Crypto Was Always Smoke and Mirrors
The fall of FTX shocked everyone. Except this guy.
The world of cryptocurrency is rich with eccentric characters and anonymous Twitter personalities. So perhaps it shouldn’t be a surprise that one of the early figures who called attention to the problems with Sam Bankman-Fried’s cryptocurrency exchange, FTX, is a 30-year-old Michigan psychiatrist who investigates financial crimes as a hobby.
James Block, who runs a crypto newsletter called Dirty Bubble Media, has gotten overlooked in the swift and spectacular collapse of FTX. On November 2, a report from the crypto publication Coindesk highlighted the troubled balance sheet of Bankman-Fried’s crypto-trading firm, Alameda Research. Two days later, Block’s post titled “Is Alameda Research Insolvent?” went viral, and for good reason: Block had connected the dots from Coindesk’s earlier work to suggest that both FTX and Alameda had their money tied up in their own made-up tokens—an unsustainable circular flow of cash that would eventually sink FTX. Within a week, the company filed for bankruptcy.
Currently, Bankman-Fried is under investigation from federal prosecutors who are looking into whether he engaged in illegal market-manipulation tactics. He’s also supposedly going to testify before the House Financial Services committee in the coming weeks. Ignoring the advice of his lawyers, Bankman-Fried has given a series of interviews with independent journalists as well as national media outlets. Throughout, he has continued to deny wrongdoing, maintaining instead that he was ignorant of Alameda’s market positions. “I didn’t knowingly commingle funds,” Bankman-Fried told The New York Times at a conference late last month.
Block, a vehement crypto skeptic, has spent the past 18 months doing forensic blockchain research. He uses open-source tools to follow flows of money between crypto companies, repeatedly demonstrating how shadow banks and nefarious scammers inflate the value of worthless assets in order to generate enormous wealth that exists only on paper. Earlier this week, I called him to talk about how he got sucked into the world of financial-crime investigation, why decentralized finance isn’t actually transparent (or, in many cases, even decentralized), and whether there’s any value at all in the crypto ecosystem.
Our conversation has been edited for length and clarity.
Charlie Warzel: I’m very curious about what your day job is like. My fascination is with your crypto work, obviously. But a side fascination here is that you do this in your spare time.
James Block: I’ve always just been fascinated with the weird mechanics of financial stuff and fraud—the mechanics of it and the complexity of how something so simple ends up being so bizarrely intricate. I’d heard about bitcoin, obviously, but I never really knew anything about crypto until probably June of last year. And then I found out about Tether, this company that claimed to have $69 billion under management but wouldn’t show anybody the books. And so that was just like candy to me. I couldn’t resist becoming interested in something like that.
Warzel: The world of finance has always been intimidating and impenetrable to me, but the more I learn, the more I get what you’re describing: complex, but actually very simple. And it all hinges on the vocabulary. I was reading about hedge funds recently, and it’s like, Oh, that financial instrument, they just made it up!
Block: This is a great way to talk about FTX and Alameda Research, and how they got into trouble with their stupid tokens. They created this incredibly convoluted mechanism out of thin air. A token is just code they created that has no value, but then you can make it very visible and pump it up to make it valuable. But it’s nothing. It’s smoke and mirrors. There’s nothing really complicated there, but it looks complicated if you don’t understand what they’re doing.
Crypto hides behind all this complexity, and people hear words like blockchain and get confused. You hear about decentralized networks and mining, and it sounds complicated. But you get right down to it, and it’s just a ledger. It’s just like somebody writing down numbers in a book, and it’s page after page of numbers. That’s all it is.
Warzel: So what made you start poking into FTX? From your newsletter, it seems you were looking at the collapse of Celsius—a large crypto lender that promised investors large yields but ultimately filed for bankruptcy this past summer—and saw a lot of links with FTX. Is that what raised your hackles?
Block: I’ve always been crypto skeptical, but like everyone else, I believed the stories that SBF was the smart one in the ecosystem who was making the money. I never thought he was a genius, but I didn’t think he was as insolvent as he was. Even after I wrote the article, I thought I’d be proven right about FTX maybe a few months later. I didn’t think it would be three or four days later. That was incredible. I was shocked to find out just how big the hole in FTX’s balance sheet seemed to be. I suspected for a long time that FTX and Alameda were almost certainly gambling with their customers’ money. It’s just common sense based on the fact that the companies were so closely related and on some of the things I had seen on the blockchain that I didn’t really know how to interpret.
Warzel: What were those things on the blockchain you weren’t initially able to interpret?
Block: It’s hard to attribute ownership of certain addresses on the blockchain. You can follow the money perfectly—every single transaction is legible, and you can track the money wherever it goes. But it’s hard to know who owns things sometimes. When it came down to Alameda, I had a few starting points, and I could see funds coming out of FTX and going into Alameda in a way that was odd. And you think that maybe there’s something weird here about how they’re treating customers’ money.
