There is no fire at Binance yet, but the smoke is filling the building.

Following the collapse of FTX all eyes have turned to the other opaque offshore exchanges, waiting and wondering which could be insolvent and about to detonate next. The similarities between FTX and Binance are numerous which is a major cause for concern. In the Crypto industry often where there’s smoke, there’s fire.

Binance’s Similarities with FTX

Both exchanges are located offshore, outside of the reach of major nation regulators. While FTX appears to have been cozy with the regulators in the Bahamas; Binance seems to have no fixed address, instead hopping between jurisdictions looking for friendly regulators along the way. This hasn’t been limited only to suspect jurisdictions like Dubai and Singapore, Binance most recently cozied up to regulators in France, gaining registration in the region as a home base for European operations.

We have very little information in the corporate structure of Binance. What little we do know is that there appears to be a complex web of ownership and subsidiaries scattered across various jurisdictions.

As Bloomberg put it in June: Binance “is based in who knows where and owned by god knows whom.”

The similarity in the exchange tokens offered by each company is obvious. FTX famously offered their FTT token to give discounts to users on the front end. Behind the scenes the token allowed FTX and their associated hedge fund, Alameda Research, to functionally print their own collateral to take loans against and use to fund buyouts throughout the industry.

Binance’s BNB token had similar origins, but has now moved on to become the ecosystem token for the fully fledged Ethereum competitor, Binance Smart Chain. There is no direct evidence that Binance has leveraged BNB in a similar way that FTX used FTT; but it’s not difficult to imagine some of the same balance sheet tricks have been used.

We do know that Binance operates a large ecosystem incubator called Binance Launchpad. This program allows startups to access funding in exchange for launching their projects on Binance Smart Chain. Recently details have emerged indicating that in order to list tokens on Binance, projects would be required to post a sizeable insurance deposit with the exchange. These deposits would be denominated in BNB, adding additional demand for the token.

Binance was the first money into FTX

Back in 2019, when FTX was getting off the ground they took on Binance as their first strategic investor. The size of the Binance investment remains undisclosed but we do know that alongside this investment, Binance received a sizable allocation of FTT tokens.

In July 2021, FTX suddenly bought out Binance’s stake, again for an undisclosed amount. What we didn’t know at the time was that despite raising $900M from fresh investors at the same time, FTX still funded a portion of the buyout using FTT tokens rather than fiat currency.

Binance was building up a gigantic bag of FTT tokens.

We all know what happened next, in November this year Binance CEO CZ announced that they would be divesting of their FTT tokens, crashing the market and shortly afterwards resulting in the bankruptcy of FTX.

While this background is important, it doesn’t necessarily follow that Binance is also insolvent. The links between FTX and Binance are simply too deep to ignore. The similarities in strategy are too many to dismiss as merely a coincidence.

It is entirely possible that Binance runs its business using exactly the same tricks as FTX but at a much larger scale.

Have you got my money?

Over the past several weeks, customers have decided to test the liquidity of Binance. After the collapse of FTX, Binance was one of the few exchanges that were seen as relatively trustworthy and saw inflows as users moved funds around. This all stopped recently when Binance published their “proof-of-reserves”.

Binance tried to promote their proof-of reserves report as an audit. It was nothing of the sort.

The report showed that Binance did indeed have some wallets with billions of dollars worth of Bitcoin in them. The report didn’t prove anything about non-Bitcoin assets and reserves. It didn’t prove how much the exchange owed to customers.

The report didn’t even prove that Binance had control of the wallets.

Industry figures immediately called Binance out. Kraken CEO Jesse Powell was particularly strong in his warning that the report proved basically nothing. The audit firm that conducted the report stopped working with Crypto firms shortly afterwards and deleted all of their publicly available Crypto reports, including the Binance reports.

Does Binance have enough reserves? Probably, but customers weren’t waiting around to find out.

In the week after the report was published, customers withdrew around $8B worth of assets. An additional $5B in assets flowed into the exchange, however some of these flows appeared to be emergency liquidity provided by other firms, used to service withdrawals. At one stage Binance halted withdrawals of USDC, claiming that they needed to wait for regular banking hours to top up their wallets.

Just like FTX, customers were draining the funds out of Binance.

Binance has largely serviced the withdrawals so far. That’s to be expected, it’s a gigantic entity and has a large amount of reserves. It might not have enough reserves to service withdrawals indefinitely, but for now the funds appear to be flowing.

What’s different this time?

Taking a closer look at the FTX run on deposits can give us some insight into how and why Binance might ultimately fail. The biggest difference between the two exchange runs is that the run on FTX began with a sell off in the exchange token, FTT. In contrast Binance’s BNB token has taken some punishment but the sell off has been nowhere near as extreme.

If Binance is running the same shell game as FTX, they will be solvent until BNB drops in value.

At FTX, the exchange token and various other Solana ecosystem tokens were the lifeblood of the exchange’s balance sheet. FTX and Alameda were holding FTT as a significant chunk of reserves, their internal financials were leveraged off FTT, and FTT was the major collateral held at external lenders.

FTX only hit problems when that collateral value fell and lenders pulled their credit lines.

According to Nansen, Binance holds around $54B in reserves. We don’t know what the liabilities attached to these assets are, but around $5.5B of these assets are BNB tokens. We know that Binance subsidizes margin loans for users using BNB as collateral. We know that 20% of BNB tokens are held off market and do not circulate (this is not uncommon for 2017-present era cryptos). We do not know how much of Binance’s business is based on leveraging BNB collateral. We have no idea whether Binance has an embedded market maker, like Alameda Research. We do know that Binance has cold wallets and reserves, while no one could ever find cold wallets for FTX.

There isn’t an obvious problem with Binance so far, but if something is going to break over at Binance it will likely start with a rapid devaluation of BNB tokens, rather than a bank run.

What happens next?

Binance has already weathered a major run. BNB has drawn down by almost 30% since problems showed up at FTX in early November. The stress is palpable, but at the end of the day Binance is a juggernaut. It is the largest exchange by a long way. It has daily volumes an order of magnitude larger than all of its competitors bar Coinbase. We know there are reserves and the exchange has been servicing a huge amount of withdrawals with relatively small hiccups.

I still don’t trust Binance. There is no reason to store your coins on Binance unless you are trading them.

I fully expect that a gigantic amount of Binance’s business is leveraged off BNB being used as collateral, and that if the value of BNB drops too much it causes some major problems. But I don’t know for sure. In June, while the rest of the Crypto markets were blowing up BNB was defended strongly at $200. Make of that what you will.

Overall these problems at Binance feel a lot like previous waves of FUD surrounding Tether. The entire thing looks and seems dodgy, but over the last 5 years basically everyone who has been too enthusiastic and piled into shorts has been chewed up and spat out.

The casino isn’t fair, but betting that the house will break is usually a losing bet.

Stepping back, I don’t think that Binance will end up blowing up like FTX did. They don’t seem to be taking the same sorts of risk with their business operations. If there is an issue that ends up bringing down Binance it seems much more likely that a major regulatory crackdown does the just than just a run on deposits.

There are plenty of angles that could get attacked by regulators. Binance operates a regulated Crypto on-ramp in a multitude of jurisdictions. They are allowed to accept bank deposits through these entities. Any major attempt to shut down Binance via these local on-ramps could have significant ripple effects throughout the rest of the Binance empire by constricting fresh deposits.

For now, Binance looks the shakiest it has since 2018. They have giant reserves and regulatory obfuscation. They’ve also been playing this game for a long time and have grown the largest among competitors.

That’s not a good excuse to leave your funds there. This is one you want to watch from the outside (Editor’s note: We’re so adamant you should be self-custodying your Bitcoin that we’ll even pay you to do it. )

Eventually Binance could break, and I don’t want to wait to find out. For now, there is no fire. Only lots and lots of smoke.

Today’s post is from contributing analyst Scott Hill. To receive further updates of this series and our overall investment thesis for digital assets (even in this climate), subscribe to the Bombthrower mailing list. 

This is the third and final part in our recap of the collapse of FTX. In the first two issues we covered what happened in the weeks leading up to the failure of the exchange and how Alameda Research and FTX became so entangled and fraudulent in the first place.

Today we’ll cover the contagion and fallout throughout the Crypto industry and some lessons learned by Crypto investors and industry insiders.

Leveraged Unwind

The Contagion that we are seeing from the failure of FTX is mainly an unwind of built up debt between Crypto companies. This is acting with a lag as a majority of companies with financial problems were already on the ropes from earlier in the year as a result of the collapse of Luna/Terraform labs and Three Arrows Capital.

The list of Crypto lenders that have so far filed for bankruptcy as a result of these earlier problems include Voyager, Celsius and BlockFi. Gemini’s yield program has halted withdrawals. Nexo has announced that they will exit US markets but have not yet announced financial problems.

If you haven’t already, you should strongly consider whether any of the yield generating accounts at Crypto companies are worth the risk.

 These failures are all a result of counterparties defaulting on loans. Essentially, Crypto hedge funds and other entities took on loans from these lenders during the bull market and have failed to repay this year. To compound this issue towards the end of 2021 and in early 2022 the Crypto lending space was so competitive that loan terms were extremely favorable.

Lenders were growing rapidly and courting new investors. To be successful they needed to grow their loan book at any cost.

Kyle Davies, a co-founder at Three Arrows Capital explained in this interview that his Fund was offered billions of dollars in loaned funds on an uncollateralized basis. Other lenders were making loans on low quality collateral. Some were slow to liquidate loans as collateral value dropped.

This mechanism was a large part of the story of the FTX collapse. It appears that loans from other companies were being taken using FTT tokens and FTX stock as collateral with no plausible way to liquidate those assets anywhere near book value.

This is widely speculated to be the reason why FTX CEO Sam Bankman Fried attempted to bail out insolvent lenders like Voyager and BlockFi earlier this year, to ensure that they did not liquidate his FTT collateral.

This means that the contagion is very different to previous eras of Crypto collapse. It’s not hacks that are causing issues as happened in 2014. It’s not voluntary selling of assets as we saw in 2017 with ICO treasuries. It’s insolvent companies with giant holes in their balance sheets from defaulted loans.

DCG and Genesis

This brings us to the Genesis of all of the leverage in the Crypto industry, Digital Currency Group (DCG) and their subsidiary lending and prime broking service, Genesis. So far Genesis appears to have at least $1.8B owed to creditors. Its parent company DCG is on the hook for $575M that comes due in May next year and another $1.1B owed to Genesis in 2032.

Details are limited and DCG has gone quiet, but it appears that DCG has already committed to backstopping part of the faltering Genesis loan book.

We have no real idea how deep the hole is at Genesis. In early 2021 we learned that their total loans outstanding stood at $3.8B. This had increased by more than 5x since June 2020. It’s not inconceivable that Genesis had $10B in loans owed to it when it halted withdrawals in November. With so much carnage rippling through the industry it’s impossible to know how many of those loans are still performing and how many have defaulted leaving bad debt on the books.

For the first time since its 2013 founding, the DCG empire could be crumbling.

 While you aren’t all that familiar with Genesis as their dealings are mainly with other large Crypto firms, you are definitely familiar with the family of DCG companies. DCG owns Coindesk and Grayscale, which operates the Grayscale Bitcoin Trust. They also hold one of the largest venture portfolios in the industry, with fingers in almost every pie.

