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The troubling news of FTX’s collapse brings the digital asset market to an important inflection point: does this week’s events cool interest in digital assets, or is the technology and underlying adoption too strong to ignore?

‍Key Takeaways

• The “Shot Heard Around the World” – FTX files for Chapter 11 in a devastating collapse that takes the market by storm
• We discuss the many implications across awareness, contagion, regulation, and price action and reinforce the long-term theses of digital assets
• We attach Eaglebrook’s firm communication sent out on Friday related to these events

THE BIRD'S EYE VIEW

What a week for digital assets. This time, for the wrong reasons.

It turns out, the second-largest digital asset exchange in the world, FTX, has been insolvent for quite some time. The CEO, Founder, and believed-to-be-billionaire named Sam Bankman-Fried (SBF) has been compared to Warren Buffett and JP Morgan, was on the cover of Fortune and Forbes Magazines, and even provided regulatory insight to members of Congress.

After offering to bail out BlockFi and Voyager in June of this year, it appeared as if both FTX and Alameda Research (SBF’s self-reported $14 billion hedge fund founded before his launch of FTX) survived the Terra / Luna collapse in early May. After all, FTX had a valuation of approximately $32 billion, had prominent investors, and appeared to be in a position of strength.

But the truth was likely quite the opposite. FTX and Alameda Research have collapsed and filed for Chapter 11 after just nine days of drama, with signs pointing to likely significant wrongdoing done by Sam Bankman-Fried.

So, what happened?

On November 2nd, CoinDesk published an article that contained leaked information related to Alameda’s balance sheet: the trading firm supposedly had a large amount of illiquid assets, (including $5 billion of FTX’s exchange token, FTT) against approximately $8 billion in liabilities.

This led to the belief that Alameda Research and FTX were more intertwined than previously imagined - concerning much of the digital asset market.

After catching news of this, Binance (the largest digital asset exchange) announced it would sell a large portion of its FTT received from an original venture deal.

Problems then ensued. With a fear of the events that occurred in June, customers quickly requested withdrawals from FTX (reported at $6 billion plus), which the exchange was ultimately unable to fulfill.

While SBF reassured the marketplace of his company’s financial stability, he was secretly undergoing a significant liquidity crisis behind the scenes. This time, SBF could not find investors - Binance offered a deal but pulled its bid after conducting due diligence.

It’s now reported that FTX has a shortfall of around $8 to $12 billion with approximately $4 billion of FTX customer assets likely transferred to Alameda during the volatility in May and June. As a result, FTX Group, consisting of 130 entities such as FTX US, FTX.com (international), and Alameda Research, filed for Chapter 11 bankruptcy.

This “shot heard around the world” has been a significant focus of financial news outlets – a major awareness event, but one that has momentarily impacted the reputation of the industry.

These events have led to significant volatility within digital assets - grabbing the attention of nearly everybody with a cell phone or television.

Now the digital asset class faces a major inflection point – does this week’s events cool interest in digital assets, or is the technology and underlying adoption too strong to ignore?

We discuss these implications through the rest of this weekly commentary.

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Awareness

We often discuss the parabolic rise to $20,000 in late 2017 as crypto’s largest awareness event, with financial news outlets rushing to cover the speculative frenzy and grabbing the attention of outsiders who then learned about digital assets for the first time.

While that event will always be remembered, the coverage experienced around FTX is even larger.  Financial news outlets such as CNBC and Bloomberg have been covering the saga non-stop. The prominence of FTX, including the Super Bowl ads, makes this event rather glaring.

This negative spotlight may impact retail investors to a lesser degree than institutional counterparts that are just becoming comfortable with the asset class. Retail has remained steadfast through many of bitcoin’s ups and downs and will likely not be deterred from the long-term thesis. On the other hand, institutions are often more careful with investment selection and may “check both ways” when crossing the street into a new digital asset allocation. Investment platforms, selection, and security will be increasingly important going forward.

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Contagion

Contagion remains the main risk given the uncertainty around other firms that be impacted by the insolvency of FTX and Alameda. Forced selling would pressure digital assets lower if entities were required to liquidate their holdings.

