Nov 13, 2022

The Casino and the Genie

Reflections on crypto and trying to make sense of a nonsensical week.

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To the returning hermit, the man roused from a coma, the newcomer who decided now, of all times, to learn about the markets: in case you didn’t know – it has not been a good year for crypto. 

Terra, Three Arrows Capital (3AC), Celsius, and Voyager have all collapsed; the sector’s market cap has crashed; and NFT trading volumes have shrunk to next to nothing. But amidst a year of bad weeks, this was the worst.

That’s not strictly true by the numbers. Over the past seven days, the total cryptocurrency market cap is down 20%, still short of a 26% fall in the middle of May. 

But something deeper broke over the last seven days. On Tuesday morning, cryptocurrency exchange FTX announced it had agreed to be purchased by rival Binance. The news came after days of bickering between CEOs Sam Bankman-Fried and Changpeng Zhao (CZ), with the Binance CEO calling into question the financial stability of his rival’s empire. By agreeing to the sale, Bankman-Fried confirmed that CZ was correct, at least in broad strokes. As customers pulled out of the exchange, FTX was left with a hole it could not fill, one as large as $10 billion by some accounts.

On Thursday morning, the tune changed. Binance stepped away from the deal after taking a closer look at FTX’s finances and finding them even worse than it had imagined. The next day, Bankman-Fried announced he was stepping down as CEO, and that FTX and associated entities were filing for bankruptcy. Since then, rumors have swirled about a $515 million “hack” of FTX funds –  which may instead be an inside job.

It is too soon to know exactly what happened. Bombshells seem to be dropping by the day, and crypto has a rare gift for making even the surefooted scramble. Whatever actual events unfold may not matter from a high level. FTX’s implosion represents a crucible moment. It is a crisis of faith for the industry and should force us to update our mental models aggressively. It is an opportunity to reflect on what crypto is, what it should be, and the vast distance between here and there. If it is not already clear, I say these things as much or more to myself as to the broader sector. Personally, this week has prompted a hard reset in how I think about crypto and the reasons I remain positive about its (maybe very) long-term potential. 

So, what happened?

The edge

What seems indisputable is this: a company seen as one of crypto’s most impressive, innovative, and regulatorily proactive did something to leave it vulnerable to collapse. Right now, that something seems to have been lending $10 billion of customer funds to bail out sister organization Alameda. This was a company that attracted billions in funding from legendary investors like Sequoia Capital, bought the naming rights for an NBA stadium, scooped up battered lenders like Voyager, ran an extremely profitable cryptocurrency exchange, turned Tom Brady into a quippy advertising icon and Larry David into a Super Bowl smash, and attracted coverage from nearly every media outlet on the planet, including this one.

Those that have followed The Generalist for a while will know I considered FTX one of the most remarkable startups on the planet. Their growth and efficiency were mesmerizing: what rivals had needed years and thousands of employees to achieve, FTX had done in 18 months with an almost hilariously lean team. When I first wrote about them, they were on an $803 million revenue run rate and relied on just six developers. In Sam Bankman-Fried, they had a gigabrained CEO with the right blend of ruthless pragmatism and solid moral fiber. A consummate trader that had adapted exceptional systems thinking and an outsider’s ingenuity to turn crypto on its head – and with a sufficient horizon to recognize the importance of building a brand not only in mainstream America but in the corridors of D.C.

This isn’t to say that I didn’t see risks in the way that Bankman-Fried ran his empire. In my very first piece on the company, I wrote: 

From FTX’s inception, [SBF] has been willing to act controversially to achieve his goals. 

In preparing for this piece, I spoke with someone familiar with both Alameda and FTX’s early days. They highlighted the clear conflict of interest posed by the relationship between the two organizations. Wouldn’t FTX’s exchange favor the market maker founded by its CEO? How could other traders be sure they were receiving a fair shake? 

The truth is they may not have. The individual I spoke to explained how vital Alameda had been to FTX initially, providing liquidity for the new market. What’s perhaps less clear is whether Alameda received something in return. 

The source noted that FTX drew strong traffic partially because it quoted such tight markets. It seemed impossible to this person that a market maker could actually make money on such spreads, which suggested one of two things were going on: either, Alameda played on a level playing field with others and lost money (essentially subsidizing FTX), or the firm received some kind of advantage. This might have been a first look at the exchange’s trading volume, for example.

