06 Jan 2023

Word of the year 2022: Contagion

The crypto credit crisis defined 2022. Its origins can be traced back to the 2020 Grayscale-arb. Terra was the catalyst, which in turn led to the fall of 3AC, Celsius, FTX, and more. As we enter 2023, the cycle is about to close full circle with DCG.
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2022 has been a yearlong hangover. 2020-2021 was a zero-interest rate policy party, rewarding the most suave party attendants for extreme risk-taking. Combine easy money, extreme returns, and nascent explorative visionary tech with intricacies understood by few, and you have a proper breeding ground for charlatans and fraudsters. During the two-year-long extravaganza of 2020 and 2021, many were enchanted by the suave. This caused an unsustainable build-up of credit towards the “bravest” risk-takers. Cheap dollars, utter conviction, poor risk management, and bad business decisions were the precursor for the devastating credit crisis experienced in crypto this year.
The birth of crypto contagion: Grayscale
The crypto credit crisis originates from the massive buoyancy and prolonged premiums of the trusts of DCG’s subsidiary Grayscale. As the contagion still ravages, the credit loop is about to close full circle, with DCG subsidiary Genesis currently facing massive pressure following FTX’s fall.
Source: Ycharts, Skew
Simplified hindsight analysis to follow. Grayscale’s trusts always traded at strong premiums in secondary markets up until 2021. Funds “arbed” this premium successfully for a while by allocating in-kind to Grayscale’s trusts. In 2020 this “arb” was massively scaled up, with the likes of 3AC and BlockFi flocking to the trade facilitated by credit, in part provided by Genesis. Meanwhile, accommodative monetary policies fueled investor demand for risk assets and alternative investments, propping crypto toward higher highs. This created massive spot demand for bitcoin and ether and caused credit to build up in the crypto trading ecosystem. Grayscale shares later saturated the market, and the “arb” became unprofitable. In 2021, this was no problem. Monetary policies remained accommodative, and crypto soared. Enter 2022, the FED pivots – easing turned into tightening. The built-up leverage represented a structural risk in crypto, and for the music to stop, a catalyst was needed. 2023 Prediction:
Grayscale’s funds will not be dissolved. DCG will either resolve the current crisis, or a big traditional finance conglomerate will acquire the massive cash cow that is Grayscale’s close-ended funds.
The catalyst of crypto contagion: Terra
The contagion erupted from Luna’s collapse closely after Luna introduced its BTC reserves strategy.
Source: Blockchair, DeBank, Tradingview
Algorithmic stablecoins was the key narrative as we entered into 2022. Subsidized by unsustainable yields, both retail and institutional investors flocked into UST to earn a 20% yield on the quazi-cryptodollar through Anchor. Crypto lenders entered Luna to facilitate high yields for retail deposits and funds invested in Luna. Luna acknowledged a need for building reserves to have fire powder to maintain a peg in periods of distressed markets and built a $2.5bn BTC reserve of 80,000 BTC to be used in dire times. Luna’s BTC purchases were partly financed by Three Arrows Capital, who borrowed funds to invest in Luna from crypto lenders who sought more yields to service a growing base of retail customers. The initial BTC purchases from Luna in March were conducted through open market orders, leading BTC to outperform other risk assets. The last BTC batch was purchased using an OTC swap with Genesis and Three Arrows Capital. Shortly after the initial BTC acquisition target of $2.5bn BTC was reached, UST’s peg was challenged and quickly buckled under the pressure. In the process, Luna sold off massive amounts of BTC, leading BTC to plunge in a highly correlated punishing market meltdown. Investors with leveraged long exposure to the crypto market were pressured. Funds and lenders with direct exposure in Luna saw massive irreversible losses. Contagion was unleashed and would ravage the market throughout 2022.2023 prediction:
Contagion has not fully settled.
A wave of selling ensued: The virus is spreading
One fund was particularly involved in Luna - Three Arrows Capital. The fund also had a very sizeable exposure to GBTC and suffered from a lack of liquid assets. Regardless, 3AC had a strong reputation in the space and had vast access to credit from more or less all crypto credit providers. Keep in mind that during the zero interest rate policy regime, the name of the game for growth companies was to focus on growth at all costs. Crypto lenders battled for venture funding by propping themselves up as the biggest loan facilitators in the crypto space, expanding their loan books. Forgetting principles such as caution, due diligence, risk management, and sound growth along the way.
