What the End Game for Crypto Will Look Like

The implosion of crypto exchange FTX is not just an Enron moment -- one particular company collapsing under the weight of fraud. It is crypto’s Lehman moment, too. The interconnectedness of FTX’s crypto platform, the use of leverage, and the lack of a lender of last resort ensure that the fallout will be widespread and lasting. Here’s what the end game could look like.

Four crypto names hold the keys

The price of Bitcoin has held up well in the face of a calamitous collapse of the once-celebrated crypto exchange FTX. After dipping below $16,000, the bellwether cryptocurrency has recently traded around $17,000. But don’t let that fool you. There is more pain to come for crypto investors. For one, the cascade of bankruptcies resulting from FTX’s downfall are just beginning. BlockFi is the first major firm to enter bankruptcy after FTX. A few other players like Genesis and Gemini are still limping along but their woes are far from over.

the leverage in the system that will take us to the next chapter in crypto. That’s because, without a robust lender of last resort or a floor on cryptocurrency prices, collateral used for loans can quickly plummet in value as it happened with FTT and Serum tokens on FTX’s balance sheet. That means each bankruptcy in the space has a knock-on effect on other firms.

The risk, then, is a washout for crypto that is severe as the market capitalization of lesser-known cryptocurrency “altcoins” gets destroyed. The end game for the space hinges on the fate and actions of four firms in particular: Tether because of its connection to fiat currency, Digital Currency Group because of its Genesis subsidiary’s woes and the important Grayscale ETF, BINANCE due to its size and COINBASE because of its position as a highly-regulated entity in the US.

We're closer to the end than the beginning but so what?

Admittedly we know from past twentieth and twenty-first century business cycles that the biggest frauds are uncovered near the end of the cycle. That’s because the suspension of disbelief which enables fraud combines with a veneer of excellence at the bigger frauds, such that the “bezzle” is only uncovered in the most dire of economic circumstances.

Ben Thompson of Stratechery points out in the case of FTX:

FTX... specifically promised customers that their funds would not be lent out. The fact that they were was fraud, and it is mystifying that so much of the media refuses to state what is, without question, a fact.

Incompetence or fraud? The courts will likely decide. But the concept that we’re closer to the end than the beginning of the crypto collapse shouldn't give you any comfort if you're leveraged to the crypto space since those last months of a bear market before capitulation are often the worse. In fact, it’s that very term, leverage, which is the problem. Here’s how the FT put one example over the weekend:

Digital asset trading group Genesis and its parent company Digital Currency Group owe customers of the Winklevoss twins’ crypto exchange $900mn as the collapse of FTX reverberates across the market. New York crypto exchange Gemini, run by Tyler and Cameron Winklevoss, is trying to recover the funds after Genesis was wrongfooted by last month’s failure of Sam Bankman-Fried’s FTX crypto group, according to people familiar with the matter.

What that tells you is that when one major player goes down, invariably others follow simply because the liabilities of one bankrupt firm are the assets of another. When liabilities of one firm become subject to bankruptcy protection, they are unavailable for other companies that might need liquidity because of jittery investors. And that can take those firms down too.

Lehman’s collapse is a good precursor

Think about how this played out in the financial system in 2007 and 2008. Once house prices came off the boil, the demand for securitized mortgages did too. By 2007, it got to the point that companies like British lender Northern Rock, which financed the growth of its mortgage loan book substantially with short-term financing in the money markets, simply couldn’t roll over debts because potential lenders had concerns about the value of mortgage assets. Eventually the firm was nationalized.

In the US, after Bear Stearns was forced into the hands of JPMorgan Chase and Fannie Mae and Freddie Mac were nationalized, Lehman Brothers was allowed to fail. It was then that all hell broke loose given Lehman’s connections to various systemically-important financial institutions around the world. The resulting panic forced the US government to step in to ensure that the most systemically-important institutions had enough capital and would not fail. The Federal Reserve also had to ensure that the market for securitized mortgages had a buyer of last resort.

The same sort of cascade is happening in cryptoland right now. After crypto assets peaked in November 2021, the decline in value this spring was severe enough that investors started to re-think their more speculative bets.

Eventually,  TerraUSD, the third largest of a class of cryptocurrencies called stablecoins that are pegged to fiat currencies like the US dollar, began to falter. Terra had backing from traditional finance gurus who moved into the crypto space like Mike Novogratz. That imprimatur meant that, despite its speculative structure as an “algorithmic” stablecoin, Terra generated a lot of interest. 

The attraction was the high yield it paid adherents as an incentive to lure people to the platform in order to build network effects.  (That’s what attracted punters to the now-bankrupt crypto lender Celsius, too.) It was a house of cards and it came tumbling down almost overnight in May as crypto went through a savage downturn when the Fed started hiking interest rates aggressively. In a week’s time $45 billion had been wiped out.

By mid-June, the Singapore-based cryptocurrency hedge fund Three Arrows was bankrupted as it failed to meet margin calls. It also failed to repay money lent by cryptocurrency broker Voyager Digital, which meant that Voyager was in trouble, too. It went bankrupt. Genesis Trading also incurred huge losses from loans to Three Arrows but had a deep-pocketed parent, Digital Currency Group, to rescue it. And BlockFi, another digital asset lender which was caught up in this mess, was “rescued” by FTX in July. 

No lender of last resort means cascading failure

Here’s the thing. We now know FTX couldn’t rescue BlockFi because they were in trouble themselves. FTX had loaned out customer funds in non-arms length transactions to the affiliated Alameda Research, which lost that money, bankrupting itself and FTX in the process. So, now BlockFi has also applied for bankruptcy protection. The cascade of defaults and bankruptcies will continue until the threat of counterparty risk is negligible.