Honestly, though, this is true for most crypto. There’s rarely separation between a company’s ownership of assets and an individual’s holdings. So it never would have shocked me to know that SBF was commingling assets between these firms. And I had evidence to think that that was the case. But I didn’t have enough to write about it, you know?
Warzel: I want to go back to your November 4 newsletter, which may have helped accelerate FTX’s unraveling. Coindesk’s story showed that Alameda’s largest asset was FTX’s token, FTT, which of course was created by FTX, SBF’s other company. And what you did was further that reporting by following the money. As you put it, SBF was “printing billions of dollars out of thin air against which he was able to borrow massive sums from unknown counterparties.” You produced a rather alarming chart showing that FTT tokens were actually just flowing in a circle. When you saw that, was it an “oh shit” surprise moment?
Block: Not really. I knew things were very bad as soon as I saw that the distribution of FTT was almost entirely in Alameda’s own wallets. And I knew it was bad because this is what Celsius was doing—it's a big, stupid circle. And that’s actually true for most of these tokens. And a lot of this is what these market makers do—they “provide liquidity,” but in practice, it’s just wash trading. But here’s the hard part: You can’t prove it’s wash trading without the exchange’s internal records. So I’m stuck just showing that, well, all these people that are supposedly buying this thing just end up sending it right back to the exchange. So what’s actually going on?
Warzel: There’s this idea that crypto is supposed to be decentralized and deeply transparent, that it’s supposed to be so easy to see where all the money is going at all times. And some of your work speaks to that promise. But it also strikes me that these centralized entities like Alameda or FTX play in the crypto world, and yet their balance sheets are not transparent. FTX is not a decentralized entity.
Block: There’s always stuff going on the blockchain, but these companies also have agreements off of the blockchain, right? Everything they have inside these exchanges is not on the blockchain. It’s using regular old database technology, and it’s not traceable at all. So yeah, a lot of the most important economic activity in crypto has nothing to do with blockchain at all. Huge percentages of people who do this kind of retail crypto trading, they don’t even know how to take what they bought off the exchange and put it in their own wallet.
Warzel: Post-FTX, I’ve heard a lot of chatter from crypto true believers about what needs to happen to the ecosystem. But what’s always struck me as a foundational problem in this space is that decentralized finance seems to have no real utility behind it. So much of what is created is just financial instruments and speculative assets. Can you speak to that part a bit?
Block: The AMC-meme-stock thing is a good example of how this can happen. People buy the stock of a semi-worthless company because they have this idea about short squeezing, or whatever. They are not financial experts and have a loose or maybe even wrong understanding of how finance works, and want to try to move the market. Crypto takes this abstraction a step further, because there’s nothing linked to it at all. There’s no economic activity in this space. There’s nothing produced by these companies. In fact, it’s a negative-sum game because of the cost of running the blockchains alone—the computational cost is tremendous. The amount of time and money people put into just running these things is tremendous. And they produce nothing of value. There’s a reason these massive companies aren’t all using blockchain for their processes: It is incredibly inefficient. And realistically, who actually wants their financial information public and visible to everybody?
The vast majority of people who got involved in this have no interest related to the technology or in the political or ideological aspects of crypto. They just see an opportunity to get rich. And a lot of those people end up absorbing and parroting some of the crypto ideals back to you, but they don’t really care to understand what’s going on. It’s just their excuse for what they’ve already done, which is gamble on something they thought was going to make them wealthy.
Warzel: Do you think most entities in the crypto space are insolvent and know it, and are just pretending right now, post-FTX?
Block: Absolutely. That’s because of what I said earlier about crypto. There’s no value created by any of these companies. It’s all just moving money from Person A to Person B. And look at the economic conditions. You have interest rates rising; people and companies are being squeezed economically and not willing to gamble. The fact is that there are fewer suckers aping into this system, and Ponzi schemes rely on new money to survive. I think most crypto companies are, like FTX, just borrowing from customer deposits to keep things afloat. And even the companies that aren’t doing that—I think Coinbase, for example, isn’t doing anything illicit, but their business model is based on this ecosystem where new money comes in. And that’s stopping.
Warzel: By that logic then, what is the future for crypto? Do you see this ecosystem existing in a few years?
Block: I mean, Beanie Babies still exist. Pogs still exist. Will bitcoin still exist? I think it’ll be like owning a ham radio, with hobbyists doing their niche thing together. I mean, who knows. But you know if they were to really regulate the industry, it couldn’t work the way it does. It would look unrecognizable.
One thing that is interesting is the psychology of all this. I’ve shared a lot of really damning things over the past year with people online—stuff that, if you were to hear about it, you would think any rational person would think, What am I doing with my money? I need to get it out as quickly as possible. And there were some people who reacted that way. But for every one person who listened, there were at least 10 who didn’t. And it’s just been fascinating to see. But this was almost more fun for me when I was on the losing side—when crypto was booming, and before it was obvious to everybody that this was all a scam. Back then, it was just a minority of us saying, “None of this makes any damn sense, guys.” That was fun. Now it’s kind of sad watching the consequences play out, especially because the people who get hurt the most are the people at the bottom of the food chain.