Tell me if you’ve heard this story before. A vast new market opens up, and an investment and credit boom soon follows. Real wealth is created alongside a speculative excess. Banks spring up all over to extend credit to market participants.
New financial instruments are created. Trading firms start trading these instruments on margin. A massive firm blows up with a series of leveraged trades, causing losses to its creditors. The main partners at the firm flee the country. Panic follows, kicking off a liquidity crisis and a wave of bank runs. Major lending institutions go bankrupt and credit contracts rapidly.
CoinDesk columnist Nic Carter is partner at Castle Island Ventures, a public blockchain-focused venture fund based in Cambridge, Mass. He is also the co-founder of Coin Metrics, a blockchain analytics startup.
1772-1773 credit crisis
Sounds like the crypto market in 2022? It also describes the European credit crisis of 1772-73. That particular banking panic is one of the lesser-known crises of the 18th century. After the Treaty of Paris in 1763 ended the French and Indian War, Great Britain gained a stable claim on territories in North America. That made it safe to invest in the new territories, and bankers in Europe obliged with enthusiasm.
Colonial planters needed credit, and British merchants wanted commodities to sell to more markets. A credit boom resulted, as did a speculative fervor among traders in London and Europe. Shares in the British East India Company rallied sharply in 1772 as traders heaped on margin to trade with.
In mid-1772, events came to a head as the London bank Neale, James, Fordyce and Downe failed, having shorted East India Company shares with leverage. Among its major creditors was the Scottish bank Douglas Heron & Co., also known as the Ayr Bank. Scotland was operating on a laissez-faire or “free” (as in speech) banking period at the time, and largely unregulated, startup banks were the norm. The Ayr Bank had been formed just three years prior by major landowning families in Scotland. It was intended to serve as a kind of private Scottish central bank.
Ayr was a full liability institution, with deposits guaranteed by the land holdings of its shareholders. In its short existence, it eagerly issued credit and banknotes, quickly becoming one of the largest banks in Scotland. It had a reputation for extending credit on loose terms to close affiliates. When the Fordyce bank blew up on leverage, it took down the Ayr Bank as well. Fordyce himself fled to France. It later emerged that he had been temporarily covering losses with inflows from customer funds.
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A credit crunch developed in the following weeks, hitting London, Edinburgh and Amsterdam, bringing down dozens of financial institutions. Credit conditions froze up. As for the Ayr Bank, its liquidation ended up taking decades, bringing down some of the largest landowning families in Scotland. A material fraction of Scottish lands was sold off to make depositors whole.
You might think that, post crisis, Scotland would have reconsidered its laissez-faire banking system. Quite the contrary. The Ayr Bank is remembered as the major failure of the Scottish free banking era, which lasted from 1714 to 1844 and was a model of stability – all without any central administration. Other Scottish banks did fairly well throughout the crisis, as they were able to redeem Ayr banknotes for underlying reserves. And the lessons of the Ayr collapse – chronicled by none other than Adam Smith at the time – were successfully internalized by the market.
Today, bitcoiners are gleeful about the collapse of credit in the crypto industry. As I write, a few high-profile bitcoiners are gathered in a Twitter space entitled “RIP Celsius. Long Live Bitcoin.” To be clear, I’ve never been a fan of Celsius Network, and I have long been skeptical of its approach. But the failure of that institution and many of its peers, alongside a new spate consolidation in the lending sector, doesn't make crypto credit obsolete. It simply ensures the sector will reemerge invigorated, reformed and more prudently managed.
Bitcoiners attacking lending institutions are undermining their own interests. Many adherents to the Bitcoin maximalist doctrine maintain a curious disdain for credit. They often follow a Rothbardian ideal, believing fractional reserve banking to be “fraud,” even though the idealized “full reserve banking” generally never emerges in free market conditions.
During Scottish “free banking,” a fully laissez-faire, markets-based system, reserve ratios were commonly 2-5%, and the system worked swimmingly.
“Full reserve” banks wouldn't be able to extend credit or transform maturity – they can scarcely be described as “banks” at all. A world with no credit is a dismal one. Credit – responsibly extended – is the cornerstone of civilization. It unleashes savings and puts the money to work in productive areas of the economy. A world without credit is a sterile, stagnant one.
In case you think I’m making this anti-credit crusade up, just read the words of self-described maximalist Stephan Livera, under the heading “what do Bitcoin maximalists actually believe?”:
In practice, most of the maximalists I know are simply not interested in nonmonetary uses and are more interested in distinguishing bitcoin from all of the “crypto” garbage out there. And at times like these, with so many crypto lenders stopping withdrawals (Celsius, Vauld, Voyager), filing for Chapter 11 bankruptcy (Voyager) or taking bailout deals (BlockFi, Voyager), there’s a strong case to say the maximalists were right.
