The most basic principle of Bitcoin has become the biggest problem of cryptocurrencies

In Ernest Hemingway’s 1926 novel Even the sun rises one of the disillusioned young adults of the interwar era is asked how he ended up bankrupt. “Gradually and then suddenly,” he replies. This quote, so apt it has become a cliché, describes in a nutshell the exponential curve that defines so many events. Things happen little by little, and then all at once.

Less known is the following paragraph, in which the young man is asked what “caused” his financial ruin. “Friends,” he replies. “I had many friends… Then I also had creditors. He probably had more creditors than anyone else in England.”

Sam Bankman-Fried, the 30-year-old founder of the now-bankrupt cryptocurrency exchange FTX, had many friends, with whom he did fun things like creating a complicated mass of companies from the Bahamas or making large political donations. Now, he reportedly has fewer friends and more creditors. Much more: According to his company’s latest bankruptcy filings, FTX and its associated companies may be in debt to “more than a million creditors.” Many of these are retail investors who have gambled their savings on FTX; others are institutions owed hundreds of millions of dollars.

The most important of these may be Genesis Trading, which provides the type of “prime brokerage” lending and trading services to professional investors using cryptocurrencies that banks in the City of London and on Wall Street provide to fund managers investing normal money. Genesis is especially important, not just because it’s a large trading company in its own right, but because it’s a subsidiary of the Digital Currency Group, a major pillar of the cryptocurrency economy.

Genesis said on Nov. 9 that it has “no material exposure” to FTX or its steeply declining FTT token and estimated the aftermath of the FTX crash could cost it around $7 million. The following day Genesis recalled that it had $175 million locked up in FTX, which most people would consider at least a small little material, but which “would not have an impact on our market-making activities”. By the middle of the following week, however, Genesis had suspended withdrawals from its lending arm, and by the next day the Wall Street Journal reported that Genesis was seeking a $1 billion capital injection to help it negotiate a “liquidity crunch.” In a statement, Genesis said it had “no plans to file for bankruptcy anytime soon.”

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For readers for whom a “cash crunch” is the result of trying to eat a Cadbury’s Crème Egg in one bite (is there another way?), this means that Genesis has the money, but it’s in the form of something else that may require little to sell. Sadly, the same phrase was used to describe FTX’s predicament in the days before it became apparent that the illiquid assets on its balance sheet consisted largely of FTT and Solana — tokens that Bankman-Fried and his friends had, to be blunt. , invented, and which were not the store of value that some people had previously believed them to be.

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There is no suggestion that Genesis did anything untoward, but Genesis also has many friends. Its central position as a lender gives it exposure to the broader indecency of the cryptocurrency market: Its two biggest borrowers are, a source told Reuters, bankrupt Bankman-Fried hedge fund Alameda Research and Three Arrows Capital (also a hedge fund, also now in bankruptcy proceedings). This also means that problems for Genesis are problems for other financial institutions that rely on it as a lender.

Indeed, Genesis has not only friends but also brothers: Grayscale Investments, also owned by Digital Currency Group, is the single largest active holder of Bitcoin through the original and largest Bitcoin investment fund, the Grayscale Bitcoin Trust . Even that seems a bit steep at the moment, with its shares trading at a discount of more than 40% to the market value of the underlying assets.

Genesis, Grayscale and others are now being challenged by the same problem Bitcoin was designed to solve: trust.

Cryptocurrency evangelists have spent a decade cornering people at parties (I’m never invited to these things but I hear reports) and explaining that in their world, the messy business of trusting fallible human beings is blown away by the immutable and unassailable blockchain. But this immutable, unhackablah blahchain is also surprisingly expensive – a single Bitcoin transaction can consume as much energy as 1.8 million credit card transactions – and in the early days this made trading costly and inefficient. To create a liquid market they had to introduce all the other things that make modern financial markets fast and efficient: market makers, trading companies, lenders, stock exchanges and, of course, people.

Trust in people and institutions hadn’t disappeared – it had simply moved from trust in established banks and regulators to trust in new companies like FTX and people like Bankman-Fried.

The reason many people hastily withdraw their money (or attempt to) from cryptocurrency exchanges and test the liquidity of that market, is that they have realized that there may be more Sam Bankman-Frieds in a system that does, let’s face it, it looks rather like it was designed by and for exactly that kind of person.

It shouldn’t be difficult for the cryptocurrency markets to overcome this lack of confidence. Each exchange, currency provider and asset manager could publish a detailed and independent audit of its activities by a well-known auditor. But few are willing to do it. It should be easy for Grayscale to prove to investors exactly what and where its assets are (they are, after all, registered on the famous immutable and unhackable blockchain) but Grayscale refused to do so on Monday, citing “security concerns” (the firm it has since issued a letter from cryptocurrency exchange Coinbase claiming it holds Grayscale’s digital assets, but does not share any of the “addresses” used to identify these assets). The largest “stablecoin” — a cryptocurrency backed one-for-one by real dollars, to facilitate trading — is Tether, which has likewise never released a full, detailed audit of its $65 billion reserves. The largest cryptocurrency exchange, Binance, will not even say where its headquarters are.

The cryptocurrency market is clearly aware of this issue and companies are belatedly adding “proofs of reserves” to their websites in an effort to reassure investors of their creditworthiness, but simple trust in crypto technology has been eroded. The cryptocurrency community is realizing that you can be a friend or a creditor, but you can’t be both.

[See also: How politicians failed to protect the public from crypto]

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