Last Friday, after we published our most recent market thoughts, FTX and dozens of its affiliated companies including the troubled prop trading firm Alameda Research filed for bankruptcy protection. The filing concluded one of the swiftest and sharpest downfalls in corporate history. In 7 days since the initial CoinDesk article by Ian Allison, $40B of equity value of FTX.com and FTX.US was wiped out, taking along with it potentially $18B of deposits for over a million customers.
The FTX and Alameda saga has been covered in-depth by traditional media outlets and even better by the community on Twitter. Rather than rehash the blow-by-blow series of events that continues to happen in near real time, we think our value add at this point is to synthesize high-level takeaways and present a potential path forward. We don’t pretend to know everything the future may hold but given our vantage point and collective experience in operating through crypto cycles and traditional financial market dislocations, perhaps we can offer a valuable opinion. Facts will likely change and thus it is still important to be flexible about the path forward.
One of the most important things one can do in a time like this is an accurate and unbiased accounting of the present situation. Right now, FTX, Alameda, and most of their associated entities have filed for bankruptcy protection. Any entity that FTX held money on behalf of, including retail investors, OTC desks, service providers, and institutions, will likely become creditors in this bankruptcy. This also includes entities that lent money to Alameda, the largest of which was likely FTX. This means that billions of dollars invested in crypto are presently frozen, likely to take a haircut of some unknown magnitude and paid back to depositors at some unknown date. A full accounting of all the liabilities will likely take some time to produce. So far, we have heard from dozens of companies, including trading desks, VC funds, crypto projects, and lenders that have had exposure to one of the entities, but outstanding questions regarding the full extent of the damage remain unknown.
With numerous companies announcing losses or exposures to FTX and Alameda, questions have been swirling as to what the next domino is to fall. There are some inklings, but the picture is not quite clear. On Wednesday morning, the lending arm of Genesis Trading suspended withdrawals while it assessed strategic options. At its highest point, Genesis had a $14.6B loan book, but following the calamitous events of 2Q, its loan book had shrunk to only $2.8B by the end of 3Q. The direct impact of the Genesis news was immediately felt by the exchange Gemini, which suspended withdrawals from its earn product. Gemini is reported to have lent Genesis $700M. BlockFi is reported to be readying a bankruptcy filing following its bailout by FTX in 2Q. Several other service providers have piqued the curiosity of crypto sleuths as potential next dominoes, but we hesitate to speculate too much without hard evidence. Regardless, industry participants are on edge for even the slightest signs of stress and continue to pull balances off exchanges. Sales of Ledger hardware wallets, which allow individuals to safely hold crypto off exchanges, have spiked as users rush to move balances off exchanges.
With billions of dollars of client funds lost in FTX and Alameda itself as well as ancillary companies caught in the fray, it is natural to point fingers. While there are plenty of scapegoats, including Sam Bankman-Fried, given the scope and scale of what just occurred, numerous factors are to blame. The industry trouble started with the implosion of Terra (LUNA), TerraUSD (UST) in early May. There have been accusations that Alameda caused the initial de-peg of UST, and while that may have been the case, uneconomic rates paid by the Anchor Protocol and insecure economic design of LUNA/UST ensured its ultimate destruction, destroying $60B worth of crypto wealth in a few short days.
Most DeFi protocols operated as advertised through the volatility this year, minus the ongoing hacks within the ecosystem. Decentralization is an important characteristic for the ecosystem, but it is important to remember that just because something is on a blockchain or has its own blockchain doesn’t mean it’s decentralized. Even the definition of decentralization can be tricky. There are many levels on which decentralization might be measured, such as miners/validators, code contributors, code control, node operators, asset owners, and governance to name a few. Furthermore, decentralization measures have gradations. “Decentralized” isn’t just a toggle switch that can be somehow turned on and off. With that in mind, perhaps “DeFi” is a misnomer. One of the early contenders for the name of this subclass of protocols, OpenFi, probably would have been a more apt name than DeFi.
With the Big Bang coming from DeFi, it was then centralized financial companies, CeFi, that did the rest of the damage. Poor risk controls, conflicts of interest, excessive leverage, unclear accounting, counterparty risks, and poor management were just some of the factors at play. Furthermore, the use of an equity-like token, FTX Token (FTT), as collateral exacerbated the issue. Hedge funds, lenders, yield platforms, market makers, VCs, and of course exchanges all were culpable in the washout of 2022. In some ways, the mistakes at play with the failure of Mt Gox, the seminal event that defined counterparty risk for the industry, are still being repeated, but this time at a much grander scale.
