Crypto Winter — Episode 11, Season Finale
What Actually Happened?
Since the weekend, all eyes have been on the very public spat between the CEOs of two major crypto exchanges, Sam Bankman-Fried (SBF) at FTX and Changpeng Zhoa (CZ) at Binance.
Last week, a report revealed that Alameda Research, a crypto hedge fund controlled by SBF was heavily exposed to FTX’s native currency FTT, a hugely illiquid token, and the fund was potentially insolvent due to its excessive leverage.
This, coupled with revelations that SBF was involved in politically lobbying in a manner which CZ felt would be prejudicial to Binance’s business, led to an announcement from CZ that he was looking to sell his $500m position in FTT token.
This put huge selling pressure on the FTT token, which ultimately sparked a run on the FTX exchange. After $6bn worth of withdrawals on the exchange over the past two days, FTX stopped processing withdrawals yesterday.
In the event, it transpired that Alameda’s large debt exposure was arranged through FTX and backed by FTT tokens and therefore Alameda’s financial position had actually been questionable ever since the 3AC/LUNA collapse in May.
On Tuesday, CZ signalled that Binance and FTX had come to a non-binding agreement whereby Binance would buy FTX.com and cover the liquidity crunch.
Managing Exchange Risk
When managing a fund, there are many types of risk that professional investors monitor and control, and one of these risks is exchange risk — i.e. how much of the fund’s capital is sitting on any particular exchange.
Exchanges can be regulated or unregulated and this is one consideration of risk. The choice of exchanges is based upon a range of risk management metrics, for example, average daily liquidity.
Overall, experienced fund managers try to limit individual exchange exposure where possible, by diversifying across multiple exchanges. This type of diversification helps protect the fund from the kind of rare event that we saw yesterday in regards to FTX.
The alternative to keeping your tokens on exchange is to store them in a ‘hard’ (or also known as cold) wallet. Cold wallets are the ultimate protection from exchange risk but come with their own drawbacks.
You sacrifice speed, efficiency, and the range of supported tokens in return for this additional layer of safety. For these reasons, fund managers tend to use these types of wallets primarily for longer-term token holdings.
Outlook
We at Dragonfly Asset Management are broadly unmoved by recent events. However, we feel frustrated that this is a case of yet another highly leveraged hedge fund getting into trouble and wreaking havoc on a wider ecosystem.
Sadly, for those of us with long memories, this is an all-too-familiar event in financial markets: numerous examples over the years of crises brought about by excessive levels of leverage going badly wrong in a once widely revered hedge fund or financial institution leading to not only their own demise, but to short term chaos throughout the whole market.
But where are we now? We feel that after the collapse of Luna and other highly leveraged funds exposed to it, the failure of FTX represents a necessary and ultimately positive unwinding step for the sector as a whole.
We actually hope that the shocking failure of FTX turns out to be the final contagion event linked to the Luna/3AC crash almost six months ago. This would mean — as was the case in 2008 where markets bottomed six months after Lehman’s actually collapsed — that the digital asset market is now cleared to move forward in a more constructive way.
Although the fall of FTX is huge, it is important to note that it does not in any way negate the positive longer term fundamentals of a sector experiencing high growth in users and meaningful big business adoption.
The other upshot of this shocking event is that it is likely to hasten the implementation of regulation. As we have said before, we actually see regulation as a positive catalyst for the sector. Most institutions in fact say a more certain regulatory backdrop is what is sorely missing in crypto.
But perhaps even more importantly, I believe we will soon see how this sector ‘autocorrects’ to protect itself in the future. What was fascinating to me when I started investing in digital assets was the amazing capacity within this industry to ‘self-regulate’ when new problems surface.
The failure of FTX highlighted some risks that were hitherto not apparent. Just 24 hours later, we are already seeing nine prominent crypto exchanges pledging to regularly compile a ‘Proof of Reserves’ (via a Merkle Tree reserve certificate, detailing total user assets on the ledger) to mitigate against this type of situation ever happening again. This type of proof would essentially remove all questions over an exchange’s ability to maintain liquidity, by demonstrating how customer funds are held, and ensuring consumer protection in the process.
The implementation of Proof-Of-Reserves for centralised exchanges would represent a very positive step-change in the industry and goes to show that even before we get regulation, the industry is adapting with better, more secure practices.
Overall, It is our belief that this too shall pass as it always does with these types of market events. Counterintuitively, there are actually often big beneficiaries in a negative situation like this and we are actively looking to identify them …
PTLIB is CIO of Dragonfly Asset Management.
DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.
