The Breakdown - The State of Post-FTX and Alameda Research Market Contagion

Episode Date: November 16, 2022

This episode is sponsored by Nexo.io, Circle and Kraken.   On today’s episode, NLW explores the state of the market in the wake of the collapse of FTX and Alameda Research. He looks at hedge funds that have reported funds stuck on FTX as well as overall liquidity conditions. He also looks at the divergence between crypto and other risk assets over the last two weeks. - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - 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. You’re covered by industry-leading security and award-winning Client Engagement, available 24/7. Sign up and trade today at kraken.com. - “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 “Razor Red” by Sam Barsh. Image credit: Alex Wong/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 nexus.io, circle, and crack it, and produced and distributed by CoinDesk. What's going on, guys? It is Tuesday, November 15th, and today we are checking in on the market reactions to the FTX collapse. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it. rating, give it a review, or if you want to dive deeper into the conversation, and boy, is there a lot to discuss right now, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. All right, friends, well, first of all, thank you to all of you

who have sent messages and shared your thoughts after yesterday's episode. It seems to have helped many people understand, and I'm really grateful for all the feedback. Second, in terms of going forward with content. On the one hand, I am, like I'm sure many of you are, pretty ready to not have everything be the Sam Bankman fraud show all the time. But that's said, the fallout from FTX continues to dominate industry news. And so for this week, at least, I expect a lot of the show to be continuing to give updates as that story develops. What's more, SBF's incredibly narcissistic main character syndrome seems to mean he won't let himself stay out of the limelight. So we're going to be dealing with that as well. However, a couple of announcements that should give you some non-SPF light at the end of the tunnel.

The first is that next week, for the second year in a row, I'm doing a Thanksgiving week interview series called Grateful for Bitcoin. I'd been planning this second edition for a while now, but in light of the last couple of weeks, I think the series is even better time than I had imagined. I'll have a number of folks on who are in the Bitcoin mining space, a number of entrepreneurs building on Lightning, a Bitcoin CoreDev and more. When all is said and done, I think it should be a pretty awesome way to really get a feel for the state of Bitcoin, not just from a price or macro perspective, but in terms

of the people who are totally invested in building in and supporting the ecosystem. Now, this series is part of something broader that I hinted at in yesterday's show. My belief is that the rest of 2022, and probably a lot of next year as well, are going to be a really reflective soul-searching time. It's going to be a time when those of us deciding to stick around in this industry really return to fundamentals and ask how we can help both the people who are here now, and those who come in the future, engage with the best parts of it in the right ways. Given that the theme for the breakdown for the rest of the year is back to basics. I'm still going to do the same high-level big-picture power shift coverage I always do,

but interspersed with that, we're going to have discussions of self-custody and the tools that can help with that. We're going to re-examine the fundamentals of decentralization. We're going to hammer, and I mean hammer, a lesson that we've all been forced to relearn. Don't trust, verify. Sometimes these Back to Basics explorations will be just me, but a lot of times they'll feature guests as well, as with the Grateful for Bitcoin series. I'm excited to share that starting today and throughout the rest of 2022, I'll be joined by Cracken as a partner for this Back to Basics theme. You'll hear a message from them alongside our other sponsors, and they'll also be a collaborator for some of this Back to Basics content. Cracken and their outgoing CEO, Jesse Powell, have been one of the absolute stalwarts of U.S. Bitcoin and crypto, with their history going back 11 years.

They've long been a leader on issues like transparency that are more important than ever now. For example, Cracken has been doing proof of reserve since 2014, before most of us were even thinking about Bitcoin. Now, I think it's important to be clear that after all of this, we've learned again brutally why you should never, ever leave your Bitcoin or crypto on exchanges unless you're actively trading. However, when it is time to buy seller trade with integrity, there aren't many better venues you could find than Cracken. I'm excited to have their partnership for Back to Basics. So with that, let's turn to today's updates. Let's talk first about the market context of Bitcoin and crypto over the last couple of days.

One of the most short-term crushing second-order effects of the FTX collapse is that this should have been a big week for Bitcoin as macro headwinds have eased. The dollar index or Dixie, a measure of the U.S. dollar's relative strength against other major currencies, has cooled off significantly, dropping by 5.3 since its peak at the start of the month. Long-term U.S. government bonds also look like they're forming a local bottom, with the 10-year Treasury interest rate falling from more than 4% to a more calm 3.8% last week. US equities have put in a strong rally on the back of these softening monetary conditions. The S&P 500 rose by 5.9% last week, with the NASDAQ outperforming with a 7.1% gain.

