Why this bubble will be (slightly) different

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Steve Sokolowski
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Why this bubble will be (slightly) different

Post by Steve Sokolowski » Mon Feb 08, 2021 2:39 pm

Cryptocurrencies have been around for a decade, and everyone always predicts that "this time is different." Of course, the end result is still bubbles and crashes. There will still be a crash at the end of this bubble, too - it just won't be as bad due to the advent of lending.

Since the last bubble, a number of finance companies have sprung up, holding billions of dollars of assets. DeFi contracts on Ethereum have also ballooned. At many of these companies, you can earn 3% on bitcoins and much more on other types of coins. These companies have sucked in a huge amount of money. Note that for the purpose of this article, I'll be talking about the low interest rates they provide on coins, although the money driving this boom is coming into stablecoins, which are earning 8.6-10.5% APY.

Lenders can choose from very risky unaudited smart contracts that pay even higher interest rates, unregulated and anonymous companies like Nexo, and companies that have banking and money services business licenses like BlockFi. After performing 100 hours of research, I've referred many people to BlockFi myself, as they are the only legitimate business that has all the necessary licenses currently operating in this space, and which also provides reasonable customer service.

For borrowers at these services, one can take out a collateralized loan against cryptocurrency. Usually, the loan is paid out in dollars, and if the value of the backing coins falls, then the collateral is exchanged to dollars to cover the dollar-based loan. The companies also offer loans to large companies like Genesis Capital, a real-estate firm for large construction projects. The riskier companies, like Nexo, use DeFi contracts themselves to earn money.

Counterintuitively, I propose that this form of lending is safer than that of a traditional bank. Most banks issue loans that create money many multiples of the deposits they actually have on their books. For a traditional bank, for example, the reserve ratio is just 3%, which means that a bank run would occur if just 3.1% of the bank's depositors request a withdrawal. In the case of the private loans offered by BlockFi, the loans are called when the value of the collateral is still 1.42 times the value of the loan - a 40x difference.

For the majority of people who don't know a lot about cryptocurrency, lending is also safer than cold storage, because of how easy it is to make an irreversible mistake with wallet security. "Not your coins" only means something if you know exactly how to secure coins, and most people aren't an expert in that. Today's services are light years ahead of Mt. Gox in that regard. Remember, Mark Karpeles still stored a billion dollars of customer money in his personal bank account and everyone at the company had production access. His incompetence tarnished the reputation of today's exchanges that comply with regulations that stricter than those governing traditional banks.

Having passive interest income is great, but the biggest benefit with cryptcurrency lending is the tax advantages. There is controversy over the difference between First-In-First-Out (FIFO) reporting and Last-In-First-Out (LIFO) reporting, and which is permissible and preferable under IRS regulations. The consensus among many seems to be that FIFO is safest from a fines and penalties standpoint, but using FIFO creates a huge problem for everyone, given that as of the time of this post, every single person who ever acquired a bitcoin is in profit.

Imagine that someone pays you for a service you offer in bitcoins, and then you use those specific bitcoins to pay for another service ten seconds later. Using FIFO accounting, you would not be able to pay the second person the entire amount, because you would owe capital gains taxes on the first bitcoin you ever purchased. The IRS pretends that the first bitcoin is the one that you spent on this thing you are paying for. For someone like me, who remembers going to Wal-Mart to wire money to BitInstant to buy bitcoins in April 2013, that results in losing 24.45% of the money, even though the price of bitcoins didn't change in the few moments you held the bitcoins.

We need to reconsider, with the advent of lending, whether cryptocurrency is still best considered an "investment." It is true that this transaction raises your cost basis on your "investment," if you still call the new financial system an investment, and would cause you have to pay fewer taxes later.

But if the price of bitcoins doesn't return to the same price before you need to spend the "new bitcoins," then you've lost money, given that you can only declare $3,000 of losses per year on your taxes. Further, if you never had any intention of selling the initial "investment," then you paid taxes unnecessarily.