Among other things, Genesis loans are used as the counterparty to many yield products throughout the industry. The first shoe to drop was Gemini’s yield program, which simply passes through Genesis loans onto consumers, which is why they were forced to gate withdrawals shortly after Genesis.

Problems at DCG are problems throughout the Crypto asset class.

As the major Crypto prime broker and lending provider, the halting of withdrawals at Genesis is a major problem. Even if the lender can tidy up its books and continue to operate, their pause in normal operations likely means that Credit and business operating loans throughout the industry are much more constricted than normal.

How will Genesis Shake Out

Problems at DCG are not the same as problems at smaller Crypto Firms. The company has a wide range of assets that they can sell off to recapitalize the business and can seek outside investment if push comes to shove. There have been rumors about fundraising attempts while an offer to purchase Coindesk for $300M was apparently rejected as too low a bid. The main point is that DCG appears to need additional funding to maintain operations, but it might not be at a crisis point where the whole company is about to go under.

For example, early rumors that the Grayscale Bitcoin Trust could be liquidated seem to be unfounded.

That’s not to say that there aren’t deep problems. It would not be at all surprising if Genesis were sold off or allowed to enter bankruptcy. A sale of Coindesk would not be surprising. The total collapse of DCG and the sale of Grayscale, one of the major revenue sources for the corporate group, would be surprising to say the least.

With all that said, we just don’t know. DCG has been uncharacteristically quiet for weeks and nothing they have said inspires any confidence.

Silvergate

Another institutional Crypto company having problems is Silvergate bank. Silvergate is a US registered and publicly listed bank whose place in the industry was providing banking services to Crypto companies. In 2017 Crypto companies had awful trouble finding reliable banking services who would not close accounts. Silvergate fixed that and gained most of the banking business in the industry.

They claim not to have any exposure to FTX, but they were the banking partner

This opens up two big problems. Firstly, a major part of the FTX story was the dubious banking arrangement, where customers were asked to wire funds to the affiliated hedge fund, Alameda Research, rather than to FTX bank accounts. CEO Sam Bankman-Fried claims that FTX did not have access to banking at the time, but it appears that this practise carried on far longer than could be considered reasonable.

If Silvergate were aware of this arrangement and allowed it to continue, regulators will have some serious questions to ask.

The second and more minor issue is that banking naturally carries significant settlement risk as funds are debited and credited across accounts, sometimes opening up short term loans as settlement finalizes. It doesn’t appear that FTX has left a big gap in Silvergate balances through settlement failures, but it’s a possibility.

The other angle here is that if Silvergate had a major part to play in improper banking for FTX, they could find themselves liable for fines and even clawbacks of funds into the FTX bankruptcy. Members of Congress have already asked for information and it seems likely that a regulatory investigation is coming.

Solana Ecosystem and Wrapped Tokens

It’s no secret that FTX and Alameda had a big role in investing in and guiding the Solana ecosystem. Sam Bankman-Fried and associates had an outsized position in several ecosystem tokens like Serum and Maps. Solana token price has already been cut in half since FTX failed and ecosystem tokens are even more badly down.

The less obvious problem in Solana was that the major wrapped assets were custodied by FTX. Sollet, the wrapped Bitcoin token is currently trading at a 95% discount to Bitcoin. Most traders missed this small but important point as the FTX collapse was happening, but it’s a useful piece of information to keep in mind.

Not all wrapped assets are created equal.

 If you participate in DeFi you no doubt use wrapped assets. They allow you to trade and use assets from one blockchain on a different one or sometimes just provide a different token standard as a wrapper.

The major wrapped assets to be aware of are wBTC and wETH. The differences are important and useful to understand.

In the week after the FTX collapse there was a Twitter joke about wETH having problems. This led the asset to depeg from normal ETH tokens, despite being exchangeable 1 for 1. Articles were written in an attempt to calm panicked sellers of the wrapped token after the joke was reported seriously by Bloomberg.

Types of Wrapped Tokens

Wrapped ETH is a token which places an ERC-20 wrapper around ETH token, allowing it to take advantage of more advanced features of the Ethereum Blockchain. This process is handled entirely by a smart contract. The stash of ETH tokens can be viewed on the blockchain. The total supply of wrapped ETH can be audited in real time to monitor for problems. Nothing can go wrong with this system and funds can’t be stolen unless there is a smart contract exploit.

A big part of what makes wETH extremely safe is that it is self contained in the Ethereum ecosystem.

These sorts of smart contract wrapped tokens are similar to bridged assets. These wrapped tokens also operate by smart contract, but across different blockchains. They feature smart contracts on both blockchains which will custody native tokens and mint wrapped tokens on a different blockchain as requested by users on a 1 for 1 basis. At least that’s what they do when they’re operating properly.

Bridged tokens often break and have security exploits, the technology is extremely complicated and open to hacks.

Bridge exploits are by far the most common DeFi hack, with more than $2.5B stolen from bridges in the last two years.

The final type of wrapped asset is a custodial wrapped asset, which includes the Solana wrapped assets which were custodied by FTX and other more commonly used wrapped assets like wBTC and stETH on Ethereum. wBTC is custodied by BitGo and operated by a DAO, they have fairly good transparency and seem unlikely to suffer problems, but it’s important to be aware that if BitGo goes into bankruptcy, wBTC could have issues. stETH is issued primarily by Lido and is set up in a similar way with similar risks.

The main point is that if you are using wrapped assets, you should understand who holds the custody of the underlying token and whether they are at risk of financial problems.

Solana Wrapped assets are trading at a giant discount and unlikely to be fully convertible. I don’t think there’s a high likelihood that wBTC or stETH have similar issues, but it’s worthwhile being aware that they could have problems. If you’re holding wrapped tokens, know who the counterparty that can unwrap them is and whether or not they are trustworthy and solvent.

Lessons

Here are the big take-aways from all this…

Self Custody

The first and most important lesson out of this giant mess is that every investor in Crypto needs to know how to self-custody their assets. It’s the same lesson that was learned out of the 2014 Mt Gox collapse. It’ll likely be the lesson from the next Crypto crisis.

There is no excuse. Learn how to take custody of your Crypto. Easy self-custody is the major innovation.

There’s a range of options, if you’re only dabbling then use a software wallet like Metamask or Exodus. If you’re a little more serious you’ll want a hardware wallet like a Ledger or a Trezor which are available for less than $100. At the high end it might be worth considering a shared recovery service like Casa.

Whichever way you go, know how to Self Custody. Know how to move your Crypto off an exchange and onto your wallet. Practice doing it so that you can remove your funds when things go poorly.

During the FTX collapse, the people that could remove their Crypto the day that things started looking bad kept their coins. Others lost theirs.

Know Your Counterparty

The firms in the Crypto industry are not like banks or stock exchanges. They don’t have anywhere near the same regulatory scrutiny. They don’t have the same insurance. They don’t do the same audits.

This isn’t the wild west, but it’s still close.

If you’re giving your money or your Crypto over to an exchange or custodian know your counterparty. Know their counterparty. Read the terms of service and see what the risks are. The most surprising failure out of the FTX collapse was Gemini Earn closing down. They weren’t exposed to FTX but they used Genesis who suffered losses in the FTX collapse.

As a general rule, if you’re earning yield then your Crypto is being lent out. At the moment most of the yield products are closed down or bankrupt, but keep this in mind for next time. It doesn’t even have to be your chosen custodian that has problems, this industry is small and most firms have exposure to a wide range of counter-parties.

Always gauge whether the risk associated with the yield you’re getting is worth it. During this cycle plenty of investors lost their entire investment because they were chasing 10% yields. When the next bear market starts, your first thought should be whether you still want exposure to lending firms.

Know what you own

Not all Crypto assets are created equal. If you’re dabbling in altcoins and DeFi, know how the tokens you own are connected to the larger ecosystem.

As we already covered, wrapped assets have unique risks and that needs to be recognized. Ecosystem tokens, that is altcoins within a broader protocol should be viewed as having a strong correlation to the ecosystem they live in.

Problems in one place can easily spread.

Understanding how these tokens move together and how problems in one part can affect other parts is vital as the Crypto token ecosystems get more and more interlinked.

Proof of Solvency

While my advice would be to not have any tokens on any exchange or with any custodian at the moment, that’s not practical for everyone and people do need to trade sometimes. Ryan Sean Adams at Bankless has coined a phrase that I think explains how to think of exchanges at the moment:

Think of an exchange like a public restroom. Go in, do your business, and get out.

This isn’t the period where you want to hold assets on an exchange without a good reason. We’re heading into Christmas which is historically a low liquidity period. While a lot of insolvent firms have been flushed out, it feels decidedly like there are more shoes to drop.

While Binance has performed a proof of reserves there are numerous problems with their approach and some weird activity on their order books has left traders nervous. It’s unthinkable that Binance could be insolvent, but I wouldn’t want to have any funds there at the moment.

Kraken is the exchange that has the longest history of doing proof of reserves. Their CEO has recently been pointing out problems with other firms auditing, including Binance. He has also been advocating self custody.

If you need to keep assets on an exchange, Kraken appears to be safer than most, but their CEO is telling you not to keep your assets on any exchange.

Coinbase is the other big exchange. They’re publicly listed. They’re rigorously audited. Does that mean they’re safe? No. Do I trust them not to have problems? No. But they’re also safer than most.

There should be no real reason to keep a lot of Crypto assets on an exchange at the moment. If you plan on doing so, make sure you know how to get them off the exchange in a hurry.

Watch out for the next blowups

This all could be over. It also might not be. The blow ups in the first half of this year were fast and destructive. Luna and Three Arrows Capital blew up and took out huge chunks of the industry overnight.

This time around the blow ups are slow and large.

Genesis looks like it’s going to take December off and then come back and talk to creditors next year. Their parent company DCG is a multi-billion dollar behemoth. If they are going to blow up they are going to do it slowly. It takes forever to unwind an entity as large as Genesis.

The good news if you don’t have exposure to any of the already bankrupt firms is that most of them have already gone through the period where they sold off all of their assets in a fire sale. FTX was the poster boy for this phenomenon, ending their life with zero Bitcoin on their balance sheet, despite billions in Bitcoin owed to customers.

If more things explode, there likely won’t be a fire sale of coins rushing to market.

I fully expect there to be at least two additional offshore exchanges blow up in the next 6 months. I don’t expect them to have a large amount of assets to sell off, but things could get weird and an exchange blowing up will impact the price of tokens.

The Tail Risk is still out there

The Stablecoins are the biggest question mark still left on the board. After years of assurances, we still haven’t seen Tether’s books with any real certainty. Circle recently canceled its public market debut and will no longer be providing public financial reports. The less said about Binance USD the better and the other more minor stablecoins are plagued with questions.

Stablecoins are not dollars in a bank. If you want US dollars, own US dollars.

US short term government treasuries are currently yielding almost 4%. Bank accounts have insurance. There’s really no reason to be holding a large amount of stablecoins in this environment unless you’re using them in DeFi.

I don’t want to bet against Tether. Shorting Tether is the widowmaker trade in Crypto. Even if you’re right, your counterparty will likely be insolvent and won’t pay out.

I don’t even really think that Tether will fail in this cycle, but it’s a tail risk to be wary of.

Stick around for the next cycle

The biggest takeaway from all of this is that Crypto isn’t going anywhere. Bitcoin isn’t dead.

