All About the Crypto Crash

Jeff DeMaso:

The crypto markets have been in a tailspin since one of its largest exchanges filed for bankruptcy. So how did this happen, and what does it mean for both the future of digital assets and your portfolio?

Hello and welcome to another The Adviser You Can Talk To Podcast. My name is Jeff DeMaso, and I’m a portfolio manager at Adviser Investments. Today I’m joined by my colleague Senior Research Analyst Liz Laprade. Liz, welcome to the pod.

Liz Laprade:

Good to be here, Jeff. Ready to try and weed through the crypto sphere with you.

Jeff DeMaso:

I know. I know. It’s holiday season, so it’s got to be time to talk cryptocurrencies. I feel like it was 2017, so I guess a few years ago, but that was when bitcoin first caught popular attention in a big way. And its rally peaked in December 2017. So I just remember five years ago bitcoin dominating my holiday tables, dinner tables, and it feels like that might happen again.

Liz Laprade:

Yeah.

Jeff DeMaso:

So this time, we’re not talking about bitcoin because of soaring prices but because the second-largest cryptocurrency exchange, FTX, recently failed and filed for bankruptcy, and the fallout is still spreading across the crypto sphere. And again, it’s dominating the media, might end up at your holiday table.

So with that in mind, I think what would be helpful today for our listeners, Liz, is if we could just provide a bit of a primer on the situation with FTX. And we don’t need to go deep into bitcoin or cryptocurrency. And we have a special report that we can link to in the show notes that covers the basics or 101 about cryptocurrencies. But this story also isn’t necessarily just about cryptocurrency. There’s elements of leverage, mismanagement, poor risk controls, storytelling, and I think there are lessons for all investors. So we’ll start out and we’ll talk about FTX and we’ll definitely talk about crypto, but I think we can zoom out a bit and try and discuss the bigger picture. So with that as my table setting for our holiday dinner conversation, what did FTX do as a business, Liz?

Liz Laprade:

FTX is a cryptocurrency exchange that was established actually only a few years ago, in 2019. Similar to other exchanges, it served as a platform to buy, hold and trade digital assets. Unlike other crypto exchanges, though, it offered leverage to its customers, which basically means people could borrow and lend to either basically buy more crypto or short crypto. Another difference was that FTX sold its own cryptocurrency, the FTX token called FTT, and customers could actually use that coin as collateral for their leverage. So you basically end up with an exchange that has a lot of liabilities, a lot of which are backed by a cryptocurrency whose price can fluctuate up and down incredibly dramatically.

Jeff DeMaso:

Okay. So is it one part of that that led to FTX going bankrupt, a combination of the two? How did this play out a little bit more?

Liz Laprade:

There are definitely a handful of things that led to the bankruptcy, but I would say the high levels of leverage and then that choice to offer and use its own coin as collateral is ultimately what led to the bankruptcy. The card that made the house fall, though, was really FTX’s relationship with its sister trading firm, Alameda Research. It turns out FTX had lent more than half of its customers’ assets to Alameda to prop up their trading desk, which frankly is a huge conflict of interest at best and very illegal at worst. Alameda also had a ton of FTT on its own balance sheet. So when a few weeks ago Binance, the largest crypto exchange, sold $2 billion worth of FTT, well, that set off a chain reaction of selling. This meant that the value of FTT nose-dived, and suddenly, FTX couldn’t sell enough to cover withdrawals and Alameda couldn’t cover its debt it owed to FTX. So the exchange had no choice, really, but to file for bankruptcy, and Alameda operations were shut down entirely.

Jeff DeMaso:

Yeah, I mean, lending out customer assets is definitely a big no-no. And it reflects I think a lack of proper management. And we have John Jay, who stepped in to manage the bankruptcy here as the new CEO of FTX. And John Jay’s known for stepping in to unwind Enron, and he has not held back any punches. He’s been pretty harsh in his comments. And one of the quotes just really jumped out to me is he said… And again, as I say this, remember that he was there to unwind Enron. “Never in my career have I seen such a complete failure of corporate controls. From compromised systems integrity and faulty regulatory oversight abroad to concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” I mean, that’s pretty harsh.

Liz Laprade:

It is. And Jeff, when I hear you say that, the thing that gets me is that there were smart people that invested in FTX at a $32 billion valuation really not that long ago. So firms like Sequoia Capital, SoftBank, BlackRock, names a lot of us know. So then how did they miss this?

Jeff DeMaso:

Yeah. I think it’s a great question. And these are “some of the smartest people in the room.” And I think they missed it because a rising tide lifts all boats. So when prices are rising, everyone is making money. A, that covers up a lot of mistakes and mismanagement, but also it’s really, really easy to get caught up in the hype that comes with those rising prices and profits. So when you hear and see everyone around you profiting, it’s really easy to hear and see what you want to if it means that you’re getting your piece of the pie. And I think the important lesson for investors here is that this can happen to so-called smart investors or the smartest investors. It can really happen to anyone. And as a reminder to tread carefully when you’re in the crypto space, which, to me, raises the next question, which is “What does this mean for other parts of the crypto markets, and are we seeing contagion across other parts of the crypto sphere?”

