WEEKLY, Nov 12, 2022

Hi everyone! In a week that felt like a year but flew by in a minute, we were reminded of the value of community, the role of communication and the need to keep learning. It was a week that has left all of us grappling with the sadness that so many are suffering, as well as with concern that we won’t know the full impact for some time, and that it won’t be good. As we digest the shock of the week’s events, let’s remember why we’re here – to learn about a technology that has the potential to offer more choice and independence to anyone, anywhere, and in so doing empower individuals, make markets more accessible and efficient, and support new forms of creativity and production.

This is the free weekly edition of Crypto is Macro Now.

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MARKETS

The crypto market’s key driver this week – in spite of a better-than-expected CPI figure, the risk sentiment adjustment, a key election in the US that did not go as expected, and the dollar’s drop to a three-month low – was the expected fallout from the collapse of one of its leading exchanges, FTX.

While the S&P 500 rebounded almost 6% over the week and the dollar index saw its largest one-day drop in a decade, BTC and ETH fell a painful 21.3% and 23.6% respectively.

I go into more depth in market drivers in the premium daily Crypto is Macro Now – since this was a particularly key week, I’ll make the past few issues free to access here if you’re interested. And if you are, do please consider subscribing!

COLUMN

We Will Trust Again: What the FTX Collapse Says About Where We’re Going

After one of the most dramatic weeks in crypto history, in which a large and highly regarded trading platform was revealed to be engaging in shady financial management resulting in a multi-billion-dollar balance sheet hole and the bankruptcy of over 130 related companies, we’re left wondering how this could happen in an industry created to obviate the need for trust.

That question is naïve, however – while details are starting to emerge around how much money was moved where and why, the underlying reason is this: we chose to trust.

The instinctive reaction, then, familiar to all who have had trust broken, will be to vow to never be that vulnerable again. In finance, we do now have the technology to facilitate a relatively trust-free financial relationship with atomic swaps, transfer monitoring and balance verification. But, just as our bruised souls almost always eventually recover from personal disappointment and we again open our hearts to others, we will see that we can’t live without centralized services that require us to believe they are doing what they say.

This is a consequence of internal and external systems that we can’t do much about.

The internal system is our emotional makeup. We humans are wired to rely on others for survival. It’s why our ancestors formed tribes, clans, countries. Modern times have given us the means to feed ourselves and shelter without help, and yet most of us still seek out friendship and a sense of belonging because satisfying emotional needs alone is not yet something we are good at. The parallel in commerce and finance is the energy-saving convenience of having specialists handle as much as possible, creating satisfying connections while freeing up our time for other pursuits.  

The external system is the regulatory framework many of us live in. When it comes to financial services, our choices are limited to those offered by counterparties that have satisfied certain requirements designed to ensure that we are making informed decisions and that our assets will be recoverable. Hardly anyone reads the small print of the terms and conditions we need to accept before we can transact – it’s a better use of our time to assume that they make sense. We also don’t demand proof that the firm follows sound practices – we assume that it would rather avoid the punishment of non-compliance with the law.

But crypto was created to be different. Perhaps too much so for us to emotionally adapt in such a short timeframe.

We didn’t have to trust FTX – there are decentralized alternatives, after all. But we chose to. We could have insisted on more clarity on the balance sheet, done some forensics on token movements earlier, asked why no investors were on the board of directors. But we didn’t.

We fell into the ingrained habit of trusting a centralized provider, for many reasons: the convenience, the potential for return, the sense of belonging, an instinctive respect for smarts and eloquence, as well as the uplifting satisfaction of rooting for the scruffy underdog and seeing him succeed.

This is perhaps the result of drawing inferences from patterns – if a company is big and successful, it must be legit, right? If it has so many offices in so many jurisdictions, if it is supporting the growth of the industry in so many areas, if the founder has so many famous and powerful friends, then surely the verification work has been done, right? Throw in a hefty dose of ideology, and you get a supportive crowd whose strong desire for the concept to triumph suppressed the normal checks on common sense. And there’s the affective reflex that drew in even non-believers: who doesn’t love a nerdy outsider who quietly and intelligently explains how he’s going to make the world a better place by reforming finance and giving away most of his money?

I’m not pointing any fingers here, except perhaps at the mirror.

So, what next? Do we eschew centralized platforms forever because we can’t be trusted to vet them properly? That sounds appealing right now, and the resilience and growth of decentralized applications paint a landscape of empowering potential. But we know that many of us will slip back into the habit of instinctively choosing convenience over safety, convinced that we will be better at spotting danger signs next time. After all, convenience breeds efficiency which generates economic gain, and as humans we instinctively gravitate toward comfort and collaboration.

We can do better. We can accept that centralized platforms will form an integral part of our markets, while learning from this debacle and designing tools that make trust less based on blind faith. This is already happening – over the past week, several platforms have announced that they will publish “proof of reserves”, a combination of cryptographic and traditional audit that enables users to independently verify that a platform’s assets match or exceed customer deposits.