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But were they? If their victory condition is “no credit is ever extended based on a crypto asset ever again,” they guarantee a loss. Yes, the lending industry has taken a hit, but it certainly won’t cease to exist. The desire for leverage and a lower cost of capital on one hand, and yield on the other, is inherent to free, capitalist enterprise, and that urge will never disappear. Bitcoiners who ostensibly believe in free markets should recognize that this necessarily includes the market for money, as well.
Bitcoiners embracing the Rothbardian view cannot reconcile the demonstrated history of “fractional reserve” credit extension under total free market conditions, free of state interference. Consumers throughout history have preferred banknotes to hauling specie around. Businesses and individuals have desired leverage, and banks have been happy to give it to them.
Even in the most radically unencumbered conditions, free of state influence, “full reserve” banking doesn't emerge naturally. Just look to laissez-faire banking regimes in Scotland, Switzerland, Sweden or Canada in the 18th and 19th centuries.
In defense of credit
In a 2020 defense of crypto credit creation, I wrote the following on CoinDesk:
"By no means is the state of credit in the crypto industry perfect. I expect many more failures from these depository institutions. But with each failure, depositors will gain an appreciation for the merit of diligence, and will start to scrutinize these institutions more carefully. And each failure is evidence that financial institutions can, indeed, fail, without the state stepping in. These painful lessons will force the industry to adopt best practices around transparency, depository assurances and reserve ratios. Lacking a paternalistic state to backstop credit and bail out excessive risk-taking, the industry can benefit from negative feedback."
Well, here we are. We have suffered our first true systemic credit crisis. Virtually no lender has been unaffected. We got no government-level bailouts (the “bailouts” bitcoiners derisively refer to are simply private markets distressed asset transactions – normal in any market), no state intervention, and yet the credit markets will recover from here.
The dust still hasn’t settled, but it’s clear that we already have the tools to build a more robust lending system. As it happens, bitcoin is the perfect form of collateral upon which to build banks. As a cryptographically auditable, digital bearer instrument, with cheap physical delivery, it vastly outperforms gold specie as a collateral type. The problem with gold is it’s costly to verify, meaning it ends up in walled gardens and consumers rarely want to redeem notes for specie. So the gold-based system empowered banking institutions at the expense of depositors.
An opaque market
The problem with the 1.0 version of crypto credit markets was the opacity of the system, its dependence on artificial DeFi (decentralized finance) yields (as chronicled by myself and Allen Farrington) and a general undercurrent of fraud, facilitated by the loosest financial conditions in living memory.
This can obviously be improved upon. Hybrid CeFi/DeFi credit markets are already extending credit under-collateralized in a fully transparent manner, a massive improvement compared with the default CeFi (centralized finance) model.
Both consumers and regulators alike will insist on transparency, and the emerging DeFi infrastructure is poised to give it to them. We are seeing lenders experimenting with proofs-of-reserve. This will surely be refined and extended. Underwriting standards are being tightened. And future lenders, mindful of the rapidity of the bank runs possible with crypto assets, will have to maintain more prudent liquidity and reserve ratios.
The bitcoiner “not your keys, not your coins” doctrine is also ironic in this context; if bitcoiners had spent more time building better tools to use bitcoin in a noncustodial manner, they wouldn’t have been subject to the false binary of full custodial intermediation versus full self-custody.
Intermediate models are possible: Anyone who has used blue-chip DeFi protocols knows that you can harmonize financial innovation and self-custodial key management.
Ironically, the emergence of DeFi – which caused users to pull their coins off exchanges so that they could deploy them directly on-chain – did far more for individual self-custody than the Bitcoin preachers ever did. Tens of millions of people use MetaMask, while no widely used equivalent wallet for bitcoin even exists – as there’s no DeFi applications to use it with.
Maximalists interested in a better managed credit sector won’t achieve anything by bleating to each other about the dangers of crypto lenders. If everything is a scam to them, their warnings contain no information. They cannot extinguish the demand for credit or yield – and entrepreneurs will always emerge to fill this need.
Instead, they should start their own financial institutions, using bitcoin as a neo-gold with superior collateral qualities and setting reasonable underwriting standards. It is a mistake to view bitcoin’s success as trade-off against the creation of credit. Its future depends on it.