If you’re here already, stick around. Fortunes are made in bear markets and collected in bull markets. Learn about the space. Hone your strategies. Figure out what you want to own and why. Get ready to deploy funds when the Crypto winter is waning.

The Federal Reserve can’t stop printing money forever

Today’s post is from contributing analyst Scott Hill. To receive further updates of this series and our overall investment thesis for digital assets (even in this climate), subscribe to the Bombthrower mailing list. 

Last week we covered the collapse of FTX as it happened but there’s a lot more to the story. How did FTX grow from a tiny Hong Kong bucket shop into a top three Crypto exchange over the course of just a few years? What was Alameda research and were they ever legitimate? Most importantly, how exactly does an exchange lose track of up to $10 billion worth of customer deposits?

Most of this material is still an educated guess, but the guessers are out there putting together clues from private discussions which have been leaked, the bankruptcy proceedings and first hand dealings shared on Crypto Twitter.

It’s worth noting that there is a whole deep state angle to this story.

I won’t go into it in this article because so little is known (see endnote – ed.)

What we do know is mostly confined to the fact that FTX CEO Sam Bankman-Fried (SBF) was the second largest donor to Democrat political campaigns since 2019. His Co-CEO for part of the FTX Empire, Ryan Salame, was a top 10 donor to the Republican party in the same period.

Sam Bankman-Fried met with SEC Chairman Gary Gensler seeking a “no action” letter on an enforcement matter in April, shortly before SBF began pushing the DCCPA, a bill which the Crypto industry mainly saw as a subtle crackdown on DeFi wrapped in a reasonable sounding regulatory framework.

The biggest question mark is the identity of FTX CTO and co-founder Garry Wang. The man is a ghost with very little online presence and only a handful of photos. Famed short seller Marc Cohodes is under the impression that Wang is a state actor for the CCP.

These questions are important and interesting, but they don’t make for a useful article because of the complete absence of detail.

Alameda Research

Alameda Research, the market maker or crypto hedge fund founded by SBF in Hong Kong during the bull run of 2017 is the start of the rot. The official story is that the firm was formed from a team of young hotshots who learned to trade at Jane Street, a notoriously secretive global market maker which trades more than $10 trillion in securities volume each year.

In January 2018 as Bitcoin was collapsing, Alameda research were performing the Japan arbitrage trade. They purchased Bitcoin in the US, moved it onto Japanese exchanges and cashed in on the gap between markets. The spread was often as wide as 10%. SBF claimed the firm made $10M on the arbitrage over the course of several weeks.

This was a complicated trade. Japanese capital controls are strict with only Japanese nationals allowed to hold bank accounts, making it extremely difficult to get the money out of Japan and requiring a reasonable level of sophistication and corporate legitimacy to pull off.

Following the Japan arbitrage, Alameda went after the “Kimchi Premium”. This was the same type of arbitrage trade, with Bitcoin on South Korean exchanges worth up to 20% more than Bitcoin on US exchanges. The capital controls were tighter, the ability to set up corporate infrastructure in the nation was more restricted and Bitcoin was in the middle of collapsing making trading the asset much more risky.

Some people are suggesting that Alameda lost $10 million on the Kimchi Premium trade, but no one really knows whether any of this story is even true.

I’m deeply skeptical of this entire backstory given what we have now seen about how careful SBF is with his public image.

It’s entirely possible that this whole story was a fabrication to paint the picture of a boy genius trader with a Jane Street pedigree striking out on his own in Crypto land.

Completely Absurd Fundraising

In early 2018, Alameda Research established headquarters in Hong Kong. While SBF was a complete unknown to Crypto insiders at the time, Alameda Research was making a name for itself, frequently up the top of the Bitmex trading leaderboard.

Crypto markets in 2018 were very different to the last few years. While 2017 had seen a burst of activity during Bitcoin’s bull run, volumes were still tiny and there were very few professional firms taking the asset class seriously.

It’s completely plausible that in the absence of professional market makers, Alameda Research could have done very well. It also seems likely that the edge that such a small team had would have disappeared quickly as the market became more professional. Alameda Research only had a handful of employees. Nowhere near enough to build and execute a sophistical algorithmic market making strategy, such as those employed at Jane Street.

In December 2019 an investment pitch deck for Alameda Research circulated among Crypto insiders. The firm was seeking to raise $200 million in debt funding and was offering 15% payments on the debt. The pitch itself made ridiculous claims about the firm’s edge and was riddled with red flags.

“High Returns with no risk – These loans have no downside”

Insiders that viewed the pitch deck were confused. The whispers within the industry were that this firm was highly profitable yet they seemed desperate to raise $200 million. Most stayed away and it’s unclear whether or not the fundraising was successful.

Launch of FTX

FTX was founded in May 2019 but had very little volume until the following year when they established the regulatory status to allow US customers to trade. FTX later acquired Blockfolio to obtain additional US licensing and the bones of a trading app. Even with this boost in volume, FTX was considered an unfavorable exchange to make markets for among established industry participants.

The presumption was that Alameda Research was an embedded market maker that was given an unfair advantage on the platform and rival firms stayed clear.

At the time SBF was still the CEO of both companies. There were claims of a separation of the firms, but it was known that they both operated out of the same offices in Hong Kong. It was rumored that Alameda had full access to customer position data and would hunt for liquidations.

FTX was seen as a shady offshore bucket shop.

By early 2021 little had changed in the industry perception of FTX, but volume was growing. In January SBF was busy arguing on Twitter, leading to the infamous “I’ll buy as much Solana as  you have, right now, at $3” tweet. He was not taken seriously until later that year when this huge Solana bet seemed to pay off.

FTX gains Legitimacy

By the middle of 2021, with Crypto in a raging bull market and FTX capturing significant market share, the exchange became too large to ignore. A big part of the story was China putting in place another round of Crypto bans in September which forced many major Crypto traders and market makers to find new venues to trade.

Zhu Su, founder of disgraced Crypto Hedge fund Three Arrows Capital said recently that he had moved his fund’s trading from Huobi and Okex to FTX and Binance in the wake of the China ban.

FTX gave them extremely favorable terms.

A big reason that firms began to feel comfortable with FTX was the splashy fundraising FTX was able to pull off. Market participants assumed that among the billions of dollars of venture capital money that had been invested in FTX, someone had done basic due diligence on the firm. We now know that during these heady days of free money SBF was demanding investment commitments quickly from VCs or he would move on to the next phone call.

There was a giant line of VCs desperate to get into an FTX round.

The July fundraising list was a who’s who of Silicon Valley VC. Led by Sequoia, the round included Softbank, Temasek and VanEck. Apparently none of these firms insisted on even the most basic corporate controls, like installing a board of directors. A later round included a strategic investment from Blackrock. FTX was a blue ribbon investment.

They all needed Crypto exposure now and FTX was the hottest Crypto startup in town.

The other piece of the puzzle was that trading firms were now making money on FTX, when before they were simply getting their positions hunted by Alameda. Leverage was handed out in ample servings. Compliance was lax. Payouts were quick. It seemed to most that FTX had moved on from its shady beginnings to become a legitimate venue for market makers to use.

Tokens

A giant part of understanding exactly what went down at FTX is understanding the Tokens they had launched or partnered with. In 2019 FTX launched FTT, an Ethereum ecosystem token which represented a cut of exchange fees and offered discounts to traders for holding it. It was the same model that Binance launched their token with in 2017. Tokens would be bought out of the market with a portion of exchange profits on a regular basis, delivering a return to investors.

A huge portion of FTT tokens were held on the FTX balance sheet as an asset.

Even more egregious were the Solana ecosystem tokens which FTX helped launch. The leaked balance sheet showed that FTX had large holdings of Serum, Maps and Oxy.

It showed Serum tokens marked as a $2.2 billion asset. Available market cap at the time was less than $500 million.

We don’t know for sure, but it seems likely that loans were taken out backed by FTT and other minor tokens.

Essentially, it seems that SBF invented his own currency from this air and then took out US dollar loans against it from anyone that would offer. 

We haven’t heard from any major Crypto lender about whether or not they took FTT as collateral. We may never hear an admission on that point. What we do know is that Solana DeFi, where SBF had significant influence, largely took these minor tokens as collateral for loans on much more generous terms than seems reasonable now.

And why wouldn’t Crypto lenders offer loans to FTX on whatever collateral was offered? FTX was the fastest growing exchange in industry history. It had prestigious investors. Its CEO was throwing around cash on advertising and political donations. Surely FTX was profitable enough to service their loans.

So what happened to the money?

When FTX blew up there was a balance sheet hole of somewhere between $6-10 billion. It was reported as “missing customer funds” but judging from recent public comments made by SBF it seems more likely that there was a complex web of loans and cross company funding arrangements than just straight up theft of customer assets.

An underreported part of this story which fills in a key gap is that the offshore FTX entity apparently didn’t have its own bank account. Wires to the offshore exchange would go directly into a bank account held by Alameda Research. It seems that FTX didn’t secretly transfer customer funds to its associated hedge fund, it probably didn’t even make loans between companies.

The most likely explanation is that Alameda Research just had direct access to customer funds  which were wired to them.

While shocking, it wouldn’t be as egregious if the FTX terms didn’t explicitly say that assets were held on trust for customers. FTX wasn’t supposed to touch customer funds once they were deposited. Maybe that’s the whole point, that SBF was relying on some bizarre technicality or legal fiction to convince himself that he had the right to deal with customer assets. Did I mention that both of his parents are compliance lawyers, with one a leading expert on tax havens.

If there’s anyone that could access the advice to set up a complex piece of legal fiction entitling him to pilfer customer funds in a defensible way, it’s SBF.

Liquidations

That only explains how Alameda Research got access to customer funds, but how did they lose the funds? Alameda Research is a market maker primarily and was the key integrated market maker on FTX. Among other things that gave Alameda the ability to purchase liquidated positions of customers, likely at a huge discount.

In a bull market this is a hugely advantaged position to be in. Say Bitcoin drops 5% in an hour and longs get liquidated, Alameda was able to purchase those long Bitcoin positions and then resell them later, after the liquidation cascade was over and price had recovered.

Alameda was exempt from liquidation on FTX, so they could hold underwater positions for as long as they wanted without being forced to close them.
In a bear market, Alameda would likely accumulate underwater positions that they couldn’t get out of without incurring a large loss. Other market makers will generally sell a liquidated position off as soon as possible, to avoid being liquidated themselves. This doesn’t appear to be a check and balance that was in place for Alameda’s operations on FTX.

Another key feature of the leverage trading offered at FTX was cross asset collateral. Essentially this means that leverage was offered on the entire portfolio of a customer. There wasn’t a segregation of collateral, users could simply offer up a mixed list of tokens and take margin loans against the whole pie. This included FTT and Serum at much more generous collateral ratios than other exchanges offered.

Whatever low quality collateral you had, FTX would take it, and it seems that it would end up on Alameda’s books when a customer was liquidated.

Luna Eclipse

In a collapsing market, this lack of controls over Alameda is potentially disastrous. Luna had the most high profile collapse in the history of Crypto tokens in May this year, losing 99.7% of its value in a week before getting as close to absolute zero as possible. FTX and Binance were the major venues for trading the Luna collapse. Traders bought the dip on leverage all the way down.

It seems likely that Alameda took all of those liquidated positions onto their own balance sheet.

Luna started its collapse at around $90. The following week it was at essentially zero. There is no way that Alameda could have sold off all of those liquidated customer positions as the token collapsed. This type of liquidation transaction is known as “toxic flow” and is a surefire way to bankrupt a market maker.

