Crypto Crash

On November 11th the world’s second-largest exchange for crypto currencies filed for bankruptcy. According to Barron’s, the FTX Group conglomerate was worth $38bil a few months ago, and is now worthless. Client accounts are frozen. The filing said FTX may have more than 1 million creditors.

FTX went down in a similar way to Citigroup back in 2008. That is, once people figured out the balance sheet was ridden with low quality assets, loss of credibility and confidence caused lenders & investors to shy away from bailing it out, and caused depositors to demand their money back. Hence, a classic run on the bank.

The crypto world is a real wild west of finance. And FTX was perhaps wilder than most. Much of the activity in crypto markets is unregulated. And the company’s Bahamas domicile helped it avoid accountability. FTX’s subsidiary Alameda Research was apparently using FTX exchange customer assets for its trading operation. That practice is as illegal as it sounds for any US-based broker.

The way FTX went down suggests some intrigue. Competitor Binance, getting wind that Alameda’s balance sheet held a large quantity of FTT tokens, announced it would be selling more than $500mil of those tokens that it had acquired. Predictably, the price of FTT plunged, and so did the value of FTX’s assets. FTX’s stock fell

Now, I need to pause a second and explain that this token was created by FTX and primarily used by FTX customers to access features and services on that exchange. It is no different than the tokens your kids used at Chuck E. Cheese arcades. They’re not dollars, but can be used to buy stuff within the arcade. Needless to say, FTT only lent a veneer of quality to the company’s balance sheet.

Binance knew this, of course, and as the financial pressure on FTX ramped up, Binance announced a bid to buy out FTX (presumably at a big discount). But according to Bloomberg News, the due diligence process broke down quickly because “the issues are beyond our control or ability to help.”

That’s when things really started going downhill. Customer withdrawals initially surged, but FTX’s weak liquidity position (i.e. lots of FTT but not enough cash) meant the company couldn’t honor all the withdrawal requests. Bankruptcy quickly followed.

Unfortunately, this outcome was neither as surprising as FTX’s former CEO claims, nor is it one-off. The crypto complex was down roughly 60% during the first 10 months of 2022 for obvious reasons. This has not been the year of the gambler. When the “animal spirits” are sucked out of the market, investors get pretty sensitive about the quality of assets, cashflow and profits.

Contagion is spreading. The Wall Street Journal reports cryptocurrency lender BlockFi is “preparing a potential bankruptcy filing” due to its exposure to FTX. BlockFi apparently “extended millions of dollars in loans partly collateralized by FTX’s FTT tokens.” With the collateral nearly worthless it’s a good bet a portion of those loans won’t be repaid. Voyager Digital, another troubled lender which FTX tried to bail out, has been left stranded in bankruptcy with no buyer for its assets. Further, a host of hedge funds, pension funds and endowments will be forced to mark down the value of their crypto-related investments.

Bloomberg columnist Edward Harrison says we’re witnessing a “sea change that’s going to keep sweeping through the investment world as an era of easy-money-fueled speculative excess yields to a more hard-headed time driven by results and long-term prospects.” Just like dot-coms in the wake of the Tech Wreck, and banks & mortgage lenders in the wake of the Housing Crisis, crypto will likely suffer a “full-scale retrenchment that lasts years.”