Professional Investor Report - November 2022

This was originally published December 6, 2022, and was part of a paid newsletter for professional investors interested in bitcoin or bitcoin credit facilities. The price of bitcoin was $17,000. This is being republished for archival purposes. They will also be referenced in future writings.

FTX, due to mismanagement, poor control structures, lacking risk management, and what appears to be fraud, unleashed a contagion that affected BlockFi, Genesis, Gemini, Galaxy Digital, Multicoin Capital, and many more. This lack of market confidence provided the catalyst to cut the bitcoin market cap by almost 20%. We'll show why we believe the market is holding less risk, our single most important metric continues to improve, and the aggregate cost basis of the network is moving to a key inflection point.

TL;DR (Too Long; Didn't Read)

• If you didn't hear, FTX went bankrupt.
• The largest lending desk, Genesis, suspends redemptions and new loans.
• Hedge funds, public-facing yield instruments, and even the government took losses from the fallout of FTX.
• From a proprietary metric tracking active digital asset loans, in 2022 loan books have shrunk by 80%.
• We discuss risk management when dealing with yield products and why it's so difficult for the average investor.
• The measure of the bitcoin network aggregate cost basis is continuing to move in the right direction.
• Exchanges took a beating.
• Smallholders capitalized to acquire cheap coins amid the storm.

FTX Bankruptcy

FTX, the third largest digital asset exchange by volume, collapsed this month, and they didn't go alone. CoinDesk published an article on the inconceivably risky balance sheet of Alameda Research. Alameda is (was) a quant trading firm founded by FTX founder and CEO, Sam Bankman-Fried. Alameda had significant exposure to the incentive token on the FTX platform, FTT.

The Alameda balance sheet had $14.6 billion in assets. $5.82 billion was liquid FTT and collateral FTT. Alameda also held about $1 billion in Solana, mostly locked. Even less liquid is the $2 billion in equity investments, mostly early-stage investments based on the Alameda website, which is now private. On the liabilities side, it's reported to be $7.4 billion in outstanding loans, making up most of its total $8 billion in liabilities.

Following the CoinDesk article, it was reported that Binance would be liquidating its FTT positions. FTX experienced a bank run. An estimated $6 billion was withdrawn from FTX. Binance then announced a non-binding agreement to purchase FTX. The next day Binance said they would not be purchasing FTX due to concerns of mishandling of customer funds. FTX then halted withdrawals and filed for bankruptcy a few days later alongside Alameda Research and its subsidiaries.

What we later learned is that Alameda had preferential treatment on FTX. Alameda was exempt from margin maintenance requirements. Instead of being required to post more collateral or liquidating the position, when a margined position was underwater, FTX let it ride and continued to provide that margin.

It was reported by the WSJ that Alameda was given information about tokens soon to be listed on FTX. This allowed Alameda to build a position on that token and dump it after the attention from the public listing.

FTX also gave customer funds to Alameda. A clear violation of the Terms of Service, which would equate to theft. Sam Bankman-Fried stated that Alameda owes FTX about $10 billion. Sam used customer funds to make a loan to his hedge fund.

Alameda gave FTX executives massive personal unsecured loans. $4.1 billion, massive. Sam Bankman-Fried has $1 billion in loans from Alameda. Director of Engineering Nishad Singh received a $543 million loan. Ryan Salame, co-CEO, received a $55 million loan. Think about where this money came from;

Traders put money in FTX and used FTT. That FTT was printed out of thin air and sold to traders for a 100% profit margin. Alameda was given those coins to make the market and prop up the price. Alameda then used the FTT on its balance sheet to take loans. Those loans were used to continue to make a market on FTT and other assets on FTX. Alameda then gave loans to its inside circle. Those loans were effectively backed by FTT and a bloated balance sheet of bloated assets.

Secret Sauce: Our risk model SIGNIFICANTLY downgrades those who utilize an incentive token. It's one of the reasons we stayed away from Celsius. Native token/incentive tokens/exchange tokens, they all create misaligned incentives for everyone involved. They are also ripe for fraud and manipulation.

FTT (the incentive token), fraud (from the mishandling of customer funds), insider activity, and stupidity on top of it all led to more than 1 million people being unable to access funds and $3.1 billion owed to just the top 50 creditors.