None of this is illegal, but it’s thorny territory. So far, it has proven worth the risk. SBF has driven both organizations to new peaks. As time passes, Alameda and FTX seem to be growing increasingly independent, perhaps diminishing potential conflicts of interest. But the willingness to operate at the limit of acceptability tells us something about SBF’s orientation and his desire to win, however turbulently. 

The data at the time suggested that Alameda and FTX were, indeed, becoming more independent. Numbers provided by the company showed the percentage of FTX’s volume coming from Alameda falling from +50% in May 2019 to approximately 5% by mid-2021. There was no indication that Alameda’s finances were a concern. Indeed, they may not have been then – these were point-in-time assessments. With the benefit of hindsight, we can look back and say that we were clear on the potential for conflict, the possibility of self-dealing, and Bankman-Fried’s occasionally chaotic methodologies. Ultimately, the available data seemed to show a diminishing rather than escalating risk. We now know that was far from the real story. 

Of course, every startup dances with risk. Something I don’t think VCs like to talk about is that building a great company requires transgression. This is especially true when a company must parry with regulators or confront parties with entrenched interests. 

Uber “toe-stepped” its way over regulators as it brute-forced a market into being, Airbnb aggravated city governments by flooding metropolitan markets with tourists, Facebook nicked its raison d’etre from the Winklevii, and Microsoft’s MS-DOS operating system may (or may not) have been partially filched from a competitor. French author Honoré de Balzac was believed to have said, “behind every great fortune is a great crime.” It is not quite so blatant in entrepreneurship – but it is not completely wrong. It might be truer to say that behind every great company is a litany of infringements and encroachments, soluble sins. 

If you believe that entrepreneurship is an essential driver of human progress (I do), then some degree of this is desirable, within reason. (An unsatisfying debate we could have: what does “within reason” mean?) 

In college, I remember asking a political science professor whether they had ever considered running for office. After all, they were young, brilliant, ethical, and absurdly charismatic. They told me they never would because politics didn’t allow for purists. For a time, that seemed eminently sensible to me, the morally courageous path. In recent years, I’ve come to question it. While the purist may be able to thrive in the arts or academia (I don’t know if that is fantasy or not), it is impossible for anyone that enters the arenas of business or politics. To do something, anything meaningful requires compromise.

All of this is to say that I thought FTX would act similarly to many exceptional organizations. Bankman-Fried would take them up to the edge when he needed to but was sharp enough to keep them on the right side of the meridian. While there might be a few savvy shortcuts here and there, FTX was too smart to invest customer funds, dabble in high-risk lending, or build its structure such that Alameda became a load-bearing wall. It wasn't foolish or cruel enough to defraud customers or engage in potentially criminal behavior. And it certainly wouldn’t do these things while aggressively lobbying for greater regulation. Right?

(A brief aside: If you were one of the few who saw this coming, I commend your shrewdness. The optimism surrounding FTX was second only to Stripe among companies I have studied.)

It’s premature to say if and when all of these things happened. FTX previously insisted it did not invest customer funds, for example. That seems utterly impossible now, but there is perhaps a vanishing chance something else occurred. We also don't yet know whether it has broken the law and may not for some time. On current evidence, it looks likely, however. What is beyond doubt is that FTX acted irresponsibly, taking a risk that put the company and its customers in jeopardy. That FTX’s exchange was so profitable makes it a particularly bewildering move and one that seems to speak to some of the fundamental problems in the sector. 

The casino

Historically, I’ve seen crypto as a debaucherous hackathon. Sure, some off-color activities might take place here and there – some light gambling, for example – but it is fundamentally a sector defined by what it is building. Over the past year, I’ve learned that not only is this wrong, it’s perfectly wrong. Crypto is not a hackathon with a little betting; it’s a casino where spontaneous entrepreneurship occasionally breaks out. The emphasis I’d assumed should be inverted, flipped on its head. 

How much entrepreneurship is there in this bizarre Monte Carlo? I don’t know. At various times, I might have put the split between real building and speculation at 70/30, 60/40, or 50/50. It’s starting to feel closer to 20/80 or 10/90. 

By shifting the orientation, almost all of your assumptions have to change. You effectively admit that each new game that spins up is more likely than not to be a game of speculation. By extension, you acknowledge that if you want to find genuine opportunities in this casino, you will have to take extraordinary measures, wading through ringing slot machines and clattering dice and drunken friends pulling you to felt tables. And, because you are not perfect, you must consent to being fooled – and made to look foolish. The only people that enter a casino knowing they will make money are The House or a cheat. If you are either, then good for you – no need to worry. (Oh, and by the way, in this casino, The House is also a cheat a lot of the time.) 

