Patricia: Crypto and Dark Magic III

Let us assume that you are Patricia, let us also assume that you did NOT steal users’ money. Let us assume that you run a sincere financial service whose only crime is that you did not register your financial services. Please do not do this, it is a grievous crime, and when you face the music, I will not be there with you. That said, what can you do if you were silly enough to lose customers’ money while running an unlicensed service in that region?

If you are in Patricia's shoes, your number one concern is to prevent a bank run or buy as much time as you can. A bank run happens when all customers want all their deposits back, all at the same time, and the bank cannot provide it. If the bank cannot raise money, it means the bank would sell all its assets to settle the debts and then become bankrupt, ultimately closing up.

The logical consequence of the news about Patricia’s hack is that everyone will try to withdraw ALL their money, triggering a run that could in fact end the crypto exchange’s survival. You would be insane not to withdraw your money if you heard that your financial service provider was hacked. Although Patricia says only BTC and Naira balances were affected, everyone would empty all their accounts with Patricia even if these accounts are not in BTC and Naira. We know this because other crypto exchange services like Celsius, Voyager, BlockFi, Genesis, Gemini Earn, and  FTX all collapsed when news of their troubles became public and customers demanded all their money all at once. If customers demand all their money all at once, and you can not provide it, you are going under.1

When a bank run happens to licensed banks, they would usually run to the Central Bank to save them. The Central Bank generally loans them money to give their customers, that way everybody gets their money back. We will explain this further later in this series when we look at licensed banks that have had troubles in Nigeria.

With entities that are not regulated banks, or, in this specific case, a crypto exchange, you cannot run to the Central Bank to loan money to give back to your customers. This makes sense seeing as you refused to come under their regulation. Yet, you must prevent a bank run. This is not financial advice, it is an educative illustration to help you understand what might be going on at Patricia.

Obviously, one of the first things you could do, and a very easy thing to do, as the management of the crypto exchange, would be to disable withdrawals. Then you can start to think of how to source cash to give your customers. Again, this is assuming you are sincere. To be clear, your sincerity does not matter much. You are a lawbreaker for providing financial services without a licence, and shutting down withdrawals only means you are potentially committing more crimes. That said, Patricia took that route and shut down withdrawals.

Then Patricia’s next step was to issue a token from thin air to replace the lost monies and assets. Let us discuss what Patricia has done with its conversion.

Again, Patricia created a token. The question is how was the token created, and how does it get its value? Patricia provides no answer at all in its initial announcement, just that 1 Patricia Token would always equal 1 dollar and that the Patricia Tokens are fully backed by the US Dollar. Let’s explain what it means to be “backed by a dollar”.

A token backed by a dollar means that for every unit of that digital token that exists, there is an actual real dollar, somewhere in a bank (or buried somewhere?), to represent it. This is important because it means that if all customers decide to exchange all tokens for real money, all at the same time, everyone gets their money. Claiming that a token is backed by a dollar means giving an assurance that a bank run cannot happen because all the tokens have a real dollar for it somewhere. The value of that token simply cannot fluctuate, so the value crashing is not a concern.

However, in reality, there are only a few tokens that even claim to be backed by dollars. Of those few that make such claims, the majority of them are accused of blatantly lying that they are backed by dollars. None have been able to convince the world that it has real dollars for its token. 

In any case, Patricia has reportedly lost $2,000,000, so what dollars could possibly back these tokens? And if there are dollars backing these tokens, why are customers forced to take their balances in tokens instead of the dollars that, you know, back them? These unanswered questions have led people to the conclusion that it is unlikely that Patricia is backed by real dollars as it claims. This is another error on Patricia’s part given that people are already skeptical about their affinity for the truth. If the Patricia Token is not backed by the dollar, what other way can it have value? There is still one way. Spoiler alert; it is dark magic.

Let us look at how coins that do not claim to be backed by the dollar get their value. To answer the question of how tokens not backed by dollars would usually get their value, here is a run-down of how crypto tokens get their value. The point of this is to see if there is a chance at value for Patricia Tokens, you know, in case it is not backed by dollars as it claims. This is where the dark magic lies.

Sam Bankman-Fried (SBF) explains this dark magic in the podcast episode I referenced earlier. In summary; there is no inherent value for tokens, but if everyone agrees that it has value, then they can be sold for whatever price, provided that people have confidence in it. I will reproduce the necessary parts here for you, abridged for easy understanding. Don’t worry about the technical details, I will break it down later. Just pay attention to how the other guests on the podcast point out the ridiculousness:

SBF: (21:28) Let me give you sort of like a really toy model of it… You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It's just a box… It doesn't do anything but let you put things in it if you so choose. And then this protocol issues a token, we'll call it whatever, ‘X token.’ And X token promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens. They can vote on what to do with any proceeds or other cool things that happen from this box. And of course, so far, we haven't exactly given a compelling reason for why there ever would be any proceeds from this box… So anyone who goes, takes some money, puts in the box, each day they're gonna airdrop, you know, 1% of the X token pro rata amongst everyone who's put money in the box. That's for now, what X token does, it gets given away to the box people. And now what happens? Well, X token has some market cap, right? It's probably not zero. Let say it's, you know, a $20 million market...

