The FTX Bankruptcy and contagion to other platforms is likely to be the Lehman moment for crypto assets. While we don’t know the exact details leading to the failure, on-chain analysis shows the 3AC failure in June as a flash point. We wish the analysis had been presented a few weeks prior, and not after the fact.
The FTX failure has already spread to BlockFi and Genesis. The cascading impact should be felt in days and weeks, not months. Crypto markets are starved of capital, and there’s no lender of last resort. The market clearing mechanism is likely going to be price. The June downdraft had already engineered substantial deleveraging in the market, which is the silver lining. Prices were already depressed when SBF struck.
The likely fraud (dipping into customer funds) at FTX highlights the urgent need for robust global regulation of crypto market intermediaries. FTX’s problems arose at the international arm based out of Bahamas. The US operation functioned normally even as international paused withdrawals. It’s fair to ask why US regulators didn’t question FTX’s leveraged futures offering to US consumer (who used VPNs) in the same way that the US prosecuted Bitmex. The event will hopefully motivate Congress to enact much needed regulation to provide clarity.
Dispatch #20 on November 16th, 2022 is on the FTX bankruptcy.
FTX Bankruptcy
FTX, the crypto exchange founded by Sam Bankman-Fried (aka SBF), imploded last week. Based out of the Bahamas, FTX international slowed client asset withdrawals starting Sunday (6th), halted withdrawals on Tuesday (8th) and filed for bankruptcy on Friday (11th). This has been a fast-moving story and we’ve had to re-write this post many times. For an excellent chronology of events earlier last week read Arthur Hayes’ (Bitmex founder) summary/analysis. He provides a play-by-play of how FTX succumbed swiftly to a combination of liquidity and leverage (excess debt) pressure. For a first-person insider account, we recommend this 60-minute podcast by FTX marketing staffer and The Breakdown podcast host Nathaniel Whittermore.
The definite (as of Nov 17th) analysis of the collapse is presented in this 82-tweet thread by researcher and investor Adam Cocharan. Tweet #34 is shown below.
Blockchain analysis has quickly provided a reasonable picture of how SBF choreographed the hole in FTX’s balance sheet. This Glassnode video presents on-chain data that shows FTX’s token balances dwindling. The Head of Research of Coin Metrics tweeted this on-chain analysis that points to the 3AC blowup in June causing the initial damage at FTX. It would have been so much better if this analysis had been presented several weeks prior.
Gensis failure could be a bigger flashpoint
The FTX failure has cascaded across the industry with crypto yield firms BlockFi and Genesis Global Capita halting client withdrawals. Gemini Earn, which was a pass through to Genesis has been similarly impacted. Genesis is one of the largest intermediaries in the space, as this Tweet thread by the founder of crypto news site Blockworks explains. This is a fast-moving environment and Blockworks reports that Binance may buy the Genesis loan book. That’s one way to stem the failure of one of the most important institutional players in crypto assets.
Any crypto firm that offered yield on clients’ token balances will be challenged. Yield was generated by taking on credit risk and/or liquidity/duration risk. With the extreme liquidity stress in crypto markets, risk management of these yield firms has proved inadequate. This was already clear in June with the failure of many yield firms. The contagion could spread to other exchanges as well, since many were trading counterparties to FTX. Importantly, the Genesis trading arm is segregated and is functioning normally at present. Crypto market participants are unlikely to trust “all is fine” statements from companies as many have proven false. This week, it’ll be a case of run for the hills as first speculation of trouble. Only the well-run companies, with segregated client assets, will survive.
Problem started at Bahamas-based FTX International
The problem was at FTX International, which offered leveraged futures trading and accounted for >95% of overall FTX trading/assets. Exposure to FTX was exacerbated when many countries banned Binance, which made FTX the largest accessible exchange with future trading. The US arm FTX.us, where US citizens are supposed to trade, was operating normally until the bankruptcy filing on Friday. The international arm had slowed withdrawals starting Sunday and stopped on Tuesday. Regardless of this US vs offshore demarcation, the US Department of Justice is on the case as this WSJ article details.
We have yet to discover if the June 2022 failures of Celsius, Voyager, et al. was incompetence (a large dose) or fraud. Let’s hope that the DoJ gets to the bottom sooner with FTX.
We have less faith in the SEC’s efforts. Gary Gensler went on CNBC quickly to claim that crypto needs to be regulated and current rules are adequate (5 min CNBC video). The SEC has parroted that line while many financial service companies offering crypto products failed. Why did the SEC not prevent these failures if they have the regulatory authority? Similarly, why did the US (DoJ, CTFC et al) not scrutinize FTX’s role in offering futures trading to US clients?
This was House Financial Service Member Emmer’s response to the CNBC appearance.
Expect more political sparring as the FTX fallout widens, especially since Republicans have gained control Congress. SBF and FTX contributed over $40m to Democratic candidates and PACs in the recent election cycle as this Politico article explains.
Regulation is needed, but requires nuance
It should come as no surprise that vitriolic politicians are staying the course and doubling down on their prior criticism. The failure of FTX International that later engulfed FTX.us should raise the question of regulatory gaps.
Source: @SenWarren
Let’s bash every US company offering crypto services is perhaps what’s caused the regulatory gaps. There was indeed “smoke and mirrors” at FTX, but did the lack of regulatory clarity facilitate deceit by moving to the Bahamas? US-based exchanges Coinbase, Kraken and Gemini (watch for collateral from Gemini Earn) has remained robust with token inflows during this crisis.
The response above from Coinbase CEO provides the nuance that politicians making new rules need to consider. The Head of Policy at the Blockchain Association provides more color on how rushing to regulate US-domiciled entities might not be a solution.