When you build or invest in crypto, this is the game you are playing. We should be clear about it.

If you’ve been in a casino for a prolonged period, you’ll know it affects your cognition. That a myth persists that Las Vegas pumps pure oxygen through its air ducts indicates how distorted the environment can feel. Losing $500 in thirty seconds might be catastrophic in another context – in a casino, it feels like the point.

Crypto-native people have been living in the casino for years. (I would lump myself in this category, though perhaps I’ve ducked out for a few more coffee breaks.) The result is that a large percentage of the culture is entirely acclimatized to risk. In some respects, this is healthy, adaptive behavior. If you want to survive in a volatile industry, you have no choice but to develop a thick skin and a sense of humor. Anyone who visited crypto Twitter this week will have witnessed a puckish pass-me-the-popcorn glee from many in the industry. From a community that has seen endless rug pulls and scams and implosions, the response when another catastrophe occurs is often, here we go again, lol. 

Again, this makes sense. Everyone gets fooled in the casino, and we need people to commiserate with when it's our turn. The downside is that it downplays calamities and occasionally heroizes irresponsible actors. For example, in the aftermath of the FTX announcement on Tuesday, the Twitch stream UpOnly went viral for pulling together an impromptu panel to discuss proceedings. Guests included Jim Talbot, Do Kwon, and “pharma bro” Martin Shkreli. Understandably, many found this funny. The sheer chaos of it was a kind of theater. But the punchline doesn’t flatter anyone, especially not those in crypto. It goes something like, we’re here to talk about a meltdown, and look who we got to join! A guy who oversaw a massive collapse and a scammer that jacked up the price of life-saving medications! Lol!

Where does this humor come from? 

In part, it’s a direct reflection of modern internet culture. A generation raised amidst financial crises, extreme political dysfunction, and climatic doom often communicates with humor located somewhere around chaotic nihilism. It also feels particular to crypto – a consequence of two attributes. 

First, crypto people have long been the butt of a joke. Initially scoffed at for their belief in a speculative alternative financial system, eventually ridiculed for the different schemes and machinations in the casino. The result is a community that seems subconsciously keen to make itself a joke before someone else does. Many call themselves “degens” to claim a potential insult as a badge of honor.

Second, the industry’s cultural mix has skewed in recent years. Crypto’s early adopters were a blend of technologists, idealists, and enterprising criminals. As more money has been made, professional investors and amateur speculators (you cannot always distinguish between the two) have flooded in. It now feels like these groups outnumber the mission-driven builders, forging an atmosphere that’s more WallStreetBets or Liar’s Poker than techno-anarchism. It does not seem like an accident that 2022’s Architects of Doom, Do Kwon, Sam Bankman-Fried, Stephen Ehrlich (Voyager), Su Zhu (3AC), and Alex Mashinsky (Celsius) all got their start in crypto in 2017. This downturn was not catalyzed by stalwarts like Brian Amstrong and Jesse Powell; this is a crash set to new music.

If we want crypto to be more substantive, turning the Belaggio into Bell Labs, we can’t let this culture continue to flourish. This is a difficult change to make – the internet doesn’t run on seriousness, and crypto is particularly allergic to moralizing. But we should be embarrassed by the state of our industry and fight to change it.

The casino doesn’t only warp our reaction to loss; it also skews how aggressively we pursue wins. One uniting lesson from this year’s collapses: stepping away from the table is harder when you’re winning. Three Arrows Capital earned billions in 2021, FTX was ingesting market share at a clip rarely seen, and Celsius had a balance sheet of $25 billion before its nose-dive. All played risky hands and won. Instead of wiping their brows and saying, well, we probably shouldn’t do that again, they doubled, tripled down.

The window of reasonable behavior is wider in a casino. In what other environment does it make sense to jeopardize a colossal stack to win just a few more chips? Why risk a business earning eight figures a day for a couple more marginal wins? 

This is irrational behavior. Even stranger, it’s irrational behavior from extremely intelligent people that, I would guess, started out as morally normal. The casino deranges, pushing people to bet just a little bit more. It doesn’t help that this casino is effectively “livestreamed” to an audience of millions on Twitter and beyond. 

The feature

The traditional counterpoint to these objections is that crypto’s liquidity is a feature, not a bug. The argument goes something like, most casinos are members-only, but this one is open to anyone! Come in, place your bets, and change your life!  

A sub-argument is that running a casino attracts attention. When people make money, that’s a good story. When people lose money, that’s also a good story. The more attention the casino gets, the more people will come to it. 