Exchanges have begun to provide “proof-of-reserve”, or the wallet addresses that hold customer assets. The full and public transparency of blockchains allows anyone to use an explorer to audit and track exchange holdings, which should improve confidence that the assets are at least, there. While proof-of-reserves is a positive development, it does not imply they are enough to cover customer liabilities, and while a step in the right direction, this initiative is not perfect.

Along with approximately 5 million customers, most institutions and market makers that held assets on FTX lost their funds. As a result, altcoin bid-ask spreads are likely to be wider until market makers re-enter and provide liquidity. Small and mid-cap altcoins held predominantly by FTX or Alameda are likely to fail, making altcoin selection increasingly important in this environment.

Related to FTX’s and Alameda’s “buyouts”, BlockFi has again paused withdrawals, while Voyager has reopened its bidding process. While these companies are unlikely to survive without another investment, other firms may be interested in these assets. Only time will tell.

The venture capitalist and firms that invested in either FTX or Alameda have already written their investments down to zero. Many firms that have received investments from SBF, FTX, or Alameda are looking to offload their ownership to avoid forced sales when liquidators arrive.

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Regulation

The prominence and media coverage of this collapse will likely bring in greater regulation at a faster pace than previously expected. While FTX was an offshore entity, a lack of regulatory clarity in the United States is likely to have driven investments offshore. Perhaps the SEC will finally pass the regulation that the market has been longing for.

Unless the tone changes, the US has illustrated the desire to regulate digital assets for the better. This not only means protection from securities laws and token scams but also means ensuring a sound ecosystem of regulated and compliant digital asset exchanges. Semi-annual audits and even a proof-of-reserve monitoring system could underpin confidence in exchange solvency – which would certainly support digital asset investment.

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Price Action

As a result of this news, bitcoin entered new lows for the year, hitting an intraday low of $15,574 on November 9th, before bouncing and closing at $16,635 by Sunday evening. Even so, bitcoin declined 22.5% on the week.

Ether hit a low of $1,073 on the same day, while closed Sunday at $1,216, declining 24.2% on the week. Interestingly, ether remains 34.8% above its mid-June lows, supported by the Merge rally, a decline in new issuance, and incremental interest in Ethereum’s growing ecosystem. This relative strength is noteworthy - a hold of these levels would signal strength within both ether and digital assets broadly.

Unfortunately, this FTX news has occurred at the intersection of a potential inflection point within macro and equities. Thursday’s US CPI report was the first to come in meaningfully less than expected, with year-over-year core inflation of 6.3% below the 6.5% estimate. More importantly, the 0.3% month-over-month pace now annualizes to just 3.6% year-over-year core inflation.

This one single data point supporting peak inflation led to a significant move lower in the DXY Index (-4.1% on the week) and yields, with the 10 Year US Treasury declining 35 basis points to 3.81% by the end of the week.

While the S&P 500 posted the best week since June and closed at 50-day highs, digital assets did not participate in last week’s risk rally given fear of contagion.

This brings digital assets to another inflection point: do these events and potential contagion warrant a new, lower range, or is contagion less impactful, with improvements in macro supportive of a retrace back to previous levels?

We will discuss further next week.

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Long-Term Thesis Unchanged

While this news is certainly disappointing and harmful to reputation, the asset class has not only weathered a significant amount of historically tough headlines, but often comes out of these events stronger than before.

In our recent whitepaper titled Staying Power, we discuss the persistent, strong characteristics of Bitcoin and Ethereum that survive despite price weakness. The events that have occurred this year are predominantly a failure of centralized institutions that took too much risk with too little risk management.

Overleverage, greed, and fraud are not unique to digital assets – bad actors are often driven to rapidly growing industries. Bitcoin, ether, and digital assets broadly face increased scrutiny through tough times due to the ongoing debates around their true economic value – skepticism naturally rises given the emerging nature of the asset class.

The events that occurred over the last six months do not reflect the underlying technology of bitcoin and ether, nor does it reflect the potential for altcoins to disrupt several traditional industries.

While volatility remains and it’s important to be cautious through these times, we continue to believe the recent environment offers a historically attractive opportunity for long-term investors. We highlight 10 considerations for today’s bear market in our recent research report.