If FTX’s famously specialized liquidation engine simply meant that customer positions were shunted onto the Alameda balance sheet to be cleared at a later date, then the amount of toxic flow from junk tokens in the last year would build up quickly.

This seems to be the only way the size of the hole makes any sense.

Other Problems

If we assume that Luna blew a giant hole in the balance sheets within the FTX empire then what happened next makes a whole lot more sense. SBF went on a buying spree as Crypto lenders collapsed, backstopping insolvent firms and being proclaimed as Crypto’s JP Morgan.

In the cold light of day a more likely explanation than wanting to save the industry is wanting to save himself.

If insolvent Crypto lenders like Voyager and Celsius had given loans to FTX, taking FTT and other minor tokens as collateral then those tokens would be seized and sold into the market during a bankruptcy, cratering the price and liquidating FTX loans with other lenders. Don’t forget, for tokens like Serum, FTX held and likely pledged as collateral more than the entire free float on the market.

All of this isn’t to say that funds didn’t go missing in other ways though.

According to the Bankruptcy filings, FTX had loaned more than $1 billion to SBF individually and $2.3 billion to his investment company, Paper Bird Inc. There were also 9 figure loans to other executives and Bahamas real estate purchased by SBF’s parents and associates worth $300 million. There are even suggestions that the $420 million meme fundraise in October 2021 basically just ended up in the pocket of SBF, rather than productively invested in the company.

It seems like the FTX balance sheet was used as a slush fund for SBF.

None of this in any way can add up to $6-10 billion in stolen customer funds and it’s unlikely that the mechanism was brazen theft. The scenario outlined above, poor trading controls at Alameda creating bad debt within the corporate structure and a CEO that was scrambling to keep the empire afloat, is far more likely. This also casts a new light on the “generous terms” offered to other major market participants in 2021.

Taking VC money

What if Alameda’s goal wasn’t to make money, but to lose money to other traders in a perverse growth hack used to attract the next round of “smart money” investors?

After all, at best Alameda had been making a few hundred million from trading over the course of its existence and likely much less than that. As spreads closed with more market makers flooding into the asset class it’s much easier to take money from Sequoia and Softbank than it is to make money trading.

Running an unprofitable casino is a terrible business, but selling an unprofitable casino that looks extremely busy to a private investor is a fantastic business.

This part of the story seems like the inevitable end state of the 2010s dominance of Venture Capital and private investing. After a decade of easy money, low interest loans and an insatiable appetite for tech investments we were bound to see someone game the system. In 2021 VCs were not doing diligence, they were shoving newly raised funds into startups as fast as possible. Venture capital firms invested $643 billion in 2021. Almost double the pace of 2020 and five times as much as was committed in 2012.

For context, noted scam company Theranos raised $1.4 billion over 13 years. FTX raised $1.8 billion in only 3 years.

The entire story of the growth of FTX is a story of the driving forces of tech stock investing being applied to Crypto and fintech. The problem is that when a social media company blows up, users just lose their photos and social graph. When a fintech or Crypto company blows up, customers lose their funds and lives are ruined.

A big part of the problem with FTX was that tech growth hacking and the infinite pot of VC money was applied to financial services with little regard for the safety of users. No one did the diligence. The regulators were asleep at the wheel.

“Grow fast and break things” isn’t an appropriate model for the financial sector.

We Have Questions…

This article mostly dealt with how FTX managed to grow so fast and then blow up so spectacularly but it didn’t touch on the why. As stated in the introduction, there are some major question marks about state entanglement, potential involvement of intelligence operatives and the corruption of captured regulators are all major open questions that I just don’t have answers to.

Was FTX a plant to bring down the Crypto industry and justify tighter regulation?

Was FTX a front for money flowing from Crypto traders and Tech VCs into Democrat coffers?

Why is the mainstream media reporting on this event as if SBF is just a failed entrepreneur who dreamed too big, rather than a fraud who appropriated customer funds?

Who was behind the success of FTX? Who is Gary Wang?

We likely won’t ever get satisfactory answers to these questions. The family political links between major characters in this story are deeply suspicious. As one Crypto Twitter account that has been covering the news relentlessly said:

“This FTX fiasco is *really* doing its best to confirm every single conspiracy theory anyone has ever had about anything.”

Next week in the conclusion of this three part article I’ll cover some of the fallout surrounding the FTX collapse that is important to understand and the lessons being learned by the industry in its attempt to rebuild.

Endnote

[A good place to start down the deep state rabbit hole in all this is Mathew Crawford’s  ‘A Grand Unified Theory of FTX’ – which I printed off to read and it clocks in around 65 pages – markjr]

Today’s post is from contributing analyst Scott Hill. To receive further updates of this series and our overall investment thesis for digital assets (even in this climate), subscribe to the Bombthrower mailing list. 

(Part 1 of 3 special to Bombthrower by digital asset space analyst Scott Hill)

On November 2nd Coindesk published a leaked balance sheet from FTX affiliated market maker Alameda Research.

Ten days later the third largest Crypto exchange in the world was bankrupt and its founder was under international investigation for fraud.

In this article I’ll go through how Crypto giant FTX fell apart. There is a lot of backstory to this situation which I’ll cover in a following article, discussing the beginnings of Alameda research and the story of how a sketchy hedge fund turned into a major exchange.

As you’ve no doubt heard repeatedly this week, self custody of your Crypto is the safest approach until we know who is insolvent and the extent of the contagion. If you’re not confident with self custody, Coinbase and Kraken seem to be the safest Crypto exchanges, but that is still a counterparty risk that I’m not willing to take personally in these market conditions.

The Balance Sheet Leak

The exclusive scoop from Coindesk looked bad for Alameda Research. The firm, which performed market making on FTX as well as taking directional bets and venture capital investments, seemed insolvent on a realized value basis.

Their balance showed $14.6 billion in assets held against $8 billion in liabilities. On paper solvent on a mark-to-market basis, but digging in there was no way that mark was reasonable.

The most egregious example was $5.82 billion worth of FTT tokens on the asset side, around a third locked and the rest unlocked and available to trade. FTT is a token created by FTX, a sort of pseudo-equity token which represented some share of the exchange revenues. Kind of.

FTX had been doing periodic buybacks of the token which were supposed to represent a distribution of exchange revenues to holders. Holding the token also entitled traders to a discount on trading fees. The token was at the time worth around $26. At its peak it was worth around $80.

The main thing that FTT was used for though, was pledging as collateral by FTX and Alameda. 

You read that right, a token which the exchange invented a little over 3 years ago was used as collateral for loans. We know for sure that it was acceptable collateral in various Solana DeFi protocols, which FTX had a significant amount of influence over; but reports are also surfacing that it may have been used to purchase real estate in the Bahamas and quite possibly with various institutional Crypto lending like Genesis which is now facing major problems.

Possibly the most relevant ad you’ll see today…

The problem with FTT

There’s nothing inherently wrong with using Crypto tokens as collateral if there is a robust and deep market pricing them. If the loan goes bad, lenders can seize the collateral and sell it off, covering some of their loss.

FTT didn’t have a deep and robust market.

There was barely any volume. There was barely any liquidity. If a lender had to sell a large volume in a hurry there weren’t any buyers ready to step in.

While Alameda was claiming to have $5.82 billion of its balance sheet held in FTT tokens, the entire available market cap was less than $4 billion.

Read that again, Alameda’s balance sheet held more than the entire market cap of FTT. 

So this wasn’t a situation where a lender might make a loss on selling the collateral, this was a situation where there were potentially billions in loans floating around in the Crypto ecosystem with essentially no collateral that could be liquidated without detonating the market.

Just to top it off, some of this FTT was likely pledged to multiple lenders.

Industry Reaction

The initial reaction was general indifference. Alameda looked like it was playing with fire and had gone all in on the exchange token for its sister company FTX alongside various other FTX supported coins like Solana and Serum. It was an open secret in the industry that Alameda and FTX were more intertwined than they claimed, but if push came to shove it was assumed that Alameda would be allowed to fail and FTX would continue being the highly profitable exchange that everyone assumed it was.

FTX was highly profitable, right?

There were a few that were calling the bluff, but the main gripes were conflict of interest within FTX related companies and unsavory business practices by FTX, trading against customer positions and liquidating accounts improperly. The usual bucket shop tricks. No one seemed to be expecting a total insolvency across the FTX group of companies.

But still something didn’t feel right. Caroline Ellison, the newly appointed CEO of Alameda Research tried to calm fears on Twitter, claiming that the leaked balance sheet was only a partial balance sheet, there were another $10 billion in assets elsewhere within the corporate structure, and they’ve paid down most of their loans.

It was a strange and deeply unsettling response, shrugging the issue off as if the industry should just take her at her word.

Enter the CZ Dragon

Even CZ, the CEO of rival exchange Binance, didn’t seem to be suggesting that FTX was in trouble. Late on Sunday November 6 CZ announced that he would be liquidating the FTT held by Binance.

All $500 million of it.

Binance had been the sole investor in the seed round for FTX.  In 2021 they were bought out for $2.1 billion in cash and FTT tokens. This alone wasn’t enough to push markets into panic. CZ said he would do this over a number of months, carefully and slowly in an attempt to “minimize the market impact”. In a follow up tweet, CZ said that he was doing “post-exit risk management, learning from Luna”

Everyone in Crypto knew what he meant by “learning from Luna”

In May Luna detonated, dropping to zero. The protocol is now seen as a deeply flawed project in the best possible light and a blatant ponzi scheme in the more realistic assessment.

Did CZ, the most powerful man in Crypto just call FTX a ponzi scheme?

Panic

Crypto industry figures were in disbelief. Surely FTX, the darling of the industry, was a highly profitable, solvent and legitimate business. But the reaction was off and deeply troubling. The CEO of Alameda Research quickly asked CZ if she could buy all of the FTT tokens off-market at a price of $22.

The market smelled blood.

Over the course of the next few hours FTT was aggressively shorted, Caroline had put a floor under it at $22 and traders were going to bleed Alameda dry defending that mark. Why did $22 matter? It’s only conjecture, but it seems likely that below $22 Alameda would be liquidated by its lenders and a cascade of FTT tokens would need to be sold into a market unwilling to buy them, flattening the firm.

But traders only thought they were going after Alameda, the predatory market maker.

 In hindsight it’s obvious, you shouldn’t short an exchange token to death on the exchange that issued it, but FTX was the main venue for the fight for $22. A huge amount of volume flowed through the order books and everyone was looking forward to getting paid as the token dropped, first to $18 and later to $6.

While the traders were battling it out, regular users were getting out.

FTX experienced massive outflows and on-chain analysis showed some deeply troubling signs. Alameda was pulling liquidity from everywhere. Every dollar that was deployed in DeFi got pulled. Weird tokens got dumped. But the liquidity wasn’t going into Alameda’s wallet, it was going into FTX wallets to pay customers.

Surely FTX wasn’t funding customer withdrawals from Alameda’s DeFi degen positions?

FTX was supposed to be a full reserve exchange. As an even higher bar, the terms of depositing with FTX were that customers retained title to their assets. Assets were held on trust, they weren’t supposed to be lent out or touched except as directed by the customer.

