I’m kind of getting sick of the word “contagion”. However, it looks like the C word is coming to the digital asset space again. By now, we are familiar with the collapse of FTX, one of the largest cryptocurrency exchanges in the world. But it is far from over.
LUNA set the precedent
While the crash here doesn’t compare to the infamous UST and LUNA death spiral (to refresh my post-traumatic stress), this scandal shows just how far reaching the tentacles of a sudden loss of capital can be. UST was worth $18.6 billion and LUNA $29.7 billion on the eve of Earth’s collapse in May. Within a few days, those numbers were zero. FTX, on the other hand, is looking at a hole in its $8 billion balance sheet. So the numbers aren’t as comparable, but the domino effect might be. Numerous companies were caught up in the Earth crash, keeping UST on their balance sheets, as well as being overexposed to other crypto assets, all of which crashed after the scandal. We saw Celsius declare bankruptcy, owing $4.7 billion to more than 100,000 creditors. Voyager Digital, another crypto lending company, also had over 100,000 lenders at risk – albeit for a smaller sum of $1.3 billion. Then there was Three Arrows Capital, owing $3.5 billion to 27 different companies. I could go on but you get the point. The crypto industry was very incestuous, with companies owning parts of other companies despite all being exposed to the same systemic risk. In retrospect, it all looks like a wake-up call for risk management and diversification. How crypto companies saw it wise to trade their own Treasuries, assets, and whatever other liquidity they had, in the same highly volatile asset class their businesses were already exposed to, is beyond me. But they did, and the domino effect ensued.
Who is exposed to FTX?
The question now is this: who is exposed to FTX? Hopefully the industry has learned a lesson from the Earth and will therefore be more prudent this time around. On the other hand, FTX looked as safe as possible: funds were stored there in stablecoins and fiat – not just highly volatile cryptocurrencies. Just as those who fell victim to the UST thought it was a stable asset pegged to $1, there are those who were caught off guard by the FTX, simply leaving their funds on the exchange quoted in fiat currency. We now know that Sam Bankman-Fried had other ideas, sending those funds to his sister company Alameda Research after a series of bad investments and loans being called in. Ironically, these loans were probably canceled after the LUNA crash, when scared investors moved to get their crypto funds by any means possible. Companies are already starting to wobble. BlockFi, another cryptocurrency lender, stopped withdrawals and issued a statement describing that the damage was complete. “We have significant exposure to FTX and associated corporate entities encompassing obligations owed to us by Alameda, assets held on FTX.com and amounts undrawn from our credit facility with FTX.US,” BlockFi said. They had signed an agreement with FTX in July for a $400 million revolving credit facility. It’s hard to see them bouncing back after a lull in withdrawals – what we now know is the death knell. In fact, money goes beyond aggressive crypto companies. Sequoia Capital, SoftBank and Tiger Global, which are as big and boring as traditional investors, were all burned. “Based on our current understanding, we are reducing our investment to $0,” Sequoia said in a note to LPs. I think we can all agree that it’s a fair decision. SoftBank reportedly lost $100 million, while Tiger Global apparently lost $38 million.
I was let go by Sequoia Capital today. Buck had to stop somewhere. I was the 27 year old associate responsible for copying and pasting revenue and profit numbers from a spreadsheet in the FTX data room into a PowerPoint slide in an investment memo as diligence — Kyle Russell (@kylebrussell) November 10, 2022
A quick look at the chart below should tell you all you need to know:
From now on
As I said, I don’t expect it to be as severe a liquidity crisis as LUNA. But it would be delusional not to expect more pain – and that includes some grim announcements that will come out of nowhere. There will be companies involved in this mess that will surprise people. $10 billion is a lot of money. It cannot disappear without reverberations elsewhere. Hopefully, the damage is the least that could be expected, given the lessons taught by the LUNA fiasco. But surely it will finally persuade CEOs and treasury managers to allocate their capital wisely, conduct diligent stress tests, pay due attention to diversification, and just… be sensible. Will it be?
