This is Bloomberg Crypto, a daily Bloomberg I Heard podcast, and I'm Stacy Marie Ishmael, Managing editor of Crypto for Bloomberg News. Let me cut to the chase. Matt Levine, my colleague on the Bloomberg Opinion side of the house, is perhaps the greatest finance blogger ever to do it, and in what is both a flex and a service, He's just written tens of thousands of words on the subject of crypto for a special issue of Bloomberg Business Week.
Matt's gone deep into the blockchain to break down its origins, it's possible, futures, and the current state of a technology that's showing up everywhere in industries ranging from finance to shipping too, of course video games. And we're going to be bringing his exploration to you in audio form thanks to the talents of Bloomberg editor and professional voice actor Mark Ledoff. You'll get weekly chapters of the special Crypto
issue of Bloomberg Business Week. Welcome to the fifth chapter of the special audio edition of the Bloomberg Business Week Crypto issue, written by Matt Levine and narrated by Mark Ledoff. Mr Chapter needs to catch up you can find previous episodes right here in the Bloomberg Crypto Podcast feed Part three. The crypto financial system. Let's step back a bit and abstract from what we've discussed so far. Crypto is one a set of tokens which are worth fluctuating amounts of money.
We can say that these tokens are financial assets, like stocks and bonds. Two. A novel set of way is to create new tokens and distribute them and try to make them worth money. Three a novel way of holding financial assets. Instead of the databases that people use to hold stocks and bonds, you can own your own crypto on the blockchain. Four A novel way to write contracts and computer programs computer programs that are contracts and contracts
that are computer programs. If you read only that description, you might object, Yes, fine, but what is crypto for? What do these tokens do? Why are they worth money? Nothing in that description answers those objections. I suppose the last one does in a sense. Crypto tokens are for building smart contracts, for trading crypto tokens. But it's not a very good answer because it's entirely self referential. Yes, fine, but why are you trading the tokens in the first place,
and you might have another complaint. Classically, a financial asset means a contractual claim on the cash flows of some person or entity. A share of stock represents a claim on the profits of a company. A bond represents a claim on repayment from a company or government, etcetera. My financial asset represents a liability or equity issuance of somebody else. Each financial asset has both an owner and an obliger. Some crypto, I would argue, looks a lot like that.
It's an equity claim on the value of some cryptoe business. But a lot of crypto is consciously not like that. Bitcoin is digital gold. It's specifically not a financial asset. Owning a bitcoin doesn't represent a claim on anyone else. A bitcoin exists as an independent thing that you can own, not a contractual relationship between parties, like stock or a bond.
In the text, I use financial asset in the extremely loose sense of like a thing with a fluctuating price that you can see on your computer screen, and that hedge funds can trade. But cryptocurrencies aren't technically financial assets, or not always anyway, But for now I want to set such objections to the side. If you're a certain sort of financial person, a financial engineer, an arbitragere, a market structure enthusiast, a builder of high frequency trading systems,
this abstract set of facts is incredibly, incredibly beautiful. You wake up one day and there's just a whole other financial system. It's full of smart people building interesting things, and it's full of idiots making terrible mistakes. People have built brilliant new ways to make financial bets that you can use, and they've built insane new ways to make financial bets that you can exploit. How can you not
want to join in? It's so interesting, so intellectually appealing, such a blank canvas for all of your aesthetic views about how markets should work. Also, so many idiots are getting rich. Why shouldn't you? There are other appealing properties when you compare this system to traditional finance. The cryptosystem is philosophically one of permissionless innovation. The workings of the
major blockchains are public and open source. If you want to build a derivatives exchange, or margin lending protocol or whatever in ethereum, you just do it. You don't need to set up a meeting with vitallic Bouteran to get his approval. You don't need to negotiate access and fees with the Ethereum Corp. There is no Ethereum Corp. Anyone can try anything and see if it works. If you're a smart young person coming from traditional finance, this feels liberating.
If you're used to spending months negotiating credit agreements with prime brokers and setting up direct access to trade on a stock exchange, the idea that you can just do stuff in crypto with no preliminaries is amazing. Obviously, it's a bit alarming as well. Some of those long, slow processes in traditional finance are there to prevent money laundering or fraud or ill considered risk taking, but empirically a lot of them aren't really preventing any of those things,
and aren't doing so in an optimal way. A lot of them are just how it's always been done. Nothing in crypto is how it's always been done. It's all too new, and so people invented a financial system for crypto. It runs alongside the traditional financial system, though they touch at many points. In some ways, it looks a lot like a copy of the traditional financial system. In other ways, it looks totally different. In some ways, it's a streamlined
and modernized and innovative evolution of the traditional system. In other ways, it's a chaotic and stupid devolution of the traditional system, a version of traditional finance traad FI, as crypto people call it, that unlearned important historic lessons about fraud and leverage and risk and regulation. It's so fun. Let's talk about it. A your keys, your coins, your
hard drive in a garbage one holding crypto. Maybe the first thing to say about the crypto financial system is that the traditional financial system is deeply intermediated, and the crypto system is not. If you have money, your bank tracks your money for you. If you have stock, your broker tracks your stock for you, et cetera. One dumb, simple thing that this means, if you have money in the bank, your bank has to give it to you.
