Where Are We? Part II: The Cost of Being Right

What's happening in crypto is nothing new—it's a tale as old as 1848.

I.

Every word they spoke seemed to elicit some new dollar. It was a financial baptism, praise the cash gods, a vision of a new economic order. And so, wallets agape, the investors chattered about The Technology.

A new network that would allow anyone to coordinate and transact around the globe. Yes, yes, fast transactions between any two traders would be the immediate application of this technology, one investor intoned with a recondite raise of the eyebrow. But think about it instead as a protocol for others to build their own applications on top. There would be businesses to support this network, yes, and there would be businesses that would grow thanks to this network, but most importantly, there would be entirely new businesses enabled by this network that couldn’t exist otherwise. You see, my fine friends, letting people share assets beyond their usual jurisdictions would also enable new forms of coordination and new primitives for goods. This—this was the power of this new network for human coordination.

And oh, the investor smiled smugly, there’s just one point I almost forgot. This system would standardize the transfer of financial assets across the world, which meant that it would also make them more legible, trackable, transparent. It was a revolution in data and accounting too! Mind you, we’d have to be a little patient there, no trouble really, gentlemen, since those accounting practices naturally hadn’t become normalized yet, so the actual financial data about the success of this system was, as is the custom, opaque.

Unfortunately, the investor neglected to mention one other point: the accounting data was also wrong.

You see, it turned out that the top figure in the industry, a math whiz of one of the country’s finest bloodlines, well-respected by the gentry for mentally tracking the vast sums of capital he had accumulated through various hand-wavey ventures, was manipulating accounts to pay out money he didn’t have while embezzling company funds. That ostensibly genius brain of his turned out to be a double asset, or rather, a double liability: it won the confidence of investors, just as it let him conveniently neglect to write down his accounting in any verifiable way.

By now, you know the story I am telling: the story of how a revolutionary technology in financial transfers and transparency would, in its early days, exploit the lack of existing financial transparency to milk carefree investors. It is the story of overeager speculation, of capitalists making the right bet on a century-defining technology so excitedly that they would end up losing everything. It is the story of one man who destroyed the industry he represented, and the story of naysayers repeatedly claiming victory as the industry bubble would burst and burst again.

It is the story, of course, of Railway Mania.

II.

The best piece I know on the railroad bubbles of the 1840s and the crimes of “Railway King” George Hudson is Andrew Odlyzko’s essay on how the double crashes of 1848 (a general market crash) and 1849 (an ensuing crash due to widespread fraud) led to accounting revolutions. Investors lost vast sums of money due to miscalculating their returns, so a Crash of Cooked Books forced them to actually, you know, start making balance sheets and income statements for the industry on which they’d incinerated all their cash. In today’s terms, we’d say that investors traded in the hopium of youth for the cold, hard math of a mature industry.

Indeed, the story of how the early railway industry collapsed under corruption into a much-mocked bear cycle is probably the most instructive tale for how things have gone wrong in crypto today. Odlyzko summarizes contemporary reactions succinctly:

“As time went on, and shareholder anxiety mounted, blame for declining share prices tended to be assigned primarily to three factors:

– the nefarious activities of short-sellers, then called “bears”

– actual or suspected corruption by managers

– the difficulty shareholders had in paying their calls”

Plus ça change, plus c'est 1) the same trader bears facing off against 2) the same industry scammers, funded by 3) the same skittish investors who only buy into industry theses at market tops. Odlyzko, writing some time before history’s inevitable repetition, offers some helpful context as to the definition of a “bear,” and assures us that “calls” are an artifact of another time. If only. It’s 2022, and it goes without saying: bears are memes, certain managers are still corrupt, and LPs of funds are, yes, paying calls. One hopes.

But how did we get here? Odlyzko starts by adducing the usual suspects: higher costs than expected and, for that matter, lower revenue than expected, as the railroad was essentially servicing entire new industries for which demand did not yet exist. But this is only the beginning of parallels with modern times.

