The Internet’s Casino Boats

It’s impossible to understand the societal risk posed by crypto assets without understanding something about the economics of the gatekeepers of the crypto ecosystem—offshore crypto exchanges. The majority of speculators enter the crypto asset market through centralized exchanges, which at face value might look somewhat like normal brokerage accounts, but are in fact quite different in both the products they sell and the regulatory circle they fall under. When you peel beneath the surface of this industry, what you see is more like the internet’s version of offshore casino boats that offer games with loaded dice, and operate in “international waters” (via VPNs) to let customers gamble outside their jurisdiction.

Exchanges really want the public to believe they offer a valuable market making service and that they should be valued as technology companies, however the truth is far from that. Their story goes that they take customers’ funds* which can be used to make claims* on digital tokens, and those tokens can be traded and exchanged with other customers at fair* market prices with best* execution. When the customer is done gambling they can cash out their winnings into real money* and withdraw* them into a local bank account. And all of this is somewhat true, but with some very large disclaimers around every asterisk related to counterparty risk of the platform itself.

In principle there’s nothing wrong with gambling as a form of entertainment if done responsibly. When you go to Vegas or Monte Carlo everyone knows the games have fixed rules and odds that are rigged in favour of the casino, and the house is taking a rake on any action. The expected returns on paying a slot machine is obviously negative, if you play long enough you’re guaranteed to lose. So why is that different from gambling on negative-sum crypto investments where most people are guaranteed to lose money as well? The answer to that question will really depend on what the product and alleged “market” is being advertised as.

Every day on my commute home in London I see an endless barrage of crypto app advertisements on the tube, and every single one of them is characterised by naked psychological appeals to fear of missing out wrapped in the clever facade of presenting the illusion of trading normal financial instruments. It almost passes the sniff test if you don’t read the cut-off text at the bottom saying these products are unregulated and have no consumer protections. Although two financial products both have a ticker, a OHLC chart, and you should “buy low sell high”, there is a vast universe of difference between Apple stock and Shibu Inu token.

The point of the stock market is to enable price discovery and encourage capital formation. It allows investors to get global exposure in economic activity, and allows companies to raise money to fund their projects which leads to expansion of new products, services and ultimately grows the economy. The purpose of a dog meme coin is simply to make the creators of the coin rich off some nihilistic parody of markets. But apparently the “value nihilism” reading of economics is really en vogue these days and that’s what the kids want.

However the pretense that crypto exchanges are acting as fair market makers is laughable at best. It’s unclear what “fair” would even mean on an investment which has no fundamentals, no intrinsic value, whose market arises from the theory of the greater fool, and whose price action is only based purely on sentiment predictions on infinitely recursive speculation. But crypto tokens are far more insidious that just being a greater-fool-sentiment random number generator for lemmings—since there’s no regulation on book making or price formation on crypto assets the exchanges offering these tokens can play all the dirty games that have been banned in public markets since the Crash of 1929.

The core trading activity of most global crypto exchanges remains almost entirely unregulated. The scofflaw crypto exchanges fall under no regulation and simply try to push the boundaries of whatever they can get away with while playing cat and mouse games with banks and legal entities set in the Caribbean islands. The few that try to operate in United States and Europe come under a patchwork of very loose money service business licenses which don’t regulate ANY price making or trading activity. Jurisdictions like Wyoming have hilariously lax licensing requirements that can be bought for a few thousand dollars. This is vastly different from the framework that regulates market makers, brokerages and clearing houses for public equities which have far stricter consumer protections and controls on price making.

Crypto is basically an anything goes markets like we saw in the 1920s before the Securities Act of 1933 cleaned up the mess of illegal practices. Exchanges can wash trade, which means being the buyer and seller of buy sides of a trade to create the illusion of market activity. Some reports put wash trading at an unprecedented 70% of all trading volume. Exchanges can front-run their own customers by putting their own trades in before client execution and trade on their advance knowledge of their customer order flow. Exchanges can offer 100x leverage on derivatives which allows them to liquidate their customers’ funds if the price (which the exchange sets) of the underlying moves by even 1% out of range. Exchanges can arbitrarily halt trading or cancel trades if any market conditions aren’t to their liking and there’s no obligation on them to report any accurate price information or give any kind of best execution. If you work at the exchange, or are friends with someone there, you have foreknowledge about every listing and you can insider trade with no consequences. They even brag about trading against their customers openly.

And then there’s the pump and dump schemes which are rampant coordinated buying activity by insiders to synthetically manipulate the price of a token upwards while simultaneously selling it. These are the same dirty tricks played by Wolf of Wall Street. On normal assets this is illegal since it only results in wealth transfers from less sophisticated participants to market manipulators. In a recent study on crypto asset market distortions, the researchers found a truly unprecedented amount of pump and dumps occurring nearly constantly:

There is at least one pump on 133 days out of the 175 days in our sample, indicating that there is almost one pump per day on average. Such a high rate of manipulation is unprecedented in financial markets

Crypto is a cesspit of people swapping claims on non-economic nonsense in one giant orgy of internet memes and fools trying to screw each other playing mutual harm negative-sum games while chanting “we’re all going to make it”. All this while the house takes an enormous rake and changes the rules of the game to its liking whenever it likes. It’s a great racket, but like the poker idiom goes: “If after ten minutes at the table you do not know who the mark is—you are the mark.”

It’s really quite a stretch to call something this manipulated a “market” anymore. It’s probably even a stretch to call it gambling given how variably-rigged it is. This is where the moral hazard of this entire ecosystem and the false advertising of these platforms as markets comes into the realm of public policy. Is it good for society to have these smartphone casino boats running? And to put them in the hands of every school child? What public good do highly manipulated markets for speculating on dog memes and hot air serve other than separating fools from their money?

If you peel back the slick marketing and technical obscurantism of every crypto exchange you’re confronted with a simple inescapable cashflow question about their Ponzi-esque business model. Where will all the money come from to pay out all these new paper bitcoin millionaires? The answer is simple: they need it to come from you.