If you’ve been keeping up with the news at all over the last couple of months, you are bound to have heard about the sensational collapse of FTX. Founded in 2019, FTX enjoyed meteoric success before collapsing in less than a week in November 2022 and declaring bankruptcy. This collapse was triggered by a “bank run” in which the exchange was unable to process customer withdrawal requests and was found to be insolvent (1). When it was all said and done, approximately $8 billion in customer deposits was unaccounted for, making this the largest case of corporate fraud in America since Bernie Madoff was found to have defrauded investors of $20 billion (2). Understandably, this has caused great skepticism around Crypto. However, I would argue that this event only validates the core principles that underline Crypto.
Before getting into that, though, it may be helpful to define what exactly Crypto is and the technologies that enable its existence. Crypto is a catch-all term for digital assets which rely on distributed ledger technology, more simply known as blockchain, to prove ownership. Digital assets can include things like cryptocurrencies, stablecoins, and NFTs (3). A public blockchain relies on a distributed network of computers, each of which maintains a copy of the ledger so that the ledger cannot be altered without the consensus of the network. As new records are generated, they are grouped in blocks. Blocks have limited storage capacity, and once that capacity is reached, the block is closed and linked to the previous block using cryptography. These linked blocks are collectively known as a blockchain (4).
Creating a digital asset on a blockchain requires the usage of a smart contract. A smart contract is computer code that runs automatically once predefined conditions are met (5). For example, a developer may decide to create a smart contract that automatically generates a new NFT once a predefined amount of cryptocurrency is supplied. In simpler terms, blockchains can be thought of as underlying infrastructure in a similar manner to roads, electrical grids, and plumbing. While smart contracts can be thought of as businesses reliant on this infrastructure to function, and digital assets as physical assets or currency that are moved or exchanged between businesses. Compared to existing digital infrastructure, blockchains have a number of benefits. They are highly transparent, decentralized by nature, theoretically immutable, and reduce the need for third parties in transactions.
Now with these benefits in mind, you may be wondering how something like the collapse of FTX was possible. FTX was, by nature, a highly centralized entity and an antithesis of the benefits outlined above. While anyone could see the digital assets on-chain held by FTX, most customer deposits were held in cash in offshore bank accounts. As FTX was based offshore, it had little to no oversight or compliance requirements. This, combined with the opacity of offshore banking, were key enablers in the collapse of FTX. Had all assets been held on-chain using smart contracts, anyone would have been able to immediately notice if funds were misappropriated, preventing the collapse from occurring.
With this being said, I would like to give a real-world example of a market where Crypto has the potential to be revolutionary. It is a market that many of you have likely never heard of, and it is the high-interest consumer lending market. For those who are unfamiliar, the high-interest lending market consists of things like payday loans, installment loans, and title loans. These loans often come with predatory interest rates, as in the case of payday loans which have an average interest rate of 390% in the United States (6). To illustrate the impact these loans have on individuals, I would like to tell you a story about a woman named Kimberly Richardson who found herself in a situation where she needed emergency cash and took out a line of credit from CashNetUSA and drew $2,500 from it at an interest rate of 276%. Kimberly ended up paying this company back almost $10,000 but still defaulted on the loan because the interest rate was so high. Furthermore, she ended up having to declare bankruptcy because of this loan (7).
I think everyone can agree no one should feel their only option is to take out a loan at a 276% interest rate. Yet it happens all the time in the United States and elsewhere. What is more startling is that the largest backers of this industry are some of the largest financial institutions in the world. For instance, CashNetUSA is a subsidiary of Enova International, and the largest single shareholder of Enova International is Blackrock (7)(8). So, whether or not you know it, there is a high probability that your parent’s retirement account is helping fund this market. Governments at both the state and federal levels have tried to cap the rate at which lenders can lend, to no avail. Some states have managed to pass usury laws, but lenders can get around this using a number of workarounds, including a rent-a-bank scheme (9).
It is clear that current market incumbents have no incentive to change and that the government is incapable of regulating the market out of existence. As such, a new solution is needed. In the past, companies such as Lending Club have tried unsuccessfully to create peer-to-peer lending platforms to help address this issue. Yet, for a number of reasons, they were unsuccessful. One reason was that they found it was easier to deal with one lender with a large amount of capital than it was to deal with thousands of smaller ones (10). Smart contracts don’t care how much money you have. To code, it doesn’t matter if you have $100 or $100 million; it treats everyone the same. They also remove the need for intermediaries such as payment rail providers allowing for cost savings that can be passed on to borrowers and lenders. Perhaps, most importantly, blockchains are an open-source capital aggregation layer, and in the age of online communities, that is a paradigm shift. Individuals now have the ability to pool capital in such a manner that they have the ability to compete with the largest financial institutions in the world. So, if a group of people found the high-interest consumer lending market problematic, they could pool their Crypto on the blockchain to create an alternative. In closing, the real power of Crypto and its underlying technologies is that they give us the ability to reimagine the systems that govern our lives more transparent and freely.
1. Silverman, Sam. “Who Lost Money in FTX? Tom Brady, Kevin O’Leary, and More.” Entrepreneur, Entrepreneur, 25 Jan. 2023, https://www.entrepreneur.com/business-news/who-lost-money-in-ftx-tom-brady-kevin-oleary-and-more/443653#:~:text=From%20Tom%20Brady%20to%20Kevin,scrambling%20to%20recoup%20their%20funds.
2. Chatelain, Ryan. “Kevin Bacon: Family Losing ‘Most’ of Their Money in Madoff Scheme.” Kevin Bacon: Family Losing ‘Most’ of Their Money to Madoff, 11 Oct. 2022, https://www.ny1.com/nyc/all-boroughs/entertainment/2022/10/11/kevin-bacon-opens-up-about-family-losing–most–of-their-money-in-madoff-scheme#:~:text=Madoff%2C%20who%20died%20in%202021,%2465%20billion%20in%20paper%20losses.
3. PricewaterhouseCoopers. “Demystifying Cryptocurrency and Digital Assets.” PwC, https://www.pwc.com/us/en/tech-effect/emerging-tech/understanding-cryptocurrency-digital-assets.html.
4. Hayes, Adam. “Blockchain Facts: What Is It, How It Works, and How It Can Be Used.” Investopedia, Investopedia, 19 Dec. 2022, https://www.investopedia.com/terms/b/blockchain.asp.
5. “What Are Smart Contracts on Blockchain?” IBM, https://www.ibm.com/topics/smart-contracts.
6. Nguyen, Stephanie T. “Payday Lending.” Federal Trade Commission, 16 July 2021, https://www.ftc.gov/news-events/topics/consumer-finance/payday-lending.
7. Scigliuzzo, Davide, and Christopher Cannon. “Charging 589% Interest in the Pandemic Is a Booming Business.” Bloomberg.com, Bloomberg, 17 May 2021, https://www.bloomberg.com/graphics/2021-payday-loan-lenders-apple-news/.
8. “Enova International, Inc. (ENVA) Stock Major Holders.” Yahoo! Finance, Yahoo!, 13 Mar. 2023, https://finance.yahoo.com/quote/ENVA/holders?p=ENVA.
9. “The Rent-A-Bank Scheme.” The Rent-A-Bank Scheme | Center for Responsible Lending, 4 Feb. 2021, https://www.responsiblelending.org/RentABank.
10. Salmon, Felix. “Peer-to-Peer Lending Failed.” Axios, 8 Oct. 2020, https://www.axios.com/2020/10/08/lending-club-peer-loans.