SBF concedes

On Sunday afternoon, Sam Bankman-Fried (SBF), the CEO of FTX said that the problems with the Alameda balance sheet were just “unfounded rumors”. He explained that FTX had processed billions of dollars in withdrawals and that they would continue to do so. He claimed that they were hitting node capacity, something that I’ve never heard of, and needed to slow down withdrawals.

By Sunday night, withdrawals of some assets had stopped entirely, but there was no announcement from FTX. Radio silence from the team.

We now know that during this period SBF was frantically going to investors to do an emergency fundraise of between $6-10 billion dollars. The terms which later leaked were insane. It was obvious that no lawyer had reviewed these documents.

They seemed to be written by a child, imitating a businessman, who was in way over his head.

Industry insiders at the time thought that FTX had likely lost some amount of user funds, would need to take a loan to cover them and could move on with rebuilding trust. We were shocked to wake up on Tuesday to the news that Binance had made an offer to buy out FTX entirely, subject to due diligence. This isn’t what a rescue package for a competently run business looks like.

This was a fire sale of a dumpster fire.

The previous day SBF had claimed his exchange was fully solvent, just having minor liquidity issues. The next day he was handing the keys to their main rival. Now that balance sheets have been leaked for FTX we know what Binance would have seen as soon as they started their diligence, a balance sheet crammed with dodgy tokens and full of holes, unaudited and put together in excel with no real supporting evidence.

The rumored sale price was one dollar.

CZ quickly walked away from the deal, citing misuse of customer funds and regulatory concerns; leaving SBF to fix his own mess. With the exchange still operational, but withdrawals closed, SBF posted yet another long thread trying to talk his way out of the problem, claiming to be trying to set everything straight and get emergency funding. While he had not yet admitted that it was all over, he did make a bizarre reference to CZ “well played; you won”

As we came to learn later, for this sociopath that’s all it was, just a game to be won or lost.

The Insanity Begins

The rejection of the deal from Binance was the first mention of misuse of customer funds. Until then there was speculation that there was a minor balance sheet hole, remember, no one knew at that time that SBF had been seeking $6-10 billion in emergency funding. The next day the news started pouring in.

Reuters reported that there was a secret back door in the accounting at FTX which allowed customer funds to be moved around without alerting anyone. It also claimed that $10 billion dollars worth of customer funds had been secretly moved to Alameda.

SBF remained silent, but elsewhere there was chaos. Alameda funds were moving around frantically on chain, placing gigantic bets and actively trading.

Was SBF trying to trade out of it?

Tether put a stop to this later in the day, freezing Alameda’s funds on the request of law enforcement.

On the exchange the chaos was even worse. Justin Sun the founder of Tron had shown up to offer to redeem Tron tokens trapped on FTX. Prices spiked as customers flocked to get cents on the dollar via this exit ramp. There was talk of taking complicated cross-platform trades to make a synthetic exit ramp.

The Bahamas Loophole

As the insanity deepened, FTX posted on Twitter that they were processing a small amount of withdrawals to customers in the Bahamas as requested by local authorities. A week later we found out this was a lie, there was no request, but even at the time it seemed likely to be a way for insiders to exit their funds before the inevitable bankruptcy.

Suddenly, traders with stuck funds were desperately trying to obtain a fraudulent Bahamian passport and complete identity checks in the Bahamas. Some even managed to do it apparently and successfully withdrew funds. Black market prices on passports spiked and a secondary market for trapped funds emerged, with accounts trading for 15 cents on the dollar.

NFTs were being traded for entire balances in order to move the funds to an account which could still withdraw.

On the actual exchange things were just as chaotic. Traders with trapped funds were treating their accounts like paper money, trading nonsense on high leverage and dislocating markets. FTX was removed from pricing feeds to restore order elsewhere.

This was the first time in the whole saga that it became clear, it was all over for FTX.

FTX US halts withdrawals

This entire time the story had been that FTX US was a separate entity. Their funds were firewalled off from FTX international. The exchange remained open for withdrawals and appeared to be functioning properly.

This relative calm on the US side of the company instilled some faith. Surely, despite the havoc going on in the Bahamas, the US exchange was well regulated. Surely, the books were audited and no client funds could go missing in the US.

On Thursday afternoon, FTX US halted withdrawals.

Bankruptcy and the Hack

On Friday morning SBF resurfaced and announced that FTX would be put into bankruptcy. The motion was filed in the US and included FTX US. It would later be revealed that SBF had stepped down as CEO and John J Ray III, a lawyer famous for taking over Enron post-collapse, would be similarly guiding FTX through bankruptcy. Everyone breathed a sigh of relief, it was finally done.

But the fun and games weren’t over

Shortly after the bankruptcy was announced funds started moving on-chain. A lot of funds. Over $600 million left FTX affiliated wallets, moving to fresh wallets. The speculation was that there was a hack, perhaps by an insider looking to get the last of what they could out of FTX.

It quickly became clear that there were two teams working. One appeared to have simply moved worthless tokens into storage, a plausible move by a “white hat” or good guy team seeking to preserve user funds from a compromised system.

The other team, the “black hat” team, took the vast majority of the $600 million and moved it all into Ethereum DeFi, trading other coins into Ethereum tokens and consolidating them all together. This consolidation took place across multiple blockchains and traded with reckless abandoning, losing gigantic sums on slippage along the way.

Once the dust had settled, the hacker was one of the largest individual holders of Ethereum.

We don’t quite have the full story on what happened here yet. The Bahamian authorities claim that they seized the assets, with many assuming that they are referring to the hacked funds. It seems far more likely that they are referring to the “white hat” funds only, as the “black hat” funds demonstrated much more sophistication in blockchain use that could be expected of a regulator.

The funds have stopped moving for now. Sitting idle with more that 241,000 ETH, a little less than $300 million worth. No one really knows what will happen with these funds.

Where are we now?

After a week of complete mayhem as the exchange fell apart and another week for the adults to take over and begin the clean up we have two competing bankruptcy procedures. One taking place in the US, overseen by the lawyer who cleaned up after Enron collapsed. The other taking place in the Bahamas, overseen by two accountants from PriceWaterhouseCoopers and a senior local lawyer who has a decades long history of high level appearances in the Supreme Court of the island nation.

It’s not entirely clear which action will take precedence, but they are opposed to each other. The US bankruptcy is seeking that all the companies be wound up together and users are compensated with whatever assets are left across the entire conglomerate.

It turns out, FTX was made up of over 100 individual companies.

The organization chart looks like the web a drunk spider would spin. It’s not the sort of corporate structure that would be constructed for anything other than hiding funds and playing shell games.

The Bahamian action appears to be seeking to have the main FTX company dealt with separately, screwing US customers out of funds and leaving the bankruptcy in the hands of the Bahamian government which seems to have taken some pretty significant donations from FTX in the past.

In filings made late this week FTX was referred to as a “disorganized mess”. There was a lack of proper accounting. The auditing was done by “the first accounting firm in the metaverse” that doesn’t appear to have a physical address. There appears to have been loans made to company executives in the hundreds of millions of dollars range. There was no corporate board. There was no human resources department. There was no accounting department. There was no real tracking of customer funds.

The lawyer handling the FTX bankruptcy also conducted the Enron bankruptcy. He says this is far worse.

Enough for now

This is just the walkthrough of how everything fell apart in front of our eyes. The corruption, the lies and the scandal have all been uncovered in the wake of this collapse. In another article coming shortly I will cover the rise and fall of FTX and Alameda Research, delving into the backstory that allowed this fraud to grow under the cover of one of the most well regarded companies in the industry.

Today’s post is from contributing analyst Scott Hill. To receive further updates of this series and our overall investment thesis for digital assets (even in this climate), subscribe to the Bombthrower mailing list. 

Basketball Entrepreneur, Shaquille “Big Sexy” O’Neal just crossed the line. Here’s the Etherscan page for Shaq’s NFT project showing the sanctioned, illegal transaction. The US Treasury announced sanctions applied to Tornado Cash transactions beginning last Monday. I’m not suggesting that Shaq’s done anything wrong, but this is an example of why the Treasury’s attack on Crypto mixing services via sanctions is unworkable.

Who Gets Invited To The Crypto Mixers?

Mixers are tools within the Cryptocurrency ecosystem that allow users to deposit tokens, combine them with other people’s tokens, and then withdraw to an unrelated wallet. They can be used simply for privacy reasons, or it can be used to hide the tracks of illicit funds.

The US Treasury was obviously focused on the latter when it sanctioned Tornado Cash, with an estimated $455M washed through Tornado over the last few years by North Korean hacker group Lazarus. 

I’m not defending the ability to hack and launder money, but you can walk the line if one can actually be laid down. Lazarus has been a scourge on the Crypto industry since at least 2017 and I would love nothing better than to see them dealt with effectively and severely. But that’s the problem…

The solution to Crypto hacks needs to be effective or there’s no point.

According to Chainalysis’ research on the topic, for every criminal use of crypto mixers, there appears to be a legitimate use. So a large part of the pushback on this round of sanctions is to do with preserving privacy tools in an increasingly aggressive surveillance state that jeopardizes citizens’ legitimate need for privacy in everyday life. 

Privacy is normal and needs to be defended.

Among notable legitimate and extremely necessary uses of privacy tools that have come out since the sanctions announcement are Ethereum founder Vitalik Buterin using Tornado Cash to donate money to Ukrainians. This reduced their risk. Blockchain developers can also use untraceable funds to seed new projects without exposing their entire net worth.

However, this article isn’t about privacy. There’s plenty written about that elsewhere. I’m talking about why sanctions aren’t the right tool for this problem. 

Sanctions Didn’t Stop Party Crasher Lazarus

This isn’t the first mixer the US has sanctioned. In May, the Treasury sanctioned Blender.io, another mixing service that had also been used extensively by Lazarus group. In that case, the sanctions worked well to shut down the service.

They had no meaningful effect on the Lazarus group who simply kept hacking and moved to the next mixer.

Blender.io was a custodial mixer. Users deposited funds into a centralized custodian who would then mix your funds and return them. The people running the service were targeted by sanctions and shut down. 

Tornado Cash is structured differently. Rather than having a centralized custodian making decisions it’s simply a smart contract hosted on the Ethereum blockchain which holds funds prior to mixing and withdrawal. It’s just a piece of code that will continue running indefinitely and doing what it was designed to do. No one that can take it down. It is an immutable smart contract. 

Tornado Cash is Bitcoinesque. It cannot be changed. It cannot be removed. 

The Treasury seems to not really be aware of this distinction. The actual text of the sanctions has identified a range of wallet addresses associated with the smart contract as being prohibited to transact with. Treasury hasn’t identified any specific people or organizations, other than a website that hosts a front end for accessing the service. That makes this the first time the Treasury has sanctioned code, rather than people or corporations.

Enforcement: “Buzzkill” US Treasury Just Doesn’t Get It

How will this be enforced? No one really knows, but so far Circle has frozen USDC currently held in the smart contract awaiting withdrawal. Circle’s CEO doesn’t seem very happy about being forced to do this. There are also significant amounts of Ethereum and Wrapped Bitcoin also held in the smart contract.

BitGo, the issuer of Wrapped Bitcoin can’t freeze their tokens and Ethereum also can’t be frozen at the protocol layer. The only logical way that US based companies like Coinbase can comply with sanctions is to prevent tokens that have been through Tornado Cash from being deposited onto their platforms.