Source: Leaked Affidavits
Per the massive 1,157-page-long 3AC liquidation recognition, 3AC had borrowed from just about every institutional lender in the business while also cooking their books and using borrowed funds to pay off the interest on other loans, enabled by the opaque nature of backdoor lending agreements with centralized crypto lenders. Celsius, Babel Finance, Voyager, BlockFi, and miners fell shortly after that. Voyager and BlockFi were temporarily bailed out through credit lines from FTX, which seemingly withstood the market turmoil and utilized the distressed market to consolidate. Of course, November taught us that also FTX was swimming naked. We estimated 240,000 BTC to be sold by known entities from May 12 to July 31, in what turned out to be BTC’s worst quarterly performance since 2011.2023 prediction:
Contagion will settle in early 2023.
The final blow: FTX
Sam was a scam. A period of calmness ensued after the summer contagion havoc. BTC traded at low volatility, Ethereum finally merged, and promising inflation figures prompted investors to grow slightly more optimistic. Then, in early November, Coindesk published the most important crypto news article of 2022, illustrating a huge concentration of FTT in Alameda’s balance sheet. A bank run on FTX ensued, and suddenly withdrawals were halted. It came to light that FTX was indeed insolvent, defrauding customers by co-mingling customer deposits while attending Capital Hill meetings contributing to laying the groundwork for crypto regulation and attracting institutional capital en masse. FTX’s balance sheet whole is estimated to $8-10bn. Genesis, Galois, Galaxy Digital, GSR, FalconX, Wintermute, CoinShares, Coinbase,, and several other crypto institutions were impacted. Genesis Lending quickly suspended withdrawals and sought an emergency loan due to illiquid assets in Genesis’ balance sheet. Gemini’s Earn program was halted, and the market geared towards more Chapter 11s to follow. BlockFi filed for a Chapter 11 bankruptcy after FTX’s collapse and became the third crypto lender to be guided by Kirkland & Ellis in the Chapter 11 proceedings this year, alongside Celsius and Voyager. Per now, Kirkland & Ellis have netted more than $15m on the chapter 11 frenzy in crypto. Legal proceedings directed towards the FTX fraudsters have begun and are likely to end with well-deserved jail time for those involved. Nevertheless, no amount of jail time will reimburse the real losers in this chaotic and sad year for crypto – the 8 million honest market participants at FTX who trusted the company or the 300 million crypto owners who have suffered extended losses due to a complete negligence of risk-management by trusted crypto institutions. The industry can do better, and hopefully, we have learned.2023 predictions: FTX fallout implications
  1. Negative regulatory implications on the market, exchange tokens to be labelled as securities.
  2. A further dampening of institutional presence in the market.
  3. Contagion to last longer.
  4. A new un-eventful low volatility trading range will ensue, and it will define most of 2023.
  5. Correlations between crypto and other risk assets will subdue as general interest in crypto dwindles.
  6. The SEC to reassess its stance towards BTC ETFs, leading towards spot ETFs being approved to safeguard investors from dabbling in offshore markets and maintain investments onshore.
2023 prediction:
The FTX bankruptcy case will not be anywhere near settled by the year end, and will be a long-lasting scar, similar to the still on-going Mt. Gox bankruptcy proceedings.
Crypto Credit Market Outlook
While 2022 has seen a multitude of crypto lender bankruptcies, some entities maintain their operations. At face value, the main task of a bank is to provide maturity and liquidity transformation services – to provide users with a homogenous and liquid IOU (money) in exchange for claims on diverse and non-liquid assets. The liquidity contributes to narrowing spreads, increasing market efficiencies, and financing growth. Such needs are also present in the crypto market, and centralized crypto lenders will serve a role, also in the future, despite all incidents of horrifying risk management witnessed this year.
Source: Nexo, Armanino, WebArchive (Wayback Machine)
Of the retail-oriented lending venues, Nexo is one that has yet to buckle under the pressure. However, per their Armanino attestations, NEXO has experienced a near-constant bank run ever since the Luna crash, leading its customer liabilities to half since May 12th. While we believe that credit serves a role in crypto, we hold steadfast on our view the current yields far from outweigh the risks of bankruptcies, and investors should take a very cautious approach towards yield-bearing crypto services. The crypto lending market started to boom in an environment where futures traded at annualized premiums of 50%, GBTC traded at a premium, and DeFi generated massive yields. This is no longer the case. We have already illustrated the GBTC discounts and illustrate in the year-in-review report, that the crypto derivatives market offers few viable yield opportunities. 2023 prediction:
Some crypto lenders will weather the storm and service the market, but yields will be slim, and times will be dire throughout the year. Retail investors should shy yield-bearing crypto products.
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