The Breakdown - Exchange Fears Roil Crypto Following SBF’s Arrest

Episode Date: December 17, 2022

This episode is sponsored by Nexo.io, Circle, Kraken and the Galaxy Brains Podcast.   On this edition of the “Weekly Recap,” NLW looks at how the FTX bankruptcy is proceeding following the arrest of disgraced founder Sam Bankman-Fried, as well as the concerns surrounding Binance that have been present all week.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company ensures the safety of your funds and keeps innovating with products like the Nexo Wallet - a non-custodial smart wallet that allows you to create your Web3 identity. Get early access at nexo.io/wallet. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - Kraken, the secure, trusted digital asset exchange, is our sponsor for today's show. Kraken makes it easy to instantly buy 185+ cryptocurrencies with fast, flexible funding options. Your account is covered by regular Proof of Reserves audits, industry-leading security and award-winning Client Engagement, available 24/7. Sign up and trade today at kraken.com/breakdown. - Galaxy Brains: Whether it’s breaking down market volatility or analyzing the latest development, come for the latest market insights from our in-house trading professionals and renowned experts from across the industry. Stay for the occasional rap from host Alex Thorn. Check out the latest episodes here: https://www.galaxy.com/research/podcasts/galaxy-brains/?utm_source=BD&utm_medium=podcast&utm_id=CoinDesk - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “Glasgow” by Falls. Image credit: Malte Mueller/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, circle, and crack it and produced and distributed by CoinDesk. What's going on, guys? It is Saturday, December 17th, and that means it's time for the weekly recap. Now, a quick note before we dive in, there are two ways to listen to the Breakdown podcast. You can hear us on the CoinDesk Podcast Network feed, which comes out every afternoon. and features other great shows alongside the breakdown, or you can listen on the breakdown-only feed,

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If you're here, it's obvious how important it is to you to find reliable information. For more shows like this, For more shows like The Breakdown, check out the Galaxy Brains podcast. To tell you a little more, here's the host Alex Thorne, Galaxy Head of Research. Listen each week as we take you inside the biggest stories and projects in Bitcoin and Crypto. Whether it's breaking down market volatility or analyzing the latest technical developments, Galaxy Brains has you covered. Come for the latest market insights from our in-house trading professionals and renowned experts from across the industry.

Stay for the occasional rap from yours truly. Check it out at galaxy.com slash research. Now, today on the weekly recap, we are looking back at what was a pretty significant week. Obviously, on the macro side of things, there were two big events that happened. The first was that we got November's inflation numbers, and surprise, they came in better than expected. Headline inflation last month was 7.1%, which was less than the 7.3% predicted and down from 7.7% the month before. Month-over-month core inflation was up just 0.2% as compared to 0.3% the month before and 0.6% for the two months before that. What's more, as I mentioned earlier this week when we

were talking about the inflation print, is that the gains were broad-based. It wasn't just a single category that was pushing inflation down, but instead we saw inflation coming down across a number of different categories, which is something to be optimistic about. Now, that fed into the second big macro event of the week, which is, of course, the FOMC meeting. At that meeting, we got a 50-facist point rate hike, which was by and large expected by the markets. When it came to Powell's speech and presser afterwards, we got more of the there's more work-to-do message that the Fed has been sending for months now. I don't think this was entirely unexpected, but what it has done is helped market participants really understand that we are heading into a 2023 that just isn't

going to be a pivot sort of scenario anytime soon. Yes, inflation appears to have moderated somewhat, but it remains persistently high. What's more, the labor market remains incredibly tight, and so the Fed doesn't see any reason to reverse course anytime soon. We've moved our bets around when the Fed changes policy all the way out to the end of 2023 and the beginning of 2024, and to some extent it feels to me like markets are finally settling into the fact that 2023 is going to at least start rough as well. However, let's be real. When all is said and done, when the history books are written, this will forever be known as the week that Sam Bankman-Fries, disgraced former CEO of FTX was arrested.

In a sort of poetic era-to-era-era parallelism, on December 12th, 2008, Bernie Madoff was arrested, and on December 13th, 2022, SBF was arrested. Now, the first buzz happened around 6.30 on Monday, and within 10 minutes, it was confirmed. The Bahamas had arrested Sam at the request of the Southern District of New York. Now, first, people were wondering about the timing.

Remember, Sam was supposed to testify at the next day's House Financial Services Committee hearing, and people couldn't help being skeptical about the timing. Was there any chance that this was planned in order to allow Sam to avoid what would have been extremely uncomfortable and pointed testimony? Certainly, politicians from both sides of the aisle expressed their frustration. However, the next morning, by the time the indictments were unsealed, it was clear that this was not something that law enforcement was going to wait on. Sam was charged with eight criminal counts of fraud, including four different counts of wire fraud or conspiracy to commit wire fraud.

