Blockfi and Human Stupidity
Today, I would like to discuss how the heights of greed degenerate into human stupidity and why “enough” is never really “enough”. But first, I would like to share that I learned a new word, and this word is central to understanding both the fine line between greed and stupidity, and recent crypto events: rehypothecation.
Rehypothecation is a word that can only be born out of the financial field. It represents something that is not only illegal, but also unthinkable in any other field; it will basically land you in jail ten out of ten times elsewhere. It means lending out assets you have received as collateral to third parties for use in speculation. Notice I did not say “investment,” because the model requires that the assets be at all times kept whole, and usually callable within a short amount of time; both conditions not commensurate with investment which, as Mr. Market has taught us, can not guarantee neither the short term integrity of funds nor their quick repayment without sacrificing positions greatly. Investment is a long term game and rehypothecation requires short term thinking. The client may want his assets back at any time.
A client recently reminded me that a year or two ago, I recommended Blockfi to them. I admit to this fault, and I will say, to attempt justification, that I let my brain talk me into it and ignored my gut. This is something that has often served me well, but, alas, Blockfi is an edge case. You see, it struck me as a business an idiot could run, if the idiot had any common sense. Earn platforms started out with the following model: Receive crypto deposits at 6% interest, charge 12% interest on overcollateralized loans. Collect the difference. Simple.
As a student of financial history, I should have known better. I imagined Blockfi to be akin to a pawn shop. You leave your 1200 dollar gold necklace with the pawn shop and receive a 300 dollar loan. As long as the pawn shop doesn’t get robbed (or is insured) it is highly unlikely it will lose money in aggregate on this sort of loan. The fact that pawn shops can be traced back thousands of years, way earlier than the common era, speaks to the power of the business model.
But I forgot about the goldsmiths. Before there was fiat money at scale, there were goldsmiths. In the 17th century, goldsmiths held decent amounts of gold already, and already had to pay for the security and infrastructure to maintain this gold; so people started leaving their personal gold with the goldsmiths and getting paper markers in return. They traded the paper markers instead of the gold and this is one of the early forms of representative money. But the goldsmiths got wise.
The goldsmiths essentially figured out that they could issue more scripts than the gold they had in reserve, because people were highly unlikely to all want their gold back at the same time, and in this way they created money out of thin air. They also put at risk their clients assets, because when the run came, there would be more script then gold and many clients would be wiped out. There was more than one bank run. And perhaps this is the reason that pawn shops are not the same as banks nowadays. Banks just love leverage, whereas a pawn shop owner that loses your family jewels speculating with them is liable to go to jail; or get shot by the consignor.
I never thought of it this way, but there is really more honor in being a pawn shop owner rather than a banker. Or perhaps the incentives (getting shot) are better aligned. It’s a more person to person business. Unlike Blockfi. Blockfi took the model and did two things that went beyond greed and took that great leap into stupidity. They not only took demand deposits and lent them out in undercollateralized loans (breaking the first promise), they rehypothecated assets entrusted to them as collateral (breaking the second promise). They also magnified their exposure by focusing on attracting as much lending capital as possible by offering above market rates on loans they were not making. Essentially guaranteeing month to month, break neck losses on their loan books (stupidity).
There is a glorious book that recently came out called: “Reckless: The Story Of Cryptocurrency Interest Rates” by Jonathan Bier, who describes the process. The end goal was basically to accumulate as much capital as possible from retail investors and pay interest out of the funds of venture capitalists who invested in Blockfi (and the other lenders). A friend originally described a similar process to me when he launched a website intended for trading of physical goods. He paid hundreds of thousands of dollars in Adwords and other promotional endeavors per month, with the goal of accumulating as many users as possible. He did this although the platform had near zero use, “Each user is worth $8 dollars when we sell the company,” he told me. I imagine Blockfi thought something similar about its borrowed “war chest”.
I don’t wonder what made Blockfi take a stupid simple pawn shop model and make it into a leveraged to the hilt bank, it was pure greed that degenerated to blind stupidity. Why make 6% when you can make 10%? Or more. But I do wonder about the moment they decided to cross the line. They clearly knew they were going from a basically no risk business to a highly exposed position in the most volatile, liquid market on earth. But I don’t think it was just greed. Imagine operating at that level: a few billion of funds under management and you get to call the shots. It doesn’t matter that the funds are not yours, you decide what you do with them. It must be a hell of a rush.
I think there are a couple of lessons to be learned here. First and foremost, you can’t trust people in finance. There is no risk they will not take when it’s your money and their extra 1% return. There is something that clouds the mind of operators when they think about that extra 1%. The other lesson is perhaps that we should use pawn shop rules in operations that promise financial safety. The Glass-Steagal act did this after the Great Depression, speculative funds are managed by speculative entities (commercial banks) and mom and pop “safe” funds are managed by retail banks. We should think of our allocation of funds in these terms: “speculative” and “investment”; and we should be told the truth about what type of investment we are making. Though this won’t help the client I referred to Blockfi.