Remember, the negative events that have occurred this year are both historic and unusual - headwinds in the form of substantial monetary tightening and the collapses of major crypto institutions have now brought digital assets well off the highs experienced in April and November of 2021.

During the highs, many wished they had cheaper prices.

Click here to download full report. As always, please reach out with any questions or comments.

Stay tuned,

Joseph Orsini, CFA, CMT
Vice President of Research

DISCLOSURES

Investment advisory and management services are provided by Eaglebrook Advisors, Inc., a registered investment advisor. Information presented is for educational purposes only and should not be construed as providing investment advice. Past performance is no indication of future results. Investing in digital currency comes with significant risk of loss that a client should be prepared to bear, including, but not limited to, volatile market price swings or flash crashes, market manipulation, economic, regulatory, technical, and cybersecurity risks. In addition, digital currency markets and exchanges are not regulated with the same controls or customer protections available in equity, option, futures, or foreign exchange investing. Eaglebrook does not offer tax advice. Neither consultations nor information published by Eaglebrook should be construed as offering or providing tax advice.

Volatility Risk: Digital currency is a speculative and volatile investment asset. Investors should be prepared for volatile market swings and prolonged bear markets. Digital currency can have higher volatility than other traditional investments such as stocks and bonds and market movements can be difficult to predict.

Economic Risk: The economic risk associated with digital currency is in the lack of widespread or continuing digital currency adoption. The market and investors could decide that digital currency should not be valued at the current market capitalization due to a variety of factors.

Regulatory Risk: Digital currency could be banned or highly regulated by governments that would deter investors from buying or holding digital currency.

Technical Risk: Digital currency is a dynamic network with a codebase that is updated to add new security and functionality features. The updated code that is merged by the core developers could potentially have an error that threatens the security or functionality of the digital currency network.

Cybersecurity Risk: Digital currency exchanges and wallets have been hacked and digital currency has been stolen in the past. This is a potential risk that clients must be comfortable with when investing and holding digital currency. Theft is less likely when holding digital currency at a qualified custodian in offline systems (cold storage) with institutional security and controls.

The indexes presented are unmanaged portfolios of specified securities and the performance shown is gross of fees which do not reflect any initial or ongoing expenses. Indexes cannot be invested in directly. Returns for digital assets may differ significantly from the returns of indexes which hold securities. Returns are for the time periods shown.

There are significant limitations in the comparison of cryptocurrencies, notably Bitcoin, to fiat currencies and therefore the comparison of Bitcoin to fiat currencies in the presentation above is for presentation and discussion purposes and does not imply that  Bitcoin is comparable to fiat currencies.  The information presented should not be relied upon as a recommendation to invest in Bitcoin or any cryptocurrency and should not serve as an indication of the future value of Bitcoin.

Fiat currency is issued and backed by a government and is largely stable and controlled.  Through legitimate monetary policy, central banks determine the amount of money in circulation and when to increase or decrease the supply, which in part affects the value and price of fiat currency.

Cryptocurrency, on the other hand, is decentralized by nature and does not have a central authority governing it. The price of cryptocurrencies is determined by several external factors may including, but not limited to: supply and demand, investors’ expectations with respect to the rate of inflation, interest rates, currency exchange rates or future regulatory measures (if any) that restrict the trading of a cryptocurrency or the use of a cryptocurrency as a form of payment. Values of cryptocurrencies have historically been highly volatile, experiencing periods of rapid price increase as well as decline.

There is no assurance that a crypto currency will maintain its long-term value in terms of purchasing power in the future, or that acceptance of Bitcoin payments by mainstream retail merchants and commercial businesses will continue to grow.  Bitcoin and other cryptocurrencies are not endorsed or guaranteed by any government, are not FDIC or SIPC insured, are very volatile, and involve a high degree of risk. Consumer protection and securities laws do not regulate cryptocurrencies to the same degree as traditional brokerage and investment products.

BGN, Bloomberg Generic Price: A real-time composite based on quotes from multiple contributors that provides a market indication of where assets are priced. BGN uses both executable and indicative pricing, depending on the type of quotes available in the marketplace at the time of pricing. This methodology is used for bitcoin and ether.

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