The estimates I've seen for these crimes have a minimum of 115 years and a maximum of 165 years if he was to be convicted on all counts. Piling in were the CFTC and SEC who both filed complaints against Sam as well. Those cases have penalties including fines as well as not being able to basically be in business in any way for the rest of his life. On Tuesday, Sam had his first hearing where he was ultimately denied bail and reprimanded to what seems like a very unfund penitentiary. As you might imagine, a lot of the rest of the week has been more fallout from this situation.

On the bankruptcy side, on Thursday, attorneys acting for FDX filed an application that would begin the process of selling off certain FTCS subsidiaries that appear to be functional and solvent separate businesses. The filing states that, quote, based on their preliminary review, the debtors owner control a number of subsidiaries and assets that are regulated, licensed, and or largely not integrated into the debtor's operation within and outside of the United States. The debtors believe a number of these entities have solvent balance sheets, independent management and valuable franchises. The businesses which are requested to be sold off include Ledger X, the derivatives clearinghouse owned by FTX, as well as FTX Japan, FTX Europe, and Embed Business.

Part of the reason for the sale of these businesses is the halting of withdrawals across the entire conglomerate is bringing increasing regulatory scrutiny. If these entities are independently solvent, then the best outcome would be to sell those businesses off and enable them to transition back to normal operations as soon as possible. Notably not on the list of companies to be sold off as FTX U.S. In congressional testimony, this week, new bankruptcy CEO John J. Ray III, said FtX U.S. was not actually operated as a separate entity. Now, many FTX subsidiaries have had their operating licenses suspended by regulators since FTX filed for bankruptcy. The filing explained, quote, the debtors and or the businesses have been in

active conversations with a number of regulators for the businesses. The licenses held by FTX Europe have been suspended along with its operations, and FTX Japan is subject to business suspension and business improvement orders. The longer operations are suspended, the greater the risk to the value of the assets and the risk of permanent revocation of licenses. Essentially, if business units like FTCS Japan and FTX Europe are solvent and can be processing customer withdrawals, they should be doing that as soon as possible. Selling the businesses off is one way to enable this to happen quickly. The filing claims that FTCS has already received dozens of unsolicited bid for the companies more than 100 in total. If the sale of the companies is approved, preliminary bidding could begin in

late January through early February, with bid dates ranging up to March. In an ecosystem where innovation is the norm, it's the basics that are in the spotlight. NXO is a company that has never put the safety of clients' funds in question. With over 50 global licenses, $775 million in insurance, and a real-time audit of custodial assets, NXO sets an example for security standards in the industry. Apart from keeping their 5 million clients safe, NXO has kept building. They've just announced their non-custodial smart wallet. Visit nexo.io.

That's N-E-X-X-O.I-O. and sign up today. This episode is brought to you by Circle, the sole issuer of USC, and a leader in crypto that's held to a higher standard. USDC is a fast, safe, and efficient way to send money around the globe. USDC is always redeemable one-to-one for U.S. dollars

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Crypto trading firm Wintermute has gained a seat on the FTX Creditors Committee, allowing the company to help steer decisions during the bankruptcy proceeding. The Office of the U.S. trustee, a branch of the DOJ, has also named Venture Capital Company Octopus, the Gibraltar-based Wincent Investment Fund, and a number of individuals, individual investors to represent the millions of creditors owed money from FTX. A U.S. trustee told a bankruptcy court in Delaware on Wednesday, quote, we had a tremendous response to the request to sit on the committee. Among other things, the creditors committee will be expected to weigh in on a controversial

application to protect the privacy of creditors, redacting their personal information in court filings rather than publishing it according to the standard transparency measures of the court. Mainstream media outlets, including the New York Times, as well as the Justice Department, have opposed this measure saying that the publication of a full creditor list is in the public interest. Now, outside of just the legal process, the narrative fallout is intense. Congressman Richie Torres told CoinDesk this week that Sam Bagman-Fried was a, quote, pathological liar. The Democratic lawmaker who sits on the House Financial Services Committee said the details he heard during this week's hearing were, quote-unquote, shocking.

Torres said FTX had the corporate governance of a fraternity. It would be laughable, were it not so serious. Primarily, though, Torres was perturbed by SBF's tweets in the days and weeks following the exchange closing withdrawals. His tweets led the public to believe that FTX had enough assets to cover liabilities, and Torres said of them, he misled the public. He lied. Torres also agreed that there was an urgency to get regulation done. He said, we have a responsibility to act, to translate the lessons learned from the FTX collapse into public policy that will prevent future fraud, future Ponzi schemes. However, he views designating a single regulator for crypto as unnecessary and an unwise approach to legislating the industry. It's not an either-or proposition. It's both, he said. The CFTC should

regulate digital assets that resemble commodities like Bitcoin, and the SEC should regulate digital assets that resemble securities. Torres instead prefers a principles-based approach, which establishes rules related to transparency of balance sheets for crypto exchanges, protection and segregation of customer funds, and separation of powers and duties to ensure that exchanges don't host their own in-house trading firms. Now, remember, Torres is the same guy who requested an investigation into Gary Gensler's effectiveness as a regulator, and I think that his tone gets out what a lot of people are feeling right now in Congress, even those who aren't against crypto in general. Now, FTCS has not been the only exchange in the news this week. It has been a hell of a week for

