The Breakdown - The Bear Market Evolution of Crypto Institutions

Starting point is 00:00:00 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 nexus.com, and ftX, and produced and distributed by CoinDesk. What's going on, guys? It is Tuesday, August 16th, and today we are talking about an update about how crypto companies can access the Federal Reserve System. Before we get into that, however, if you are enjoying, the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes,

Starting point is 00:00:44 or go to bit.ly slash breakdown pod. Also, a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. Listen, this is what summer is supposed to feel like. Right now, and by right now, I mean literally today, could be wrong even by the time you're hearing this. markets are pretty tame. They seem to have settled into a bit of an equilibrium where moves are small in either direction. You can tell that markets are pretty tame because people have a lot of time on Twitter to argue about complete and utter BS. Right now we're in the phase where people decide to pick fights about stuff they hate. See, for example, Kobe's fight with the entire NFT space. Now, obviously, there are some things that have big fallout that we're still dealing with.

Starting point is 00:01:29 Tornado Cash has been a huge topic of conversation. it's now morphed into a discussion about censorship at the base layer and how Ethereum's move to proof of stake potentially impacts compliance with sanctions at that level, which frankly feels like a really important conversation. We haven't really seen potential regulatory fallout from the UST, Celsius, and 3AC failures, but that's something that could be in our future. But still, at least for this moment, there are just a group of relatively small stories. So let's talk about the most important of them and see if we can't figure out which way the puck is held. headed. We start with some important, if highly technical news from the Federal Reserve in terms of

Starting point is 00:02:09 how new types of financial companies, like crypto companies, can access Fed plumbing. On Monday, the Federal Reserve released its final guidance for novel financial institutions to access master accounts with the Fed. Master accounts are the accounts that allow financial institutions to have direct access to the Fed's interbank clearing and payment systems. They are critical to participation in the domestic and international banking system without having to use institutions as a banking partner, i.e. they allow financial institutions direct access to the Fed without another intermediary. In a statement, Fed Vice Chair, Lail Braynard said, The new guidelines provide a consistent and transparent process to evaluate requests for Federal

Starting point is 00:02:49 Reserve accounts and access to payment services in order to support a safe, inclusive, and innovative payment system. The final guidance is, quote, substantially similar to proposals made in March 2021 and supplemented one year later. The supplemented proposal was open to public comment, which garnered more than 300 responses. The guidance provides for the creation of a three-tiered review system where Tier 1 institutions that had obtained federal insurance would be subject to a streamlined review. Tier 2 institutions which did not have FDIC insurance, but which were otherwise regulated federally would go through a more rigorous review. Tier 3 institutions would be firms that are regulated under state charters and, quote, not federally insured and not subject to prudential

Starting point is 00:03:30 supervision by a federal banking agency. They would receive the most robust scrutiny before being granted a master account with the Fed. Now, this third tier would be where companies like Wyoming state chartered crypto banks, which have ongoing applications for master accounts, would fit into the framework. This includes custodia, which was formerly called Avanti, and Cracken. Some of these sorts of institutions have, quote, novel charters, which in some cases limits the activities they can participate in, require them to maintain full reserves, or allow them to utilize crypto assets in their banking activities. These novel charters have raised concerns at the Fed that they will bring novel risk to the financial system. However, the refusal to grant access to institutions

Starting point is 00:04:11 with novel charters, including fintech banks and crypto banks, has limited their ability to access the U.S. financial system on a level playing field. David Kininski, the CEO of Cracken Bank, told CoinDesk at the time of their application for a master account, quote, novel in terms of the factors they're including here. It's exactly the type of thing that the Federal Reserve is looking at in terms of risk to the reserve itself, risk to the payment system, and risk to the economy. Earlier this year, both Cracken and Custodia received routing numbers for master accounts, which is a key step in the process, but not necessarily an indication that their applications would be successful. Indeed, the process had drawn on so long that in June

Starting point is 00:04:49 Custodia sued the Fed. I cover this in a show called Crypto Fights Back about how crypto was availing itself of the legal system when regulatory processes were taking too long. Custodia raised allegations that the Fed had violated its mandatory one-year deadline on deciding the bank's application, which was lodged first in October 2020. This issue was also raised by Wyoming Senator Cynthia Lummis during Fed Chair Jerome Powell's confirmation hearing before Congress in January. Powell said that the Fed wanted to be very careful, as granting master accounts to banks with novel charters would be, quote, hugely precedental. He cited concerns that hundreds of institutions would soon apply. with implications for the, quote, broader safety and soundness of the financial system.

Starting point is 00:05:29 On the same day that custodias sued the Fed, Cynthia Lummis and Kirsten Gillibrand announced their bipartisan crypto-regulation bill called the Responsible Financial Innovation Act. The bill included a provision that would require the Fed to process applications, quote, on an equitable basis and an order of receipt. An aid to Lummis set on the provisions of the crypto bill, quote, giving more regulated financial institutions access to the payment system reduces risk.