Which raises a huge issue. Because tokens can’t be frozen on the protocol layer, these tokens are free to move around in the Ethereum DeFi ecosystem prior to deposit on Coinbase. Regular users will have a very hard time knowing whether or not tokens that they receive are going to be accepted with major US based companies.

We don’t have any guidance from the Treasury on how this is supposed to be dealt with, but I imagine there are currently extremely frustrated calls between Crypto exchanges and the Treasury department trying to sort out this issue without breaking Ethereum.

The Treasury department might have just accidentally broken Ethereum fungibility.

Do I think that is the likely outcome here? No, not at all. But it does speak to how recklessly uniformed and uncaring the US Treasury is becoming regarding the collateral damage of using sanctions to solve every problem. There doesn’t appear to have been any consultation with major Washington based Crypto education groups like Coin Center and the DeFi Education Fund.

Will the US Treasury be educated enough to make restrictions and reform possible. We don’t yet know how strict the Treasury will instruct US corporations to be about blocking deposits from Tornado Cash. Using blockchain records, it’s perfectly possible to trace Tornado Cash use through several transactions. It’s less possible to do the same through a DeFi system which inherently mixes up funds so that their origin can’t be ascertained.  

The maximum enforcement would be to block all deposits from DeFi because some deposits would have touched Tornado Cash at some point in time.

This highlights how useless sanctioning a medium of exchange really is. Usually transactions with a particular party are the sanctioned activity. This is what it means to have effective measures against cybercrime. These sanctions won’t shut down Tornado Cash and they won’t stop Lazarus Group. They have the potential to cripple Ethereum, if they’re applied strictly. It’s fundamentally a losing game. The USTreasury is playing whack-a-mole with privacy tools. 

So what happens when a government enacts an absurd law that can’t be enforced and doesn’t really make any sense?

People immediately break the law.

Guilty By Association: Shaq, Fallon And Others Get Dusted

Numerous celebrities and notable Crypto figures including Shaq, Jimmy Fallon, Brian Armstrong the CEO of Coinbase, Crypto Exchange cold wallets and numerous others got dusted by Tornado Cash transactions.

Dust attacks aren’t new, they’ve been around as long as I’ve been in Crypto. They describe when a wallet gets sent useless or harmful tokens without their consent. There is no need to accept Crypto transactions, they just show up when someone sends them to your wallet. 

Someone with a balance held in Tornado Cash started sending small Ethereum transactions to a range of known celebrity wallet addresses without their approval or knowledge. On the first day of sanctions over Tornado Cash. 

Did Shaq violated sanctions? Arguably yes.

Sanctions violations are strict liability offenses. There doesn’t need to be any intention to perform a transaction with the sanctioned party. There doesn’t have to be any benefit gained by transaction. All that needs to be shown is that a transaction occurred.

There is a defense that best efforts were taken to comply with sanctions. The prosecuting body will look at what steps were taken to avoid breaching sanctions, that will affect their likelihood to prosecute and the severity of the punishment. But what could Shaq have done to avoid breaching sanctions?

There is nothing that anyone could have done to avoid breaching sanctions by receiving unsolicited Tornado Cash transactions.

Obviously Shaq and Jimmy Fallon are not going to get prosecuted for sanctions violation because someone else sent them some Ethereum, but the fact that these celebrities will need to be excused for something that is arguably a breach of US sanctions according to the letter of the law is a big problem. 

If The Rules Are A Bluff, What Happens Next?

The sanctions are at best ineffective. Tornado Cash is the second mixer that has been sanctioned because it was used by Lazarus. The first set of sanctions just meant that Lazarus moved to using Tornado Cash instead of Blender.io. I imagine that due to the lack of enforceability of this round of sanctions, they won’t even stop Lazarus from using Tornado Cash as their mixer of choice. 

Will it change how Crypto exchanges treat mixed funds? Unlikely. Major US exchanges already had a responsibility to refuse shady deposits under existing anti-money laundering provisions. There were already reports earlier this year of Coinbase refusing to credit deposits directly from mixers or funds that had recently been through a mixer. 

What is the point of sanctioning Tornado cash if it doesn’t shut down the service or slow down Lazarus group?

Well it will likely prevent law abiding US citizens from accessing a financial privacy tool for non-criminal purposes. Fight for the Future compared the sanctions to banning email because it can be used for phishing scams. The Cato Institute noted that “Punishing every American by going after technology is not the solution for dealing with criminals”.

Banning mixers to stop cyber crime is like digging up roads to prevent carjackings.

I’m much more concerned about the big picture problems with this style of enforcement. The demonstrated lack of basic understanding of how this technology works and what they are doing at the Treasury department is frankly terrifying. 

It’s one thing to deliberately destroy Crypto ecosystems with regulation. It’s an entirely different thing to do it by accident. 

The Ethereum blockchain is open and readable. There are numerous firms and hobbyists who monitor transactions. All eyes will be on Tornado Cash to see if it continues to operate or if the sanctions shut it down. In the day after the sanctions came into effect almost $3M moved through Tornado Cash.

Sanctions are a powerful tool, but they are completely unsuited to dealing with decentralized or ungoverned entities like Tornado Cash. There is no one for the government to threaten here. There’s just users accessing open source code to assert their privacy. 

If the US Government is going to bluff, I’d prefer it if the entire world couldn’t see that bluff fail in real-time. 

June was the worst month for Crypto markets ever. A huge drawdown in Bitcoin pricing, bankruptcies and scandal dominated the headlines. But there is one big bright spot, one thing within the industry that can tell us that this technology isn’t going away. To understand why this is an important marker for investors we need to go through the list of what got broken in the Crypto industry in June and why it broke.

Luna and Three Arrows Capital

Patient Zero for this entire collapse was the Terra/Luna ecosystem and its stablecoin UST. There are plenty of longer form descriptions of the collapse but the point is that when the stablecoin depegged and collapsed a large portion of the industry who had been relying on the peg ended up with a massive hole in their books.

The largest example of this was Singapore based hedge fund Three Arrows Capital (3AC) who was running a highly leveraged strategy using UST. This strategy had a significant part of the fund’s assets committed to it, but the UST collapse wasn’t enough to end the fund by itself.

3AC also had large positions in the Grayscale Bitcoin Trust (GBTC) and staked Ethereum (stETH). The Grayscale position would have paid off if the Trust had been converted to an ETF this month, allowing the huge discount on GBTC to be arbitraged away to more closely reflect the pricing of the Bitcoin held in the Trust.

GBTC was the last hope for the troubled fund, but 3AC collapsed before the SEC could even make a ruling on the ETF conversion. The stETH depeg was what really put the nail in 3AC’s coffin.

stETH is a form of Ethereum that represents tokens deposited in the Proof of Stake beacon chain. This allowed stETH holders to gain a yield while still being able to use stETH in DeFi. For a long time it traded at the same price as regular Ethereum, but in mid May prices began to diverge with stETH trading at a discount.

Unlike a stablecoin peg, there were no implicit guarantees from the company that issued stETH that the two assets would trade at parity. There was no one to defend the peg.

Despite this, most Crypto companies and funds treated the two assets as interchangeable.

In a similar way to the ETF conversion being the hope for salvation on the GBTC trade, the Ethereum merge into the Proof of Stake network was the way out for the underwater stETH trade. The merge is looking good, but it has been severely delayed from projections made in late 2021. It didn’t arrive fast enough to bail out 3AC.

3AC was by far the most prominent and dominant fund in the industry. This wasn’t some small operation, nor were they unknown. Everyone in the industry loaned funds to 3AC.

Default

As it became clear that 3AC would not be able to close their bets on GBTC and stETH in profit, whispers of insolvency grew louder. Some counter parties even warned that 3AC had stopped communicating. The lenders that had given collateralized loans to 3AC began liquidating collateral. Those that had allowed 3AC to access credit based purely on reputation looked to the courts.

The unwind was brutal. Liquidation of collateral led to more loans going bad which led to further liquidation of collateral. Once the dust settled Celsius, Voyager, Babel Finance and scores of smaller Crypto lenders were forced to limit or block user withdrawals. Crypto prices tanked. Liquidity dried up. Retail investors who had placed their trust in these lenders to safeguard their assets suffered.

The pain is real and not to be taken lightly. Huge amounts of people lost investments in Crypto banks that they trusted.

The real take away from the collapse of Crypto lenders is a lesson in knowing your counterparty. It was always clear that these lenders were lending user funds out to Crypto hedge funds and market makers. The risk of this was not well understood and it’s now highly questionable whether the yields on offer were high enough to compensate for the risk being taken.

What was not so obvious was the concentration of risk. Now that we have seen Voyager’s books via their bankruptcy application we can see that 3AC was by far their largest counterparty, representing almost two thirds of their total loans outstanding. It’s beginning to look like none of the Crypto lenders were aware of how large each other’s 3AC exposure was, nor how much debt 3AC had accessed in total. There’s no way to soften this, concentrating that much risk on one counterparty was irresponsible and a complete failure of risk management.

This fallout will scar the industry for years.

Depositing your Crypto into a lending platform will never be seen as a low risk move again. Even the companies that weren’t affected as badly will have their operations scrutinized and questioned. Yields will need to justify the risk being taken. Especially as we come to see that Crypto deposits are no way near as safe as bank account deposits during a bankruptcy.

Opportunity out of Crisis

So once all the bankruptcies have been processed and the dust settles, what comes out the other side of this debacle?

The large signpost is that DeFi survived.

Through all of the turmoil major DeFi protocols functioned exactly as intended. Collateral was liquidated, yields adjusted, nothing broke, there was no impairment.

This bull run has been a rough growth phase for DeFi with frequent hacks and dysfunction, but the core, large protocols have performed spectacularly well considering these systems hadn’t been properly stress tested before. A big part of this resiliency was that DeFi loans on major platforms are over-collateralized. Losses are not possible from bad loans.

This era of contagion was a baptism of fire for DeFi and it passed with flying colors. We can take this knowledge with us to the next bull run. We now know that companies offering access to DeFi to customers who hand over their Crypto are risky. We can use this experience to inform our decisions moving forward. We also know that the undercollateralized DeFi lenders that will inevitably show up in the next cycle will be significantly more risky than overcollateralized lenders, meaning that much higher yields will need to be offered to compensate for that risk.

What this means for DeFi tokens is still up in the air. Most tokens do not offer a share of revenue from the protocol and will struggle to activate dividends until US Crypto regulations allow it. Until then these tokens simply offer a vote in how the protocol is governed which may or may not be valued by the market.

The thing we know for sure is that Crypto based financial systems work.

This is the proof of concept that the entire industry has been looking for and should mean that these systems will continue to be built, expanded and used once market conditions recover. A major factor in the losses from the 3AC collapse was their ability to take loans from multiple counterparties without disclosing their total debt position. This is impossible in DeFi where all positions and trades are transparent and auditable, preserved on blockchains for anyone to verify. The next cycle seems likely to involve much more on-chain finance as firms look for better ways to provide assurances of solvency.

In an increasingly low trust world, finance may move on-chain.

One Big Survivor

The main thing that survived this Crash is Bitcoin.

Not Bitcoin the asset. That obviously got smoked. Bitcoin the network.

Blocks kept getting mined. Transactions kept moving. The cold wallet under your bed kept your coins secure. The network survived this, just like it always does. Cementing the idea in another cohort of new Crypto traders that amongst all of the leverage and nonsense the core and solid innovation is Bitcoin. Everything else is built around it.

