Crypto-lender (read: unlicensed bank) BlockFi has announced a deal with Sam Bankman-Freid's FTX that could lead to a sale at a price of $240m or less. That would be a serious drawdown from the $1.3 billion in capital poured into the company since 2019, but far better than rumors and reports suggesting much lower bids.
BlockFi’s fate, while not great, still looks better than that of other centralized crypto lenders, including Celsius and Babel Finance, which also garnered hundreds of millions from investors. BlockFi depositors at least seem likely to get a lot of their money back, while Celsius and others seem truly insolvent. Though it’s not obvious, this group also includes Anchor, which masqueraded as a decentralized finance (DeFi) protocol on the Terra blockchain but was in reality clearly managed by a close group of backers, and has already wiped out depositors.
So where did all that investor money go?
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One to zero: Notes on startups, or how to set VC money on fire
Investments in crypto lenders went into at least two gigantic holes in the ground.
On the one hand, these lenders all seem to have engaged in some degree of reckless investing in pursuit of the high yields they promised depositors. That led them to take big swings on garbage like LUNA, Terra’s native asset, and BadgerDAO, an Ethereum-based protocol to lend bitcoin (BTC).
Some also bet on stETH, a derivative of ETH that pays staking rewards, and the Grayscale BTC Trust, a massive institutional vehicle for BTC exposure (operated by CoinDesk’s sister company). Those are reputable assets, but they're currently illiquid and wound up leaving temporary but large holes in lenders’ balance sheets. (One reason BlockFi has survived is that, according to CEO and founder Zach Prince, it avoided most of these traps.)
But another tranche of investors’ capital went not to risky bets, but directly towards funding yields that were being paid to depositors. This was explained by investors themselves as a deficit-spending customer acquisition strategy that would, in the future, translate into real revenue.
See also: Dragonfly’s Haseeb Qureshi Is Still Optimistic in the Crypto Bear Market | The Node
That’s a page ripped directly from the Silicon Valley playbook that gave rise to Amazon (AMZN) and Facebook, now Meta (FB). It was articulated as a philosophy by Peter Thiel in his book “Zero to One,” which broadly argues that startups should spend enough on early-stage growth to strangle the competition, essentially creating their own monopolies.
The success of Amazon and Facebook in particular turned the monopolistic playbook into Silicon Valley gospel. But after a first wave of genuine successes it began to falter, spawning eternally unprofitable zombie companies like Uber and more than a few absolute money-burning catastrophes like WeWork. For a time these amounted to a “millennial lifestyle subsidy” as consumers enjoyed rides or rentals at prices below their actual cost and VCs covered the difference out of (misguided) faith that it would all work out in the end.
But the infection of finance by the deficit-customer-acquisition mind virus may be its most dangerous and misguided iteration. It is a fundamentally nonsensical, and arguably fundamentally fraudulent, approach to growing a banking or lending business. The blowups we’re seeing now are far less a condemnation of crypto than of this outdated and misapplied Thiel growth playbook.
Fake friends get fake yields
How do we know investor funds were subsidizing depositor yields on Celsius and other platforms? In part, it’s simple math: Demand for deposit yield entirely outstripped demand for expensive institutional crypto loans, so the lenders in aggregate could not have actually been generating all the yield they were paying out to depositors from their loan books.
Further, while we don’t have direct visibility into Celsius or BlockFi’s spending, we do know the flows of the most elaborately obfuscated of the fake crypto banks: Anchor.
Some will immediately object that Anchor doesn’t belong in this category. But while it nominally ran on a public blockchain, it was in no sense a “real” DeFi protocol. This was obvious well before Terra’s collapse. While DeFi protocols like Aave adjust deposit returns based on real loan demand, entities in the Terra ecosystem had to repeatedly refill the “yield reserve” that was paying out artificially high depositor yields on Anchor. A backstop was necessary because Anchor wasn’t endogenously generating enough yield from loans to meet its obligations to depositors.
This was explicitly acknowledged to be a temporary fix, with the promise that “real” yields would eventually arrive – much as Uber has continued to promise real profits someday. Though not framed in these terms, it was the functional equivalent of Uber selling rides for less than they actually cost and making up the difference with investor money.
LUNA and the UST stablecoin grew so large almost entirely because of the ~20% interest being paid on deposits made to Anchor using the UST stablecoin. These subsidized returns meant Terra was, in practice, a technologically obfuscated Ponzi scheme.
Boiling frogs at 100 degrees Celsius
Whatever the legal niceties, the same argument could be made about the functional reality of Celsius and its ilk. These cases may even highlight certain “Ponzinomic” elements of venture investing as a whole, particularly the ability of early-stage investors to continue propping up the book value of their own positions in subsequent rounds. As with Anchor, as long as a VC can continue subsidizing money-losing customer acquisition, a company can trumpet growth and promise profitability down the road.
But even on its face this is simply a disastrous model for finance because unlike technology revenues and profits, investment yields don’t scale. In fact, they do the opposite of scale: The larger a hedge fund gets, for instance, the harder it is to continue delivering the same percentage returns it did with less money under management.
See also: The Case for Suing Celsius, Terraform Labs | The Node
Whether you’re investing in crypto or tech stocks, this often becomes a kind of risk trap. When people keep throwing cash at you, you have to search harder and harder for investment opportunities that will match your past performance. Those later bets, almost inevitably, either provide lower returns or present higher risks. This was the precise dynamic that played out with Celsius in particular: BadgerDAO is to Celsius CEO Alex Mashinsky as Twist Bioscience (a speculative medical bet) is to ARK Invest’s Cathie Wood.
One to zero
Another reason the Thiel model simply makes no sense for retail finance is that it is structurally impossible to build the kind of “moat” that can, at the very least, keep a crappy business like Uber limping along. A huge element of finance, certainly for retail depositors but also more generally, is that you want your deposits to be as liquid as possible. To attract deposits in the first place, customers must be convinced it will be easy to withdraw … and potentially deposit their money elsewhere. This makes banking a fundamentally very, very tough business to monopolize in even a marginally free market.
Finally, loss-led customer acquisition is nonsensical in finance simply because there’s no such thing as free money. Yields that are artificially inflated to attract customers will inevitably be forced to align with macro trends over time, and the customers will simply leave. One part of what made Celsius and Anchor functionally scams (whatever the legal conclusions wind up being) is that their outsized returns were premised on the idea that crypto somehow magically generated more yield than normal money, and would indefinitely.
That was always absurd – the past few weeks have just made it painfully obvious.
Update 7/1/22: This story has been updated with new information about FTX's deal with BlockFi.
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