Expect a cryptocontagion as the FTX crisis is far from over

I’m a little tired of the word «contagion».

However, it seems that this C-word is making a comeback in the digital asset space. We already know about the collapse of FTX, one of the largest cryptocurrency exchanges in the world.

But it’s far from over.

LUNA has created a toothpick

While the fallout here doesn’t compare to the infamous UST and LUNA death spiral (to refresh my PTSD), this scandal shows how far-reaching the tentacles of such a sudden capital loss can be.

UST was worth $18.6 billion and LUNA $29.7 billion on the eve of Terra’s collapse in May. Within days, these figures were zero. On the other hand, FTX is said to have an $8 billion hole in its balance sheet.

So the figures are not that comparable, but the ripple effect could be. Many companies got caught up in Terra’s fall by holding UST on their balance sheets while overexposing other cryptoassets, all of which fell in the wake of the scandal.

We saw Celsius file for bankruptcy, ahead of $4.7 billion and over 100,000 investors. Voyager Digital, another cryptocurrency company, also had more than 100,000 creators on the hook, although it was less than $1.3 billion.

Then there was Three Arrows Capital, which owed $3.5 billion to 27 different companies. I could go on, but you get my drift. The cryptocurrency sector is far from incestuous, as companies own shares in other companies, although they are all exposed to the same systemic risk.

In retrospect, this all reads like a differentiating role for risk management and diversification. Cryptocurrency companies thought it was prudent to trade their own Treasury bills, assets and whatever liquidity they had, based on the market, for profit;The company was already exposed to the same highly volatile asset class, I believe.

But they did, and the domino effect followed.

Who is exposed to FTX?

The question now is: who is exposed to FTX?

Hopefully, the industry has learned the lesson from Terra and is therefore more cautious this time around. Again, the downside is that FTXs appeared to be as safe as possible: funds were stored in stable currencies and fiat currencies, not just highly volatile cryptocurrencies.

Just as those who fell victim to the UST thought it was a stable asset indexed to $1, there are those who were fooled by the FTX, simply leaving their funds in fiat currency.

We now know that Sam Bankman-Fried had other ideas, sending these funds to his trading firm Alameda Research, after a series of bad investments and pre-circulations. Ironically, these pre-falls were probably called the aftermath of the LUNA crash, when frightened investors rushed to get their cryptocurrency funds by any means possible.

Companies are starting to falter. BlockFi, another cryptocurrency lender, has suspended withdrawals and issued a statement noting that losses are significant.

We have significant exposure to FTX and its affiliates including obligations owed to us by Alameda, assets held on FTX.com and undrawn amounts on our credit facility with FTX.US, BlockFi said.

In July they had signed an agreement with FTX for a $400 million revolving credit facility. It’s hard for them to settle after suspending drawdowns; what we know now is the death knell.

In reality, the money goes beyond aggressive cryptocurrency firms. Sequoia Capital, SoftBank and Tiger Global, which are as big and boring as traditional investors, have been duped.

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 this is a fair decision.

SoftBank reportedly lost $100 million, while Tiger Global lost $38 million.

I was fired from Sequoia Capital today. Buck had to stop somewhere. I was the 27-year-old associate responsible for copying and pasting revenue and profit figures from a spreadsheet in the FTX data room into a PowerPoint slide in an investment memo as a diligence

Kyle Russell (@kylebrussell). November 10, 2022

A quick glance at the following table will tell you all you need to know:

Forward

As I said, I don’t expect this to be as severe a liquidity crisis as LUNA. But it would be foolish not to expect more difficulties, and that includes grim announcements that will come out of the blue. There will be companies caught in this mess that will take people by surprise.

10 billion is a lot of money. It can’t just disappear unanswered somewhere else. Let’s hope the losses are as small as could be expected, given the lessons learned from the LUNA fiasco.

But this will end up finally persuade CEOs and treasury managers to allocate their capital wisely, conduct diligent stress tests, pay special attention to diversification, and simply be sensible.

It should be that way, shouldn’t it?

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