Over time, I suspect these arguments will be correct. It is impactful to open up early-stage investing and allow the general public to profit from an innovative sector. Extreme volatility has been brutal to endure, but it has helped crypto get memed into the mainstream. The endless drama makes it difficult to ignore.

So, it’s a feature – but it’s the buggiest feature of all time. It’s so buggy that it’s borderline unusable. It’s so buggy that you want to throw your computer out of the window or into a bathtub. Here are a few bugs: 

  • Every player in the game is biased. If you hold any crypto at all, you’re biased to some extent. All things being equal, you would like the value of your holdings to increase, incentivizing you to evangelize and convert others. This is a feature of any liquid market. However, the volatility in crypto, lack of regulation, and weak oversight make it riskier for the average person. Though it’s certainly possible to get wrecked investing in traditional markets, contemporary crypto seems particularly adept at eviscerating capital. 
  • It distorts magnitude. It’s time to admit that most crypto market caps are a joke. On what grounds is Shiba Inu valued north of $5 billion? How is Cardano sitting above $12 billion? This is not to pick on these projects in particular – I am no expert on either, and there may be interesting things happening. By any sane metric, though, they would not be in this league. By opening up liquidity, speculation takes over, distorting size beyond reason. 
  • It distorts product-market fit. If you’re not careful, it’s easy to fall into a lazy shortcut. If a company or project is of sufficient size, presumably, they’re way past product-market fit, right? You can’t become a multi-billion dollar project without fulfilling some customer need. In crypto, this is usually not true. Projects can reach decacorn status without appealing to anyone. Even those that seem to have a lot of customers might be using some mechanism to spoof product-market fit, as play-to-earn games did in the last cycle.

The impact of these bugs is considerable. We have a sector where financial interests cause intellectual dishonesty, buzzy projects are inflated beyond sense, and product-market fit is disguised.

Not all of crypto suffers from these bugs — we should not be too reductive. For example, many of the most intellectually honest, rigorous people I have met are in the sector. Equally, plenty of charlatans, pump-meisters, and empty thinkers exist outside crypto’s walls. (Ironically, many who display these traits most fully are vehemently anti-crypto.)

As with the casino, the lesson of “the buggiest feature of all time” is simple: we must recognize this is how it is right now and work to minimize the system’s flaws. To say: these are the tradeoffs we are making; they are not easy to stomach; here is how we are trying to smooth them out; we hope they will be worth the pain.

At least sometimes, they absolutely are. The truth is that crypto is a weird sector in a weird stage of its life. It is in the process of building fundamental infrastructure – the internet circa the 1970s and 80s. In theory, venture capital should have been well-placed to finance this innovation, but in reality, formal funding lagged civilian investment. Long before firms raised billions to capitalize crypto, individuals came together to finance this grand global experiment. 

The clearest example is Ethereum. When the blockchain raised $18 million in 2014, capital primarily came from individuals rather than institutions. Time has shown that this was money exceptionally well-allocated – that $18 million facilitated the creation of a world-changing technology and coordination mechanism. Could a hodge-podge of technologists and business people have raised equivalent capital on Sand Hill Road? Would so rich and deep a groundswell have emerged even if it did? When the feature works, its power is exceptional. 

The genie

I do not like casinos. You may have noticed. 

I do not like the games that are played or the atmosphere produced. I do not like the sense of being constantly, relentlessly manipulated – by sounds, by colors, by floorplan, by time, by hospitality (another drink, sir?), by friends, by lights, by brain chemistry, by myself. The job of a casino is to repeatedly unhinge you and somehow leave you grateful for the experience. 

I recognize that many see things differently. They consider the games exciting and clever and enjoyable, and I can understand that. They find the place full of bonhomie and pleasant serendipity, and again, I can see their point. It is easy for these people to find a reason to return to the casino. Gambling is a pleasure.

But if you are like me – if you don’t like casinos or gambling – why visit? Why return to the same betting house again and again? 

The only reason is this: you think there is something else there. You believe that somewhere, hidden around the fringes, something miraculous is to be found, to be made. 

And really, this should be the bar: miraculous. It isn’t worth it otherwise. We can think of it like this: Imagine a genie emerges from a lamp. He’s holding a bowl with ten chocolates in it. He says nine of the ten will make you extremely sick, but one is…amazing. You can have as many as you’d like. Would you like a chocolate?

For some of you, that’s enough information to make a decision. No way, you think. What crazy person would take a chocolate when you have a 90% chance of getting sick?