If you forget the pin code for your A T M card, or if you forget the password for your online banking, you'll have a hard time taking out money, and that will be inconvenient for you. But the bank owes you the money. They can't just be like, ah ha, got you the money. Is ours. Now there's some process by which you can go into the bank and prove that you are who you say you are, and they're like, fine, will reset your password. It's test one, two, three, four,
don't forget this time. Crypto doesn't necessarily work like that. Owning bitcoin means one having a public bitcoin address with some bitcoin in it, and to possessing the private key to that address. If you have the public address private key pair, then you own the bitcoin. You can transfer them to someone else on the blockchain. If you don't have that pair, then you can't. If you lose your private key or lose track of your public address, there's no one to recover your password for you or give
you back your bitcoin. They're just gone. There are ways to, you know, not lose your keys. Mainly, people use software wallets, which generate and keep track of their addresses and private keys and allow them to sign transactions and send and receive crypto online. The wallets maybe desktop or phone apps, or extensions on a browser. Most modern wallets require you to keep track not of private keys, but rather a seed phase of typically twelve random looking words maybe army,
truth speak, average and so on. The phrase can be used as a seed to generate lots of public private key pairs, so the wallet can create lots of different addresses that can all be recovered from a single seed phrase. People often speak of wallets holding crypto, but really what they have are these keys for various addresses. The crypto is only ever on the blockchain. Then you write the seed phrase down on a piece of paper, which is
easier to write than a long random number. But this is a developing technology, and there's a long history of people losing forgetting or throwing away their private keys or seed phrases. A guy in Wales named James Howell's periodically pops up in the news because he threw away a hard drive with the private key for eight thousand bitcoin. He's pretty sure he knows the garbage dump that has his hard drive, and for years he's been waging a campaign to dig up the dump and sift through the garbage.
If he finds the hard drive, and if it still works, then he'll have bitcoin worth about a hundred and fifty million dollars which he can use to pay all the garbage diggers. In one sense, it would be much much better to have a financial system in which the bank could reset his password and give him back the eight thousand bitcoin instead of digging up a garbage dump. In another sense, this is an extremely funny financial system, and
there's a charm to that two not holding crypto. If you're a portfolio manager at an institutional investor and you want to buy a bitcoin, and you go to your compliance and operations people and say, I want to buy a bitcoin, and I will write our private keys down on a post it that I will keep next to my computer, they will say no. If you propose better security measures, they might still say no, this stuff is
too new, too scary. If you say, Mega Bank Custody Services will hold our bitcoin for us, and we'll just have a book entry on their ledger saying we have bitcoin, then compliance might be a bit more comfortable. But that requires a bank to offer that service. But what if you go to your compliance and say, I'm just going to enter into a bet with a hedge fund on the price of bitcoin. For every dollar the bitcoin goes up,
the hedge fund will pay us five dollars. For every dollar that it goes down, we'll pay them five dollars. Then you don't have to own crypto at all all you have is an over the counter derivative with a hedge fund. Compliance knows what that is. That's an understandable thing. There are no weird custody issues there because there's nothing to keep custody of. There are no weird coins to worry about, just a contract with a hedge fund to pay you money. You can write contracts on the price
of corn, on interest rates, and on hurricane damage. So why not bitcoin. You do due diligence on the hedge fund, You get comfortable with the credit and collateral terms, and then you sign the contract and then economically you own some bitcoin. Your investment is up when bitcoin goes up and down when bitcoin goes down, without the worries of really owning bitcoin, no keys to lose. And so in
traditional finance there's a big business offering those instruments. CME Group Inc. Offers Bitcoin futures, which are basically the bet that I outlined above. You pay me five dollars for every dollar the bitcoin goes up, and I pay you five dollars for every dollar it goes down. It's a trusted, centralized, traditional finance way to bet on the price movements of bitcoin. Still, not everyone can buy futures, which require a lot of
money and aren't offered by some retail brokerages. In the US financial system, pretty much the easiest thing to invest in is stocks, so wrapping bitcoin in a stock would increase its appeal. The easiest way to do this would be a cash bitcoin exchange traded fund, a pot of money that trades like a stock on a stock exchange
and invests the money in bitcoin. People keep trying to do this, but the US Securities and Exchange Commission remained skeptical and hasn't approved cash bitcoin ETFs, though they exist in some other countries. The US has however, approved bitcoin futures e t f s, which invest in bitcoin through futures contracts. Two layers of abstraction. A bitcoin wrapped in a futures contract, wrapped in a stock, and delivered to
your brokerage account b C five one fiat on ramps. Okay, I said, one way to own a bitcoin is to write your private key on a post it note. But where did you get that bitcoin? In the early days of bitcoin, a reasonably plausible answer would be I mind it. Every bitcoin ever created has come from mining, and early bitcoin was in part a hobbyist mining operation. In modern crypto, you're not going to get very far just by mining
crypt to on your home computer. The main way people in most of the world get into crypto is that they exchange dollars or euros, pounds, you on, etcetera. What crypto people call fiat for crypto and how they do that is a tricky question. One simple way is for you to find someone with crypto and say, hey, can I buy some of your crypto? They say sure, and you arrange a deal. In researching this article, I set up an ethereum wallet and texted a friend to ask
if he had any Ether I could buy. He replied sure, and I said send me twenty dollars worth and gave him my public address. He sent me twenty dollars of ether, and then he texted me to say done. Then mom me twenty dollars. I did, and our transaction was complete. He sent me the ether before I sent him the dollars, so he took some credit risk, and in fact I was away from my phone when he sent it, so he ended up taking my credit risk for several hours.
