Winter extended

Research Nov 29, 2022

Key Take-aways

·      Crypto prices slumped after the Sam Bankman-Fried revelations resulting in  the failure of Alameda Research (the trading firm he co-founded) and the  bankruptcy of FTX (the exchange he co-founded).

·     Uncertainty as to where the bodies are buried - ie exposures to FTX either direct or indirect - will ensure contagion given the size of FTX within the crypto-sphere.

·     Proof-of-Reserves is the crypto industry’s attempt to mitigate contagion risk, but it  is not as straight forward as people suggest and requires much more than publishing a wallet address.

·      All too-predictably government regulators will use the latest crypto crisis to  justify more and speedier implementation of crypto regulation.

·     The tough times we are seeing in crypto today are down to the dubious practices of individuals not the technology (“new assets, old problems”). The sector is not going away, but is undergoing a cathartic cleansing.


Only a few weeks back, with crypto price volatility trending lower (in some cases to levels below that seen in fiat currencies - looking at you GBP, old bean), many crypto players were bemoaning the lack of price movement.

Well no more. Crypto vol is back in a big way – see chart - as the sector suffers the consequences from the failure of two Sam Bankman Fried’s companies, the trading firm Alameda Research and, more importantly given its size, the FTX exchange which he also co-founded[1].

Bitcoin 30-day Annualized Volatility

Source: Author calculations

Crypto’s Lehman Moment

Back in May I wrote a research note called Crypto Carnage[2] where I said the current environment had a distinct whiff of 2007/8. I was talking about financial markets in general, but what we have seen play out recently in crypto is very much in keeping with this theme. Indeed, many people are now calling FTX’s failure the sector’s “Lehman moment”. Certainly, what we saw back in 2008 in the tradfi sector and what we are seeing now in crypto, are extremely similar[3].

Risk aversion has surged.

In such circumstances, price action is dominated by two things: emotions (fear primarily, which triggers the primeval flight-or-fight response) and game theory (as former BoE governor Lord Kind noted during the Great Recession, “Once the [bank] run starts it was then rational for other people to join in”[4]).

The result of this heady combination is a “shoot first, ask questions later” mentality with investors stampeding like a herd of wildebeest to off-load as much risk as they can, in whatever way they can. The most visible manifestation of risk aversion is the slump in crypto prices, with the major tokens such as Bitcoin and Ethereum down between 30-40% in just two months – see chart. Solana, a token championed by Sam, has performed even worse losing more than 70% over the same time frame, a pretty clear indication of soured user sentiment towards the former golden boy of crypto, who just a matter of months ago was being heralded as the JP Morgan of the sector[5].

Crypto Price Performance

Source: Trading View

Contagion Cascade

As the title of this research note alludes to, despite such heavy losses in my view there is still more downside to come before we hit the cycle bottom (another 20-30% drop in crypto prices would not be at all surprising). The reason is we have no idea where the “bodies are buried”, by which I mean those companies with substantial exposures either direct or indirect to FTX. What we do know though is given the size of FTX – it was the fourth largest exchange globally with trading volumes year-to-date of almost $600bn[6] - there are sure to be more bodies. Contagion is pretty much guaranteed.

Indeed, as information slowly filters out, it is becoming clear that FTX’s woes were rooted in the collapse of Celsius, Voyager and 3 Arrows Capital earlier in the year. Now with FTX’s failure, more bodies are coming to the surface. The crypto lender BlockFi, which Sam Bankman-Fried bailed out earlier in the year, suspended withdrawals and is widely expected to file for bankruptcy, while two others, Genesis and Gemini, have announced a freeze on withdrawals from their lending businesses. The falling of the dominoes takes time to play out.

Judging how long this process will take is obviously very difficult. If we stick with the Lehman analogy, the US investment bank went bust on September 15, 2008 and the equity market bottom didn’t happen until March 6, 2009, so just over six months later. Obviously in the tradfi sector, central banks were able to intervene and flood the system with liquidity. This served not only to limit the contagion effect, but this action also slowed down the “body discovery” process. Absent a central bank in crypto[7], the contagion effect will be relatively greater, deeper, but also faster. A three month time horizon would seem a reasonable guess – but to be clear this is very much a guess.

Who’s Next?