See, there was also the issue of the spasmodically on-again-off-again sentiments of investors who had ultimately profited from the last manic boom-and-bust cycle. As for the railway mania of the 1830s, “it was huge,” writes Odlyzko, “it was wildly speculative, it took a long time [for work] to complete, [and] it was perceived as successful for investors, in spite of all the corruption and “mystification” that it was associated with.” Investors piled in excitedly for the shot at another cycle, then piled out when they realized they were getting it. The railway titans, too, had a 2018 before a 2022. Parallels!

More significantly, there were the glad-handed ponzis that investors and pundits happily pumped until they could pump no more. In the vernacular of the 1840s, managers like Hudson were paying dividends from capital, meaning that revenue (potentially including investments themselves) were used in place of non-existent profit to pay speculators. In the language of Anchor, we might say that reserves were used to pay out staking rewards, or in the language of FTX, we might say that (unwitting) lenders’ money was used to pay out loans. The logic of railway managers of the 1840 was no different than that of crypto celebs today: the ponzi was excusable, Hudson claimed, because it was only intended to be temporary in order to bootstrap real profit.

And finally, finally, there was the problem of accounting itself: there was no great way to audit the numbers, which were often skewed by industry critics. The railway would birth an accounting revolution, not only because it standardized business operations, and not only because it was so transformative a technology as to explode business assumptions of the time, but because unauditable accounting made the whole thing fail first. Parallels! It goes without saying: the FTX debacle never would have happened were FTX on-chain, where every 17 year old etherscan sleuth could diligence their operations. But of course FTX wasn’t on-chain, any more than railways of the 1840s published clear records, because it was an early mover of an industry that would change accounting in ways it hadn’t yet adopted itself.

So to recap:

1) an industry servicing ample transaction space for whole new industries that didn’t yet exist — the revolutionary potential of its long-term supply on a protocol level undermining its short-term demand on an app level

2) investors trained by previous cycles to get extra greedy when prices went up and extra fearful when they crashed down

3) paying dividends from reserves

4) unverifiable accounting

And the conclusion is clear: we in crypto are surely in 1848, right? And a bumpy ride aside, this is ultimately a good thing given that the railway succeeded and the investors were right, right?

Right?

III.

The easiest conclusion of the railway crash of the 1840s would simply be that investors were right in their bet, slightly overindexed on their conviction, and terribly wrong on their timing: they were just too early. But there’s a more insidious lesson I want to take from that debacle.

Investors were so right that they made themselves wrong. They bet on the right industry so forcefully that they destroyed it for years to come.

This is, in some ways, a regurgitation of Carlota Perez’s argument in Technological Revolutions and Financial Capital that bubbles aren’t a product of investors betting on wrong industries, but rather betting on the right industries in such volume and mass that valuations soar past the point of attainable returns. Investors find themselves with huge sums of money and no profitable place to deploy it—but given their confident track record of returns far past the point of reason, they continue to deploy anyway. By that point, writes Perez, “the amount of money available to financial capital has grown larger than the set it recognizes as good opportunities. Since it has come to consider normal the huge gains from the successful new industries, it expects to get them from each and every investment and will not be satisfied with less.” It’s one thing to expect a young industry to return $10M of value in a few years, and another to expect it to return $10B.

The corollary to Perez’s argument is that investors ultimately destroy the industries they love. The result of deploying more money than can be returned is not simply a paper loss—it’s the complete destruction of confidence in the industry as a whole as funds catastrophically collapse. Crashes force the financiers to recognize not only that they have made bad decisions from addiction, but that they are addicts in the first place, now facing the low lows of desperate alienation after high highs of overinflated expectations. By the time that math has been discarded for the next fix of impossibly high returns at a bubble’s end, financiers have been trained to operate emotionally—and that tendency does not change in a crash, though it does change direction. Their money gone, investors pull out desperately from the theses that have betrayed them. It is accepted that their investments were folly and so, the industry must be folly too. And that industry is left for dead.

In simple terms, successful investors raise so much money to deploy into nascent industries that there simply is no way to make it back. They best with such conviction on a winning industry that they turn it into a losing one.

