Q9 Weekly | Crypto Contagion

18 November 2022

Q9 Capital: www.q9capital.com

Crypto Contagion

• +1mn depositors owed money by FTX
• New CEO: it’s a bigger mess than Enron
• Which firms could be next?

It will take time (and multiple federal investigations) to fully understand what happened behind the scenes at FTX. But as we end week #2 of the saga the impact is already becoming clear. Over 1mn depositors are owed money and the cascade of systemic failure is in motion.

Since last week, BlockFi has shuttered its operations. Trading behemoth Genesis’ lending unit has halted customer withdrawals, Gemini suffered a $485mn rush of outflows in 24 hours after suspending its yield-earning program. Crypto.com’s Cronos (CRO) token tanked following proof-of-reserve concerns. AAX “temporarily” shut down. Temasek, Sequoia, SoftBank have taken more the $600mn in write-downs. Crypto Fund Research estimates that 25–40% of crypto hedge funds have some direct exposure to FTX.

…and much much more…

Lost Balance

The balance sheet of FTX was revealed by the FT.

Source: FT Alphaville

It showed that after the $5bn of customer withdrawals, FTX had $8.8bn of liabilities, which were largely in USD ($5.1bn), only $0.9bn of liquid assets to cover withdrawals (10% of liabilities) and they were relying on the value of its illiquid assets to add value to the company and cover its liabilities.

Source: Morgan Stanley

Sliding Sideways

Yet crypto prices haven’t collapsed. Bitcoin’s price has been relatively resilient despite the incoming headlines. This may be because crypto hedge funds and investors that have assets stuck with FTX have not yet decided how to manage risk in the rest of their portfolio. But crypto liquidity was already tightening ahead of this event and this will catalyse it — which will usher in a period of increased volatility on smaller volumes.

Major Crypto Assets vs USD, 1 Week

Source: TradingView

Fiat offramping (crypto-for-USD trades) seems to have calmed. After a spike last week, users are now cashing out of crypto at roughly the same rates they were before the FTX crisis.

Source: Chainalysis

And Bitcoin whales are leading an aggressive accumulation phase on reduced asset prices, in spite of the implosion.

Source: Glassnode

A Long Ray to Go

The new FTX CEO, John J. Ray, issued a scathing assessment of “unprecedented” poor management practices by his predecessor in a series of filings in a Delaware court. Ray has overseen some of the biggest bankruptcies ever, including the collapse of the energy giant Enron, and has 40 years of experience in restructuring companies. He said he had never seen anything as bad as FTX.

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

Here are some of his jaw-dropping findings:

• FTX’s exchanges are “expected to have significant liabilities arising from crypto assets deposited by customers . . . However, such liabilities are not reflected in the financial statements prepared while these companies were under the control of Mr. Bankman-Fried.”
• A “substantial portion” of assets held by FTX may be “missing or stolen”.
• Alameda Research gave Bankman-Fried a $1bn personal loan and a $543m loan to the director of engineering, Nishad Singh.
• The Alameda and VC divisions “did not keep complete books and records of their investments and activities”, so their balance sheets will need to be built from scratch.
• Rescue attempts will be hindered by “the absence of lasting records of decision-making”, which was “one of the most pervasive failures of the FTX.com business”
• SBF “often communicated by using applications that were set to auto-delete after a short period of time, and encouraged employees to do the same.”
• There was “no accounting department”.
• FTX never had board meetings. Neither did most of the subsidiaries.
• There was no daily reconciliation of crypto positions. A software backdoor “concealed the misuse of customer funds”.
• Alameda had a “secret exemption” from the FTX’s liquidation procedures.
• Employees submitted expense reimbursements over chat. A random manager would accept or reject those reimbursements with an EMOJI.
• FTX had no cash management system. Management had no idea how much cash was on hand at any given time, or even where all their cash was.
• FTX didn’t keep proper records of who they employed. Certain employees can’t be located: Which could mean that some employees were fake.
• Corporate funds were used to purchase personal use real estate. Employees and executives put their names on homes purchased with company funds.
• Crypto deposited by customers weren’t even recorded on the balance sheet. Presumably, all crypto assets just went into one central slush fund used for whatever.
• His report concludes “findings to date indicate that serious fraud and mismanagement may have been committed” at the company.
• He has also managed to make some sense of the chaos diagram (see our previous weekly) that was FTX’s pre-bankruptcy corporate structure:

Who’s Next?