Source: imgflip.com/memegenerator

The Crypto Golden Rule

It is not just crypto prices where we can see evidence of increased risk aversion. Due to the fact that blockchains are public, we have a lot more visibility on investor behaviour than is the case with tradfi markets. One of the clearest trends that we can observe recently is fund withdrawals from centralized exchanges. The number of Bitcoin coming off exchanges has jumped markedly – see chart. These Bitcoin are not disappearing, they can’t. Instead what we are seeing is more investors taking back direct ownership of their tokens via self-custody. In other words, users are relearning the hard way the golden rule of crypto: “Not your keys, not your coins.[8].

Source: Glassnode

Moreover, these exchange outflows are not limited to Bitcoin. The number of wallets receiving ETH from exchanges has also risen sharply as users seek to protect themselves from the risk of contagion from the failure of FTX.

Source: Glassnode

Hello Old Friend

Exchanges are not the only crypto firms in the spotlight. Tether – the largest fiat-backed stablecoin – is in the spotlight (yet again) because Alameda Research, together with another company, accounted for over two-thirds of all Tether minted[9]. That’s a lot of Tether and there have been long standing concerns about the nature of the reserves backing Tether, given they were previously fined more than $40mn by the US regulators for misrepresenting their reserves[10].

On the decentralized stablecoin exchange Curve, it’s 3pool liquidity pool became quite unbalanced in the immediate aftermath of the FTX collapse. Tether’s share (shown in the chart below as the grey area) jumped sharply versus the other two stablecoins in the pool, DAI and USDC, a clear sign that users were preferring those to Tether.

Curve.fi 3Pool TVL (Total Value Locked)

Source: Dune Analytics (@1ronman)

In attempt to allay concerns, Tether recently published it’s latest attestation of its reserves, the breakdown of which is shown in the chart below. It shows over 80% of its reserves are in cash or cash equivalents, which is better than it was before, but still short of USDC’s 100% backing. Judged by the modest down-tick in USDT’s share in 3pool, this reserve attestation appears to have eased nerves, although there remain plenty of sceptics judged by the tone of crypto-twitter[11].

Tether Reserves Breakdown

Source: twitter (via @gaborgurbacs)[12]

Next Big Thing

This push to publish proof-of-reserves for centralized exchanges (decentralized exchanges do not face this issue as crypto assets traded over these platforms are self-custodied[13]) is going to be the next big thing in crypto.

Binance last week started publishing data on its wallet addresses and others are following in their footsteps. This is certainly a good way for people to determine how many tokens Binance holds but the numbers are, in some sense, meaningless without proof-of-liabilities ie. customer deposits. For example, if Binance wallets hold crypto assets totalling $1bn versus $1bn of customer deposits then Binance is in good shape. However, if it is versus $2bn of customer deposits then Binance is not in good shape. What users really want and require is proof-of-solvency - the difference between assets and liabilities - but this is not as easy to provide in an independently verifiable way as may first appear.

Proving ownership of digital assets by providing wallet addresses is trivial, but how can one independently validate if an entity has non-digital assets, or more importantly, liabilities, such as loans outstanding in fiat currency because these are not recorded on a blockchain? In addition, periodic proof of reserves are also vulnerable to the same window-dressing risk that occurs in tradfi, whereby assets are brought “on-balance-sheet” (or on-chain in crypto) just ahead of any attestation or audit and then subsequently returned whence they came. Indeed, this is exactly the sort of behaviour that brought Lehman down[14].

Ultimately, proof-of-reserves (meaning solvency) is going to require the involvement of external auditors to verify the financial soundness of the entity. Some of the larger audit firms are upscaling their knowledge of the crypto ecosystem and developing crypto audit software and analytic tools but there is still a great deal to do, especially given the lack of universal guidance. In short, this area is very much a work-in-progress but, given earning and maintain the trust of its users is business critical for any firm, there are strong financial incentives for firms to make robust progress in this area.

Warp Speed

Publishing wallet addresses is not the only step Binance is taking in order to try to lower crypto’s contagion risks. Their CEO CZ recently announced over the latest member of Elon Musk’s corporate conglomerate that it was setting up a recovery fund to help strong firms during liquidity crises – see below. At a superifical glance, this may seem a positive step to many, but it does raise a key question: who gets to determine who is “strong”? It looks very much like a central bank’s lender-of-last resort function, a centralized model crypto was supposed to make redundant. It is hard to see this going down well with the Bitcoin maxis.

A Crypto Central Bank?