The catastrophes even overshadowed a major announcement from Jack Dorsey’s Bitcoin skunkworks built within Block (formerly known as Square). The company would be building out the Bitcoin infrastructure necessary to launch DeFi protocols based on Bitcoin.

The foundations of the next Crypto bull run are being laid in the crater of the previous run.

We’ve also seen the collapse of prominent negative narratives. “Governments will ban it”. China tried. It didn’t go so well. “It’s all frothy speculation”. Third world countries continue their adoption in the face of out of control inflation and a threatening IMF.

Using the Bitcoin network I can send value nearly instantly to anyone in the world, even if their country’s banking system has collapsed. That technology is powerful and will become increasingly useful as we see more governments collapse in what is shaping up to be a decade of turmoil.

This is the third major collapse of Crypto asset markets, but the value of the underlying technology has never been more obvious.

If you’ve seen the film “Die Hard” you’ll notice the villain is trying to steal strange assets called Bearer Bonds. Why did this entire asset class disappear from the modern financial landscape?

Which properties of these long forgotten assets are important for the future the Crypto industry is trying to build? Why did governments around the world outlaw the Bearer Asset in the first place?

History of the Bearer Asset

Until the 1980s, bearer assets were very common. Bonds would be issued on paper and bondholders would present the instruments physically to receive payment. In fact the paper certificates would often have small tear off sections that were redeemable for interest payments. This record keeping mechanism is why we still call the interest payments from Bonds, “coupons”.

In the pre-digital era assets could be represented in two ways:

Registered instruments, where every owner was recorded in a centralized registry. Transfers would be executed by a contract that was then “stamped” by the registrar. This would enable a verifiable list of owners to be kept and checked as necessary. Usually for taxation purposes or so that banks could be aware of who the true owners of a company seeking financial services were.

Then there were bearer assets.

Bearer assets were owned by whoever held them. They could be bought and sold by physically transferring the document. There was no registry of owners.

This wasn’t some niche quirky asset class. Some of the most important companies in history issued bearer stock, like the Mississippi company, formed in 1717 and responsible for the infamous “Mississippi bubble”.

Most governments issued bearer bonds to fund themselves. In the United States for example if you wanted to claim an interest payment on your government bonds you would need to physically present the certificates at your local Federal Reserve building.

Bearer assets haven’t completely disappeared. Chances are if you open your wallet you still have some bearer assets in the form of your banknotes. They aren’t even from such a long time ago. The last US Government issued bearer bond only matured in 2016.

The Problems with Bearer Assets

Starting in the 1980s there was a concerted effort to eradicate bearer assets from the world. In a combined effort from FATF, the global anti-money laundering organization, and the US government, an agenda was pursued where all assets would become registered instruments. This would ensure that the owners of all assets could be known, taxed and tracked.

The problems for governments are fairly obvious. Assets that you can hold privately and anonymously are difficult to tax. Transfers that can occur between two people without any authority being notified can be used to launder money or evade capital controls.

There’s also the issue of counterfeiting. In 2009, over $130 billion in US government bearer bonds were uncovered by Italian customs officials. Without a central register modern printing techniques had made bearer instruments far too easy to counterfeit.

The practical issues are possibly more important for this analysis. Without a centralized authority to record ownership it’s difficult to develop the trust required to exchange assets between entities who don’t already have a business relationship.

Transfers are also slow compared with changing an entry in a computer database if you’re not in the same place as your counter-party. This problem is particularly noticeable if there isn’t a ready market for assets nearby. For example, in the 1900s it would be difficult to exchange bearer assets in Nebraska where there was no market, but relatively easy to do so in New York.

The Benefits of Bearer Assets

The need for a physical marketplace for bearer assets is a large part of the reason why financial hubs like New York, London and Amsterdam arose. Bearer assets could simply be handed over in exchange for cash so traders would congregate around the largest markets. Traders could exchange bearer assets as quickly as necessary without needing to stop and register each transaction. This ease of transfer was a significant financial innovation in earlier eras and could be credited for pushing forward capitalism itself by making corporate shares and bonds easily tradable assets.

Portability and usability were also significant features. In this previous era you might take a loan on your stock or bonds by physically depositing the certificates as collateral with a bank. If you needed to relocate countries your assets could easily move with you and be used in your new country without requiring any verification from the institutions in your previous homeland.

Bearer assets opened up the ability to perform global capitalism in a way that simply wasn’t possible before their invention. A stock certificate could be issued in Paris then transported to Amsterdam and traded at their stock exchange with ease. This did open up some strange issues with corporate governance however. Shareholders scattered throughout the globe are not easy to contact and gather for a shareholders meeting.

The Modern System

Now that bearer assets are all but wiped out, the modern asset system functions using a string of registries and a plethora of intermediaries. A modern stock certificate might be held digitally with the DTCC in New York, on trust for a German Holding company who then fractionalizes the share and sells those fractions to Robinhood who then sells those fractions to an investor.

Complicated, huh?

But it all works seamlessly thanks to digital communications systems and trust. The trust part is important. This entire system is held up by trust in other countries’ regulatory authorities. In the solvency of their financial institutions. In their systems.

It could all go away very quickly if that were no longer the case.

We already see what this world would look like by examining how emerging markets operate. Would you trust an Argentine stock registry to record your assets? How about an Iranian one?

Bitcoin Fixes This

If we are heading into a fractured world as many analysts are predicting, we’ll need the return of bearer assets to keep capital markets functioning. Cryptocurrencies like Bitcoin represent the return of the bearer asset in the form of digital shared ledgers.

Just like old paper bearer assets, an individual can prove they own their digital assets directly, without the assistance and trust of intermediaries. They can simply sign using their wallet to confirm ownership of the assets held within.

People can transfer digital assets directly, globally, at near instant speeds.

This financial innovation is both extremely powerful but also extremely risky for the current institutions that exist primarily to provide trust and custody to assets.

Most people who haven’t gone down the Bitcoin rabbithole yet don’t really understand the paradigm shift that has happened with the invention of digital bearer assets. They can type an order into their stock trading app and to them that’s as good as Bitcoin’s near instant global settlement. They fail to see the fundamental difference.

Trading a stock on an online exchange relies on a huge number of intermediaries to execute the trade, to store the assets and to verify the existence of assets. If you hold a share of a company in the modern system it’s impossible to prove this fact directly. The best you can do is present a brokerage account statement and ask that your brokerage is trusted. This system of trust works fine in the functional modern world we have lived in for decades, but in a world where trust is fragmented and scarce, the ability to secure and prove your ownership of assets without asking permission may become invaluable.

Benefits of Digital Bearer Assets

Digital assets don’t have to only be useful assets for the end of the world. The ability to trade assets globally without the involvement of authorities and institutions means that unlike stocks, digital assets can tap global liquidity and allow capital formation to know no borders or class divides. It’s relatively easy for a rural Kenyan farmer to purchase a dollar worth of Bitcoin. It’s nearly impossible for the same person to acquire a dollar worth of Amazon stock.

There’s also the nature of blockchain infrastructure to consider. The entire premise of token based blockchains is that they are financial ecosystems that utilize tokens to represent ownership. This allows blockchain systems to achieve near instant financial functions with final settlement. A fundamentally different experience to using something like the Visa network which can take days to settle. A merchant would then need to ask permission from their bank to utilize those funds again after that long lag time.

Ensuring that ownership of tokens is directly verifiable and transferable by users is fundamental to using blockchains to power finance. Blockchains would not be a useful innovation with bloated middlemen getting in between transactions and adding the same delays that we currently experience.

The design of cryptocurrencies with open ledgers that are verifiable by anyone also removes some of the issues with old paper bearer assets. Tokenholders can be identified and contacted significantly more easily than the holders of paper assets. It would even be easier than the methods used under the current system of share registries and chains of intermediaries holding assets on behalf of others. This tangled web of ownership often leads to shareholder voting being an impossible to coordinate task. Instead asset holding mega-firms like Blackrock vote on behalf of all of their clients. Digital bearer assets could be a path back to functional shareholder coordination and governance.

Return to Capitalism

Digital assets fundamentally change the nature of assets back to something that looks more like traditional capitalism, where individual asset owners can pool capital directly and efficiently. Where people can truly own assets, not just be granted access to asset markets by intermediaries.

The ramifications of this increase of speed and global access to finance are staggering. We’ve really only seen the first stages of what this technology can enable.

There will be growing pains along the way. Governments and institutions will need to adapt to this paradigm shift. Just like bearer instruments unlocked the power of capitalism in the 18th century, digital bearer instruments could do the same for the 21st century.   

The collapse of the Terra ecosystem in May rocked the Crypto world. The Luna token dropped to near zero from a prior high over $100. The stablecoin UST was trading down as much as half from its peg of one dollar.

This was the nightmare scenario.

Over $40 billion of market cap was wiped out over the space of a week. Both retail investors and Crypto funds got caught in the collapse. Such a widespread collapse of a reasonably credible project hadn’t previously occurred in Crypto. The closest comparisons are Bitconnect in 2018, which was flagged as a scam by everyone in the industry, and Mt Gox in 2014, which occurred in the early days of the industry when the risk of exchange failures and exit scams was front of mind.

In August last year, Senator Elizabeth Warren warned that a “run on Crypto” might need a Federal bailout citing a lack of basic consumer protections afforded to investors in the traditional asset space.

What we saw last month was a run on Crypto. We saw what can happen with no government backstop and no quality guarantees. We saw retail investors wiped out. We saw Crypto funds taking heavy losses.

But there was no government bailout.

That’s not to say that government involvement in regulating Crypto assets would be a good thing. It almost certainly would not be. As Ronald Reagan said there is no more terrifying phrase than “I’m from the government, and I’m here to help.” It’s simply important to remember that there is no oversight body ensuring that Crypto protocols work and that tokens maintain value.

Even the Korean government, whose citizens were much more heavily invested in Luna than their stateside counterparts, didn’t flinch at the loss of wealth. They’re pursuing Luna’s founder Do Kwon and looking to do everything from freezing assets to holding a parliamentary hearing. The Korean government even resurrected their elite financial crimes division, nicknamed the Grim Reapers, to investigate Kwon and Terraform Labs.

But there was no government bailout. Retail investors will not be made whole.

Nothing in Crypto markets broke. Losses were taken and the market moved on.

Self Funded Bailout

However, there was something that looked a lot like a bailout slightly earlier in the Luna timeline.

In February, the Luna Foundation Guard, the entity which was created to hold a Bitcoin reserve fund for the Luna protocol, raised $1B from investors including Jump Crypto and Three Arrows Capital. These funds were used to bolster the Bitcoin reserves with the intention of using them to defend the stablecoin peg.

In retrospect it’s pretty clear that this fundraise represented large Crypto funds bailing out Luna ahead of time.

The failing protocol also looked for an additional $1B in bailout funds from Crypto industry heavy hitters as the collapse was occuring. These industry bailouts have become reasonably common recently. Jump Crypto bailed out the Wormhole bridge to the tune of $320M after a hack drained its funds in February.

We need to pay attention to what is going on here.

Firstly, governments are uninterested in bailing out retail investors who lose money in Crypto collapses. Do not expect the same level of investor protection and compensation in a Crypto industry failure as you would from a stock exchange failure or a bank collapse. This sometimes hamfisted government financial protection often does more harm than good as was the case with the Cypress bank failures and IMF global. But it’s important to remember that in Crypto the government isn’t coming to save you. Nor would we want them to attempt to do so.