When I did get his text, I briefly considered that it would be very funny if as part of my research for this article, I stole twenty dollars of either from him, but that seemed mean. Just so you know, Bloomberg's Code of Journalistic Ethics forbids journalists who write about crypto, including me, from owning more than a nominal amount of crypto for research purposes. This rule itself is arguably biasing. It forbids crypto enthusiasts from writing about crypto, but never mind.
In researching this article, I bought twenty dollars of ether from a friend by Venmo and a hundred dollars of ether from coin Base. This also led to coin Base giving me like five dollars of free bitcoin as a new account bonus. In seeking permission to do this, I told my boss is that one I planned to lose all my money, but two, if I accidentally made any profit, I would donate it. I did spend like eight dollars of ether on the Matthew Levine dot et h domain.
I'm not coin to lie. This was fun to do and fun to write about. It felt sillier and more exciting than my automatic monthly Vanguard investments, but it's not a good way to run a financial system. Incidentally, the day after I did that trade, I met with the team behind a decentralized finance protocol and was like, well, how would you quickly turn dollars into ether in New York?
And they had no great answers and we're like, we're working on it, and I was like, well, I texted a friend for ether and then then mode him the money, and they were like, yeah, that's probably what we would do. In general, if you get a text asking you to send crypto to a string of letters and numbers, you should throw your phone into the ocean instead. The main way that normal people by crypto is through crypto exchanges,
specifically centralized crypto exchanges. Crypto exchanges are companies coin based. Gemini Finance, f t X, Kraken and bitfin X are some big ones that accept regular money for crypto. You wire an exchange a hundred dollars and it gives you one hundred dollars worth of bitcoin, perhaps minus a fee. In the olden days, the stereotype was that a lot of crypto exchanges were run by criminals or incompetent teenagers
or incompetent teenage criminals. The standard crypto exchange transaction was one you exchange your dollars for bitcoin to buy heroin, and then to the exchange got hacked and lost your bitcoin before you could even buy the heroin. Modern crypto exchanges are less like that. For one thing, they're more careful and technically adept, so they're less likely to lose
your bitcoin. For another thing, though they're big companies, regulators are aware of them, and they try to be good corporate citizens In their role as on ramps and off ramps between traditional currencies and crypto. They do the same sorts of anti money laundering and know your customer checks
that traditional banks and brokerages do. If you show up at coin base, a US public company, with a sack of dollar bills that you got from dealing heroin and try to convert them into bitcoin, coin Base will turn you away and probably report you to the police. The centralized exchanges are very much part of the regulated financial system these days. The days of crypto being a zone of utter lawlessness are mostly gone. This is a series
of trade offs. Roughly speaking, the crypto exchanges of the olden days let you trade dollars for bitcoin without asking any questions, but they might steal your bitcoin. When the exchanges were unregulated and crime positive, the odds of them doing crime to you or having crime done to them were pretty high. The modern crypto exchanges ask a lot of questions that make it difficult for you to move tons of money in secret, but they probably won't steal
your bitcoin. Two custodians. So you've opened an account at an exchange and sent the exchange one hundred dollars to buy one hundred dollars worth of bitcoin. What does the exchange give you for your hundred dollars? One possibility. It gives you point zero zero five to one five bitcoin. It sends you some instructions on how to set up a bitcoin wallet. It asks you for a public bitcoin address.