These were usually the type of conditions where Bitcoin outperformed, given credence to those who see it at least in a market context as a high beta risk asset. However, the FTX collapse has overshadowed the macro picture. Throughout the week, Bitcoin has dropped 23%, which is the largest fall for Bitcoin markets since June. What's more, the performance gap between Bitcoin and NASDAQ, sits at its widest level since 2020. The total market value of all cryptocurrency is now around $875 billion, according to Coin Gecko. A massive fall from the lofty heights of the $3 trillion market cap for the asset class set at last year's top. Now remember, last year as institutional investors came into the space, the $1 trillion market cap for Bitcoin was seen as a threshold,

where the asset class was no longer able to be ignored by institutions and was in fact big enough for them to play. Bitcoin's market cap today stands at only $323 billion. What's more, there are also new questions to be asked about how much the broader total market cap is just smoke and mirrors. Obviously, we've seen the problems in the last two weeks of calculating the market cap of illiquid tokens, which crash as soon as they're subject to any real cell pressure. In 2021, J.P. Morgan analysts broke from their CEO Jamie Diamond's longstanding skepticism of Bitcoin and crypto in general. They called for a long-term price target of $146,000 for Bitcoin due to its ability to crowd out gold as a hard-money portfolio asset. Last week, however, those analysts were fearful,

saying that the current upheaval and contagion across the space could cause Bitcoin to fall as low as 13,000. They forecast a cascade of margin calls, their words, to ripple throughout the market. Quote, what makes this new phase of crypto-de-leveraging induced by the apparent collapse of Alameda research and FTCS more problematic, is that the number of entities with stronger balance sheets able to rescue those with low capital and high leverage is shrinking. Now, one question many have had is whether the failure of FTX will be a catalyst for institutions to leave the space. Many have claimed this will be the case, and it feels inevitable that for some it will be. Crypto now represents career risk again for CIOs who, during the last bull cycle,

all of a sudden discovered that there was career risk if they weren't exposed to the asset class. However, I don't think it's nearly as universal that institutions will turn away as it might be tempted to think right now in the midst of our agony. Check out another research piece from JPMorgan just this week. The short piece is titled Collapse of FTCS a Painful Step Back, but might prove to be the catalyst that moves crypto two steps forward. It's short, so I'm going to read the whole thing. With FTCS emerging earlier this year as a white night bailing out troubled crypto-related

companies, the news of FTCS itself collapsing this week sent shockwaves through the crypto markets. While this is certainly a major short-term setback, we see the widely publicized collapse of FTCS as potentially dramatically accelerating the timeline to which crypto-related regulation will be ushered in, similar to new banking regulation which followed the GFC. As a result, we see the news surrounding FTX is one step back, but one that could prove the catalyst to move the crypto economy two steps forward, further unlocking the utility value of blockchain.

In fact, we see the establishment of a regulatory framework as the needed catalyst to massively ramp the institutional adoption of crypto. Now, all of that so far sounds pretty J.P. Morganish. But this line, I think, the last line is the one that's giving people some amount of optimism. Quote, moreover, while the news of the collapse of FTX is empowering crypto-sceptics, we would point out that all of the recent collapses in the crypto ecosystem have been from centralized players and not from decentralized protocols. End quote. Now, of course, in the moment that we're living through right now, it's very easy to get pessimistic about our ability to explain that type of distinction to regulators.

But the reality is that a lot of hard work has gone into educating people on both sides of the aisle. And when push comes to shove, a lot of what they're seeing in failures this year is, as we discussed yesterday, not failures of protocols or decentralization, but failures based on the same thing that brings institutions down in traditional finance as well. Greed, hubris, and fraud. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on Nexo Pro. The new Spot and Futures trading platform uses aggregated liquidity of over 3,000 order books collected from multiple sources.

