The 2022 crypto selloff exposed the incompetence and hubris in many traditional crypto companies. For example, Celsius had a $1.2bn balance sheet hole on client assets of $4.7bn by the time it filed for bankruptcy. Listed Canadian company Voyager had to declare bankruptcy because it provided a loan of $674m with zero collateral. Other companies took in client deposits, then placed those funds with Celcius. This was a failure of humans rather than blockchains or crypto assets. In contrast, established decentralized finance protocols that are devoid or human intervention, operated without any hiccup. The smart contracts operated as designed and no client asset withdrawals were halted during the downturn. We need to vastly improve the human-run companies in crypto. If not, the next time this happens it might be a much larger asset class with wider contagion.
We are also delighted to see regulators punish crypto insider trading. The DoJ is prosecuting a former Coinbase employee and his associates for insider trading. The illegal activity was initially flagged by an industry analyst because blockchain activity is transparent. The crackdown was elevated this week when the Treasury Department blacklisted software protocol Tornado Cash, when sanctions had` previously been on individuals or entities. This will raise thorny issues longer term, which the courts are likely to adjudicate.
Dispatch #17 on August 12th, 2022, has the following lineup of stories:
- Crypto downturn exposed incompetence
- Crypto insider trading arrests
- Treasury Department blacklists Tornado Cash protocol
Crypto selloff exposed incompetence at many companies
Let’s start with Celsius, the crypto yield platform that has filed for bankruptcy protection. Here’s the Celsius network balance sheet shown in their bankruptcy filing.
This is a realized loss, not a liquidity crunch, which is typically what results from a “bank run”. “User Liabilities” are customer deposits and the bottom row in blue shows the $1.2bn deficit. This Coindesk article provides more information.
Could regulation have helped? Possibly. Regulation could have required reserves to be set aside and regulatory oversight of what the firm does with client funds. This is how banks are required to operate. That said, bank regulators aren’t overseeing every loan or investment that a regulated bank makes, but the banks do know that there’s regulatory oversight. Despite regulation, many banks were on the verge of insolvency in 2008, which required the Federal Reserve to step into flood markets with cash. This illustrates that regulation alone is not enough to stop a systemic collapse. It’ll remain an open question if regulation would have stopped the cavalier operations of Celsius and other companies offering crypto yield products.
We certainly should not go back to operating as these companies did until June 2022. 1.7m customers have been impacted by the Celsius bankruptcy. Many have written directly to the bankruptcy judge, as CNBC explains, to get to the top of the creditors list and ahead of larger institutions. The CNBC article, and this WSJ article, chronicles the lives upended by the failure of many crypto yield platforms.
Voyager bankruptcy is a case of inadequate risk management
Similarly, that bankruptcy of Voyager, a publicly listed company, is equally illuminating. The company extended a roughly US$674m loan to insolvent hedge fund Three Arrows Capital without any collateral. This loan was many times larger than Voyager’s net worth of US$257m at the end of March, 2022. This is NOT the risk control or operating behavior of a well-functioning financial services company. It’s hard to conclude that it’s anything other than incompetence.
Zipmex illustrates shoddy business practices
Singapore-based Zipmex was taking client deposits, then handing the cash over to Celsius and Babel (another yield platform that’s in trouble) to generate yield, as CNBC explains. Stop and think about that daisy chain. It’s like Citibank taking all customer deposits and handing them over to JP Morgan to extend loans.
One of the few companies offering crypto yield to survive unscathed was Abra. This podcast with founder Bill Barhydt illuminates the need for both credit risk and liquidity risk to avoid the pitfalls that bankrupted larger players. The collapse of many companies in crypto was not inevitable, as the Abra example shows.
Decentralized protocols functioned as promised
In contrast to the failure of traditional companies offering yield from crypto assets, yield via decentralized protocols worked as promised. These smart contracts that operate with zero human intervention continued to operate normally during the crypto meltdown in June.
The multiple failures of traditional companies operating in crypto assets join a long history of human fallibility: Lehman Brothers, the $2bn loss by the JP Morgan Whale or the collapse of Baring Brothers over 25 years ago. Given the lack of regulatory oversight and deposit insurance, the crypto yield platforms need a complete overhaul. At $3tn sector value, these blowups didn’t have a wider contagion effects in 2022. That may not be the case if the industry continues to operate in a similarly cavalier manner as the crypto industry grows over time.