It converts one hundred dollars to bitcoin at the current market price, and it sends you that number of bitcoin at your public address, and then you access those bitcoin using your private key for that address. This is suboptimal for the exchange for one thing. Dollar and bitcoin transactions have different time frames and finality. If you fund your account with a bank transfer or a credit card, and then you buy one hundred dollars of bitcoin, and then
you call your bank and say I've been defrauded. I don't recognize that charge. There's a decent chance the bank will take the one hundred dollars from the exchange and give it back to you. Meanwhile, the bitcoin transfer to
your wallet is fast and irreversible. For another thing, you know, the exchange will get some customers who don't write down their wallets seed phrase, or lose it or forget it and then can't access the bitcoin, and they'll call the exchanges customer service number and say I lost the password to my bitcoin account. Can you reset it? And the exchange will say, no, it doesn't work that way. Also, we don't have a customer service number, and the customers
won't like it. I paid you one dollars for bitcoin and I don't have the bitcoin, they'll say and blame the exchange and complain to regulators and law enforcement and the press, and especially to their bank or credit card company. Now, these problems are annoying but solvable, and modern crypto exchanges do some amount of this, acquiring crypto for self custodying customers. But there's a simpler possibility that is also quite popular.
The exchange could hang onto your bitcoin for you, instead of sending you point zero zero five to one five bitcoin on the bitcoin blockchain, it could go out and buy point zero zero five to one five bitcoin and
put them into its own bitcoin wallet. Being a professional bitcoin exchange, it could put in the effort to keep these bitcoins safe and not lose the keys, And then instead of sending you point zero zero five to one five bitcoin, the exchange just keeps a database of its customers and their account balances, and your entry in the database includes your name, your driver's license number, your account number, your email address, your phone number, your password just kidding,
a hash of your password, your mother's maiden name, and your account balance, and the exchange rights point zero zero five to one five in the balance field. And then when you log into your account, it displays point zero zero five to one five bitcoin as your account balance. And you think you own point zero zero five to one five bitcoin, and you're not exactly wrong, but really what you own is a claim on the exchange for
point zero zero five to one five bitcoin. You don't own them directly, and you don't control the private key. You just have an entry on the ledger of the exchange, you know, like a bank If you have a bank account, the bank owes you money and you trust it to keep a record of that. If you have a crypto exchange account, it's the same, but the exchange owes you bitcoin. One thing this means is that if you lose your password, you can call the exchange and it can reset it
for you. The customer service can be a bit better. There are some obvious downsides. One big one it's like a bank. If you got into bitcoin because you don't trust banks and you want to be in control of your own money. It's somewhat weird philosophically to just go and trust a crypto exchange to keep your money for you. These days, the big crypto exchanges seem to be mostly law abiding, and you can get rich enough running a legitimate crypto exchange that it seems silly to steal the
money instead. But another downside is hackers. A crypto exchange has a giant pot of money, and it has to move that money around a lot to deal with customer transactions. It's an appealing target for hackers looking to steal private keys. Again, modern crypto exchanges spend a lot of money on information security, but that wasn't always the case, and there's a long history of bitcoin exchanges being hacked or quote unquote hacked.
When all the bitcoin in it exchanges while it gets stolen, it can be hard to tell sometimes whether they were stolen by outside hackers or by the exchanges ceo. Also, while I suppose an exchange is less likely to lose its private keys than the average customer is, it can happen. In The CEO of Quadriga Fintech Solutions Corps. Died in
somewhat mysterious circumstances while on vacation in India. At the time, the company's Quadriga c X was Canada's largest crypto exchange, and it was apparently run entirely off of its CEO's laptop. When he died, he took all of Quadriga's private keys with him, meaning its customers bitcoin were lost forever, or that's what it would have meant, except that before he died he also stole all the customers bitcoin, so the
wall whose keys disappeared with him were empty. Anyway, when crypto exchanges are bad, they tend to be bad in all ways at once. Three also exchanges, though centralized crypto exchanges are on ramps to crypto for people with dollars and other traditional currencies, but they're also exchanges. If you have some bitcoin in your coin based account and you'd rather have ether, you can sell your bitcoin for ether.
If you want to actively trade among cryptocurrencies to make bets on which will go up more, you can do that on an exchange. In traditional finance, there tends to be a division between exchanges and brokerages. If you want to buy stock, you open an account at a brokerage such as Charles Schwab, Fidelity or robin Hood, and you send your broker in order to buy stock. The stock exchange is the place for big brokerages and institutions to trade stock. Retail customers need an account with a broker
to access the exchange. In practice, modern US stock trading is even more intermediated than this, and your order may get sent to an electronic trading firm and not the stock exchange. There are many layers of intermediation in crypto.