Utilizing the complete nexo suite allows you to earn interest and borrow funds as you wait for the next trade setup. Visit pro.nexo.io. That's p.r.0.n-nexo.i. and sign up today. This episode is brought to you by Circle, the sole issuer of USDC, 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 and has over $45 billion in circulation as of October 13, 2022. Plus, Circle posts weekly reserve reports and monthly attestations of reserve capital,

letting users know that USDA is safe, transparent, and compliant with regulations. Just go to circle.com backslash transparency to see why USDC is a trusted staple coin. As one of the largest, longest-lasting, and most secure exchanges, Cracken continues to set the industry example for transparency and trust. Twice yearly proof-of-reserves audits verify your assets are backed by real assets. Industry-leading security keeps your funds and information safe, and award-winning client engagement teams are available for support 24-7. Buy crypto instantly with fast, flexible funding options on Cracken.

Download the Cracken app on Google Play or the Apple App Store, or visit crackin.com to join. Even if there is some room to be optimistic that it's not totally game over for the industry, we do likely have a lot more pain to go. One of the things that people are waiting to see this week is who fails because of exposure to FTX. Sino Global Capital has announced that it had losses in the mid-seven figures range. The crypto fund, which reported around 300 million in assets under management at the start of the year, had launched its flagship Liquid Value Fund won in partnership with FTX.

The pitch deck for the fund had promoted the fund's early access to the Salana ecosystem, as well as Alameda Research and Sam Bangman-Fried as direct owners of the fund. Sino's CEO, Matthew Graham, has been uncharacteristically quiet over the past week, and still hasn't broken the silence on his personal account, but the Sino Global account did tweet on Monday, quote, Our direct exposure to FTCS exchange was confined to mid-7 figures held in custody. Our investment into the equity of FTCS was made prior to the launch of our fund, and we did not invest any LP capital into FTCX.

Independent crypto market maker Wintermute was one of the first entities to announce losses when FtX closed withdrawals on Friday. The firm's CEO tweeted that they had lost $55 million or so in FtX. Now, heartbreakingly, yesterday friend of the show Travis Kling announced that his fund, Ikega, was also one of those with funds trapped. He wrote, Unfortunately, I have some pretty bad news to share. Last week, Ikeye was caught up in the FTX collapse. We had a large majority of the hedge fund's total assets on FtX. By the time we went to withdraw Monday morning, we got very little out. We're now stuck alongside everyone else.

We've been in constant communication with our investors since Monday. The amount of support we've received has been astonishing, given the circumstances, and deeply heartwarming. It was entirely my fault and not anyone else's. I lost my investors' money after they put faith in me to manage risk, and I am truly sorry for that. I have publicly endorsed FTX many times, and I'm truly sorry for that. I was wrong.

Now, Travis went on to express an emotion that many in the space are feeling, writing, there's a ton of pontification on bigger picture issues that could be done right now, but I just don't have it in me at the moment. I'm pretty disgusted with the space as a whole, and kind of humanity in general. I'm at a loss for words at the depth and breadth of the pieces of shit that permeate crypto. So many f***ing sociopaths were granted the opportunity to do so much damage. It's hard for me to imagine the space bouncing back quickly from this ordeal. Too many got burned too hard. If crypto is to recover and continue on its journey to make the world a better place, I believe the entire concept of trust has to be completely re-architected.

Bitcoin is trustless. Then we built all these trusted things around it, and those things have failed catastrophically. It's obvious now that the space has not done enough to identify and expel bad actors. We're letting way too many sociopaths get way too powerful, and then we all pay the price. If Ikega continues on, we pledge to fight harder in this regard. It's a fight worth fighting. Now, this is the point in the show where if I were going to give it attention, I would sneer about the disgusting attempt by Sue and Kyle of Three Arrow's Capital

to use this catastrophe as a way to claw back and start their redemption arc. I may ultimately have to bring that up and give it a full show and deploy the full power of this platform to make sure that that's not allowed to happen. But for now, I will just say that I very much resonate with Travis, and I hope that this gets better for him and Ikigai. Now, outside of these specific examples, more broadly across the hedge fund space, the likelihood of contagion seems high. According to Grit Capital, 25 to 40% of hedge funds have some direct exposure to FTX equity or FTT tokens.