Crypto insider traders arrested
We are excited to see that authorities are going after illegal activity within crypto assets. The DoJ recently arrested a former Coinbase employee and two of his associates for insider trading. The employee leaked the list of forthcoming token listings on the Coinbase exchange. The associates traded profitably on that privileged information.
In a twist unique to crypto assets, the insider-leak was flagged by an outside crypto analyst. When Coinbase released the said token-listing schedule back in April 2022, a well-known crypto expert (Cobie) flagged the potential insider leak.This tweet is cited on the DoJ affidavit! This is a good example of industry self-policing because open blockchains provided access to anyone to follow and audit transactions.
FBI arrested former OpenSea employee
Several months prior to the Coinbase arrests, the FBI had already charged a senior employee of the largest NFT marketplace – Open Sea – of insider trading. The head of product at Open Sea had used his privileged position to buy NFTs before they were listed the exchange and rose in value, as this The Defiant article explains.
Treasury sanctions crypto software program Tornado Cash
Staying on the theme of regulators fighting illicit activity, this week, the Treasury Department through OFAC (Office of Foreign Assets Control) sanctioned software protocol Tornado Cash. Tornado is a mixing service used to hide the trail of crypto assets and is widely used by hackers and illicit actors. Funds from hacks highlighted in previous Dispatches have used Tornado to launder the proceeds. It’s not controversial to state that the bulk of the dollar value of activity on Tornado was illicit.
The Treasury Department press release highlights some of the highest profile illicit activity and actors using the service.
From a practical short-term perspective, the sanction should be a positive development for most participants in crypto. It may temporarily shut a software program used by criminals, especially hackers.
However, it’s unclear if the OFAC action will have a lasting impact. As an open-sourced software code, Tornado can be copied easily and new un-sactioned services spun up. This Tweet thread from Matthew Green, Johns Hopkins Professors of Information Security, provides better color.
Longer-term implications are nuanced
There are, also, more nuanced longer-term implications of OFAC sanctioning a software program instead of an entity or persons. One example is usage of Tornado for legal activity. The Dispatch knows people who have used Tornado to anonymously donate crypto assets to Ukrainian charities. High-profile individuals, like Ethereum creator Vitalik Buterin, have done the same.
These folks may now be in breach of US government laws, which is punishable by a prison term of up to 20-years! Furthermore, from a technical perspective, crypto wallets can’t reject income transfers. Any inbound transfers from a Tornado wallet address can’t be rejected, which exposes innocent individuals to illegal activity. This very feature is being tested by someone who’s transferring small amount of Ethereum to celebrities with public wallet addresses. Coinbase CEO Brian Armstrong, Jimmy Fallon and Shaquill O’Neal’s Foundation have all received ETH from a blacklisted Tornado wallet, as this The Block article explains. We can all see the transaction from the Tornado wallet here on Etherscan.
Battle between privacy and public safety
For a deep understanding of the issues surround the OFAC sanctioning of a decentralized software protocol, we recommend the readings below.
- From Coin Center, the crypto advocacy and Think Tank.
- Tweet thread from Seth Hertlein, Global Head of Policy at Ledger, the security hardware vendor.
The Hertlein tweets highlighted below encapsulate the argument against the Treasury action.
So does this one from the Head of Policy at the Blockchain Association.
This is a debate about the trade-off between access to privacy and protecting society from criminal activity. The career staff at Treasury will claim that Tornado is not a decentralized software protocol, but one that is controlled by people. That line appears to be in play already as Dutch police announced on August 12th the arrest of a “suspected developer” of Tornado Cash. The Dutch see additional arrests coming. The trade-off requires more debate, and it’s highly likely that the Treasury action will be challenged in the courts over the coming years.
Testing our biases
We are constantly evaluating our economic and market thesis against new information. The July CPI data, while favorable against market expectations, was within our estimates. That said, if the pace of slowdown continues, we will need to re-evaluate our sticky core inflation view.
The chart below shows that the 2022 decline is well within the normal range for non-recessionary downturns. Therefore, we are constantly on the lookout for data that suggests that activity is improving. Management commentary from the recent earnings season appears to skew towards activity worsening, even though you won’t spot it in share prices. Our risk management is based on data other than stock prices in order to reduce emotional biases.
We hope everyone is enjoy the summer. Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
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