Improved regulatory clarity for US investors was something in the works that we had been hoping for in the coming year. However, with the FTX fiasco and SBF’s growing political influence before the crash, the path in DC has grown more complicated. Regulators will now be on their toes and increasingly more likely to use their current authority to enforce existing regulations and possibly issue new ones. At the same time, if history is any guide, policymakers in Congress will hold a series of hearings on the FTX debacle and then consider what, if any, new legislation is appropriate. However, with a newly divided legislature come January and a presidential election cycle approaching it remains highly unclear if significant bipartisan legislation will gain enough traction to become law. The House Financial Services and Senate Banking committees have planned December hearings into FTX and perhaps then we will get a clue as to how legislators have changed their approach to regulation. The Digital Commodities Consumer Protection Act (DCCPA), which previously had bipartisan support and would have relied on the CFTC for regulation of assets deemed digital commodities, is still outstanding, waiting for markups, but its future is not clear. While we can sympathize with the desire for greater regulatory clarity, it’s important to note that FTX.com wasn’t even a US entity, which raises the question of how impactful improved US regulations would have been, at least with respect to preventing the specific recent events surrounding FTX.
Right now, the industry is largely in shock at the events that just transpired. Anger, fear, and distrust run high throughout the community. Not all is settled right now and many questions remain unanswered. At some point, however, this too shall pass. The death of Bitcoin has been marked time and time again, each time proving to be wrong. We can’t predict when the volatility will end or what price will be the ultimate low, but given the price reaction function on recent news, that bitcoin was only down slightly on the Genesis news, perhaps a bottom is beginning to form.
Looking at previous cycles, public conversations on Twitter have been a good proxy for investor interest in the asset and therefore price. Looking at the 2017 cycle, we see a pronounced ramp in Bitcoin tweets that then fell as the price of bitcoin went through its corrective path. Looking at the 2021 cycle, we see a similar rise in tweets but have yet to see a full retracement in conversations, implying things still need to quiet down. Certainly, the events of the past two weeks have caused a spike in conversations, so we will likely need to see a resolution of the FTX drama before the chatter dies down.
This exploration of social conversations brings up an important observation. With each bitcoin price cycle, the drivers, narratives, and investor base has changed. The peaks and valleys seem to get less exaggerated each cycle, but the pattern remains the same, lasting 4 years and centered around block reward halving dates. This might be one of the oddest and most obvious patterns in all of financial markets.
What will be the driver of the next cycle or new case that emerges? That’s anyone’s guess. In 2015, it was hard to predict the uptake from investors in southeast Asia, Initial Coin Offerings (ICOs), and the Dapp platform mania that were hallmarks of the 2017 cycle. In 2018, the growth in institutional investors, macroeconomic backdrop, and explosion in DeFi and NFTs were not apparent for the 2021 cycle. In some sense, this could just be the continued growth in the asset, up and to the right but punctuated by brief periods of investor mania and despair. We like to think that bitcoin’s price swings about an axis of growth are just an expression of investor psychology, which can at times be overly pessimistic or overly optimistic.
We do think there are valuation metrics that can help identify cycle peaks and troughs. We showed bitcoin’s market cap to realized cap (MVRV) ratio recently, but another valuation ratio, market cap to thermo cap, also tells a similar story. This ratio compares the current total market valuation with the value of each bitcoin at the market price when it was created (mined). In that sense, it is similar to a price to book value ratio. And while the ratio isn’t as extreme compared to historical levels as MVRV, it tells a very similar story – price is near a cyclical low. Of course, all of this is predicated on bitcoin not fading into the sunset, but given the importance of its technology, we think that's a safe bet.
The price of bitcoin fell 7.6% on the week driven by the continued fallout from the FTX bankruptcy. Equities were mixed on the week with the S&P 500 down 0.2% and the Nasdaq Composite up 0.3%. Both gold and oil fell on the week, with gold down 2.0% and oil off 5.6%. Bonds were mixed on the week with Investment Grade Corporate Bonds up 1.5%, High Yield Corporate Bonds down 0.2%, and Long-Term US Treasuries up 2.1%.
FTX + Alameda:
FTX Balance Sheet Revealed - Financial Times
Facilitating Wholesale Digital Asset Settlement - Federal Reserve Bank of NY
The Regulated Liability Network White Paper - Regulated Liability Network
December 2 - November Jobs Report
December 13 - November CPI Reading
December 14 - Next FOMC rate decision
Thanks for joining us again this week. Please reach out with any questions or comments.
The NYDIG Team
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