Regulatory oversight needed to provide consumer protection
Ironically, crypto started with Satoshi Nakamoto’s (Bitcoin creator) desire for an alternate to the trust-based banking institutions. Fourteen years later, we trusted FTX, a traditional company, with our crypto assets, which has ended disastrously for most customers. One of the solutions is to return to the original self-custody ethos. However, crypto today is like the internet before the Netscape browser. Interacting directly with decentralized blockchains is not user-friendly. Centralized entities provide a far better user experience, which will be needed to onboard beyond early adopters. Self-custody will not onboard the next billion users, so a robust regulatory framework is needed to regulate companies offering centralized crypto services. This framework needs to think globally so we don’t repeat FTX-style failure of offshore entities.
Crypto intermediaries like FTX are free-riders on the trust established by banks and exchanges over many decades. For all the flaws of the current system, western consumers have not experienced losses from bank or brokerage failures in recent decades. Consumers view crypto exchanges/brokerages through this inappropriate lens, which has proven disastrous to crypto savers. Perhaps crypto consumers will reassess the risk-reward of the asset class following this failure. The immediate, post FTX, signs are encouraging. A record number of bitcoin have been withdrawn from exchange to self-custody this week. This is a key solution to removing wider contagion. Coins leaving exchanges is typically a bullish sign, which may need to be ignored during this unusual period.
The multiple bankruptcies of traditional crypto intermediaries have shaken the ecosystem. We’ve ignored key principals of decentralized blockchain, and the events of 2022 will hopefully drive the industry toward a future with far better investor protection.
Key learning point from the FTX failure
None of this is investment advice. Speak to us in person if you want our insights on crypto asset investing.
- Interact directly with robust decentralized blockchain.
- Defi makes the mistakes/fraud of FTX impossible. Yes, protocol hacks are a risk that shows why it’s important to interact with the largest 10-20 protocols (aka robust) and not the tail of 15K+ protocols.
- Interact directly with blockchains. For many consumers, this will a challenge, but for those that can, the yield will be low and risk of permanent loss lower. The unsustainably high interest rate offered by centralized crypto companies (Celsius, Voyager or BlockFi), came with outsized risks including permanent loss, we discovered in 2022.
- Self-custody was the main point for Bitcoin’s creation. If you had purchased crypto assets on FTX and then self-custodied those tokens, your assets would be safe today. Self-custody brings its own set of security risks, and the user experience is fiddly. We are happy to offer our insights on the trade-offs of self-custody.
- Focus on genuinely decentralized protocols. The FTT token issued by FTX was controlled by the company and clearly not decentralized. Bitcoin epitomizes decentralization and no one controls the protocol. From there, protocols gradually become less decentralized, which means more control by a person or persons.
- Transparency will be required of centralized exchanges. Many exchanges have already published proof of reserves, which can be tracked on the Defi Llama CEX audit page. Proof of reserves is not a silver bullet because we still won’t know the liabilities of exchanges.
- Do not use leverage. Cryto assets have an annualized volatility in the 80-90% range. That means in any given year, your assets could rise OR fall 80-90%. Adding debt on top of a high volatility will amply the swings even further, which is not an appealing characteristic. The high volatility means keeping position size small.
- Better global regulation of centralized companies is needed. This event highlights the urgent need to regulate human-run companies that offer crypto services. Regulation needs to be global as the existing rules in the EU and US were circumvented by Bahamas based FTX International. Unworkable rules or lack of clear rules can drive companies to regulation-light offshore locations.
Lehman Brothers moment for digital assets
Ultimately, the FTX bankruptcy is the crypto industry’s Lehman Brothers moment. Unlike Lehman, the cascading impact will be felt in days not months. Many months passed between the failures of Bear Stearns and Lehman. Neither does crypto have access to global central bank liquidity. The next week is likely to expose which exchanges are unclothed as the FTX bankruptcy ripples through the industry. Most of the several hundred million early adopters in crypto should be able to distinguish that the weakness is from tradifi firms and not the decentralize crypto protocols themselves. The bear market should also illustrate that most of the >15K tokens are get-rich-quick endeavors that offer no utility or value. The cleansing should support the development of a stronger crypto asset ecosystem with a robust regulatory structure in place. Let’s hope the next Congress gets to work quickly.
Finally, let’s not lose the forest for the trees. Global economies are laden with unsustainable levels of debt, demographics are in structural decline and, UK pensions, have already shown our addiction to Central Bank liquidity. Digital assets are very early in the adoption curve, and the FTX debacle shows that decentralized protocols have a future to reduce out reliance on trusted humans.
Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
Important Disclosures
| This is not an offer or solicitation for the purchase or sale of any security or asset. Nothing in this post should be considered investment advice. While the information presented herein is believed to be reliable, no representation or warranty is made concerning its accuracy. The views expressed are those of RockDen Advisors LLC and are subject to change at any time based on market and other conditions. Past performance may not be indicative of future results. At the time of publication, RockDen and/or its affiliates may hold positions in the instruments mentioned in this newsletter and may stand to realize gains in the event that the prices of the instruments change in the direction of RockDen’s positions. The newsletter expresses the opinions of RockDen. Unless otherwise indicated, RockDen has no business relationship with any instrument mentioned in the newsletter. Following publication, RockDen may transact in any instrument, and may be long, short or neutral at any time. RockDen has obtained all information contained herein from sources believed to be accurate and reliable. RockDen makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice, and RockDen does not undertake to update or supplement its newsletter or any of the information contained therein. |