Source: Twitter

What it does serve to underline though is in many respects, what we are seeing is crypto replaying the same mistakes made in tradfi over the past several decades – if not centuries. The only difference being that it is occurring at warp speed.

Cathartic Cleansing

Regardless of whether crypto firms try to clean house themselves, it is clear there is a regulation ramp-up coming. As I noted in a recent tweet, policymakers never let a crisis go to waste and a very next day the CFTC Commissioner commenting on the FTX fallout used those exact words – see image.

Source: twitter

Regulation will be beefed up and implemented sooner in response to the FTX crisis. This is likely a necessary condition for broader public adoption of cryptocurrencies because regulation brings with it the perception of legitimacy. It also removes one of the key impediments for institutional adoption of crypto because they are used to operating in a regulated environment.

This is an important point because the tough times we are seeing in crypto today is not down to technology, it is entirely due to the dubious practices and behaviour of individuals within the industry. That was made starkly evident in the FTX bankruptcy filing paperwork. The CEO that replaced Sam Bankman-Fried to act in the role of liquidator, John J. Ray III, in his affidavit[15] stated:

Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” [My emphasis]

Strong words, particularly coming from someone who he has worked in the legal and restructuring industry for over 40 years and was involved in the failure of Enron (a plausible alternative to the Lehman analogy). The crypto industry is not going away. Too many people – including central banks and tradfi institutions in addition to millions of users – can understand and appreciate the benefits of distributed ledger technology. Nevertheless, it will have to be subject to greater regulation. After such egregious behaviour, if regulators were not to respond with tougher laws then they would be open to accusations of dereliction of duty.

Not everyone in crypto will welcome greater regulations (an understatement for sure) but, after all of the recent turmoil, it is simply unavoidable. Indeed, contrary to the anti-regulation camp, in my view, this will be a positive development for the industry[16]. As I mentioned above, the introduction of regulations, which will also help facilitate independent audits by clarifying the legal frameworks around crypto-assets, will be a key catalyst to bring in institutions. This is a necessary next step towards broader public adoption of crypto, something no one within the crypto world would contest. Once we get through, what I consider to be this “cathartic cleansing” period, crypto will emerge even stronger. Until then we will have to run the gauntlet of more accusations that crypto is nothing but a gigantic bubble in the process of popping.

Tulips, South Seas, Madoffs and Ponzis

The basic idea underpinning such comparisons is that cryptocurrencies are just “bits” floating around in the ether and not backed by anything. This is incorrect. They are backed by something – the extent to which the world’s populace distrusts using the USD-dominated fiat money system. As I have outlined in several prior research notes[17], the extent of this distrust is rising not falling.

Almost all fiat money, and certainly all electronic money used by the general public[18], is backed by debt. For fiat money to be worth something these debts must be paid back in something whose value is maintained in real, or inflation adjusted, terms. With global debt levels, whether measured just in terms of the public sector or including the private sector, at record highs confidence that fiat money will be able to satisfy its store-of-value function (one of the three main prerequisites function of money) is waning – see chart.

Global Debt (% Nominal GDP)

Source: IMF Global Debt Database[19]

As Satoshi himself made clear when publishing the Bitcoin white paper more than 13 years ago[20], the history of fiat currencies is littered with instances of central banks debasing their currencies in order to reduce the debt load on their fiscal authority (governments in this day and age, monarchs previously). What makes the current situation particularly precarious is that the surge in debt is not a result of war financing – as has been typical throughout history – which is quickly curtailed when military action ceases, but is due to sticker fiscal trends. It also does not take into account future unfunded liabilities associated with higher pension and healthcare costs due to ageing populations, liabilities which are far from negligible[21].

Furthermore, as the Russia central bank found out earlier this year fiat money denominated in another country’s currency and held outside your national borders can be frozen/banned. This is the fiat equivalent of “Not your keys, Not your coins”. Concomitant with rising geopolitical tension, distrust of fiat money by nation states such as Russia, but almost certainly others including most significantly of all given its size China, is rising. In light of this, they have clear incentives to develop alternatives. One utilizing cryptocurrencies is a distinct possibility. Not all cryptocurrencies are well-suited to be used as a crypto-based alternative to the current fiat system, but Bitcoin is by virtue of the fact that like gold – the traditional safe haven asset held by governments – it’s an outside asset[22] and able to perform a similar function[23]. In fact, it is arguably better than the yellow metal due to it being much easier to transport across nation-state borders.