Starting point is 00:05:55 because it allows more visibility into who owes what, and if there's a systemic crisis if a bank were to fail, there wouldn't be as many ripple effects in the economy. Now, of course, the naysayers think all of this is just creating more risk. Arthur Wilmarth, who's an emeritus law professor at George Washington University, said in June, I'm very concerned about the idea that uninsured banks of any type would have access to Fed services and more broadly proliferate, because we've had very bad experiences with non-federally insured banks in the past. I'm concerned they'll become more systemically important and would end up needing us to bail them out if it looked like they're going to fail. It continues to be hilarious to me how much the old world of academia and financial experts

Starting point is 00:06:33 always seem to talk about crypto institutions needing bailouts, when we're basically the one industry at scale where the government hasn't had to step in, and businesses and people can still actually fail. Regardless, folks in the know understand that this is an important, if admittedly, inside baseball step. Jeff John Roberts, the crypto editor at Fortune Magazine, says this is big, as a Fedmaster account is a big part of operating a bank. The Fed has been withholding approval from prudent law abiding crypto applicants for no apparent reason. Anyways, at the end of the day, this is a small but important step. The two most important parts of it, to me, seem to be first giving novel institutions a path to direct access rather than just going through an intermediary. But beyond that,

Starting point is 00:07:12 the big thing here is just the transparency. One of the big complaints from custodia is just not having any idea what's going on or what they need to do. Now, a last note on this topic today is technically the deadline for the Federal Reserve to file a response to custodia around its lawsuit. So I will keep an eye out for anything interesting on that front. In times like these, security of your assets should be your number one priority. If you want to offset risk as much as possible and still stay in crypto, you need a trusted partner by your side. NXO is a security-first company that manages risk by relying on mechanisms such as over-collateralization,

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Starting point is 00:08:32 by visiting us now at chainalysis.com slash coin desk. The breakdown is sponsored by FTXUS. FTXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FtXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use Referral Code Breakdown to support the show. Let's move now to a couple related if slightly different topics. In the institutional crypto world, there are some new entanglements and some detanglements. Cryptoventure firm Dragonfly has acquired Metastable Capital, which is one of the oldest. crypto hedge funds for an undisclosed amount. Metastable was founded in 2014 by, among others, Naval Ravacant. It had over $400 million in assets under management as of their Q2 filings and was

Starting point is 00:09:39 an early investor into Ethereum, Avalanche, Cosmo, Starkware, near Zcash, Filecoin, DFINITY Algo, Rand, and Moore. Now, Dragonfly has been a fund on the rise. In April, they raised $650 million for their third crypto fund and LPs included Tiger Global, KKR, Sequoia, China, and many others. One of the interesting dynamics you're seeing during this crypto bear market has to do with long-term money, in other words, venture capital, which is locked up for much longer than liquid hedge funds, being in a slightly stronger position relative to those liquid funds. Those liquid funds are looking nervously about a potential wave of upcoming redemptions, where investors withdraw their funds reducing the total AUM and making it harder for those liquid

Starting point is 00:10:20 funds to continue. That means on the one hand that some of those more liquid funds are trying to add venture arms. Dragonfly, for its part, has both ventures and liquid, two very different approaches for different investment strategies. On top of this, though, pretty much all funds in the crypto space are thinking about how to position themselves for just a very different type of investment environment than previous venture capital. One of the common threads you're seeing is a lot more emphasis on hiring coders and technical researchers. Dragonfly says in their post announcing the acquisition, quote, crypto is driven forward by technological breakthroughs, an investment

Starting point is 00:10:55 approach that doesn't understand the underlying technology is always going to be shallow. That's why much of our team is composed of technologists, hackers, and researchers. Now, you've seen this from a ton of firms, and it's a fairly big shift. There was another piece of news today that made this point well. Jump crypto, which is the crypto arm of the massive jump trading group, has been building in crypto for a while now. They were a driving force behind wormhole, which was a cross-block chain bridge that was exploited earlier this year, leading to jump spending $320 million or so to

Starting point is 00:11:25 cover losses. Clearly, then, they have the battle scars of this space. They just announced today that they're building a new validator client for Solana. The project is called Fire Dancer. Jump Crypto President, Khan of Korea, who, by the way, started as an intern, wrote, first attempt at a second independent client implementation outside the ETH world, as far as I know. Years of working in the Salana community has only deepened our conviction in the project, and we're pumped to get our hands dirty and doubled down. So this is basically software to help secure the blockchain, but they're also working to propose a number of, quote, significant upgrades to Solana's open source core software. Anyway, the point relative to this show is that

Starting point is 00:12:04 this is increasingly normal behavior for investment firms, whereas Web 2 investors always used to talk about how much value they could add in terms of connections or advice. This is a different paradigm where investors are actually building tools that make protocols more useful and theoretically then more valuable. However, as I mentioned, in addition to new alignments like Dragonfly and Metastate, there are some breakups happening as well. Last year, Galaxy Digital started to work towards an acquisition of crypto custodian BitGo, but it hasn't gone so well. Frank Chaparro from the block wrote a few years ago, Galaxy's acquisition of BitGo, which was touted as the largest crypto deal of its kind at $1 billion last year, still hasn't closed after 16 months. If the deal falls through,

