FTX spreads contagion and anxiousness

On Tuesday last week, major crypto exchange FTX halted withdrawals, following a week of dramatic events. On Friday, the exchange filed for bankruptcy after the largest crypto exchange Binance scrubbed its intent to acquire the troubled exchange the day before.

Today, the new CEO and chief restructuring officer of FTX, John Ray, filed the first declaration following the bankruptcy of FTX. On the very second page, Ray states that he has never seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information”. For context, John Ray led the restructuring of Enron. The filing presents countless ways, in which the control of the company has been in a few hands. Further, the declaration states that Alameda Research borrowed billions of dollars from FTX, which was later lent to former FTX CEO and co-founder Sam Bankman-Fried (SBF) and other key employees of FTX.

Contagion from crypto companies to funds

As we speak, the most notable contagion has been with respect to Genesis Trading. The large trading firm announced shortly after the collapse of FTX that it had $175mn stuck on the exchange. Yesterday, Genesis announced that its crypto-lending unit is halting customer withdrawals, citing “abnormal withdrawal requests which have exceeded our current liquidity”. The firm further said that its trading and custody units remain operational, while it expects to publish a plan for its lending business next week. It appears that its parent company, namely Digital Currency Group, tries to raise money. On top of this, crypto lender BlockFi has halted withdrawals. Following BlockFi’s own collapse earlier this year, FTX was about to acquire the troubled lender, so BlockFi halting withdrawals was fairly expected. As of now, other exchanges and brokers that have come forward have allegedly lost more immaterial amounts.

Next, various funds have lost a consequential part of their assets under management, for instance, Multicoin Capital and Ikigai Capital by keeping the majority of their assets on FTX. In our view, this can for years negatively impact to which extent funds can access capital outside of the crypto space, as the trust in the latter has taken a severe hit.

Various exchanges commit to more transparency

Paradoxically, Bitcoin was created during the financial crisis in 2008 to form transparency and reduce reliance on financial intermediaries. Yet, the case of FTX indicates that the crypto market is everything but that. For crypto to evolve into more than a speculative asset class, it must return to the values that laid the foundation for its creation, instead of being a market, in which shadow banking can seemingly emerge.

Fortunately, many exchanges have stated that they intend to provide proof of reserves frequently. This includes Binance and OKX, whereas Kraken and BitMEX are already doing proof of reserves. In the future, market participants will hopefully only choose exchanges that make proof of reserves. The latter does not replace proper accounting or regulation, yet it is a step in the right direction, as the case with FTX would likely have been discovered quicker had the firm provided proof of reserves.

Funds flow from exchanges and hardware wallets are acquired

The hole in FTX’s balance sheet came as a surprise for the market, effectively spreading fear that other exchanges and brokers are facing liquidity issues or insolvency. About this, on-chain data suggests that many investors are preparing for this scenario, as billions of dollars worth of crypto assets have left exchanges in the past week. Notably, the number of Bitcoins and Ether stored on exchanges have decreased by around 240,000 BTC and 2mn Ether, respectively. Too, hardware wallet manufacturers such as Ledger and Trezor have experienced an increase in sales since the collapse of FTX.

If this outflow of funds from exchanges to self-custody continues, we are likely to realize sooner rather than later whether other companies face liquidity issues or insolvency as well. This indicates that the next couple of weeks is crucial in terms of potential greater contagion.