That's not generally true. Big crypto exchanges such as coin base or f t X let anyone open an account and trade crypto directly on the exchange, and you wouldn't normally connect to the exchange through a broker, though traditional retail stock brokerages are increasingly getting into the business of
buying crypto for their customers. Every step that goes into making a trade happen getting your money into the account, taking your by order, matching your order with someone else's cell order, settling the trade, putting the crypto in your account. Keeping track of your account is done by the exchange. Let me spend a bit more time on one of those functions providing leverage. If bitcoin isn't exciting enough for you, you can find an exchange that will let you borrow
money to buy more of it. You put in one dollars, the exchange lends you nine dollars. You get one thousand dollars worth of bitcoin. If bitcoin goes up ten percent, you double your money. If bitcoin goes down ten percent, you lose everything. Bitcoin goes up and down by ten percent a lot, so this is an exciting way to gamble. Traditional finance also provides leverage, but it's a complex and
intermediated system involving brokers and clearing houses. Crypto exchanges are more integrated, so in many cases of crypto exchange is basically in the business of managing market risk. Say, instead of bitcoin going down ten percent, it falls, you're not only down your original one dollars, but now you owe
fifty dollars. Crypto exchanges have to decide when to make you post collateral, put up more money to ensure that you're good for your losses, and when to liquidate your position so you don't lose more than you can pay back. The crypto exchange may have customers with big leveraged bets on bitcoin rising they're long in the language of finance, and customers with big leveraged bets against bitcoin they're short.
If Bitcoin moves too far in one direction too quickly, then the long or short customers will be out of money, which means there won't be money to pay back the short or long customers. On the other side, the exchange has to think about how volatile its assets are, set leverage limits so blow ups are unlikely, and monitor leverage levels to ensure no one is in imminent danger of
blowing up. If someone is likely to blow up, the exchange has to seize their collateral and sell it ideally in an intelligent way that doesn't destabilize the market too much, and in periods of high volatility, the exchange might shut down trading rather than deal with all this. That's a lot of centralized decision making. We'll be right back with more from Bloomberg Business Week Special Crypto issue written by Matt levine a narrated by Mark Leadoff. See stable coins.
Bitcoin is good at keeping track of who has bitcoin. This is technologically interesting and also useful in so far as bitcoin are a store of wealth. And if bitcoin were the dominant currency in the world, if it were digital cash and you could use it to buy stuff, and the prices of things were set in bitcoin, then it would be even more useful. But it isn't. You use dollars or pounds or yan or euros to buy stuff, and the price of bitcoin in dollars, etcetera is very volatile.
One thing that would be cool is if crypto could keep track of who has dollars, then you could get the benefits of crypto decentralization, smart contracts skirting the law along with the benefits of dollars. Your bank account isn't incredibly volatile. You can buy a sandwich. A stable coin is a crypto token that's supposed to always be worth
one dollar or one unit of some other traditional currency. Though, whilst two dollars, if you have a stable coin, then you have one dollar on the blockchain, you hope one collateralized. The simplest sort of stable coin is what sometimes called a fully backed stable coin. Popular examples include us DC and tether. The idea here is one some reasonably trustworthy institution sets up a stable coin factory to issue stable coins on one or more popular block chains. Two you
give the issuer one dollar. Three it gives you back one stable coin. Four it puts the dollar somewhere safe. Five If you ever want your dollar back, you give the issuer one stable coin and it gives you back the dollar. Or maybe not you, but an institutional investor. This description makes a stable coin issue where an on off ramp between regular currency and crypto, which is risky
for the reasons we discussed earlier regulatory credit, etcetera. If you want to hand the issue where a stable coin and and get back a dollar, it will probably at least want to do know your customer checks to make sure it's okay to give you dollars, or the issuer might limit redemptions to some list of large institutional investors. Rather than letting just anyone show up with a stable coin.