Going forward, VC investors, some of whom will have a bit of uncomfortable explaining to do over the coming weeks, will become more rigorous in their due diligence, at least until the next hot fad comes along. Lobby groups and policy teams will work with regulators to draft disclosure rules while fending off hasty limitations and destructive definitions. Institutions will step back from the edge of radical innovation but are likely to continue to support an emerging structure that looks familiar but can deliver better returns. And the industry will continue to build a stronger offering that showcases a fundamental tenet of its existence: greater choice for individuals, anywhere. Those who want to use decentralized services should be able to do so. Those that prefer the convenience of a centralized offering deserve reliable services.

This may read like wishful thinking. But I trust human nature to do what it does best – find a collective solution to the generalized demand for protection while supporting niche solutions for outlier groups. After all, throughout history these non-mainstream idealists have been the innovators that succeed in pushing through reform when their ideas end up delivering better efficiency and empowerment than the existing system.

We will trust again. As we should – it’s part of who we are, and a necessary feature of communities that build value. We have to understand the concept better, though. An awareness of why we trust is an essential part of designing systems to deliver what we need while mitigating vulnerabilities fed by our short-sightedness.

The FTX debacle has left pain and anger in its wake. It’s in our hands to make sure nothing like this happens in our industry again, while at the same time understanding how we got here. It’s also up to us to pick ourselves up, support those that are struggling, and continue moving forward. Part of the process will involve accepting that centralization will be a necessary but carefully crafted feature of the decentralized system we hope for. Part will be believing that, with the help of technology and much better messaging, we can achieve our goals without trying to change the nature of the people that make this industry the diverse force that it is.  

KEEP AN EYE ON

(The main themes from the week, summarized.)

The biggest thing to happen this week, arguably ever in crypto, was the rapid disintegration of the FTX empire. And I do mean rapid – the embers started smoldering last week, but it only took four days to go from “everything’s fine!” to what is likely to end up being one of the most complicated bankruptcies ever.

It would take volumes to do the drama justice, but let’s abbreviate by looking at a handful of the key aspects.

What happened?

A summary timeline:

Nov 2

In what turned out to be an industry-shattering exclusive, CoinDesk shared details of the balance sheet of crypto market maker/hedge fund Alameda Research showing an unhealthy concentration of assets related to FTT, a token issued by its sister company crypto trading platform FTX. This raised concern because FTT was 1) illiquid, and 2) its value was directly related to revenues of sister company FTX, both of which intensified risk.

Nov 6

Alameda’s CEO Caroline Ellison tweeted that they have $10 billion more than reported, and most loans have been returned. All good.

Just over an hour later, CZ – the founder of FTX’s largest competitor Binance – tweeted that he planned to sell his FTT. Given the token’s illiquidity, this triggered a sharp price drop.

Concerns started to circulate around FTX since presumably its balance sheet also had a significant amount of FTT. Not good.

Nov 7

FTX founder Sam Bankman-Fried (generally known as SBF) tweeted that FTX assets were fine (the tweet was later deleted).

Nov 8

Only maybe they weren’t so fine. FTX and Binance announced that Binance signed a Letter of Intent to acquire FTX. (This is where everyone working in the crypto industry collectively went “WHATTTTT???” And when alarm started to really spread, since apparently they don’t like each other much.)

Reuters reported that FTX had seen $6bn of withdrawals over the past 72 hours.

A few hours later, FTX suspended withdrawals.

Nov 9

FTX and Alameda websites went dark.

In a move that dismayed everyone but surprised no-one, Binance backed out of the deal.

Bloomberg reported that SBF had warned investors earlier in the day that FTX needed $4 billion to stave off bankruptcy.

Semafor reported that FTX’s compliance and legal teams had resigned (it had a compliance team?).

The WSJ reported that the SEC was investigating FTX.

Nov 10

FTX suspended customer signups.

SBF tweeted an apology and offered hope that FTX could be saved. He also confirmed the closure of Alameda.

A slew of announcements hinted at preparations for a wind-down:

• FTX Japan ordered to halt trading

• FTX’s General Counsel ordered documents preserved

• FTX US resigned from the Crypto Council for Innovation

• FTX US said that trading may be halted in a few days

• Bahamian regulators froze the assets of FTX Digital Markets and related parties

• FTX Australia called in the administrators

Nov 11

FTX and 133 related entities including FTX US and Alameda declared bankruptcy, and SBF stepped down. John J. Ray III, who played a key role in managing several notable bankruptcies including that of Enron, took over as CEO.

How bad is this?

It’s very bad. This is arguably the worst blow to the crypto industry ever, in terms of confidence and eventual economic impact. It’s worse than the Mt. Gox exchange implosion – that was painful for all involved, but it was in the early days when the ecosystem was limited to a growing cadre of bitcoiners who all accepted that they were dabbling in the “wild west”. It’s worse than the Terra ecosystem implosion – that was an innovative experiment based on a flimsy incentive structure, and even most of those hurt acknowledged that, bummer, the bet didn’t pay off. It’s worse than the collapse of Three Arrows Capital – that was a hedge fund engaging in unsafe financial practices, and while it cut deep, well, it’s not the first hedge fund to do that.