Starting point is 00:12:47 Galaxy will have to pay Bitgo $100 million. Deal was originally expected to close during Q4 of last year, but looks like Galaxy's plans to list. its shares domestically are being held up by the SEC, which is in turn impeding this deal. Frank wrote that on August 7th. This week, on Monday, BitGo announced that it is planning to sue Galaxy for backing out of this $1.2 billion merger. It's seeking $100 million in damages and in a press release said that Galaxy was refusing to pay this breakup fee. The law firm representing Bitco said an attempt by Mike Novogratz and Galaxy Digital to blame the termination on BitGo is absurd. Either

Starting point is 00:13:23 Galaxy owes Bitgo a $100 million termination fee as promised, or it has been acting in bad faith and faces damages of that much or more. A spokesperson for Galaxy said that the company believes, quote, BitGo's claims are without merit. BitGo did not provide certain BitGo financial statements needed by Galaxy for its SEC filing. Galaxy's board of directors then made the decision to exercise its contractual right to terminate. Now, we still don't have a ton of details, but it shows that deals are never done until they're actually done. Staying on this theme of institutions, despite a down market, the big guys keep nudging in. Steve Cohen, the billionaire behind hedge fund.

Starting point is 00:13:58 Point 72 asset management, is setting up a crypto-specific asset management firm. The hedge fund manager has been investing in crypto privately since 2018. The new firm, which is still in the planning phase, will focus on trading spot cryptocurrencies as well as offering crypto derivatives and providing capital to external crypto hedge funds. Earlier this month, Colin had backed out of plans to make a personal investment in crypto trading firm radical. Right now, I would characterize 0.70,000.

Starting point is 00:14:23 22's best contribution to crypto as helping Travis Kling learn about trading in his formative years before he started his own fund, so we'll see if they can top that now. A last note on institutions that relates to markets. We had been in a string of institutional inflows since around the end of June when markets troughed. For six weeks in a row, we've seen net inflows into crypto funds. Indeed, July's $471 million or so of net inflows almost completely erased June's 481 of net outflows. But last week, that street came to a stop, with a very minor outflow of $17 million. James Butterfill, whose coin shares investment manager, wrote in a report,

Starting point is 00:15:01 It's difficult to discern if this is a meaningful change in sentiment given its small size, although minor outflows were seen across a broad set of providers. It also comes at a time of low trading volume and a recovery in prices, suggesting there could be an element of minor profit-taking. As you can see, this is very much within our theme of what summer is usually like. But our last topic in the realm of crypto today is a bit of an update on the situation with Celsius. The crypto lender who filed for bankruptcy last month appears to be running out of money. According to a court filing made on Monday, the firm is projected to run out of cash by October.

Starting point is 00:15:35 The filing also said that the firm has $2.8 billion less crypto than it owes depositors. Last month's bankruptcy filing from Celsius acknowledged a $1.2 billion hole in the balance sheet, but included an estimated value for the firm's mining equipment and other unspecified assets. One of the most concerning holes to people is the one with their Bitcoin holdings. The filing stated that Celsius owes 104,962 BTC, but only holds 14,578 BTC and 23,348 Wrapped BTC. That's a deficit of around $1.6 billion at current Bitcoin prices, which will obviously increase if Bitcoin's price goes up. The firm also holds about $1 billion less ether than it owes to users, but it does own

Starting point is 00:16:16 $410,000 staked ether, which would make up a significant amount of. that shortfall. Still, this wasn't what most of crypto was discussing regarding Celsius. This morning, a financial time story posted about how Celsius CEO Alex Machinsky took control of the firm's trading strategy at the beginning of the year. The context was the January Fed meeting. Quote, In the days before the Fed met, Machinsky personally directed individual trades and overruled executives with decades of financial experience, according to multiple people familiar with the matter. In one case, Mashinsky ordered the sale of hundreds of millions of dollars worth of Bitcoin, refusing to wait to double-check Celsius' often unreliable information on its own holdings.

Starting point is 00:16:55 Celsius, which at the time held $22 billion of customer crypto assets, bought the Bitcoin back a day later at a loss. Quote, he was ordering the traders to massively trade the book off of bad information, one source said. He was slugging around huge chunks of Bitcoin. Now, this story remains, like a lot of things around Celsius, a bit unclear. There are points and counterpoints from different anonymous sources within the piece. Still, it's financial times and it's well-sourced, and it's a fairly good secondary document on what the last six months inside Celsius were like.

Starting point is 00:17:27 So, there we have it. Crypto proceeds on. It continues to work its way into Tradfai. Institutions continue to get involved, in part in traditional ways like consolidation during bare markets, and in part in non-traditional ways, like investors building products and protocols that sit on top of their investments. And of course, we continue to learn more about the contagion of 2022 and what the fallout might be. For now, I want to say thanks again to my sponsors, nexus.io, chain aliasis and FTX for supporting the show.

Starting point is 00:17:55 And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

The Breakdown - The Bear Market Evolution of Crypto Institutions

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