Big Cryptos Struggles with Basic Accounting and Economics by Martin Walker – Attack of the 50 Foot Blockchain

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Guest post by Martin Walker

Big Crypto executives seem to have a huge problem understanding basic concepts of conventional finance such as balance sheets, auditing, and cash flow.

Changpeng Zhao aka CZ of cryptocurrency exchange Binance recently described how they handled over $580 million worth of FTT crypto tokens: We never touched it, we actually kind of forget it. Sam Bankman-Fried has expressed endless confusion over asset management by cryptocurrency exchange FTX and hedge fund Alameda.

Even before the collapse of FTX, Sam had some unusual insights into the methods the crypto industry uses to generate value:

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

Cynics, like most of the mainstream media and the Securities and Exchange Commission (SEC), have finally started to get used to the idea that much of Big Crypto is run by recklessly incompetent and/or criminal people. . Some of them might be. But it is worth trying to understand how billionaires (and recently ex-billionaires) developed their ideas about the financial world.

In 2016, I co-authored an article that pointed out that cryptocurrencies such as Bitcoin are an asset with no liabilities. In other words, created from scratch defying the laws of double-entry bookkeeping. Financial assets are always someone else’s responsibility. If it is not someone else’s responsibility, who is going to pay for the returns on the asset that ultimately gives it value? No one, so they have no core value.

Big crypto companies haven’t been buying and selling anything for so long, mostly in exchange for different bits of nothing, that many have sincerely come to believe that taking nothing, giving it a name and sometimes a history combined with a bit trading and with friends, doesn’t yield anything of enormous value.

Whether huge valuations for nothing of tokens come simply from the rising price of the old-school cryptocurrency market or the creation of complex DeFi (decentralized finance) structures, belief in the value of nothing does it is easy to lose sight of the fact of the underlying reality: it is the influx of real money rather than technology, community, network or freedom that gives value to crypto assets.

A crypto enthusiast struggling with the idea that financial assets have corresponding liabilities must find the concept of a balance sheet quite mind-boggling. Unfortunately, the misunderstanding of basic accounting is reinforced by fundamental misunderstandings about banking and economics.

Big Crypto executives, including those regularly polled on sites like CNBC, mostly seem to have learned banking and finance by repeating fairy tales, tweets and blogs ultimately based and ancient on the Austrian economy. Most of them sincerely seem to believe that banks create money out of thin air, selfishly enriching themselves and defrauding the public by creating inflation. If they had some understanding of balance sheets, they could understand how making a loan creates both an asset for the bank (the loan) and a liability (the funds placed in the borrower’s account) and that the bank does not not create money for itself out of thin air, with even the amount of credit creation controlled by the requirement of having sufficient equity.

Strangely, given the contempt for inflation generating fiat currency, Big Crypto is truly creating money out of thin air. Their preferred way of dealing with the resulting dissonance is based on further misunderstanding. They believe that having a fixed supply of a given token representing nothing protects against inflation. Even though some major cryptocurrencies such as Ethereum and Dogecoin do not have a fixed supply.

Maybe if they studied some basic monetary economics and learned the four letters of the quantity theory of money equation:

Clearly, the price level (P) is kept constant, i.e. without inflation, only if the rate at which money (V) is spent is constant and there are expenditures actual goods and services (Q). Since there is no true spending of crypto on goods and services, it does not matter if the money supply is fixed.

Which brings us to the crypto industry’s struggle with the concept of auditing. CZ said of auditing firms that many of them don’t know how to audit crypto exchanges. With the crypto industry largely living outside the fundamental laws of finance and economics, what hope do auditors have of applying their old-fashioned ideas of assets, liabilities, and balance sheets? Very few but not only because of the crypto industries struggling to understand the basics.

One of the principles of the Crypto faith is that everything is transparent because it is on the blockchain. Audits are not really necessary and, if they must be carried out, they involve complex mathematical analysis. Unfortunately, blockchains don’t make things transparent in the traditional way of auditors. A certain amount of crypto may be held at a particular address on the blockchain, but that does not mean it is under the control of the audited party. An auditor cannot simply see an asset in the accounts and reconcile it to a bank statement.

In the world of crypto, the best guarantee that you own the crypto you claim is to move some crypto from one address to another and hopefully come back like Craig Wright notoriously failed. Unfortunately, even that gives limited assurance. A typical audit can verify who has permission to move funds from a bank account. In the crypto world, anyone who has seen the private keys related to crypto funds can take them, and there is no central party to ask if they are authorized or even reverse the transaction.

Hopefully now the reader has a little more sympathy for the poor confused rulers of Big Crypto. If one of them unfortunately ends up in jail, the least society can do for them is to provide them with basic accounting and economics lessons. Something safe to help with rehabilitation. Perhaps taking the right courses could become a condition of parole to encourage more diligent study.

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