This was a reputable crypto platform that lost a colossal amount of client funds. This platform, the fourth largest in terms of volume, had business interests in almost all areas of the ecosystem: trading, lending, payments, credit cards, venture capital, NFTs, sports sponsorships, charitable donations, gaming, music festivals, even luxury fashion for some reason… A couple of weeks ago, it was reported that it was working on a stablecoin. It had operations in the Bahamas, US, Europe, Africa, Australia, Japan and Turkey. It was helping the South Korean city of Busan develop a stock exchange and blockchain integration. It had stakes in non-crypto financial companies such as banking app Dave, traditional exchange IEX and Robinhood. It bought stock-clearing company Embed to move into equity trading. Its reach was vast, and the mess that needs to be cleared up is for now unfathomable.

What’s more, the CEO of this platform, the man solely responsible for the loss, was the most vocal proponent in our industry for greater regulation of crypto platforms. He was the best-known crypto face in Washington DC, had influential friends and investors, and was generally well-liked. That he turned out to be solely responsible for the loss (details are still coming in, but the evidence so far points to his mismanagement) feels like a betrayal on many fronts, and is likely to end up significantly hurting our industry’s credibility.

Collateral damage

Many clients of FTX have funds trapped on the exchange, and most of those funds have probably vaporized. These are retail clients, who perhaps counted on those funds for future expenditures or even living expenses. They are also institutional clients that are now going to have to find a way to plug the hole this leaves on their balance sheets. We are already starting to see a trickle of announcements from companies disclosing the extent of their hit. This will continue for some time, and we could end up seeing other companies also have to fold.

This could end up leading to more asset sales which in turn could lead to more margin calls and more asset sales. And the uncertainty as well as the expectation that institutional buyers will now be much more cautious in entering the industry could keep prices down for a while.

But there is some upside

I’ll talk more about the upside next week since it feels a bit too soon for now. It is definitely there, though, and it revolves around not just lessons learned leading to a stronger ecosystem, but also the removal of even more leverage.

The bottom line is: the industry will survive this hit. Blockchains still work, pseudonymous transparency is much better than no transparency, decentralized financial functions will end up disintermediating many of today’s bottlenecks and the promise of greater choice when it comes to transaction tokens and rails will continue to empower more people in more jurisdictions.

Even industry old-timers are rattled by this. Some will take a break. Many uber-smart people hovering on the edges may think twice before entering. But I’ve encountered very few that are planning to abandon the potential entirely. Those of us that have been around for a while know that we will get through this, and emerge stronger.

A YEAR AGO

(This section looks back at what was going on this time last year, so we can see how far we’ve come and how far we haven’t.)

Different times. Thursday was the one-year anniversary of BTC’s all-time high, when it broke through $69,000. Sigh.

More carefree times. NFT creativity was in full swing this time last year. Spanish soccer team Valencia CF launched “in game” NFTs, the Country Music Association released an NFT collection for its latest award show, and Universal Music Group, the largest music company in the world, created a Bored Ape band.

More constructive times. Early November 2021 saw some eye-watering raises (including a whopping $725 million for blockchain gaming platform Forte), and Solana was the absolute darling of the layer-1 blockchains.

GOOD READS/LISTENS

• An excellent write-up by Arcane’s Vetle Lunde from earlier in the week, with a passion that hinted at the debacle that was to unfold.

• A good read from BitMEX founder Arthur Hayes.

• Lucas Nuzzi of Coin Metrics does some forensics on how the FTX hole happened

• Some relevant on-chain analytics from Glassnode, also in video.

• Podcast: Unchained – Laura Shin talks to Erik Voorhees and Cobie about the FTX fallout, SBF’s motivation, and some potential consequences.

Have a good weekend!

After the week we’ve had, most of us in this industry are probably feeling exhausted, sad, reeling from shock, or most likely all of the above. The life coaches will tell you that at times like these it is helpful to get outside and look up at the sky. But it’s raining where I am and it just might be where you are, too. So that won’t help. What WILL help is this: as soon as you have a clear night sky, get outside and look up at the moon. It really does quieten the mind.

There is something poetically humbling about remembering that we are tiny specks on a celestial body that gracefully arcs through space not too far from another celestial body that sometimes lights up the night with a beautiful glow. For some the moon is a giant spherical rock that can influence tides, for others it is the stuff of myth and legend, for many it’s both… but I have never met anyone who doesn’t occasionally stand open-mouthed, looking up.

This week this is particularly relevant because on Monday we had a blood moon eclipse, the last total lunar eclipse until 2025. I didn’t get to see it in person because of the timing, but I did watch the livestream and it was beautiful.

(screenshot via CNN-News18)

(other photos by me)