Comments

Some numbers don't add up, like how much money FTX lent Alameda (and vice versa) and how much Alameda reported in its bankruptcy filings. Most numbers are coming from inside sources who remain anonymous. I suspect this will be resolved later, but that's just to say the entire situation is evolving quickly. I rewrote this section several times as new articles and documents were released.

Those Affected

Genesis and DCG

Genesis Trading, which operates the largest spot, lending, and derivatives desks in the industry, had issues earlier in the year when the hedge fund, Three Arrows Capital (3AC) went bankrupt. Genesis had $1.2 billion in outstanding loans to 3AC. This debt was absorbed by Genesis' parent company Digital Currency Group (DCG), in the form of a promissory note due in June of 2032.

Genesis closed its lending desk on November 16th.

"Today Genesis Global Capital, Genesis's lending business, made the difficult decision to temporarily suspend redemptions and new loan originations. This decision was made in response to the extreme market dislocation and loss of industry confidence caused by the FTX implosion," said Amanda Cowie, vice president of communications and marketing at DCG.

Many have speculated that Genesis is close to bankruptcy. I think it's less likely due to the following;

DCG (parent company) owes $575 million to Genesis, due in May 2023.

DCG is on track to do $800 million in rev this year (2022).

Genesis has a $1.1 billion promissory note due to DCG in June 2032.

Genesis has $2.8 billion in outstanding loans (as of Q3). They did almost $10 billion in spot volume in Q3. Based on their reported spot and derivatives volume, using conservative spreads, they likely did north of $300 million just this year. Genesis also charges tens of thousands of dollars per quarter to access their trading desks. This isn't the type of business a parent company would want to cut their losses on.

DCG and Genesis make enough money and DCG has a long enough time horizon to restructure Genesis' loan book and keep the business running. If they do that successfully, will the reputation hit force many clients elsewhere? Absolutely. At this point, there is no way out of this where everyone is happy.

Disclosure: The Fund is a customer of Genesis. We are not a lender to Genesis or DCG.

BlockFi

BlockFi halted withdrawals on November 10th. Then on the 14th, they disclosed "significant exposure" to FTX. BlockFi filed for bankruptcy on the 28th.

FTX and Alameda Research owe BlockFi more than $1 billion—$671 million on a now-defaulted loan to Alameda and $355 million in funds frozen on FTX. (Decrypt)

Gemini Earn

Gemini Earn is Gemini's interest-bearing account for qualified customers. Their primary yield provider on the back end was Genesis. When Genesis suspended redemptions, it effectively closed Gemini Earn.

Galaxy Digital

"As of the date of this filing, the Partnership has an exposure of approximately $76.8 million of cash and digital assets to FTX, of which $47.5 million is currently in the withdrawal process." (Galaxy Digital press release)

The State

The Missouri state pension fund took a tiny hit.

Galois Capital

In a letter to investors, the hedge fund specializing in OTC trading and market-making disclosed that half of its funds were locked in FTX. An estimated $100 million.

For the record, yes we did have significant funds stuck on FTX. No, we did not use any Bahamian method to move funds out.

— Galois Capital (@Galois_Capital), November 11, 2022

Galois is the funniest hedge fund on Twitter.

Wintermute

We spoke about Wintermute a few months ago when a key generation exploit resulted in a $160 million loss. They announced via Twitter exposure to FTX and some funds frozen.

5/ We do have remaining funds on FTX, and while this is not ideal, the amount is within our risk tolerances and does not have a significant impact on our overall financial position.

— Wintermute (@wintermute_t), November 9, 2022

Multicoin Capital

10% of the firm's assets were in FTX. An estimated $863 million. It was reported the fund lost half of its value in 2 weeks.

Nexo

It appears Nexo dodged a $219 million bullet when it withdrew funds from FTX during the first week of November. Verified by on-chain analytics platform Nansen. Nexo did disclose a loan to Alameda, which was luckily fully collateralized and closed.

.@Nexo has a small loan to Alameda (<0.5% of our assets), fully collateralized by digital assets that were sold in full by our team two days ago, resulting in 100% principal recovery and $0 losses for the company.

More on Nexo's fundamentals: nexo.io/security

2/

— Nexo (@Nexo), November 8, 2022

Risk is leaving

Through various channels, we track the estimated value of outstanding loans for or with digital assets. This would include collateralized bitcoin (secured loans), leveraged positions (secured or unsecured), short-term and long-term credit facilities, and even things such as floating assets for ATM businesses.