Liz Laprade:

Yeah. The fall of FTX has definitely rocked the crypto ecosystem. I would say the most obvious impact is on any crypto-related firms or investors that held large amounts of FTT. I think, though, the worst has been felt by companies supported by FTX. So FTX as a company actually backed other digital asset businesses, both from an investment standpoint, like Solana, and from a lending standpoint for companies like BlockFi and Voyager.

So if I take Solana as an example, FTX was heavily invested in its ecosystem, so the fallout has pushed their token down about 60% over the last three weeks. As far as BlockFi goes, it declared bankruptcy Monday morning, and Voyager is left still looking for a bailout so that it can pay its own customers back. The collapse has also obviously scared crypto investors away in general, driving them to withdraw from other exchanges and lenders like Gemini and Genesis, who both have had to also halt withdrawals. So far, I would say that when we see halting, it’s been a pretty good precursor to bankruptcy. Genesis has said it doesn’t plan to file. However, it is now seeking emergency funds to meet withdrawals and they’ve hired an external financial adviser. So we’ll see if they can actually avoid filing or not.

But to wrap my contagion bit up here, I’ll end with a positive comment for those wondering if the entire system will collapse. Well, bitcoin and ethereum have actually mostly traded separately from this crisis, and both ended last week positive. So the crypto contagion isn’t all encompassing, at least not yet.

Jeff DeMaso:

Yeah. It’s interesting when you describe the ecosystem around cryptocurrencies. And even going back, thinking back to your answer earlier about what’s going on at FTX and what led to the bankruptcy and some of the mismanagement there, is that it stands out to me that we shouldn’t be too surprised to see these exchanges and other crypto-related businesses going belly up. And it’s because the crypto crowd in one sense is almost trying to rebuild the financial system, for all of the flaws about the modern financial system. I think it’s pretty safe to say that we’ve learned a lot of lessons over the years when it comes to regulation, keeping customer assets safe and not lending them out to our own sister trading firms. And crypto companies are relearning those lessons.

And I guess that leads to the next question about contagion, “What does this mean for more of the traditional finance?” I’m thinking your more traditional stock and bond, mutual funds, ETFs. Are we seeing contagion there or is this more isolated?

Liz Laprade:

I’d say it’s mostly isolated to crypto. I think the area of traditional systems that would be most affected would be any venture capital or private equity firms, like I mentioned earlier, that did invest in FTX because they now have to go and write down their investment toward zero. But as far as our banking system goes, I don’t think there’s anything to worry about. And I’ll go ahead and use some stats to back that up. The first is that the total crypto market cap equates to just about 2% in global M2 money supply, and that the combined market cap for crypto equities is less than half a percent of the S&P 500 index. So I’m not really seeing any serious contagion on the traditional side so far.

Jeff DeMaso:

Yeah, when you give those stats out, it makes it sound like the crypto markets have a lot more bark than bite for their size. They sure make a lot of noise and a lot of headlines.

So if this is not, at least so far, really impacting the traditional stock-bond portfolio, for those people who have invested in cryptocurrencies or are thinking about it, how should they think about investing in bitcoin or other cryptocurrencies?

Liz Laprade:

Right. Yeah. We haven’t seen huge contagion in the stock and bond markets. Since the announcement from Binance that it was selling its FTT through this past Monday, the Agg and S&P 500 are both positive. So the stock and bond markets have mostly shaken off any crypto concerns. But when you think about your overall portfolio, coming from me, I just want to continue giving the advice I’ve been giving all along, and that is: As long as the crypto ecosystem is still navigating its way to stability, do not invest any more money into it than you’re willing to lose.

Jeff DeMaso:

Yeah, I think that’s a great way to look at it. And I’d also just caution being very, very careful around any “new coins.” I really think that there’s a lot that just don’t have a use case, are probably worthless. And quite frankly, there’s a lot of fraud out there. So to your point earlier, bitcoin, ethereum, they’ve been through some crises before and come out the other side. So far, they’re certainly down, but it’s hard to say that we should count them out. But to your final point there about not investing more than you’re willing to lose, I think of it as saying that a bitcoin investment or any cryptocurrency investment isn’t actually an investment, it’s speculation. And so, think about how much you’re willing to speculate and again, potentially lose before you jump into the crypto waters. And I think that’s probably a good note to end on, Liz.

Liz Laprade:

I agree. Thanks for having me, Jeff.

Jeff DeMaso:

Thanks for helping us unravel what’s going on in the crypto markets and in the headlines.

This has been Jeff DeMaso and Liz Laprade from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you’ve enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback is always welcome. If you have any questions or topics you’d like us to explore, please email us at info@adviserinvestments.com.

Before closing, I’d like to thank our editors, Kailey Steele, Ashlyn Melvin and Tim Veidenheimer, for making this podcast possible. And thank you for listening, and have a very happy holiday season.