Well, that’s my own theory of Perez’s theory anyway, or an attempt to make sense of the nonsense normalized today by the over-optimism of number-allergic lenders on one side and over-pessimism of the crypto investors who daily tell me that they’re not sure crypto verticals are investable categories right now, given how much money they lost in the bull. As Warren Buffet famously said: “Be a cash-gobbling Daddy when others are greedy, and be fucking terrified as shit when others are fearful.”

It’s important to note that for Perez, technological bubbles do usually have one back-stabbing saving grace: a second bubble a few years later, this one in financial credit products that were conceived to consume the excess capital from bubble #1. The first bubble pulls in speculators with technological opportunity; the second pushes advanced lending products that were developed out of the first. The railway busts of 1848 (tech) and 1849 (accounting) are one example; 2000 and 2008 is another; and in crypto, this will likely be the story of 2018 and 2022. What is CeFi if not an attempt to rectify the failures of markets a few years ago by somehow making them so, so much worse?

Which is another way of saying: what we are witnessing in crypto is industry suicide, not only by the hands of scamming lenders operating out of hastily-labeled google sheets, but by investors who loved this technology for all the right reasons that they couldn’t help but smother it to death. We’ll see how many survive; we’ll see how many post any kind of returns. At the same time, if you take the long-view, we’re fine. Tulips are anomalous; most bubbles happen because a technology is genuinely revolutionary enough to incite mass fervor, and ultimately that technology wins out. There are few industries with crypto’s phoenix-like ability to continually immolate itself and rise from its own ashes.

But in the short term, things are bad—real bad. Writing on Perez’s double bubble thesis a year and a half ago, Annika Lewis and I wondered how low low low things could get:

“But what happens in a time where a transformative technology like cryptocurrency is also a transformative financial technology that can continue funding its own technological growth through loans in a long, virtuous cycle? We might end up with a “mother of all bubbles” scenario that could threaten the traditional world of finance as well if it became dependent on these new technologies for its own financial success.”

You probably figured this out from my embittered tone: I didn’t listen to what I wrote. I rarely do.

IV.

Let’s end with the caveats. Unlike railways, crypto doesn’t require vast expenses of physical resources—part of crypto’s promise is that it’s fairly cheap, not only because tech is generally cheap, but because permissionlessly building on top of others’ smart contracts effectively replaces the upfront costs of licensing or subscriptions with the future royalties from revenue. Also unlike railways, crypto has a whole other arm that is genuinely transparent, known as actual crypto, aka DeFi’s on-chain transactions; crypto’s seppuku as an industry is strangely bullish for crypto as a technology. And finally, unlike railways, crypto is a 21st century technology in a time of massive technological acceleration. Industries come to life, flourish, and die in the matter of months, not years.

So to watch an industry destroy itself is also to watch it create opportunity for new entrants. That’s just another way of articulating what should be obvious: the worse things get at the center, the better the opportunity for those on the sides. We in crypto are very much in the right industry at the wrong time. But the wrong time is often the best time for deploying capital.

And there’s another reason to think that too. Take the state of crypto as a technology today, and it probably seems pretty bad. DeFi is food fights, NFTs are cringe, DAOs are events agencies, self-custody is hackable, bridges are hacked, governance is centralized, and wallets charge you in tokens you don’t even have to do anything on-chain: it’s like we recreated companies as 7th grade clubs and though we’d succeed by invoicing people tens of thousands of dollars to get a sticker showing they joined.

And yet, whether or not investors care, we have solutions to all those problems. Technologically, the past year was probably the greatest in crypto history, with the rise of gasless relayers, cheap L2s, zk-IBC, threshold cryptography, private blockchains, MPC wallets, scalable storage, data backpacks, modular stacks, community-led governance, and restaking protocols, just to start. Whether they can keep getting funding after raising at untenable valuations remains to be seen.

But if there is one lesson of railway mania, it’s that when you kill a thing you love, you don’t really kill it at all. You die as an investor for your mistakes, but the technology does what it’s intended to—it gives no shit about you. It moves on, and eventually, it wins.

For Annika, with whom I wrote Part I of “Where Are We?” 18 long months ago, as we descended into this inescapable industry. I’d have it no other way.

— David Phelps
Nov 22, 2022