There's an even greater problem. Let's say that you decide that the capital gains taxes are a sunk cost that will need to be paid eventually, and you will just sell more bitcoins to pay the taxes on the first-in-first-out basis. When bitcoins had no real use, that wasn't a big problem; you didn't lose any actual after-tax dollars in the end. You might have decided to buy bitcoins one day, "cash out" in the future, and then invest your money into stocks or something else using 75% of the profits. After all, only dollars were useful for any real purchases; it's not like Tesla would ever accept bitcoins for its cars. Using Pennsylvania as an example (and Pennsylvania has the lowest income tax rate in the country), someone with so many bitcoins would owe 24.45% in taxes upon sale. Owning 75 bitcoins at the current cost basis would have been the same as owning 100 bitcoins at a cost basis of zero in that "investment" paradigm.

But now bitcoins do now have a real use - lending - and they will likely relatively soon have other uses that have yet to be invented. Stocks, a common investment, are things you buy, hold, and sell, and can't use for much else. Cryptocurrency is no longer like that - it now has the golden "use case" that people were pining for for the past decade.

Now that bitcoins have a use case, 75 bitcoins at the current cost basis is no longer the same as 100 at a cost basis of zero. If I had 75 bitcoins to deposit into BlockFi, they would give me a quarter less interest than I would earn if I deposited 100. That quarter less interest continues for the rest of my life. It could mean the difference of tens of millions of dollars over a life expectancy of 40 years for someone with that number of bitcoins should prices hit $100,000 mark. And the reason why I use such high numbers of bitcoins in my examples is because people with holdings like that are the people who are affected by capital gains taxes most and they are the people who move the market most with their sales.

The difference between 100 and 75 is 25%. The tops of cycles rarely last more than a week. Even with the higher volatility of past cycles, would you count on yourself to be able to time the top and buy back in 25% lower to end up with the same number of bitcoins? I certainly don't have that confidence. And what if Democrats raise capital gains taxes to 39.6%, as some believe is likely (I do not,) therefore raising the requirement to an impossible 44.05%? By definition, only very few people could make that kind of profit in a cycle crash, because if everyone made that much, there wouldn't be that large of a crash.

Now, consider another choice for the rich version of me. I could simply never, ever, sell any of the bitcoins, regardless of the bubble cycle's ebbs and flows, and take my interest payments in a coin I don't currently own. I decide how much I'm going to spend in a given month, take that amount in the "designated coin," and re-invest the remainder in bitcoins to earn more interest next month. I could use USDC, a stablecoin that is unlikely to change in value. I could charge everything I ever buy onto a credit card, and then exchange the designated coin immediately to pay down my card balance by that amount.

That's what the real me now plans to do. When I previously decided I would exit in the $80-90,000 range, I was not aware of these lending platforms. Given the advent of crypto "banks," I can live off the interest and my earnings from jobs or my business. If I die before the singularity or a world-ending pandemic/nanotechnology disaster/superintelligent AI, the coins can go to charity without anyone ever paying the taxes.

The advent of lending platforms has changed the game. It won't be long before Wells Fargo and Bank of America see what BlockFi and Celsius are doing and realize how much profit they are missing out on. I don't expect that we're going to see an 86% drop again, as was common during the previous two cycles. The crash will be contained because rich people and big corporations don't see a reason to pay taxes selling "property" that can be used to earn interest. In this case, the government's comical view that coins are not currency will actually reduce volatility and cause money to never return to the legacy system.
RussianNeuroMancer
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Re: Why this bubble will be (slightly) different

Post by RussianNeuroMancer » Tue Feb 09, 2021 12:45 am

Steve Sokolowski wrote:
Mon Feb 08, 2021 2:39 pm
I've referred many people to BlockFi myself, as they are the only legitimate business that has all the necessary licenses currently operating in this space, and which also provides reasonable customer service.
Got 403 Forbidden on main page of their web-site. I assume they operate only in US?
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Steve Sokolowski
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Re: Why this bubble will be (slightly) different

