Fraud in the blockchain space

28-11-2022

Fraud in the blockchain space

Marcus Schmalbach, RYSKEX

Marcus Schmalbach of Ryskex looks at crypto fraud and its relationship to the digital transformation process of the captive insurance industry.

Unicorns have an almost universal appeal, to almost any generation. The first time I was aware of a unicorn was through the 1982 movie “The Last Unicorn”. As a child, this was a beautiful, enchanting story.

However, today, when I talk about a unicorn, I’m talking about a startup company with a valuation of more than a billion dollars. There was a time when this was something special and almost unattainable, but nowadays in the startup world you are really impressive only if you have reached a $10 billion point, when you can call yourself a decacorn.

The reasons for this are relatively simple: the low-interest phase of recent years and the oversubscribed venture capital funds and their sometimes ludicrous investment sums all caused unicorns to sprout like springtime flowers.

However, there can be weeds as well as flowers in the world of investors as well as the world of nature. Unicorns had become as rare as McDonald’s, the next big thing seemed to be discovered every day and comparisons were drawn with digital pioneers such as Facebook, Google or Apple. Every week, relevant journals discovered the next Elon Musk, Jeff Bezos or Steve Jobs. At times, it felt as if Silicon Valley had more unicorns than Argentina had cattle.

But for whom exactly are they making the world a better place? More likely for themselves. Some founders would have been better off following Google’s code of conduct, which is “don’t be evil”.

Want an example? Sam Bankman-Fried. You might not know the name, but you’ve probably heard of his company before. He founded the crypto exchange FTX. The company was backed by world-renowned venture capital funds Sequoia, Paradigm, Tiger Global, and Softbank and was valued at $32 billion until two weeks before collapse. So not a unicorn, not a decacorn either, but a decacorn on steroids.

“This is fraud,” stated Alesia Haas, chief financial officer of Coinbase in an interview with The Wall Street Journal. The reporter asked her if this was the “Lehman moment” for the crypto industry, to which she replied in the negative. What exactly had happened, and was it really not comparable to the collapse of Lehman Brothers?

The Lehman Brothers bankruptcy is closely linked to the 2008 financial crisis—triggered by the collapse of the US housing market. For all readers who are a bit younger and are now wondering how the so-called subprime crisis can trigger a global capital market crisis, here is the solution: mortgage-backed securities (MBS).

“All crises have been triggered not by machines or technology, but by human error and greed.”

The inventor and spiritus rector of the MBS in the 1970s was Lewis Ranieri, a bond trader at Solomon Brothers. The development of this financial market product resulted in a global economic crisis that caused the bankruptcy of the investment bank Lehman Brothers in 2008 and snowballed from there. This development was attributed to the greed of individual Wall Street bankers, and there were calls for more intensive regulation of the banking system.

In the wake of that, a single person or a group of people calling themselves “Satoshi Nakamoto” had a new idea. They wrote a white paper and developed the blockchain protocol Bitcoin—unintentionally the beginning of a new bubble.

 A simple idea

The idea of a decentralised financial system was as simple as it was ingenious. Banks were to become obsolete, all power returned to the community. The beginning of a new era. For several years, little or nothing happened. The Bitcoin price in relation to fiat money was small and only the nerds of the world were fascinated by the idea.

There was no figurehead, no one to inspire people with the idea. These people slowly but surely appeared on the main stages of startup events in 2015. Charismatic visionaries, no longer with gelled hair and suspenders like the investment bankers of the 1980s, instead they were young men in hoodies and flipflops, who were educated at the top business schools in the world and marketed cryptocurrencies not as an alternative to the fiat money of central banks, but as an investment opportunity. An investment opportunity that meets the zeitgeist, cool, digital and especially associated with a high yield.

Crypto investments became the measure of all things, chief executive officers became rockstars, and hardly a day went by without an initial coin offering (ICO) being announced as the next big thing.

Venture capital firms did their due diligence only moderately—it felt as though they were throwing their lasso out at anything with a head. If one caught an old donkey, the valuation was pushed so much and the PR machine was started until every disbeliever acknowledged the donkey was in fact a unicorn, when in truth it was nothing more than a donkey with a party hat.

The greed knew no bounds; the world’s startup centres were infiltrated by the flair of Wall Street in the 1980.

However, little by little, realisation arrived. The highly pushed unicorns and decacorns could no longer live up to the expectations of the investors, or their own. Driven by desperation or the overestimation of one’s own capabilities, the number of fraud cases is increasing. FTX is the current tip of the iceberg who lent their own branch $10 billion to gamble with it in order to fulfil the high expectations—nothing else than a Ponzi Scheme.

What’s next? Analogous to the Lehman bankruptcy, FTX is certainly not an isolated case. The whole of Wall Street was affected by the subprime crisis, and indeed the banking system of the entire world. Some got off lightly, others were simply bought out. The same will happen in the crypto industry—the bubble has burst and some companies will be dragged into the abyss.

 Human errors

Some readers will now think back to the title of this article and ask themselves, what exactly does this case have to do with the digitisation of the captive insurance industry? Answer: absolutely nothing. However, the uncertainty in our industry is widely felt and the scepticism towards this—supposedly—ground-breaking technology is rather increased than decreased by such reports.

Simon Kolkmann, CTO of BlockART sums it up as follows: “It drives me crazy that people are associating this case with blockchain. It’s like blaming paper for the 2008 financial crisis because the credit default swaps contracts were printed on it.

“B3i’s bankruptcy already had a negative impact even though the use case was simply bad and in this case blaming the blockchain for human error is complete nonsense. Tokenisation of risks as well as the use of smart contracts will shape the industry, there is no doubt about that.”

In fact, such events are unfortunately associated with a negative impact on the advancement of the digital transformation of the risk and captive insurance industry. However, the future of the industry will be shaped by digital marketplaces, smart contracts, tokenisation and machine learning-based underwriting models. Quality always wins out in the end, it’s just a question of when.

In summary, all crises have been triggered not by machines or technology, but by human error and greed. It remains to be seen how many more horror stories there will be before the final market adaptation is complete.

 

Marcus Schmalbach is the chief executive of Ryskex. He can be contacted at schmalbach@ryskex.com

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