This is probably fine. If there are enough institutions who can redeem stable coins for dollars, then they will buy stable coins for a round a dollar, and you can just sell your stable coins to them. Your stable coin lives on some blockchain and can be traded and used like any other token on that blockchain. Most of the big stable coin issuers issue on multiple blockchains. Tether lives mostly on Tron and Ethereum, USDC lives mostly on Ethereum, but is also on Salana, tron Avalanche, and to a
lesser extent, for other blockchains. If you have ten thousand dollars stable coins on the Ethereum blockchain and you want to buy some Ether, you can buy ten thousand dollars worth of Ether with your stable coins without putting more dollars in, and if you have ten thousand dollars worth of either, you can sell it for ten thousand dollars
stable coins. Having ten thousand dollars stable coins is like having ten thousand dollars, but the stable coins live on the blockchain in your crypto wallet rather than in a
bank account. This is useful if, for instance, you don't have a bank account, or if you don't live in the US and it's hard for you to set up a dollar denominated bank account, or if you plan to use the ten thousand dollars to buy more crypto later and you don't want to move it back and forth between the regular and crypto financial systems, or if you want to send the ten thousand dollars to a smart contract which can deal directly with your crypto wallet, but
which has a hard time talking to a bank. Banks are suspicious of crypto, and crypto is suspicious of banks, so it's always a bit painful to connect the cryptosystem to a bank. This smart contract will send me dollars if the Jets win this weekend. No bad, doesn't work. This smart contract will send me stable coins if the Jets win. Yes, fine. Stable coins are wrapped dollars dollars that live on the blockchain. More generally, this is useful if you think the crypto financial system is better than
the traditional one. If sending tokens over a crypto blockchain is faster and cheaper than sending dollars by interbank transfer, then stable coins are a better way to send dollars If the blockchain lets you develop interesting derivatives, contracts, and trading applications in a quick and permissionless way, and the traditional financial system doesn't, you'll want to use stable coins
instead of regular dollars. One important point about the collateralized stable coin model is that it requires you to trust the issuer. The dollar nous of the stable coin happens as it were, entirely off the blockchain. As a crypto matter, what you have is a receipt for one dollar from some institution that you trust. If that institution incenterates all
the dollars, that receipt shouldn't be worth a dollar. One of the longest running and funniest controversies in crypto is about where Tether, the biggest stable coin, keeps its money. Tether is replete with colorful characters the Mighty Ducks Guy, etcetera, and they go around boasting about how transparent they are without actually saying where the money is. They also go around promising to publish an audit, but never do it.
They probably have the money more or less, but they seem to be going out of their way to seem untrustworthy. Still people trust them. One you can collateralize other things. The collateralized stable coin model is a way to wrap non crypto assets and put them on the blockchain. You could imagine all sorts of assets getting wrapped. For instance, what if you wanted to trade stocks, but in crypto You might want to do this for reasons similar to
why you might want to have dollars. But in crypto you like the cryptosystem, the smart contracts, the permissionless innovation, the decentralized exchanges, frankly, the lack of regulation. But you also like stocks, which represent ownership and productive enterprises, and are also a very popular tool for speculation. The cryptosystem doesn't talk all that well to the stocks system. Your broker is suspicious of crypto, and crypto is suspicious of
your broker. Less and less so, but still putting the stocks on the blockchain lets you trade the things you want stocks the way you want in crypto. Conceptually, one way to do this is that some fairly trustworthy institution buys a bunch of Tesla ink stock and holds it in its vault, and then it issues wrapped Tesla tokens on some blockchain. Each w ts L a token corresponds to one share of Tesla that the institution has in its vault, and you can trade them on the blockchain
exactly as you would Ether. And in fact this exists. F t X, a leading centralized crypto exchange, offers tokenized stocks on the Salana blockchain, though not to US customers. Binance, another leading exchange, offered tokenized stocks for a while, but then stopped. If you're going to try this, you'll want to run it by your local securities regulator. It's legally sensitive to find new ways to sell people new not quite stocks, But if it works, it's interesting for a
crypto exchange. It's a way to keep your retail gamblers gambling on your platform. Someone who wants to bet on bitcoin and Ether and Tesla stock can do all of it on one crypto exchange. More broadly, though, it's a way for the crypto financial system to ingest the traditional financial system. Have a financial asset, put it in a box, and issue tokens about it. Now it's a crypto asset.
If the crypto financial system is good, if the computer programs, payment rails, and institutional structures of crypto have competitive advantage, is against the programs, rails, and structures of traditional finance. Then some people will prefer to trade their stocks or bonds or other financial assets in the cryptosystem two algorithmic. The fully backed stable coin model has problems. One is that you might not trust the issuer of a backed stable coin. Another is that you might not want to
trust any issuer. An issuer of a fully backed stable coin is by necessity using the US dollar financial system. It's keeping the backing dollars in a bank or in other traditional finance dollar instruments. It might be subject to the regulatory pressures of that system. What you want is something that's worth a dollar but exists purely on the blockchain. Can that be done one good algorithmic, sure, and with a fairly simple and traditional bit of financial engineering. It
starts with leverage, or just borrowing money. Leverage is a way to amplify the risks and returns of betting on Krypto. Instead of putting in one hundred dollars and buying one hundred dollars worth of bitcoin and making ten dollars if bitcoin goes up ten percent, I put in one hundred dollars and borrow one hundred dollars and buy two hundred dollars worth of bitcoin and make twenty dollars. If bitcoin
goes up ten percent, or I lose twenty dollars. If bitcoin goes down ten percent, or I lose everything if bitcoin goes down for me, that's a high risk, high reward proposition. But what if I borrowed the money from you? What does that proposition look like for you? Well, if bitcoin goes up ten percent, you get back one hundred dollars. I sell my bitcoin for two d twenty dollars, give