The slightly strange among you might ask a few follow-up questions. Ok, you said that one of them is ‘amazing.’ Amazing, how exactly?

The genie tells you that no one is exactly sure what the final chocolate does, though there are some wonderful, miraculous theories. A great many texts have been written on the subject. If you would like to learn more, here they are. 

Maybe you would go away for a few days and study some of the books the genie provided. Days might become months which might become years. Eventually, you would come to a nominal plan of action, picking a path. 

You might say: What am I doing? I’ve spent three years studying mystery chocolate! All my friends think I’m insane, and I’m still not sure what the best thing to do is. I’m going to tell the genie I don’t want his chocolate

And then, you would go on with your life.

Another thing you might say: I’ve done my research, and I’m pretty sure it's just a regular piece of chocolate. Sure, there’s a tiny chance it’s something better than that, but how much better? 

Again, your life would continue. Every once in a while, you might think about the genie and his chocolate and wonder whether you should have tried it. 

A final thing you might say: I think there’s something to this chocolate. I’ve thought about it a lot, I’ve studied, and I believe it could be something remarkable. Something miraculous. 

This is why I am still long crypto. Despite its many flaws, I believe it has miraculous potential to improve our world. Self-sovereign money, smart contracts, and digital property rights are radical, revolutionary ideas that we are in the early innings of understanding and applying. In a matter of decades, we may look back on the state’s rigid stranglehold on money as a quirky artifact, an obvious overreach. Decentralized finance (DeFi) has its own quirks, but it has held up well, by comparison, showing that code is often less corruptible than people. We may see it bloom more fully in the coming years.  

The second reason I am still long crypto is the people. That may sound counterintuitive given the description of the casino we are currently in. Who wants to be surrounded by a swarm of gamblers? 

While crypto may have plenty of them, it also has some of the most fiercely intelligent, driven, and gritty people I have met. Though infuriated and disappointed by much of this week, I have also been reminded of these qualities. Founders, investors, and operators I speak to know their jobs have become much harder and are determined to continue, undaunted. These people believe (as I do) the movement is too important to abandon; it will emerge stronger.

Of course, you can disagree with this assessment. Most will hear the genie’s offer and decide it is a fool’s bargain. Indeed, I would be lying if I didn’t say that a part of me wishes I felt this way. That I had done my homework and decided crypto was neither particularly important nor interesting. While there’s a pragmatic element in my embrace of crypto – I see it as a significant opportunity – I suspect my life would be simpler if I eschewed it. As we’ve established, this is a casino that routinely makes you look like an idiot; a bowl of chocolate that, more likely than not, will make you sick. My lowest points as an analyst have come directly from advancing an opinion about the sector that is later disproven; the worst was this week. I expect I will be wrong again on many subjects in the years to come. 

Naturally then, this is not a break-up letter. Far from it. In a recent piece, Floodgate GP Ann Miura-Ko spoke about the importance of criticizing from a place of love. It rhymes with one of my favorite quotes from British author Julian Barnes, “The greatest patriotism is to tell your country when it is behaving dishonorably, foolishly, viciously.”

Crypto is behaving dishonorably and foolishly. Loving it, believing in it, requires us to recognize this reality – and act to improve it. 

We are in a time of destruction. What may be needed is not less, but more. 

Take a hammer to the slot machines; run a knife along the craps table’s green felt. 

Smash up the fountains’ burbling cherubs and crystal chandeliers – opulence is the reward of a fat, late-stage civilization, not a scrabbler searching for meaning. 

Tell The House there are rules it must follow and punish it when it strays. 

Search for the card counters and charlatans and beware those that look least like con men; beware of them, especially.

Recognize the place you are in and the games you are playing. Recognize that for now, at least – until we can build something better – this is a casino, and it is more likely than not that you will lose money, you will make mistakes and bad bets, and you will look like a fool. 

Stay calm when you see others on a winning streak, and question those that seem unable to lose.

And, somehow, do not let this jade you completely. 

Leave the casino if you want to, but if you are going to stay, stay with those that believe in something, in miracles. Not the ones where statues weep and a piece of toast becomes a Pietà, but where the sum of human knowledge travels by light and computers can paint and money moves like water. Because what is a true miracle except for unexpected technology? 

As I wrote at the beginning: I say these things to myself. Above all, I am speaking to myself. 

The Generalist’s work is provided for informational purposes only and should not be construed as legal, business, investment, or tax advice. You should always do your own research and consult advisors on these subjects. Our work may feature entities in which Generalist Capital, LLC or the author has invested.