Post by Steve Sokolowski » Tue Feb 09, 2021 6:42 am

RussianNeuroMancer wrote:
Tue Feb 09, 2021 12:45 am
Steve Sokolowski wrote:
Mon Feb 08, 2021 2:39 pm
I've referred many people to BlockFi myself, as they are the only legitimate business that has all the necessary licenses currently operating in this space, and which also provides reasonable customer service.
Got 403 Forbidden on main page of their web-site. I assume they operate only in US?
What browser and operating system are you using? Where are you located? I haven't seen such an error, and have never had a single issue with BlockFi. Note that the "trivially provable" rule also applies to third-party services, so some sort of evidence needs to be provided within 24 hours or your account will be banned. If it is true that you always get a 403 error, this proof should be easy to post.
RussianNeuroMancer
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Joined: Mon Mar 13, 2017 10:56 am

Re: Why this bubble will be (slightly) different

Post by RussianNeuroMancer » Tue Feb 09, 2021 3:09 pm

Steve Sokolowski wrote:
Tue Feb 09, 2021 6:42 am
What browser and operating system are you using? Where are you located?
Since you asked for additional information I tried to open their web-site from several computers and a couple of locations:
Firefox 85.0.1 on Ubuntu 20.10, Netherlands - 403 in web-browser, but wget and curl get normal html.
Chromium 85.0.4183.121 on Ubuntu 20.10, Netherlands - same as above. (Yes, this one is not updated in a long time)
Firefox 85.0.1 on Ubuntu 20.04, Netherlands - same as above.
ChromeOS 89.4389.41, Netherlands - web-site works.
Microsoft Edge 88.0.705.63 on Windows 10 19042.746, Netherlands - web-site works.
Firefox 85.0.1 on Ubuntu 20.04, Russia - could blocked on ISP side with assistance of DPI:

Code: Select all

~$ nslookup blockfi.com
Server:		127.0.0.53
Address:	127.0.0.53#53

Non-authoritative answer:
*** Can't find blockfi.com: No answer

~$ nslookup blockfi.com 8.8.8.8
Server:		8.8.8.8
Address:	8.8.8.8#53

Non-authoritative answer:
Name:	blockfi.com
Address: 0.0.0.0
Steve Sokolowski wrote:
Tue Feb 09, 2021 6:42 am
If it is true that you always get a 403 error, this proof should be easy to post.
Not sure what verifiable can be provided in this particular case, as screenshots could be easily faked. So what kind of proof you would accept?
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Steve Sokolowski
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Location: State College, PA

Re: Why this bubble will be (slightly) different

Post by Steve Sokolowski » Tue Feb 09, 2021 3:23 pm

I think there's some sort of issue with your web browser. If curl gets normal HTML, then that sounds like an OS or browser issue.
ajs
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Joined: Sat Jun 16, 2018 2:43 pm

Re: Why this bubble will be (slightly) different

Post by ajs » Sun Feb 14, 2021 9:57 am

This post was very eye opening, and changed my thinking about taxes, and how to long term hodl. I agree that these services will become more common - Kraken Financial in Wyoming seems to be heading this way. After the price rises to meet this new demand, these vehicles (and the nature of the new money coming into this space) will create more (relative) stability. (Not stable mind you, just not the huge swings we are accustomed to).

Every bubble is different. But his one is feeling even more so.

I mine with Prohashing for many reasons. The fact that you provide thought leadership in the area is one of them. Thank you.
ajs
Posts: 58
Joined: Sat Jun 16, 2018 2:43 pm

Re: Why this bubble will be (slightly) different

Post by ajs » Sat Mar 06, 2021 11:23 am

An article about these new services. I think the point they miss (although they focus on the risk of an uninsured company) is the tax benefit that Steve points out in this post. If it is your intent to HODL, and you can tolerate the risk, this provide a wonderful tax benefit to the lender.

https://www.wsj.com/articles/you-can-ea ... 1614959768
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