Secondly, the industry will intervene if it’s in their own interests. Jump Crypto is not interested in protecting your investment, but they will defend their investment.

But Jump won’t throw good money after bad. They weren’t willing to bail out Luna a second time.

Jump Crypto is not the Fed or the US Government. They can’t print infinite money to save the system.

Bearer Assets are Different

Crypto assets are fundamentally different to modern stocks or bonds. They are bearer assets. You are in charge of their safe custody and how you manage that is up to you. You aren’t shepherded into a government approved asset custody scheme like you are in traditional assets.

There is no FDIC insurance if an exchange disappears overnight. Your assets are gone. There is no customer service department that can recover your private keys if you lose them. If your Bored Apes get stolen, the Apes are gone.

The catchphrase, “not your keys, not your coins,” is just as applicable now as it has ever been.

As we enter a downturn where the financial stability of entities in the Crypto industry will be tested, it’s important to understand which risks you are taking. Decide who you trust to custody your assets and ensure you understand how your security solutions work.

If you have no security plan for your digital assets, you have no security.

It’s quite an odd adjustment to make as we’ve all only ever lived in a world where your bank, your government and your exchange have layers of security and guarantees to protect your assets. But it’s a crucial difference to understand. Literally no one in the world cares if you lose your Bitcoin so it’s up to you to ensure you have the ability to protect your assets.

If you haven’t done it already, it’s time to review your security. Get a hardware wallet and learn how to use it safely. Decide how you want to spread your assets among exchanges. Make active choices about your risk and your security rather than leaving it to chance.

Do Your Own Research

The other thing that the Luna collapse teaches us is that knowing what you’re invested in is more important than ever. Luna was actively promoted and suggested by several big industry experts. I don’t call them out to throw rocks or to say, “I told you so.” They are all financial product salesmen of one type or another. They get things wrong, that’s to be expected. It happens all the time and is completely normal.

My point is that these people are used as a source of guidance and advice by the investing public. They are clearly good resources over the longer term. But we’re no longer in the sort of asset market where you can throw a dart at the wall and make money. The experts are getting things wrong. It’s more important than ever to understand what you are invested in and why. Form your own conclusions from a number of sources. Seek to understand, rather than blindly follow.

If you can’t explain the difference between Luna’s tokenomics and Bitcoin’s tokenomics, then you need to do more research.

You don’t have to become an expert or understand everything, but you do need to take responsibility for your own investment decisions and understand why you are making them. No one else cares if you lose money by making bad decisions and taking too much risk.

In Crypto, there is no stock exchange listing board making sure that assets are safe for the public or that the issuance of tokens is done in a reasonable way. In Crypto, if you don’t understand how many protocol tokens exist today and how many will exist next year, then it’s important to recognize that and take your risk accordingly. We don’t want the government telling us what we’re allowed to invest in, but that means that the responsibility to investigate assets falls on each investor personally.

Following the Luna collapse, the financial press is filled with anecdotes of people who took out a mortgage or a margin loan to take excessive risk on Luna. There’s no excuse to ever be surprised when this sort of bet fails. There’s a reason every newsletter on Crypto will always say, “don’t trade on margin, don’t lever up, don’t risk more than you can afford to lose.”

It’s time to listen to those warnings, especially if you feel yourself trying to chase losses and make it all back in one big trade.

You will have more opportunities to make money in these markets, but only if you don’t destroy your finances chasing losses.

Risk is Opportunity

Crypto is a really strange market compared to what traditional financial markets have become. In traditional financial markets, we have become used to governments and central banks intervening if things break. Support of risk asset markets and the continual lowering of interest rates have become entrenched in the way western economies work.

With inflation above 7%, it’s not clear we can assume these features will continue.

While Crypto does get impacted by Fed policy and macro conditions, it is mostly at the mercy of them rather than dictating them. If the treasury market crashes, you can bet the Fed will be in there the next day propping it up. If Bitcoin crashes, the Wall Street Journal will gloat and remind you that you should have just been paying Blackrock their cut by buying index funds.

We are investing in the frontier of what could be a new and fairer financial system design but this is all untested theory; we have no guarantees. That is a big part of why the returns have been so large. We are taking excessive risk for the chance at excessive reward. We are providing capital to the dreamers and the builders, the people who want to remake the world in a way that doesn’t just funnel wealth to Goldman Sachs.

This piece isn’t intended to scare you, only to open your eyes to the risk. If we don’t discuss risk then we can’t mitigate risk. You can do all sorts of things to reduce your risk: research protocol design, look to multiple sources to inform your thinking, listen to the skeptics and judge how credible their critique is.

In Crypto, there is no FDIC insurance. There is no Fed bailout. There is no one in government who cares about protecting your assets. Your security is your own responsibility. You can take insane risk and no one will stop you from doing something stupid. If you make a mistake, own it and learn from it. Don’t expect to be made whole.

No one is coming to save you. You have to save yourself.

Related

• If you thought “The Coinbase bankruptcy disclosure” was bad….

P.S Today’s post is from contributing analyst Scott Hill, who will be providing additional insight of this space for our premium newsletters.

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Nobody loves Coinbase.
Nobody loved Amazon, either.

A bald and slightly malevolent CEO isn’t the only common factor between the behemoths of Crypto and Consumer Goods. When looking at how to value Coinbase and trying to figure out where they are going, it is instructive to compare them to a once tiny internet bookshop that went on to dominate a diverse range of tech markets from Web Services to Home Security.

From the Ashes of the Tech Bust

Amazon wasn’t always a Wall Street darling. Amazon crashed from highs above $100 in December 1999 to a low under $10 over the course of the next 16 months. The commentary at the time was filled with incredulity, “How could we be so stupid to value a bookstore at $100?”

The road back was long and painful with Amazon taking around a decade to recapture their $100 share price. The important thing to note about the path back to prominence is what Amazon did with this time. They built things that people used.

Not things people wanted to use. Things that people needed to use.

In 2006 Amazon launched AWS, their Web Services division. At the time, Business Week ran a cover on “Amazon’s Risky Bet”. The brightest financial analysts in the world couldn’t see the use for commoditised Web Services. That market segment is now known as Cloud Computing, it’s a $445 billion market and Amazon has captured a third of it.

Captured adequately describes the user experience with Amazon. You can leave at any time, but most users don’t. From AWS to selling on the Amazon Web Store, the costs to leave are often so onerous that most users don’t. They just stay and complain about the monopoly power that Amazon exerts over the US economy. No one stays because they love Amazon.

In this way, by offering essential services to internet companies, Amazon’s growth was tightly coupled with the growth of the internet itself.

No one loves Coinbase

When you talk to Crypto investors there’s broadly two camps: The regular investors that use Coinbase because it’s easy, available and they don’t mind paying a higher fee for greater peace of mind, and those that use other exchanges but practise high levels of risk management.

Almost no one uses Coinbase because they love it. They use it because they know it will still be there next year.

This is why the revelations about how Crypto could be seized from users by creditors during a hypothetical Coinbase bankruptcy shocked the market so much.

If you look under the hood about this statement from Coinbase you realize quickly that this is a legal issue with bankruptcy law that broadly applies to all crypto exchanges rather than a decision that Coinbase has made. That fact didn’t matter at all. When the foundation of the business is guaranteeing that customer funds will still be there next year then any questioning of that principle will send a wave of panic through the markets.

Coinbase is currently down 80% from its highs just like Amazon was down 90% from its highs in 2000. The only reasonable way to read this is that the market is making a bet that Crypto is going away and taking Coinbase with it.

The market made the same bet on the internet in 2000.

Coinbase is Crypto

The usual user interaction with Coinbase is through using their exchange to buy and sell, but just like how Amazon was not just a bookshop by 2010, Coinbase is not just an exchange.

Just this year Coinbase launched an NFT marketplace to compete with Opensea, a wallet to compete with Metamask and a liquid staking protocol to compete with Lido.

And that’s just the products that face the retail consumer. On the backend Coinbase provides a huge range of API, computing and data infrastructure through their cloud division. Some of these products won’t work. Arguably the NFT marketplace is already a failure. That doesn’t matter, Amazon had plenty of failed products. Do you remember Amazon Haven health services? No, me neither. Coinbase only needs to have control of the most important parts of the Crypto ecosystem just like Amazon has control over the most important parts of the internet ecosystem. They’re building every conceivable service to make sure this is the outcome.

Coinbase is building Amazon with AWS but the market is still pricing it as if it were Amazon the  internet bookstore.

Regulatory Capture – Coinbase doesn’t want to share

In 2020 Coinbase made huge waves in crypto industry circles by very publicly leaving the premiere industry lobbying group, The Blockchain Association, to form their own in-house lobbying division. Since then Coinbase has submitted their own regulatory frameworks and engaged with Congressmen on their own terms.

The other significant factor in the regulatory landscape is compliance. When a financial institution like a bank or a hedge fund wants to trade or hold Crypto they don’t devise their own custody solution and they don’t shop around for the cheapest option. They do the same thing the retail trader who is concerned about security and safety does and sign up with Coinbase as the largest regulated and trusted company in the space.

Coinbase currently has 9000 institutional customers with a total of $92 billion in Crypto assets custodied. If you need your crypto-skeptic compliance team to sign off on a custody solution then you propose Coinbase.

This has become such a known quantity within the industry that Coinbase has become a proxy for Institutional flows. There is a “Coinbase premium” which represents the additional price that institutions are willing to pay to buy Bitcoin and other Cryptos through Coinbase. Any analysis of institutional buying or selling will look to flows in and out of Coinbase in order to gauge the sentiment within institutions.

We’re even seeing market actors who want Crypto exposure without holding Crypto using Coinbase as a way to get that exposure while staying within the stock market that they know and understand. All institutional Crypto revolves around Coinbase.

Coinbase as Amazon

You’ll notice that very little of the reasoning behind this has to do with Coinbase being a superior product. It’s generally not. It has the highest fees in the industry and fairly poor customer service. There’s some important signal in that. Coinbase charges more for their services than competitors and users willingly pay for it.

Coinbase gets used because it’s the safe option. Just like no one ever got fired for using IBM in the mainframe computing era, no one will get fired for using Coinbase in the Crypto era.

This ethos won’t just be about exchanges and custody moving forward, it will extend to all areas of crypto. Given a choice of NFT marketplaces, Defi wallets, Node infrastructure, Liquid staking pools and anything else that will exist in Crypto, institutions with a risk wary compliance department will choose Coinbase over a competitor purely because the branding already conveys safety and longevity.

If you wanted secure cloud computing in 2010 you were signing up with AWS. If you want consumer goods shipped to you overnight you’re ordering from Amazon. If you want secure Crypto services you’re signing up with Coinbase. Like it or not.

Coinbase isn’t just building a Crypto exchange. They’re building a Crypto monopoly.

Arguably they already have monopoly power over the most important parts of the industry and they are rapidly building out the full suite of products and services. The Crypto monopoly hopefully won’t be here to stay but for the moment it is Coinbase’s to lose.

I don’t know what this means for Coinbase’s stock price in the short-term. All I know is that over the longer term American monopolies have tended to do quite well historically speaking.

We don’t have to like it. We just have to recognize it for what it is.

Related

• If you thought “The Coinbase bankruptcy disclosure” was bad….

P.S Today’s post is from contributing analyst Scott Hill, who will be providing additional insight of this space for our premium newsletters.

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