you back one hundred dollars and keep the rest. And likewise, if bitcoin goes up, you get back one hundred dollars. I sell two hundred forty, give you back a hundred, and keep a hundred forty. If bitcoin goes down, you get back a hundred dollars. I sell for one hundred and sixty, give you a hundred and keep sixty. If bitcoin goes down forty nine point five percent, you get back one hundred dollars. I sell for one one, give you back a hundred, and keep one dollar. Let's stop
there for no particular reason. At every point that I've named so far, you get back one hundred dollars. You put in one hundred dollars and you get back one hundred dollars no matter what. For me, this trade is very risky. If bitcoin fell forty nine point five percent, I lost. For you, this trade is very safe, very stable. What you have is a stable coin. You put in one hundred dollars and get back one hundred dollars. This
basic idea is called an algorithmic stable coin. You put in one hundred dollars and get back a thing that's worth one hundred dollars, with that value guaranteed by a larger amount of a volatile cryptocurrency. I've described this as just a direct loan from you to me a con tract, but ordinarily this would be done as a smart contract, a computer program on a blockchain. The Talent describes a rudimentary form of this in the original Ethereum white paper,
calling it a hedging contract. Here's a slightly different example that involves no dollars at all. Say you and I each put one thousand ether into a smart contract, and that when we do it, one thousand ether is worth one million dollars on some preset maturity date. The contract will send you one million dollars worth of either and I will get whatever either is left. If either doubled in value in that time, that means you'll get five ether worth one million dollars, and I'll get hundred either
worth three million dollars. On the other hand, if either's dollar value fell, you get all the ether in the pool, So you get your one million dollars back and I get nothing. You get back one million dollars no matter what. The smart contract though never held any dollars at all. There's no bank account, no treasury bills, no trusted central intermediary. But you have a claim with a steady value in US dollars. We have, in a way, manufactured dollars purely
out of crypto. A few points first, I'm being far too cute here in my original example. If the price of bitcoin falls by my two worth of bitcoin will be worth ninety eight dollars and I won't have enough money to pay you back. You're supposed stable coin is worth cents. Can the price of bitcoin fall by more than Oh? Yes, absolutely it did that this year. It's not easy to manufacture stable coins out of extremely unstable assets.
Your algorithmic stable coin has some risk of becoming unstable, but you can do a little better than the crude version I've proposed here. You could have margin calls, for instance, so that if bitcoin falls by more than the smart contract sells the remaining bitcoin to pay me back immediately. Actual algorithmic stable coins die. The stable coin of Maker Dow is a big one work this way. Second, I
am omitting interest. In the real world. If I'm borrowing one hundred dollars from you to buy a bitcoin, I'm not just paying you back one hundred dollars. I'm paying you back with interest add one dollars or whatever. An algorithmic stable coin, much like a dollar in a bank account, can potentially generate interest. Third, note that there are two sides to this trade. Some people want stable coins and will put money or ether, bitcoin, etcetera. Into this sort
of smart contract to get stable coins. Others want leverage and will borrow money from this sort of smart contract to take leveraged positions in risky crypto assets. There are different appetites for risk, so there's a trade to be done. Fourth, do you know what a bank is not in crypto just in the world. Here's what a bank is. Some people want to borrow money to make investments. The main investments are one starting or expanding a business and to
buying real estate. They borrow money from a bank. They get leverage. If their business does well or their houses price goes up, they pay back the money to the bank with interest. The bank has the senior claim on their business or house. If there isn't enough money for everyone, the bank gets paid first. Sometimes the bank loses money, but mostly it gets paid back on most of its loans. The bank then is just a pool of these loans, just a lot of senior claims on a lot of
businesses and houses. These loans are called the bank's assets. Then the bank itself goes and borrows money. A bank with ten billion dollars of assets ten billion dollars of mortgages and business loans might have one billion dollars of its shareholders money equity or for a bank capital, and borrow the other nine billion dollars. It borrows the nine billion dollars from its customers in the form of deposits.
A bank deposit is formally alone to the bank. If you deposit one dollars, the bank owes you that one dollars and it uses that hundred dollars to fund loans to businesses and homebuyers. Wait, though I said way way earlier that a dollar is just an entry in the bank's database. When you have a dollar, what you have is an entry on the books of the bank. That deposit is the dollar. The deposit is the dollar, and
yet it's also the debt of the bank. Your entry on the bank's database shows both that the bank owes you a dollar and is the dollar that you own. Isn't that incoherent? How can the bank owe you the dollar if you have it already right there in your account. Yes,
that's what a dollar is. A dollar is debt. The modern banking system is a machine that takes in risky assets at one end, takes senior claims on them, lending money against those assets with the right to be paid back first, and repeats that move a few times, taking an issuing senior claims on the senior claims. In practice,
this can be repeated many times. Banks would sometimes buy senior tranches of collateralized debt obligations made up of senior tranches of mortgage backed securities made up of senior loans on houses. At the other end of all this, it spits out dollars a dollar is distilled from risky assets. The stable coin thing is nothing new. It's just banking, but banking in a particularly clear way and in a largely unregulated way at the moment, and without deposit insurance
purified in smart contracts on the blockchain. Coming up next, you'll hear more from mt Levine's special Crypto issue of Bloomberg Business Week, narrated by Mark Leadoff. Two bad algorithmic To summarize the previous section, if you have a large quantity of risky tokens, you can, with a little financial engineering, issue a smaller quantity of claims on those tokens and
call them stable coins. But recall also one of the simplest lessons of bitcoin, which is that you can make up an arbitrary token that trades electronically and people might pay you money for it worth a shot. No, these two insides, you can make up a token and it will be worth money, and you can use claims on risky tokens to make a stable coin can be combined in a natural way to create a disaster. Here's the disaster. One.