Binance as well, as trickles of doubt turned into a torrent of withdrawals. Last Wednesday, audit firm Mazar has published what it called a proof of reserves report. Biden's spokespeople were initially a little too comfortable with calling it an audit, while industry insiders and accounting professionals called it not quite an audit and not quite even a proof of reserves. Francis McKenna, a lecturer in financial accounting at the Wharton School at the University of Pennsylvania said, quote, they did a comparison of balances per public key addresses from a list they got from management. They did not compare any balances in independent banks or custodians or depositories. This is more worthless than even the Tether or USDC report. Researcher, Zach Vohl, said this is the same

type of audit that okayed FTX and is definitely not a proof of reserves. It's PR and nothing more. Now, the actual report claim that Binance held Bitcoin in reserves sufficient to cover either 97 or 101% of customer accounts, depending on how outstanding loans were accounted for. It didn't deal with other crypto assets that didn't deal with outstanding corporate debt and ultimately didn't prove much at all. Throughout the weekend, the Fudd built, but was mostly contained a Twitter post until on Monday, a major run on deposit started. Both jump crypto and winter mute, two prominent market makers pulled hundreds of millions of dollars out of Binance on Monday, and regular customers followed suit. To make matters worse, Reuters published a bombshell report that morning,

outlining deliberations within the DOG as to whether prosecutors had enough evidence to move forward with charging Binance and CZ with money laundering related to the exchange's conduct in 2018. On Monday afternoon, Binance halted withdrawals of USDC on Ethereum. CZ claimed this was part of scheduled maintenance, but it now appears that the issue was that the USDC and Binance's Ethereum wallets had run dry, and the process to refill them required going through U.S. banks to convert Paxo's stable coins into circle stable coins, delaying the efforts. CZ explained as much at the time, but everything is being viewed in a different light, given the collapse of FTCS and especially SBF's infamous 11th hour attempt to stop the run on FtX. By Tuesday, concerns were

running hot. Inability to withdrawal stable coins was one of the earliest signs that FTX was in trouble, and CZ's communications were not calming nerves. Tron's Justin's son even showed up to very publicly deliver some emergency liquidity just as he had with FTX. But then all of a sudden, the run was over. Wintermute had returned their money, and CZ basically said this was business as usual. He tweeted, we saw some withdrawals today, net 1.4 billion-ish. We've seen this before. Some days we have net withdrawals, some days we have net deposits. I actually think it's a good idea to stress test withdrawals on each centralized exchange on a rotating basis. It costs some network fees to run these quote-unquote tests, but it keeps the industry healthy. All told, Binance saw more than 3.5 billion worth of net

outflows across two days, and handled gross withdrawals somewhere above the 8.5 billion range. Emerging on Tuesday, Bloomberg reported a leaked memo from CZ, which warned staff that, quote, we expect the next several months to be bumpy, we will get past this challenging period, and we'll be stronger for having been through it. He added that Binance was facing a lot of extra scrutonies and tough questions. But still, there was a pretty distinct narrative shift after that initial quote-unquote run earlier in the week. Part of that is that a lot of folks are looking at Binance's financial situation, and just from on-chain analysis, from identified Binance cold wallets, reports are that Binance holds in excess of $60 billion worth of crypto assets. Many people are

taking that as a sign that while we don't have good indications of the overall health of Binance's balance sheet, we do know that they have a giant pile of assets to service withdrawals with. Now, in many ways, then, the questions are turning to the nature of the collateral itself. One of the big questions for people is how appropriate exchange tokens like FTT and B&B are to be used as collateral in reserves. Also, for as much as the narrative shifted from the beginning of the week to the end of the week, on Friday, CZ got dragged all over Twitter for a CNBC clip, where he appeared to avoid questions about clawbacks after the FTX bankruptcy. To take another example in the Bernie Madoff case,

a huge portion of investors who had made net profits from the scheme had those profits clawed back to make creditors whole. Typically, payments made in the 90 days leading up to bankruptcy could be subject to clawbacks, but in cases where there is manifest fraud as a central pillar of the business, this can be extended. So far, we have no information on whether the FTX case will be viewed this way, but CNBC hosts asked CZ whether Binance could handle a clawback of their $2.1 billion buyout of FtX stock. Rather than addressing the question head on, CZ simply said, we're financially strong we would let the lawyers handle it. This clip, to be fair, taken out of context in most cases has been making the rounds around crypto Twitter and shows less about Binance and more about the

fact that right now, and hopefully going forward, we're good, trust us, is no longer an acceptable answer. Anyways, guys, as I was prepping this show, it also appears that a couple of the firms who have been most involved in auditing crypto companies, including Mazzars, and if Forbes is right, Arminino, are abandoning the industry, and that is hugely problematic. But for now, we're going to punt that, we'll return to it Monday, when I have a little bit more of a chance to actually see what's real and what's not. For now, I want to say thanks again to my sponsors next to dotio, circle, Cracken and Galaxy brains, and thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.