In today’s Exponential Investor:

  • Crypto contagion
  • Assessing the damage
  • How you can be the custodian

Shockwaves are reverberating throughout the crypto markets.

Since 7 November 2022, bitcoin is down 20.8%. Ethereum is down 21.9%.

At the centre of it all is FTX, one of the largest and most popular cryptocurrency exchanges out there.

On 9 November, FTX revealed it was on the brink of collapse following a liquidity crisis.

A series of events over the past 12 months has led to its demise.

The troubles began in July last year, when crypto exchange Binance sold its stake in FTX for $2.1 billion worth of FTT, FTX’s native token.

This came in the wake of tensions between FTX’s CEO Sam Bankman-Fried and Binance’s CEO Changpeng Zhao over attitudes toward crypto regulations.

In addition, a report from CoinDesk last week found that Alameda Research, a sister company of FTX, had billions of collateral for its loans held in FTT.

FTT can’t easily be converted back to cash, causing concerns over the financial stability of Almeda and also of FTX, which has exposure to its sister company.

Commenting via the Twitter social media platform, investment strategist Lyn Alden presented an excellent analogy for FTX’s balance-sheet instability.

Imagine McDonald’s makes its own money, let’s call them clown-bucks, keeps most of it, and sells some to the market.

McDonald’s then uses their remaining clown-bucks as collateral for actual loans. And then people remember clown-bucks aren’t real.

In response, Zhao announced that Binance would sell of its entire FTT holding, leading to a sharp decline in the price of FTT. (At the time of writing, it’s more than 90% down from its 7 November high of $23.09 to $2.87.)

Panic quickly ensued, with FTX holders scrambling to withdraw their funds from the exchange. In excess of $6 billion was withdrawn from the exchange in a 72-hour period, leading to a liquidity crisis and a suspension of withdrawals.

Binance toyed with the prospect of bailing out its stricken rival, but ultimately backed out.

Some are even calling the whole thing a conspiracy, ultimately leaving Binance with a stronger market position.

The debacle has had a wider impact on the crypto world, depressed market sentiment even further.

It also adds to a growing list of crypto companies/networks that have collapsed this year, including Celsius, Three Arrows Capital (3AC) and Terra LUNA.

At the time of writing, bitcoin’s price is about one quarter of the all-time high. Both bitcoin and Ethereum are more than 20% down since the beginning of last week.

Shocks of this magnitude can cause market contagion, leading to fire sales of crypto assets and plummeting valuations.

A classic example of this was back in 2014, when major crypto exchange Mt.Gox filed for bankruptcy despite managing 70% of global bitcoin transactions at the time.

As you can see here, the price of bitcoin plunged 55% between February and April 2014, when Mt.Gox went into liquidation.

Looking at the bigger picture

The FTX story would barely have been believable just ten months ago.

Bitcoin was cooling off from all time-highs, and FTX was sitting pretty, having just completed a fundraising of $400 million, reaching a valuation of $32 billion. It was even planning some ambitious acquisitions to fuel growth.

However, in crypto, things can change fast.

The impact of this FTX episode will likely be felt for some time. For how long is anyone’s guess.

With a growing number of companies succumbing to the freezing cold “crypto winter”, the viability and regulatory soundness of the industry is once again under the spotlight.

However, what we can say is that those who have perished have ultimately set themselves up for failure.

For example, FTX was using its own native token as collateral, leaving its balance sheet at the mercy of token price volatility and illiquidity.

Celsius was pumping customer funds into untested bitcoin mining businesses to try to generate returns.

The same can’t be said for other more reliable exchanges, such as Binance. For example, the exchange uses a Secure Asset Fund for Users, which is a type of insurance fund that can reimburse and protect users against “extreme situations”.

In fact, I even received an email from Binance last week reminding me of the protections that the exchange has in place.

Binance correspondence received by the editor, 10 November

Source: editor’s own

Although some crypto companies have clear systemic flaws, it can’t be said that all are flawed. And it’s those exchanges, networks and companies with protections in place that will emerge from this rocky patch.

There’s also the argument that we’ve been here before.

It was difficult to see a way back after Mt. Gox’s collapse in 2014, and that was even before crypto was recognised at retail, corporate and sovereign levels.

However, bitcoin would go onto recover, and to become further embedded in the global financial system.

The fact that some of the most recognised financial institutions in the world – such as BlackRock, Visa, and BNY Mellon – are involved in the crypto space, shows that this isn’t some kind of fad.

According to Blockdata, more than half of the world’s 100 largest banks have some kind of exposure to blockchain and cryptocurrencies.

Crypto is etching into the fabric of the global financial system, and it’s very easy to lose sight of this when bad news events take over the headlines.

It pays to be vigilant

During these times, it pays to be vigilant by staying on top of the news, your portfolio, and risk-management protocols.

Events like this also underscore just how important self-custody is – i.e. keeping your crypto away from exchanges.

As Mt.Gox and FTX have shown, no exchange is 100% safe when it comes to storing funds.

We recommend you store your crypto in either a cold or hot wallet (i.e. two of the main wallet types). A cold wallet is a wallet that is not connected to the internet.

The most common type of cold wallet is a hardware wallet, which is a small device (such as a USB) that connects to a computer.

Private keys denoting your crypto holdings are sent to and held in the hardware that is not connected to the internet. Examples include the Ledger Nano X wallet and the Trezor wallet.

In contrast, hot wallets are online wallets where keys are stored in the cloud for faster transfer via desktop or mobile. Examples include the Coinbase wallet and the MetaMask wallet.

Although arguably more convenient, hot wallets can be susceptible to cyber-attacks due to their connectivity to the internet.

Be sure to weigh up the pros and cons when deciding what crypto wallet is for you.

Until next time,

Elliott Playle
Contributing Editor, Exponential Investor

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