“Nothing ever becomes real till it is experienced.” – John Keats
What is something worth? Few questions are as simple to ask and difficult to answer, and yet much of global finance operates on firm numbers written with a confident precision that shrouds the nebulous nature of any answer to that core question.
The instinctive response is “whatever someone is willing to pay for it,” and a mere glance at the last market clearing price is fit for most purposes. If an investor pledges stock as collateral for a loan, a margin call on that collateral is usually dictated by the last transacted price, regardless of whether the amount of stock pledged could actually be sold at anywhere near that value. Loans are overcollateralized at origination for this very reason, often by a factor of four, and margin calls typically kick in when that ratio drops below two. Since bad news, low stock prices, and market illiquidity are often highly correlated, what something is worth when a desperate holder simply has to sell is generally much less than the last “mark-to-market” value. Just ask Bill Hwang’s bankers.
The question is even more complex in the crypto universe, where magic beans are traded back and forth between speculators but fiat only really trades hands on the rails into and out of the grand digital casino. Even though most tokens are quoted in US dollars, the price on the screen (and the balance in your “account”) are in many important ways a mirage: good luck leaving the casino with that many Benjamins unless more is flowing in to replace them. In a piece we wrote in January called Dollars Ex Machina, we told the story of an equity investment we made back in 2016. A brilliant friend had started a company working in the Bitcoin space, and despite our complete lack of knowledge about the underlying technology, we decided to bet the jockey. With some proverbial skin in the game, we set about the task of trying to understand what cryptocurrencies were, and developed the following mental model (emphasis added throughout):
“In the following months, we engaged in a series of philosophical conversations about cryptocurrencies with our friend to learn more. Concurrent with this quest for knowledge, the paper value of our modest investment began to soar, which had the understandable effect of increasing the urgency of our research. We distinctly recall drawing two circles on a piece of paper. In the circle on the left, we wrote ‘real economy,’ while in the circle on the right we wrote ‘crypto universe.’ We drew two pipes between the circles – one flowing into the crypto universe and the other flowing back to the real economy – and labeled both pipes with ‘fiat currencies.’ While we understood how fiat currencies from investors could flow in, we failed to grasp what could be occurring within the crypto universe that would create more fiat currency for investors to take out at a later date. There seemed to be many brilliant people excited to be working in the space and using a technical language foreign to us, so we concluded that our inability to understand this rather pertinent issue was a fault of our own making.”
While many crypto enthusiasts ridiculed our analysis and filled our comments section with vitriol, missing from their trolling was a compelling reason why our model was wrong. If fiat is your framework, how could it be? To be sure, many said a similar analogy could be drawn with gold, but gold is directly traded in fiat and the size of the gold market is a fraction of the global circulating supply of fiat. By definition, the total exit value of all crypto tokens as measured in fiat is capped by the amount of fiat floating in the crypto universe. Wash trading magic beans with tiny floats to ever higher “valuations” cannot change this truism.
With the recent collapse of Alameda Capital and FTX, our “follow the fiat” approach can provide interesting insights into who the biggest losers will be and what the real prospects for recovery are in bankruptcy. It’s not a pretty picture. Let’s dig in.