Is Crypto a Scam?

By now you likely have heard how poorly things are going for the crypto market this year. From the Terra meltdown, to Celsius going bankrupt, to the #2 crypto exchange globally, FTX (and it's various subsidiaries), completely collapsing, among other insolvency issues of other firms and crypto-related businesses causing the loss of tens of billions of dollars, right now it's probably difficult to think that crypto is a worthwhile investment.

What exactly is going on with crypto? Is crypto just a bad investment with no future, or is there another reason for these firms going belly-up, taking their customers' and users' hard-earned money with them?

Crypto's 4-Year Cycle

Although crypto has only been around for about 13 years, it has already established what is called a 4-year cycle. It's not actually exactly 4 years, but that seems to be the average or an approximation and what it's being called. This is in large part due to Bitcoin's halving, in which the block reward Bitcoin miners receive gets cut in half every 4 years. You can read more about that in the Escient Financial Insights article Bitcoin – The Who, What, When, Why, and How, specifically in the section titled Where Does Bitcoin Get Its Value?

What may seem unusual to hear the first time, is that the crypto market has been through this kind of situation before – at least with the amount of downturn from all-time highs, not necessarily with the amount of collapses of firms and exchanges.

Between 2012 and 2015 Bitcoin fell 73% from its all-time high. After hitting bottom, it took 1,177 days (just over 39 months) to regain the previous all-time high.

The Human Element

When looking at the major events during the current crypto bear market, there is a common element: all of them were caused by humans making poor management decisions.

Terra

The story behind the Terra Luna and Terra USD crash is that there were many warnings about the mechanism coded into the Terra ecosystem and how the Luna token and UST stablecoin were intertwined. Multiple people in the crypto industry warned that the Terra ecosystem would eventually go into a downward spiral, especially if they continued to offer a roughly 20% yield on the stablecoin through Anchor Protocol. The warnings were ignored by Terra's founder and Terraform Labs, the company that created the Terra ecosystem, and eventually it did completely collapse, erasing nearly $50 billion from the Terra ecosystem alone in a matter of days, and also caused a major crash of most other coins and tokens in the crypto market.

As you'll find out, most of the rest of the major events during the current bear market were caused directly or indirectly by the Terra ecosystem collapse.

Celsius, BlockFi, Voyager Digital

It wasn't that long after the Terra ecosystem meltdown before the crypto industry started realizing the larger affects. Multiple centralized exchanges and platforms where regular people could deposit fiat (cash) and purchase crypto that they could then earn a high yield on had been using Terra's UST stablecoin to earn high yields on Anchor Protocol. Terra was offering a 20% annual yield through Anchor Protocol and their services started using that. They took customer funds, purchased Terra UST, deposited it on Anchor Protocol, and began collecting 20% interest. They would then turn around and give their customers a lower interest rate yield and keep the difference. They also would take their customer's crypto and stake it in various protocols, which is a way of saying they would deposit it somewhere to earn interest, but it would be locked up for a certain amount of time. If they wanted to withdraw it could take up to 30 days or more to get funds back, depending on where it was staked. One of the cryptos they staked was Terra Luna, which had a lock-up period of 21 days after a withdrawal request. Terra Luna had collapsed from over $100 to near zero in only a matter of a few days, giving these services no opportunity to get their funds out of these protocols. During the chaos, many customers of these platforms attempted to withdraw their funds, creating a run-on-the-bank scenario. Withdrawals had to be halted when the platforms ran out of money, and they had to file for bankruptcy, with billions of dollars of customer funds locked up or completely lost. This event caused a severe drawdown in asset prices across the entire crypto market.

The cause of all this? Human decisions to place customer assets and funds in places with little ability to get funds out in a timely manner and poor risk management. There were warning signs about Terra weeks, even months, before Terra collapsed. These platforms had plenty of time to make changes and corrections had they paid proper attention and used better investment management and risk management strategies.

One of the bigger platforms, Celsius, was seen during the chaos paying off decentralized finance (DeFi) loans to recover collateral it had put up for those loans. Without paying off those loans, the collateral (which was customer assets) would have been liquidated or sold off and completely lost. It was the centralized finance (CeFi) loans where Celsius ran into trouble and lost assets and funds. CeFi is similar to how banks are run today... by people. DeFi simply runs on code. Decisions are made based on the programming of the protocol or service and are completely predictable. There's no one that can simply alter the code as it's done through a governance mechanism where many people in the crypto community decide on how the protocol or service should run, rather than by one or a handful of people. Therefore, individuals or entities that loaned money to Celsius through DeFi, received their funds back because Celsius knew they would be liquidated and lose their collateral if they didn't. The individuals and entities that didn't get paid back were those that were considered CeFi and were run by people instead of code.

It should also be noted, that DeFi isn't always going to be the answer, as DeFi has it's limitations and own set of risks. There will be times for some people that CeFi will still be a better option.

Three Arrows Capital (3AC)

3AC was a well-known crypto hedge fund managing billions of dollars in assets. Until the Terra collapse, 3AC was considered among the most successful of crypto hedge funds. But then 3AC lost hundreds of millions of dollars in the Terra collapse. Similar to Celsius, had the managers of 3AC paid attention to the warning signs, instead of chasing unrealistically high yields, and highly risky investments, they would have been able to avoid what happened. They lost hundreds of millions of dollars, then continued to make even riskier investments in an effort to gain back their losses. These risky investments involved borrowing hundreds of millions of dollars more, without the assets to back up those loans. They ended up making more poor investments and ended up losing billions dollars of investors' money, eventually making them insolvent and having to file bankruptcy.

