets have the characterstic price behaviour that resembles many other bubbles and market manias throughout history.

Where bubble assets have complex financial instruments built on top, there is risk of far reaching systemic damage. The 2008 subprime crisis provides a demonstration of what happens when a range of complex financial products are completely dependent on the cash flows of a fundamentally unstable asset. Just as a fall in house prices caused mass mortgage defaults by borrowers in precarious financial positions, and in doing so brought down the entire financial system propped up by their repackaged debt, the cautionary tale of Terra shows the very same vulnerability throughout the system of decentralized finance (DeFi), which hinges on speculation-driven token value.

In her 2022 paper ‘DeFi: Shadow Banking 2.0?’ Prof. Hilary Allen warns that the current defi system risks emulating the “shadow banking” services (functional equivalents for banking products which operate outside the regulated banking sphere) which contributed to the 2008 banking crisis:

“if DeFi is permitted to develop without any regulatory intervention, it will magnify the tendencies towards heightened leverage, rigidity, and runs that characterized Shadow Banking 1.0.”

Commentators have raised concerns about stablecoins in particular, describing them as analogous to the money market funds (MMF) at the heart of the 2008 crisis in their potential to cause runs. Prof. Allen explains:

“If something were to shake confidence in stablecoins’ acceptance in the DeFi ecosystem (this ‘something’ could range from a hack, to a problem with the reserve of assets backing a stablecoin, to a problem with the smart contracts managing the value of a decentralized stablecoin), we could then expect holders to exchange their stablecoins for fiat currency and exchanges to seek redemption, forcing stablecoin issuers to start liquidating the reserve of assets backing the stablecoin, depressing the market value of those assets, and cutting off credit for the corporations in which MMFs usually invest through the commercial paper market.”

This fragility and extreme vulnerability pervades the entire crypto-economy. The core mechanism – of minting tokens with no use value and who’s market price is artificially driven by speculative hype – underpins almost the whole system. What might appear as a recipe for perpetual growth and financial gain in fact appears highly likely to have created a speculation fuelled bubble.

Where does all this lead to?

• If the crypto marklet is left unregulated, systemic risk
• Inequality (money flows to the sharks)
• Distrust and cynicism in
  • society: I’m out for myself, other people are just out for themselves. Dishonesty and exploitation are a normal part of (capitalist) society.
  • markets: assuming that markets have some value then undermining faith in them is problematic.
  • the state and its institutions:When it goes wrong the state and its institutions and leaders are blamed, further corroding trust in our collective capabilities.
• Moral hazard - public is incentivized to take on disproportionate risk expecting a bailout.
• A terribly pathological form of capitalism that doesn't result in price formation on collective enterprise, goods or services.

References

Akerlof, G.A. (1978) ‘The market for “lemons”: Quality uncertainty and the market mechanism’, in Uncertainty in economics. Elsevier, pp. 235–251.

Allen, H.J. (2022) ‘DeFi: Shadow Banking 2.0?’, SSRN Electronic Journal [Preprint]. Available at: https://doi.org/10.2139/ssrn.4038788.

Burilov, V. (2019) ‘Regulation of Crypto Tokens and Initial Coin Offerings in the EU: De lege lata and de lege ferenda’, European Journal of Comparative Law and Governance, 6(2), pp. 146–186. Available at: https://doi.org/10.1163/22134514-00602003.

Cumming, D.J., Johan, S. and Pant, A. (2019) ‘Regulation of the Crypto-Economy: Managing Risks, Challenges, and Regulatory Uncertainty’, Journal of Risk and Financial Management, 12(3), p. 126. Available at: https://doi.org/10.3390/jrfm12030126.

Dhawan, A. and Putnins, T.J. (2020) ‘A New Wolf in Town? Pump-and-Dump Manipulation in Cryptocurrency Markets’, SSRN Electronic Journal [Preprint]. Available at: https://doi.org/10.2139/ssrn.3670714.

Ferrari, V. (2020) ‘The regulation of crypto-assets in the EU – investment and payment tokens under the radar’, Maastricht Journal of European and Comparative Law, 27(3), pp. 325–342. Available at: https://doi.org/10.1177/1023263X20911538.

HQ, I. (2019) The case for a small allocation to Bitcoin, Kana and Katana. Available at: https://www.kanaandkatana.com/valuation-depot-contents/2019/4/11/the-case-for-a-small-allocation-to-bitcoin (Accessed: 14 September 2022).

Huang, M. (2020) Bitcoin for the Open-Minded Skeptic, Matt Huang. Available at: https://www.matthuang.com/posts/bitcoin_for_the_open_minded_skeptic (Accessed: 14 September 2022).

Lefevre, E. (2004) Reminiscences of a stock operator. John Wiley & Sons. Malkiel, B.G. (1999) A random walk down Wall Street: including a life-cycle guide to personal investing. WW Norton & Company.