2021 was a steady increase flowing into Q1 2022. Credit markets took a big hit when yield products like Terra Luna and Celsius collapsed, along with notable funds like 3AC. Peaking at an estimated $126 billion in active loans at the end of Q1 2022.

Since then, we have seen loan books shrink by over 80%.

At this rate, I expect Q4 data to show less than $15 billion in active loans.

About the data

• This is an estimate with a sizable margin of error (9%).
• The data comes from public and private sources.
• This does not include DeFi credit facilities.
• This data is almost exclusively institutional activity.
• There are estimates inside of this estimate, which means the direction of the trend is more important than the numbers.
• This metric is updated regularly. If you are viewing this anytime after December 2022, it's likely to be updated.

Interconnected Counterparties & Systemic Risk

Interconnectedness: A state of connection between multiple parties, with an unknown degree of exposure from one party and another.

The more the market is connected, and the deeper those connections, the more sensitive it is to shocks.

Systemic Risk: the possibility (risk) that a single event could trigger severe instability or the collapse of an entire industry or economy.

Interconnected Counterparties is a form of Systemic Risk. Systemic Risk is not always due to interconnectedness.

Single overexposed positions have wiped out hundreds of billions of dollars in value this year. Groups of deeply connected counterparties with relationships underpinned by highly liquid and already volatile assets mean that when one party in the group goes down, other parties are forced to absorb that risk while also contending with new market volatility.

From a risk standpoint, everyone knows what to do; diversify, implement risk management strategies, limit leverage, and hedge your riskiest of positions (if possible).

Credit markets provide an incredibly useful tool for a portfolio. The problem for the average investor, and even some institutions, is that you will never be able to find enough information to answer your questions well enough. CeFi/CeDeFi (Centralized-to-Decentralized Finance. Such as Celsius, Voyager, BlockFi, etc.) are generally your only options. These firms are built in a way that makes finding the information to plug into your risk model incredibly difficult. Understandably, no one is showing retail clients (or even institutional clients) their big three financial statements. Understandably, no one is showing their entire loan book because those include loans (both sides) to other institutions.

What are the options?

• You can diversify to what you believe is thorough enough. You then are open to interconnection risk eventually catching up because you are working on limited information.
• You can build a super-conservative risk model that disqualifies almost everyone, but then you are left with a handful of counterparties to work with. Now you are exposed to 3 counterparties. So much for diversification.
• You can hedge every position. Good luck finding CDSs on crypto loans. Available derivatives would eat all of your returns.

In my opinion (also what The Fund does), hardline maximum exposure (per counterparty) and regular monitoring is the best option. I'm speculating, but it looks like Nexo was able to save $219 million from FTX because of regular monitoring. For the average person, maximum exposure might mean staying liquid on xx% and only making yield on x%.

Yield earned is a payment for taking risk.

Getting closer...

As we first reviewed in September and again last month in October, the cumulative supply in profit vs. loss and the historical significance is getting closer to a key inflection point, which we still expect in late Q1 or early Q2 2023. October started with 2.4 million coins of separation, and October closed at 1.8 million coins of separation. November closed at less than 1 million coins of separation. Fueled by the collapse of FTX and the subsequent sell-off, a convergence is moving faster than we expected.

A very similar model was shared on Twitter by Willy Woo, a quant fund analyst.

#Bitcoin bottom is getting close under the Max Pain model.

Historically BTC price reaches macro cycle bottoms when 58%-61% of coins are underwater (orange).

Green shading adjusts for the coins locked up inside GBTC Trust.

— Willy Woo (@woonomic), November 26, 2022

As always, the single most important metric is the number of addresses (roughly correlated to users/people) holding less than 1 bitcoin. That number has continued to rise. Since June, when bitcoin fell below $30k, we have seen a consistent increase in smallholders.

The larger (yet still relatively small) holders with 1-10 coins also grew.

Since January 2020, these groups have only occasionally slowed down their accumulation. As I have been saying all year in this report, this is incredibly bullish sentiment from smallholders who are weathering the storm in a down market while removing coins from the available supply.

With concerns of other exchanges following FTX into bankruptcy, the net flow in/out of exchanges was heavily influenced by -30,000 days.

If you found anything valuable here, please consider sharing it with someone who could benefit from this information.

Sincerely,
Johnny DeMaddalena