Irrespective of what is going on in the crypto markets short-term, this rising distrust of the fiat money system is what will drive crypto price trends over the longer-term because there are not many (if any) alternative viable forms of unbannable money able to support commerce in a world that is becoming digitally native. This is something we should not forget.

One For The Record Books

2022 will undoubtedly go down in history as one of the most turbulent years in crypto. The failure of the algorithmic stablecoin Terra set off a deleveraging cycle that has spread like a virus throughout the crypto ecosystem killing off numerous crypto lenders, hedge funds and even taken down one of the world’s largest centralized crypto exchanges. What we have experienced is a painful, but cathartic, cleansing of the entire industry. Many of the grifters, snake-oil merchants and general spivs have been – or are getting - exposed and ejected from it. For the long-run health of the crypto sector this is unambiguously good. It sets the stage for the next upcycle whose fuel will be the continued distrust of the US-denominated fiat money system. Like the seasons, spring always follows winter, and so will it be for crypto.

Until next time.

Ryan Shea, crypto economist


[1]    According to media reports at least $1bn in client funds have gone missing from FTX - see: https://www.reuters.com/markets/currencies/exclusive-least-1-billion-client-funds-missing-failed-crypto-firm-ftx-sources-2022-11-12/

[2]    See: https://blog.trakx.io/crypto-carnage/

[3]    Obviously not in terms of scale, nor in terms of the likelihood of eliciting a monetary policy response from central banks.

[4]    See: https://www.theguardian.com/business/2007/nov/06/20

[5]    There is also likely a mechanical explanation for Solana’s greater decline. As the leaked balance sheet of Alameda Research showed, after the FTX token FTT, Solana was the  second-largest holding worth over $1bn at the time of the leak – see: https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/

[6]    See: https://www.statista.com/chart/28721/cryptocurrency-exchanges-with-the-highest-trading-volume-year-to-date/

[7]    This is a subject we will come back to later in the research note.

[8]    Consistent with this trend, crypto hardware wallet firm Trezor has seen its sales revenue jump more than 300% week-on-week – see: https://cointelegraph.com/news/trezor-reports-300-surge-in-sales-revenue-due-to-ftx-contagion

[9]    See: https://protos.com/tether-minted-usdt-stablecoin-crypto-two-alameda-cumberland/

[10]  See: https://www.cftc.gov/PressRoom/PressReleases/8450-21

[11]  For an example – see: https://twitter.com/patio11/status/1593432880004202496 but there are many others.

[12]  Original source data – see: https://tether.to/en/tether-proves-resilience-of-reserves-in-latest-attestation/

[13]  There is still risk, especiall in relation to code bugs which could be exploited by hackers.

[14]  Repo 105 was an accounting loophole (now closed) that allowed Lehman Brothers to borrow short-term liquidity by pledging less liquid collateral, in order to flatter the firm’s liquidity ratios – see: https://knowledge.wharton.upenn.edu/article/lehmans-demise-and-repo-105-no-accounting-for-deception/

[15]  See: https://s3.documentcloud.org/documents/23310507/ftx-bankruptcy-filing-john-j-ray-iii.pdf

[16]  As I outlined in an earlier research note – one if I may that is a must-read for anyone interested in crypto (this is not a phrase I use lightly or with the intention of blatant self-promotion) – regulation should also be welcomed by die-hard crypto anarchists – see: https://blog.trakx.io/roadmap-to-utopia/

[17]  See: https://blog.trakx.io/fed-fears/ and https://blog.trakx.io/bitcoin-the-inside-out-narrative/ and https://blog.trakx.io/crypto-reserve-ations/

[18]  ie. not commercial banks who have access to the central bank’s balance sheet and hence reserves.

[19]  See: https://www.imf.org/en/Blogs/Articles/2021/12/15/blog-global-debt-reaches-a-record-226-trillion

[20]  See: https://satoshi.nakamotoinstitute.org/posts/p2pfoundation/threads/1/

[21]  See: see: https://www.oecd.org/economy/growth/scenarios-for-the-world-economy-to-2060.htm

[22]  An outside asset is one that is outside the private sector and has no associated liability – see: https://blog.trakx.io/bitcoin-the-inside-out-narrative/

[23]  See: https://blog.trakx.io/crypto-reserve-ations/

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io