Matt: (23:56) Wait, wait, wait, from like first principles, it should be zero, but okay.

Matt: (24:04) …when you describe it in this totally cynical way, it sounds like it should be zero, but go on.

SBF: (24:10) Describe it this way, you might think, for instance, that in like five minutes with an internet connection, you could create such a box and such a token, and that it should reflect like, you know, it should be worth like $180 or something market cap for like that, you know, that effort that you put into it… but I acknowledge that it's not totally clear that this thing should have market cap, but empirically I claim it would have market cap.

Matt: (24:57) I agree.

Joe: (24:59) It shouldn't have any market cap in theory, but in practice, they always do. Okay.

Let me rewrite that in simpler terms:

1. You create a box, for instance, a crypto exchange. You explain that this exchange is going to be the future and replace real banks.

2. You tell people that if they put real money in your exchange, you issue them a separate new token/currency as a reward for putting real money in the exchange. This reward token is free. Now they have both their real money and the token reward.

3. This reward token has no monetary value because you simply created it out of thin air. However, you tell them that the token would be used to vote on the future of the exchange, a sort of membership right. So the token is only valuable, like some sort of right to vote in the crypto company.

4. But because people believe that the box, which is the crypto exchange, is going to be the future, and the token will allow them to vote in the future, they start to ascribe value to it. Meaning, it can now be sold to people who want to have a vote in the future.

5. Suddenly, your token can actually be sold for real money. It is, first, valuable due to the general agreement that there is a great future and the token would allow you to vote in that future.

6. Some people buy the token from others in the hope that the value continues to climb upwards, not because they want to vote in the future. They know other people would consider it valuable and that they can resell it for a healthy profit margin.

7. Other people don’t want to pay to buy the token, but they want the token free. So more people put real money in the exchange in order to earn the reward token for free. They also plan to sell it and make a profit.

8. Others, who don’t even believe in the future of the crypto company, now see that people are putting in money and/or buying the token, and they see that the price is increasing, so they get it on it. It is, second, valuable due to the fact that everyone is now buying into it even if they don’t believe it is the future.

The value of the token has gone from zero to super valuable because of a consensus belief that the token is valuable. It does not matter that some think it is genuinely valuable because it will change the world, neither does it matter that some think it is valuable as something that they can resell for profit. It is simply valuable now.

So how can we find sense in all of it? Here is one possible explanation of how this dark magic could work in this case, to prevent a bank run or at least minimize the fatal effect on the business. This is just a theory, do not try this;

1. You create a box and ask customers to put money in it.

2. You suffer a hack that led to the loss of customers’ money.

3. You do not have the money to give back. User withdrawals are disabled for over three months and counting.

4. You also cannot permit withdrawals, as that would begin a spiral into bankruptcy death. What if you could find a way to buy some time?

5. You figure you may have luck by creating a token. Everyone does it, anyway.

6. However, instead of letting people earn the token, you simply mandate everyone to have the token in place of their lost funds. You issue all users some token, let’s call them “Patrick Tokens”, telling them it is backed by $1 per token.

7. The idea is that if customers want to recover their money, they had better join you to claim that the magic tokens are worth something. That way, they can maybe sell it and recover the actual money that they put in the box.

8. Users can sell to another person who for some reason believes Patrick Token is valuable. The buyer can send the $1 to their personal account, and they send them the Patrick Token.

I have no idea why anyone would want to buy such a token, but if customers were somehow able to sell all their Patrick Tokens, they would have recovered their money without the exchange having to cough up the money it lost. Again, this is very dark magic and if you try this, you potentially risk a lawsuit.

You may have noticed one very huge problem under this token model (amongst other relatively large-sized problems that we cannot even begin to discuss); there is no consensus belief that the token is useful or valuable.

Patricia created the Patricia Token out of thin air, but people are not convinced that it is the future. Instead, they lost the money people put in their exchange and told them it had been exchanged for Patricia Tokens and that 1 Patricia Token is equal to 1 real dollar, and they should be excited about it. Seriously, the announcement is drafted in very enthusiastic language, you almost forget what is at stake here. In fact, the announcement ends with “Now is the time to own a piece of Patricia”. Patricia was hinting, subtly, that this token was like other ownership tokens.

Expectedly, the shoddy announcement got such a mean backlash from the public. I guess it is very hard to convince people that you are the future if you are launching a token after losing $2,000,000.

So Patricia switched to a different storyline for its token; “trust and asset recovery”. We look at that next.

Part 4 continues here.

If you feel like it, you can also buy me a coffee.

Thank you for reading.