Their CEO, Genevieve Roche Dexter, anticipates a record number of investor redemption requests from crypto hedge funds in November, in the realm of $2 billion, which exceeds even the $1.3 billion we saw in June. Her estimate of direct exposure to FTC's portfolio companies was 7 to 12% on average across all hedge funds. She anticipates that hedge funds will enforce gate positions, limiting withdrawals due to extreme circumstances, but this would lead to a difficult fundraising environment as investors rightly question the due diligence of many funds with exposure to the FTX empire. In other areas, bankrupt lender Voyager has reopened bidding in a takeover deal which was previously looking like

it would go to FTX. The revelations about the bankruptcy of FTX have cast that deal in a new light. Many speculate that the deal may simply have been a play to stall the liquidation of either FTT or other Solana ecosystem tokens held on the FTX and Alameda balance sheets. Meanwhile, a report from Kyko has outlined the impact that the bankruptcy of Alameda research has had on market liquidity. Calling the phenomenon the Alameda gap, Kyko noted that the drop in liquidity over the last week has been far larger than any previous market drawdown and suggested that it could be here to stay. According to the Kiko report, Bitcoin liquidity around the midpoint of pricing had fallen by around 40% across 18 exchanges. Major exchanges saw drops in liquidity between 18 and 57%.

Liquidity in all coins was even more concerning, they said, with Solana's total market depth falling by 50% aggregated across all order books. While Alameda's absence as marketmaker is obviously playing a role, the general sentiment of fear and insolvency of other exchanges could also be leading in general to market makers reducing their exposure to less trusted exchanges. Finally, a big shoe that many expected to drop today, with the Wall Street Journal publishing a piece that BlockFi is preparing for potential bankruptcy now. Adam Cochran retweeted this news and said, this is what I mean by contagion unravel slowly here. BlockFi was an almost closed deal with FTX, so it was known last week 100% that this would happen, but only now are they announcing to prepare for bankruptcy.

All the funds, startups, and other entities that had bad contagion here will take time to process their books, look for options, and plan next steps before liquidating. Big things unwind slowly. Now, to close on a forward-looking note, a lot of people are asking what comes next, and on that front, there was an interesting thread from Marketmaker Cumberland. They haven't announced any losses, but wrote this thread about changing market structure following the FTX collapse. Last week was Cumberland's most active week ever. Beneath the chaos and explosive volumes, the FTCS bankruptcy has triggered some important market structure changes. For some time now,

the various functions of crypto spot trading have been trending towards a model of all-in-one platform centralization. Liquidity, clearing, settlement, custody, and even lending were coalescing under a very limited number of roofs. A similar trend was taking shape in the crypto derivatives market, where the providers of leverage were one and the same as the providers of liquidity. The events of last week triggered a handbrake turn, and while it's still too early to predict, crypto market structure now seems likely to mirror foreign exchange, a world where assets and capital aren't parked on centralized exchanges. Instead, digital assets will reside in countless silos around the world, and the functions of custody, lending, settlement, clearing, and most importantly, liquidity,

will be offered by an array of intermediary nodes and providers in an interconnected but non-interdependent web. Over-the-counter trading is the lifeblood of Spotfx liquidity, and will only become more important for crypto going forward. After all, currencies are bearer assets and so is crypto. Thus, in 2023, we expect to see the emergence of a variety of regulated entities who will become the trustworthy providers of various well-defined market services. Each will carve out their niche and partner with a network of other providers to offer a full service stack to end users, much like the banks around the world currently aggregate OTCFX liquidity into their settlement mechanisms and offer options for leverage, custody, etc., to clients. Centralized exchanges had every

incentive to push the all-in-one model. In hindsight, some of those incentives were perverse. FTCS was happy to offer 20x leverage because doing so increased the probability that a user would be forced liquidated by Alameda at an unattractive price. Ultimately, markets involve trust and the events of last week damaged trust in the crypto industry. That said, FtX's insolvency absolutely must be differentiated from the viability of blockchain technology. While it's disheartening to watch a large digital asset empire crumble into a modern incarnation of Lehman, Enron, Madoff, and Theranos, no relevant chain stopped processing blocks last week. These industry-defining events are usually the predecessors of market recovery. Now, the dimension that they're talking about this change,

i.e. market structure, may seem a little less exciting or dynamic than other things that people are talking about doing differently. But I think in many ways, some of the biggest changes that actually have the force to reshape the market in a different way could be in the form of disaggregating these centralized companies and making sure that there's no way to accrue too much power and too much coordinated power in one spot. Anyways, guys, like I said, a love. of the content this week is going to be a little bit bleak as we figure out who was really impacted by this collapse and what happens next. But I promise you there will be another side of it. Like I said, get excited for our grateful for Bitcoin series, which starts at the very beginning of next week

and we'll run throughout. And until tomorrow, be safe and take care of each other. Peace.