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This One Simple Trick
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Suppose that I run a cryptocurrency exchange. I start off my business with some amount of dollars. I then accept dollar deposits from my customers. Once the customers have dollars deposited with me, they might want to use those dollars to buy cryptocurrency. I could facilitate this myself or I could have some market maker do it for me. To keep things simple let’s suppose that I have a market maker.
Since all I do is custody the cryptocurrency, I have a really simple balance sheet. When people first deposit money, I have dollars on both the asset and the liability side of the balance sheet. When they buy a cryptocurrency, I replace the dollar liabilities they have with the equivalent amount of cryptocurrency at the sale price. At the same time, I use the actual cash I have on the asset side of my balance sheet to purchase this cryptocurrency. I then custody that cryptocurrency for the customer. The way that I earn income is by charging people for making these trades.
If any of my customers want to withdraw dollars, I transfer money held in my bank account to their bank account. If any of my customers want to withdraw cryptocurrency, I send them the cryptocurrency and the transaction is recorded on the blockchain. In either case, a liability and an asset of equal value and equal type are removed from my balance sheet.
If any of my customers want to deposit dollars, they transfer money from their bank to my bank. If any of my customers want to deposit cryptocurrency, they can send their cryptocurrency to me and I can hold it for them. In either case, a liability and asset of equal value and equal type is added to my balance sheet.
Since I am a custodian, it is also important that I have put up some of my own money. If for some reason, I lose access to some of the cryptocurrency, I can simply use some of the cash on the asset side of my balance sheet to buy the necessary cryptocurrency. This is a net loss on the asset side, but this loss is born by the shareholders of the exchange and not the customers.
To this point, all of this seems really simple. But now, let’s imagine that I have a friend named Sam. He has started his own cryptocurrency project. As part of this project, he mints his own crypto token. He sends me some of the supply of this token to me as a deposit in his account. This creates an entry on both sides of my balance sheet. On the asset side, I have these tokens. On the liability side, I have an entry that says I owe Sam these tokens if he ever comes to get them. So far, this is fine.
Now, unbeknownst to me, Sam has been using some decentralized finance protocol to trade his token back and forth with himself to create some volume and a price. I am aware of the volume and the price, but not that Sam is trading with himself. One day, Sam comes to me and says he needs cash immediately. He wants to sell his tokens and withdraw the cash value immediately.
Ordinarily, Sam would have to wait for me to sell the tokens for cash at the current market price. Then I could let him withdraw the cash. Nonetheless, given the urgency of the matter, I decide to go ahead and transfer the cash from my reserve account to Sam’s bank using the observed market price. After all, I know Sam. He is trustworthy. Plus, I can see the price of these tokens. Why make him wait until I sell the tokens to get the cash?
In this case, what I have done is removed my liability to Sam denominated in his token and removed some cash from my assets. Now, there is a bit of a mismatch, but it is fine. I see that his token has a market price and volume such that I know that I can sell his tokens for the equivalent amount of cash I just transferred to him.
When I try to sell his tokens, however, I find that there is no market for them. I cannot find a buyer. The volume and the price were an illusion. The token is worthless.
So what has happened here? Effectively, I have purchased Sam’s worthless token using real dollars. Thus, the liability side of my balance sheet looks the same as before I accepted Sam’s deposit. But the asset side of my balance sheet has substantially less cash, which has been replaced by a worthless token.
At this point, I can do one of two things. The first thing I can do is just pretend that the tokens Sam gave me actually have value. As I collect fees, I can accumulate cash. Eventually, with enough fees, I will replace my cash. Of course, this is a problem if people actually want their cash.
The other thing I can do is record the loss. At best, this significant loss on the asset side of my balance sheet costs me and my shareholders a lot of equity value. They will not be happy with me. At worst, this significant loss makes me insolvent and I have to shut down the exchange. Shareholders are wiped out and some of my customers lose money (or all of my customers lose some money).
After reading all of this, you might be thinking “this whole thing sounds stupid. Why would you effectively accept an asset that has zero value and simultaneously create a dollar liability of an arbitrarily high value? Of course this wouldn’t work.”
Sure. That is certainly a reasonable perspective for you to have.
Anyway, it is debt ceiling time again and that means that people are once again talking about this trillion dollar coin idea. If you are unfamiliar with this idea, it goes something like this. In order for the U.S. government to continue its spending and circumvent the debt ceiling, what it should do is use its constitutional authority to mint a platinum coin. It should then take this normal-sized platinum coin with a metallic value of about $1,000 to the Federal Reserve and deposit the coin on the condition that the Federal Reserve credit the U.S. Treasury’s deposit account with $1 trillion. The Treasury could then spend these deposits to meet its spending obligations and avoid the debt ceiling.
At least now you should be able to see why this proposal is silly.