And who did 3AC borrow from? Companies and lenders like Genesis and Voyager made unsecured loans up to $2.3 billion. BlockFi made a secured loan to 3AC, and liquidated the loan when 3AC was unable to pay back the loan. BlockFi still lost hundreds of millions of dollars because the collateral assets became worth less than they were at the time the loan was established since the crypto market had already declined quite a bit.

Genesis

Genesis, one of the largest trading and lending desks for institutional investors, not only provided unsecured loans to 3AC, but also kept assets on the now defunct exchange FTX, to the tune of $175 million. The loss has caused liquidity issues with Genesis, and the possibility of complete insolvency and bankruptcy.

FTX and Alameda Research

FTX just a few weeks ago was one of the largest crypto exchanges in the world, valued at $32 billion. Alameda Research was the trading firm founded by FTX founder Sam Bankman-Fried (SBF). Alameda Research was actually started before FTX. More information about the fall of FTX can be found in the previous Escient Financial Insights article The FTX Collapse, Crypto Market Crash, and How to Better Protect Your Investment. What happened with FTX was not an issue with crypto, but again amounted to decisions that were made by people. Customer deposits were used to cover investments and trades by Alameda Research, against FTX's terms of service, and unbeknownst to almost everyone at FTX and Alameda Research, except for a handful of people. Alameda Research lost money with their trades, which means the customer deposits were gone as well. It is the kind of fraud that has been seen before, many times, in traditional finance. One of the biggest and well-known of these is Enron, which the collapse of FTX has been compared to. There are also comparisons to Bernie Madoff's ponzi scheme.

If you'd like to know a lot more detail of exactly how and why this all played out, the Bankless podcast just released a new episode that reviews everything.

The bottom line here is that major issues that have been seen with this current bear market have mostly, by far, been a result of poor human decision-making and outright fraud. That isn't something new or unique to crypto. It has happened many times with traditional investments, and likely will continue to happen.

Some Traditional Investments Have Performed Similarly or Even Worse

The two major cryptocurrencies are Bitcoin and Ethereum. Bitcoin reached its current all-time high of about $69,000 on November 10, 2021. The same day, Ethereum hit its current all-time high of about $4,867. Currently, at the time of writing, Bitcoin's lowest price during this bear market was about $15,460, which is about a 77% decline from the all-time high. For Ethereum, at the time of writing, its lowest price during the current bear market was about $880, which is about an 82% decline from the all-time high.

For comparison, here are some well-known companies and how their stocks have performed this year. Note that these are their largest declines and they may have recovered some since these lows, as Bitcoin and Ethereum have.

• Netflix – down 75.9%
• Etsy – down 78.2%
• PayPal – down 65.8%
• Meta (Facebook) – down 75%
• Tesla – down 58.7%
• Shopify – down 85.8%
• Zoom – down 85%
• Peloton – down 86.1%
• Beyond Meat – down 95%

As you can see, drawdowns of 50% to 95% is not that unusual for even stocks. There are many more, especially if you start to look at smaller companies that have more volatility in their trading.

Crypto Isn't a Scam, But Scams Exist in Crypto (But Not Just in Crypto)

The foundation of cryptocurrency is the encryption and blockchain technology. To learn more about blockchain technology, check out the Escient Financial Insights article What is Blockchain and What are the Benefits of Blockchain and Cryptocurrency? Blockchain technology has many use-cases, beyond even the financial industry. It is a transformative technology that will change the ways in which the entire world functions. Most of the time you may not realize it, but sometimes you will know that you're using something that's utilizing blockchain technology. Cryptocurrency wouldn't exist without blockchain, and blockchain is what makes cryptocurrency not a scam. It's transparent, traceable, immutable (meaning it cannot be altered), secure, trustless (you don't need to trust the person you're transacting with because the blockchain verifies everything and settles quickly), and it's permissionless (anyone can use it).

There are always going to be individuals or entities (run by individuals) that will try to game the system and take advantage of others. This is were there will be scams and fraud that you need to watch out for. However, this doesn't happen only in crypto. Scams, ponzi schemes, and fraud have existed in the traditional financial system since its inception as well, going back as far as the Roman Empire to as recent as Bernie Madoff's pyramid ponzi scheme.

Crypto is More Likely Here to Stay

Crypto and blockchain is like any new technology. It will take time to mature. Crypto is only about 13 years old. The modern financial industry is 230 years old as measured by the origins of the New York Stock Exchange. The stock market has seen its fair share of volatility, scams, and fraud, especially in earlier years before modern federal regulations were enacted to protect investors only in the last 90 years or so. Right now, there is limited regulation of the crypto industry. As regulations are put in place and the crypto industry matures around those regulations, and as adoption increases, crypto could very well become much less volatile and hopefully there will be less scams and fraud. Regulation won't prevent scams and fraud, but it will make it more difficult for bad actors to implement scams and get away with them, and thus they would not have as large of an affect on markets when they do occur, and hopefully less people would be affected by them. Until then, it's important to be careful with crypto investments, and it should typically be viewed as a long-term investment due to the volatility.

The Bottom Line...

... is that crypto as a whole is not a scam. However, many crypto projects and tokens are definitely scams, and there are people who will attempt to use crypto for their scams... just as with traditional finance and traditional stock markets. Be careful and make sure you do your own research, or enlist an advisor, to help you determine which crypto projects, tokens, and coins to purchase and invest in.

Escient Financial is among the few financial advisors you'll find that is educated, trained, experienced, certified, and able and willing to provide investment advice on cryptocurrency and digital assets. If you want to know more about crypto and digital assets, and are interested in investing in crypto and digital assets as part of your investment portfolio and financial plan, feel free to...