So, if like me, you are kind of interested in this shit but completely ignorant of how it works, I've copied and pasted this reddit post which has been making the rounds lately. Feel free to critique.
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Ironically enough, Sam Bankman Fried explained it correctly and with a remarkable level of accuracy.
Imagine you have a box. It doesn't do anything, but the exchange pretends it does some magic finance shit that gives you some stupid 25% or 15% interest if you fill it with dollars.
So you empty your pockets and fill the box with dollars. The exchange hands you an IOU(the shitcoin) that always tracks how many dollars you can ostensibly take out of the box at a future time of your choosing, ie. you give back the IOUs, and the exchange hands you back dollars in a value equivalent to the value of IOU.
The exchange says that it does some magic shit with your dollars inside the box that multiplies it, so your IOU (your shitcoins) are accurate (backed). But you don't actually know that, since the exchange prints the IOUs(the coins), and you can't see inside the box(no audits!), and you are actually brain damaged so you didn't learn anything from the terraluna or celsius shit.
So you believe it! Number go up on your IOU(shitcoin), so you dig deeper in your pockets for more dollars to put in. Worse, multiple other cretins put in dollars in the box, and you do not want to be the last ngmi, right? Everyone can be rich!
Ocassionally some mook is gonna withdraw a small portion of the dollars in the box according to the IOU they hold. The exchange serves them promptly, and the mook goes and spreads the good word! It is a magic box! The box is solvent! The box is backed! Huraaah, praise the lord it is a miracle, toss more dollars in!
And then, a wobble happens. Some shit somewhere else breaks. Some big fish needs dollars NOW, and they go rummaging in the box. Maybe they take out a bunch, in return for their IOU. Rumor starts spreading that hey...that dollar filled box looks kinda empty for what the IOUs say should be left... The exchange steps in! "No! The box is magic and full, and due to entirely unrelated circumstances, no one can take dollars out of the box anymore, no matter what the IOU says. Please put more in it, though."
So the cretins are spooked now. Ok, no one can take dollars out of the box (except exchange's boss, friends and 'hackers'), but maybe they can sell the IOU on the open market? Yes, let's ALL do that. Only problem, everyone is spooked and not buying the IOUs, so their value collapses, everyone being desperate to sell at ANY price, no matter what is written on their face value.
Only, problem! Somewhere else, some other exchange reveals that they also had a magic box filled with dollars! Only their box had a fake bottom, and they took fistfuls of dollars from it, and stuffed first exchange's IOUs instead so no one could see the box is kinda empty. Only, now those IOUs are worth fuck all, and the box starts looking pretty light on value regardless. Also, for entirely unrelated reasons, they also halt withdrawals of dollars.
And now you got contagion. When shit like this happened in the real world, the feds said. "Ok, this is retarded. You shitters played stupid games behind my back, but in the interest of keeping this house of cards from collapsing, I am gonna loan you money from ME, do you can ACCURATELY stuff your boxes back, take all the shit papers out, and we'll discuss punishments neverlater, after you pay me back."
But there are no feds in the crypto space. Oh no, what do as a CEO cryptoboss of a exchange? Break open the fake box, stuff your pockets with dollars and run to Cambogia.
Got a little bit carried away there. The exhange printing their own shit IOU is pivotal to the entire scheme though. They gotta print large numbers of IOUs, so that mooks put dollars in, and NOT take them out. So long as that happens, they can write any number of them they want of their shit IOUs, and everyone pretends to believe it because line go up. This is, in essence, a Ponzi scheme. It's fake. There is no magic box (duh).
In the real world, when banks give you interest, they basically loan your money to other people, and they give you back a cut of the increased economic activity as interest. Also, they pay your interest in money that you give them, not in money that they invented and control but it's totes real and is valued at a bajillion USD(tm), because of regulations. It works, but the cut is SMOL. Like, not even joking. But in crypto? There is no increased economic activity. There is NO economic activity at all! It is worse, crypto is negative sum, so the economic activity should be negative. Bitcoin is deflationary, where the fuck do these exchanges pull 20% interest on your bitcoin from? (Are they running a reverse kind of Erdogan-o-nomics? What is even happening?) Insanity. It's a game of musical chairs and not being the last one holding the bags full of worthless papers when the music stops.
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