A Flock of Black Swans
Unless you have been off the grid for the past week, you likely are familiar with the shockingly abrupt implosion of FTX. For those just entering the fold, to make a long story short – Sam Bankman Fried (SBF) allegedly stole an estimated $4 billion of customer deposits for Alameda, the fund in which he has a significant ownership stake. Alameda subsequently lost these funds, and now due to declining prices and a run on FTX, the liquidity shortfall has expanded to an estimated $10-50 billion.
Details are still emerging, but it appears that the scam runs quite deep, and unfortunately, many retail consumers, funds, and LPs with funds custodied on FTX, as well as FTX creditors, now find themselves in a dire spot. In the past six months, we have witnessed the unraveling of a web of leverage that entangled the crypto space. It started with LUNA/UST, seemingly resolved in the 3AC unwind, only to find that SBF now appears to have been insolvent as well.
These notes do not serve to commiserate, rather, they are to inform. Therefore, we will save our more colorful thoughts on the issue for a later date.
Risk Not Quite Worth the Reward Just Yet
The Drawdown
Those that follow our work know that we have generally been quite constructive on the crypto market since around July. However, on Tuesday, following the implicit admission of insolvency by SBF, we discussed reducing exposure to SOL and raising cash in anticipation of lower lows in other cryptoassets.
On Wednesday, things came to a head when Binance walked away from a deal to purchase FTX. Crypto markets made new YTD lows on the news as investors scrambled for liquidity in anticipation of additional forced selling.
Bearish Positioning and a Shockingly Low CPI
As is typical following such substantial drawdowns, Thursday was followed up by a rather impressive bounce. However, as we will address below, it is a little premature to trust this bounce.
In assessing whether to redeploy risk, it is helpful to review the scenario under which this bounce took place.
On Thursday, we had an enormous downside surprise on CPI, sending rates forcefully lower.
Stocks had their best day since 2020. Naturally, risk-on-price action should be conducive to oversold cryptoassets (10-Year chart below).
We also saw a massive increase in bearish positioning leading into Thursday’s trading session. On a percentage basis, this was the largest increase in the put/call ratio this year. Thus, it is likely there was some reflexivity at play during the major bounce.
We Still Think Some Bodies Need to Surface
To get to the heart of things, if we have learned anything from the prior credit crises this year, it is that sometimes it takes a little while to find out where the bodies are buried. While there are reasons to be more optimistic about a faster resolution to the whole ordeal (touched upon below), the extent of the residual fallout remains unclear, as it is likely that Alameda had borrowed capital from other players in the ecosystem.
It is appropriate to wait for lower lows as there is good reason to think that there will be other casualties, which could lead to forced selling or, at the very least, bad headline risk.
It is often unwise to point out casualties in the fog of war, but we have already had several potential victims come to light. Below, we see that Genesis, DCG’s lending desk, had a significant balance locked on FTX. This comes after already taking a substantial beating from losses stemming from loans to 3AC.
To be clear, this is not to insinuate that Genesis is on the precipice of going belly-up, this is merely to point out that, once again, several major players in crypto capital markets were tied to FTX in some capacity and we are still missing clarity on the extent of the ecosystem-wide damage.
In fact, we have already confirmed at least one casualty. BlockFi, the centralized crypto services company that required a line of credit from Alameda in July (which now appears to be smoke and mirrors), has suffered its second, and likely its final, KO, reporting that it will be ceasing services for customers in the immediate term
Based on this Tweet from Frank Chaparro at the Block, we will soon gain better insight into where the holes are. Thus, we would be on high alert for the release of any creditors that might pose additional systemic risk.
The Good News is Credit Dried Up
All that being said, as supported by Genesis’ subsequent Tweet, much of the market for centralized credit dried up significantly following the 3AC unwind in June. Based on our conversations with lenders, controls surrounding leverage were tightened up quite dramatically. Thus, it is likely that anything systemic this time around will carry marginally less forced selling as compared to Q2 of this year.
The liquidations on major DeFi applications over the past couple of days support this thesis, as the quantity of forced selling on Aave, Compound, and Maker has been de minimis compared to late Q2. This has a lot to do with the general lack of appetite for putting on leveraged positions in the current environment.
Long-Term Implications
We plan to further evaluate the long-term effects of this event in the coming weeks, but for now, our job is to help clients wade through the current morass. Some immediate thoughts to be elaborated on in future notes:
- Crypto capital markets are broken, but this makes a stronger case for DeFi.
- Decentralization and transparency will hopefully regain attention in the space. Among other reasons, this is an amazing tailwind for Bitcoin, the forgotten King.
- Regulatory clarity is important such that US consumers do not resort to offshore exchanges where they might be exposed to scam exchanges like FTX.
- We expect a refined focus on building productive crypto-based applications that all this financial infrastructure can serve.
- Most importantly, things are never as good as they seem at the top and never as bad as they seem at the bottom.