I make up a cryptocurrency, call it share coin. I listed on exchanges and try to sell it to people for some money, maybe bitcoin or ether, or dollars or Korean one. It doesn't matter. Two. I make up another cryptocurrency, call it dollar coin. I set up a smart contract saying that one dollar coin can always be exchanged for one dollars worth of share coin. I can do this because I just made up share coin, and the smart
contract can issue any old amount of it. If share coin trades at twenty dollars, the smart contract will give you point oh five share coins per dollar coin. If it trades at point oh one dollar, the smart contract will give you one thousand share coins. It doesn't care. It can make all the share coins it wants. Three. Conversely, if you want dollar coins, you buy one dollars worth of share coins and deliver them to the smart contract
to get back a dollar coin. Four. As long as there's some price for share coin, the smart contract can issue a dollar's worth of share coins for any dollar coin that someone brings to exchange. Five. See a dollar coin should always be worth a dollar, I say, through the power of algorithms. The flaw in this logic is in step four. There's absolutely no reason for share coin to be worth anything. At all. I just made it up, and so no reason for a dollar coin to be
worth a dollar. But of course everything in crypto was made up by somebody in the recent past, so this objection is not as compelling as you might think. People might believe in this story, or just in the general vibe of share coin and dollar coin, they might buy dollar coin and treated as worth a dollar, and buy share coin and treated as a valuable component of a
thriving ecosystem. At some point, the process reverses. People start to want dollars rather than dollar coins, so some of them sell dollar coins for dollars on the open market. This pushes the price of dollar coins slightly below one dollar, perhaps to other people get nervous, so they go to the smart contract, which is supposed to keep the price of a dollar coin at one dollar, and trade dollar
coins in for one dollars worth of share coins. They sell those share coins, which pushes down the price of share coin, which makes more people nervous. They trade even more dollar coins for share coins and sell those. This pushes the price of share cooin lower, which creates more nervousness, which leads to more redemptions at lower share coin prices and even more share coin supply flooding the market. This
is a well known phenomenon in traditional finance. It happens when companies issue debt and commit to paying it back with stock, and it has the technical name death spiral.
It's as bad as it sounds. A couple of algorithmic stable coins have death spiraled, the most famous one being Tara u s D. Tara was a blockchain ecosystem with a native currency like our share coin, called Luna, and a stable coin called Tara us D. Billions of dollars of Tara USD were issued, backed by algorithmic conversion into one dollar's worth of Luna. Terra USD was popular because stable coins are popular, and also to be fair because
you could get interest rates on terra USD. The total amount of Terra usd reached eighteen point five billion dollars, the market capitalization of Luna rose above forty billion dollars. The system all worked, and then it didn't. A quick death spiral hit in May and tara unraveled completely. By the end of the month, terra USD was trading below two cents. Zillions of Luna had been issued and were trading at essentially zero and the whole Terra blockchain had
burned to the ground. Terra's founder Do Kwan Colorful Character, was tweeting in September that he wasn't on the run from South Korean authorities. Those authorities responded that he was obviously on the rock. Thank you, Matt Levine and thank you Mark Liedoff. As a reminder, if you're looking for these episodes in the crypt So feed, will be publishing them every Sunday through December. If you'd like to read this issue in print form, you can head on over
to Bloomberg dot com slash the Crypto story. This is Bloomberg Crypto, a daily podcast from Bloomberg and I Heart Radio. For more shows from I Heart Radio, visit the I Heart Radio app, Apple Podcasts, or wherever you get your podcasts. Send us your comments, questions, or suggestions for the show to Crypto at Bloomberg dot net or find us on Twitter. We're at Crypto. The supervising producer of Bloomberg Crypto is Vicky Vergolina. Our senior producer is Janet Babin. Our producers
are Mohammed Faruke and Sharon Barriro. Our associate producers are Ty Butler and Moses on them. Desta wonder At is our engineer. Original music by Leo Sidrin, I'm Stacy, Marie schmal We'll be back tomorrow. And the ald A pass, the shot, and a pensant and the b ever