Sounds a lot like what could have happened if the Feds hadn’t intervened after Lehman. When there’s no lender of last resort, you have to basically let it all burn out the way it did in the US in the days before there was a Federal Reserve. That’s why we had the Panic of 1837, the Panic of 1857, the Panic of 1873, the Panic of 1893 and the Panic of 1907. All of these 19th- and early 20th century financial crises ended with depressions and galvanized Congress to create the Fed. Think of crypto as being in the same position today but with extra uncertainty surrounding the value of the collateral since few crypto assets spin off any cash flows. There is nothing stopping many of these assets from going to zero.

By the numbers

Tether matters because of its connection to fiat currency

The ominous bit is that BlackRock’s Larry Fink, who says he likes blockchain technology, has come out and said most crypto companies will shut down due to FTX. BlackRock, itself, had invested a small amount in FTX, too.

Before any particular crypto asset goes to zero, many investors will try and pull their money out. Some will try to get out of crypto altogether, exchanging their crypto for fiat money. And so, the stablecoin Tether will be really important as this saga unfolds.

The Tether website states plainly

All Tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether’s reserves. The value of our reserves is published daily and updated at least once per day.

Sounds pretty good until you realize that statement once read as follows:

Every Tether token is 100% backed by our reserves, which includes traditional currency and cash equivalents, and may include other assets and receivables from loans made by Tether to third parties.

So just maybe, Tether’s assets today are partially backed by those “other assets and receivables.” That means -- although it is pegged to the dollar -- Tether’s assets are not all dollar-like in their safety. Similar to when the US was on the gold standard in the 1960s and the French wanted to convert their US dollars into gold, that’s a big problem if there is ever a rush to convert cryptocurrencies into fiat currency. It could swamp Tether’s ability to convert assets and force it to de-peg, just as the US was forced to de-peg from gold in 1971.

If Tether de-pegged, it would set off a cascade lower in the value of all cryptocurrencies.

Digital Currency Group is the immediate concern 

Hopefully, that’s just a future worry. In the here and now, the largest empire that is impacted by FTX is DCG via its Genesis Trading subsidiary. We know that Genesis was hit by the Three Arrows bankruptcy and likely by the FTX bankruptcy, too.

Genesis halted withdrawals from its lending unit on Nov. 16 after FTX failed because its customers using the cryptocurrency exchange Gemini’s Earn program had money locked up at FTX. As with TerraUSD, the attraction in a world of zero rates was the high yields you could get from staking your money in this program.

Apparently, one group of creditors represented by the law firm Proskauer Rose is looking to retrieve funds. Another group of creditors is represented by Kirkland & Ellis, a leader in crypto restructuring

 However you look at it though, the liabilities for Genesis are piling up. And that puts DCG in a bind since it rescued Genesis after the Three Arrows bankruptcy. It also owns Grayscale Bitcoin Trust,  which Ark Invest’s Cathie Wood called a “” not long ago. But that part of the DCG empire was trading at a discount to net asset value of as much as 45% in the wake of the FTX collapse. This is the largest company close to the FTX collapse and it bears watching.

Binance is the J.P. Morgan of Crypto

On the other side of the LEDGER — seemingly at least —  is Binance, far and away the largest crypto exchange in the world. The most important player in the space now, it’s seen a 30% jump in trading activity as other platforms have fallen. You could even call Binance the J.P. Morgan of crypto because it’s the only firm that has the heft to help organize an end to a panic the way J.P. Morgan did during the Panic of 1907 before there was a true lender of last resort.

There was still a year’s long depression after the Panic of 1907 ended. So, analogously, crypto is likely to still go through a fallow period once this bear market ends. But Binance having the ability to limit the losses is the best bet the industry has, to put a floor under asset prices.

Coinbase is the face of regulated crypto

I’ll end the systemic players here with Coinbase, a company founded a decade ago (ancient by crypto standards) and that had nearly $8 billion in revenue in 2021. It also became a publicly-listed company last year, meaning it has all of the accounting rigor and oversight you expect of a US-listed company.

That’s important in distinguishing it from companies like Binance or FTX which have operated offshore. I doubt the hole in FTX’s balance sheet could have existed at Coinbase. That makes Coinbase a natural survivor, a company that is more an exchange and crypto custodian and less a leveraged lender the way FTX was shown to be. That’s a much less risky business model to weather the storm.

Will it all burn down?

The cataclysm Larry Fink talks about is certainly a risk for the crypto space. Standard Chartered is talking about scenarios where Bitcoin falls another 70% in 2023 to $5,000. With that outcome, the 'interconnected' crypto space has many players whose assets are the liabilities of other potentially-bankrupt companies. And that’s worrying.

Moreover, much of the sense of panic is driven by fickle institutional investors who saw crypto as just another trading space and had no ideological attachment to the technology. They are always quick to withdraw their money to limit losses. There is still enough institutional money involved in the space to justify more bloodletting. 

When does retail throw in the towel? I don’t know. But the core base of crypto enthusiasts tells you the sector isn’t going away. It may fade from prominence as institutional money leaves. Nevertheless, it will always have a die-hard fan base, particularly in the original decentralized form that Bitcoin’s founder Satoshi envisaged. That alone puts a floor under the least speculative ecosystems like Bitcoin.

In the end though, a lack of institutional investor buy-in does mean a slow and drawn-out rebuild for the industry from a non-speculative core. With the devastating washout phase just beginning, this boom-bust cycle will set crypto back much further than the first two crypto winters. An entire generation of investors will have had their fingers burned. The collapse of the crypto bubble is an investment lesson they will not soon forget.

A word about the Fed

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Quote of the Week

Things on my radar

• The US economy is not as weak as some would have you believe.
• Bonds are getting a meme moment too. That’s not necessarily positive
• Economists see an end to covid Zero in China coming.

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