What happens next will be contagion. In the next few weeks its certain more firms will fail.

Cautious investors are scrambling to move their crypto from centralized exchanges amid growing concerns around the solvency of other centralized exchanges. Binance, Coinbase, KuCoin all experienced large deposit drawdowns. Some smaller platforms, such as AAX, Liquid and Salt, have halted withdrawals.

First expect to see borrow/lenders calling back loans, pulling liquidity and some going insolvent. Some mid-tier exchanges (and possibly a few large ones) will also likely close shop soon. Then we have the VC projects who FTX invested in — many would have been required under contract to post part or all their treasury at FTX. Many will now be unable to pay their bills so expect a portion of their 300+ VC deals to go under. Then we may see some market makers in trouble who have funds locked at FTX. This all pulls liquidity from the system just at the time when many folks, including the crypto miners, need it.

Binance in now launching a recovery fund to help rebuild the industry and is putting in a bid to rescue Voyager (FTX had previously won an auction for the firm).

Morgan Stanley compiled a list of firms (below) who have publicly announced exposure to FTX. Those that haven’t yet declared exposures are going to be probed by the markets as an area of concern.

Exchanges Exposed to FTX

Source: Morgan Stanley

Lenders, Traders, Market Makers Exposed to FTX

Source: Morgan Stanley

Venture Capital Exposed to FTX

Source: Morgan Stanley

Crypto Protocols, Applications Exposed to FTX

Source: Morgan Stanley

Regular Regulation

The FTX situation stems from old fashioned financial fraud rather than a blockchain or crypto-specific failure.

In many ways it is similar to Enron. Both relied on the role of publicly-traded assets linked to the performance of the firms themselves. Both also moved assets between entities that were nominally (or even legally) separate, but in fact served the same masters. This enabled egregious financial self-dealing in the form of balance sheets pumped up by fictional valuations. These unwound rapidly as soon as the falsely-inflated assets began to waver — in this case, FTT.

The failure now puts the entire industry under scrutiny and has dealt a blow to the crypto industry’s hopes of pushing favorable legislation through Congress in the near term and ratcheted up pressure on the SEC and other regulators to crack down. But this is probably a good thing. Gone are the days of regulatory arbitrage and black-box rehypothecation.

Leaders across the industry are applauding an abrupt shift toward transparency through providing proof-of-reserves. It’s a good first step but it needs to go much further. It doesn’t prove that the firm has more liabilities than assets or much of the other required information necessary to ascertain the financial health of a firm operating in this space.

What the industry needs is supervision. Regular and transparent audits. Segregation of client assets. The separation of facilitation and custody. Bankruptcy remote trusts. Regulatory supervision and oversight. High levels of investor protection.

While it’s unfortunate to see this type of event happen to our industry, we continue to build for the future of digital assets in a new regulated world. It’s business as usual at Q9.

In the News…

• Uniswap overtakes Coinbase as 2nd largest exchange trading Ethereum today
• Banking giants and New York Fed start 12-week digital dollar pilot
• Aussie stock exchange abandons blockchain plans, leaving $170mn hole
• Class action filed against Tom Brady, Larry David and others who endorsed FTX
• What the Genesis loan suspension teaches us about crypto lending
• Hong Kong keeps crypto commitment after FTX collapse rattles market
• Sony tries to patent NFT and blockchain technology usage in games
• How North Korea became a mastermind of crypto cyber crime