Crypto-Concern in Context

January 27, 2023

Juicy headlines aside, fallout from the FTX affair looks to remain largely contained to crypto markets.

The collapse of the FTX Cryptocurrency Exchange late last year shook the political and financial worlds, as some $10 billion of customer funds were reportedly removed from the exchange, much of which is apparently still unaccounted for. Bitcoin, which was already down 60% from its peak, fell even further in the wake of the bankruptcy.

We believe the failure of FTX has raised serious questions about the transparency, regulation and ethics of the $1 trillion cryptocurrency market. Moreover, the story is likely to remain in focus, given the reported lack of guardrails at FTX and the arrest of CEO Sam Bankman-Fried, who faces charges of fraud, money laundering and election law violations.

Show Us the Money

Nominally, FTX operated as an exchange on which customers could trade and hold cryptocurrencies. But when lenders started recalling their loans and customers sought to withdraw funds from the exchange in high volumes, an inadequate pool of liquid assets left the company unable to meet the redemptions.

Exchanges typically segregate unmargined customer assets, so they should not experience this sort of liquidity crunch. But it appears that FTX used customer assets as collateral to finance the operations of Alameda Research, the firm’s proprietary trading and investment business.

The incident raised fears about other large cryptocurrency exchanges, many of which operate offshore, like FTX, in jurisdictions that do not have stringent requirements around segregation and safeguarding of customer funds.

Low-Contagion Event

However, we do not believe FTX will prove to be a systemic risk for markets. In fact, an arguably more serious incident occurred in May, when the TerraUSD algorithmic “stablecoin,” which was supposed to exhibit a 1:1 relationship with the U.S. dollar but was not fully backed by liquid assets, effectively “broke the buck.”

The Terra/Luna ecosystem had a market capitalization close to $50 billion at the time, and the event led to the unwinding of a significant amount of leverage in the crypto universe and the failure of some of the weakest players in the industry. The silver lining is that this appears to have helped limit the damage wrought by the later failure of FTX and the related fallout, including a recent bankruptcy filing by Genesis, the cryptocurrency lender.

The Terra/Luna collapse (and subsequent failure of Celsius and Three Arrows Capital) contributed significantly to last year’s crypto sell-off. According to CoinMarketCap, the total market capitalization of all recorded cryptocurrencies has fallen from almost $3 trillion in November 2021 to around $800 billion today. For context, this compares to the $110 trillion-plus market capitalization of global listed equities.

More importantly, institutions with large holdings in traditional markets—where stresses can therefore have wider ramifications—have tended to steer clear of significant exposure to cryptocurrencies, as have most hedge funds, foundations and banks. The same is not true of high-net-worth investors, of which almost half have reportedly adopted some exposure within the last two years, but this is not something that in our view poses any threat to the broader health of the market.

Continuing, but Contained

In sum, the crypto universe remains relatively small in comparison to other risk assets like equities, with limited overlap for contagion into traditional markets. Beyond any financial implications, reports that various politicians received political contributions from Bankman-Fried may produce new storylines over time, but that’s another topic entirely.

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