Article Outline
This article will cover the “Domino effect” of contagion in the crypto market, including the following topics:
- Current Market Status
- The Dominos
- Luna Debacle & UST Peg Breaking
- Celsius Withdrawals Halted
- Three Arrows Capital (“3AC”) Liquidation
- Voyager Digital Loan Default by 3AC
- Deja Vu: stETH Peg Break
- SBF & FTX: A Knight in Shining Armour or A Wolf in Sheep’s Clothing?
- An Opportunity for other CEX
- DEX Acquisition Season
- Where Do We Go From Here?
Crypto Market Status
At the time of writing, the total crypto market capitalization (“MC”) is at $900 million with Bitcoin (“BTC”) trading at $20,000 and Ether (“ETH”) at $1,100. There has been a decline of 5-10% in the past 24 hours following concerns around the fund, 3AC, possibly facing liquidation. This is a 70% drawdown from the all-time high of $3T crypto MC (November 9th, 2021) when BTC was trading at $67.6K and ETH was at $4.8K. This equates to decreases of 70% and 77%, respectively.
Macro considerations suggest that this is not yet the bottom, particularly with contagion concerns following the recent announcement of 3AC. Events over the past few months have exacerbated the adverse economic situation within crypto following the hawkish actions by government through quantitative tightening, amidst interest rate hikes.
Could these failing centralized crypto finance entities be another bull case for decentralized finance (“DeFi”)? Let’s take a look at the corporate failures to date, assess the extent of the contagion, and hypothesize on the direction that crypto market could go from here.
The Dominos
1/ Luna Debacle
On May 7th 2022, the Luna fiasco started to gain momentum ultimately leading to a death spiral that saw the UST break and Luna lose 99.9% of its value, within days.
Retail investors were by far the largest casualty, but many crypto firms are intertwined with liabilities and deposits held within the Terra ecosystem leading to significant impaired assets and a “domino effect” that has caught the attention of the regulator.
After all, how can a “risk off” asset like UST, supposedly pegged to the USD, lose such a large portion of its value? There’s a phrase “If you don’t know where the yield is coming from, then you’re the yield” - the promised 20% returns for a supposed “risk off” asset left many investors confused. Ultimately, the higher return came with the additional risk of an algorithmic stablecoin rather than a fully collateralized USD peg like competitors, USDC or DAI. More information on the mechanics of the Luna peg breaking can be found on the Origins podcast, covered by @omega_eth.
Legislators have committed to new regulation to be implemented by early 2023, which is a lifetime away in the crypto world. In the meantime, the vigilante hacker group, Anonymous, have made a statement that they will be investigating Do Kwon for his actions in the unravelling of the Terra ecosystem.
2/ Celsius
Celsius is a centralized crypto lender that has activities within the decentralized finance space.
After crypto asset prices took a tumble, this caused a cascade of liquidations leading to Celsius announcing, on June 13, 2022, that all withdrawals, including swaps and transfers between accounts, have been paused. There were insolvency concerns with recent news suggesting their lawyers are advocating for Chapter 11 bankruptcy. Chapter 11 of the US Bankruptcy Code allows a company to continue operating while it works out its debts.
Mads Eberhardt (crypto analyst at Saxo Bank) said:
“If Celsius is insolvent, it will be a harsh hit to the industry, particularly in terms of the trust of retail investors in the industry alongside a potential contagion across the industry[…]”
Celsius CEO, Alex Machinsky, is currently silent on the matter on the advice from their lawyers but there are suggestions that while bankruptcy is on the cards they are pushing for “HODL mode” to find an alternative course of action.
3/ Three Arrows Capital (“3AC”)
This contagion effect has also seen 3AC hit turmoil. A court in the British Virgin Islands (“BVI”) has ordered the liquidation of 3AC. 3AC has been operating since 2012, when it was set up by founder Zhu Su and Kyle Davies. The financial implications are unclear, but when we examine the valuation of some if its holdings the picture is grim.
Alex Svanevik (CEO of Nansen.ai) suggests the residual value of NFT portfolio is negligible.
Mr Davies told the Wall Street Journal in an interview this month that they were "committed to working things out and finding an equitable solution for all our constituents".
He added that 3AC was exploring options such as the sale of assets, or a rescue by another firm.
4/ Voyager Digital
Crypto brokerage, Voyager Digital, has issued a notice of default to 3AC after the hedge fund failed to make the required payments on its loans of 15,250 bitcoin and $350 million in USDC.
Voyager’s platform continues to operate and fulfil customer orders and withdrawals in the meantime while the extent of the contagion risk is determined.
5/ Peg Break “Deja Vu”: stETH
stETH is intended to be on a par with ETH. It is ETH staked and locked up for the Beacon Chain merge and is redeemable 1:1 once ETH2.0 goes live.
Following the UST peg breaking, investors continued to de-risk their position by removing liquidity and selling stETH for ETH - Celsius and 3AC attempted to do the same. On June 23, 2022, Lido Finance's stETH tokens traded at $1,091 as compared with $1,143 for ETH tokens, representing about 95% of the value of ETH.
The decoupling has prompted concerns about the stability of Ethereum, liquidity for ETH holders, and the broader health of the crypto industry.
The Contagion
As can be seen from the above, the situation is rather dyer. With no signs of the macro situation changing and significant intertwined liabilities between these parties, it is reasonable to assume further downside.
Voyager Digital and BlockFi have secured lines of credit after exposure to 3AC, which hasn’t yet repaid many of its outstanding loans. BlockFi loaned $1b to 3AC and Voyager extended a loan of 15,250 BTC and $350 million in USDC ($655m total). This could cause huge ripple effects if the debt has to be written off.
The situation has recently worsened with the Monetary Authority of Singapore (MAS) stated that 3AC misled regulators when moving fund management to the BVI and also managed more funds than permitted. The watchdog will continue to investigate the firm as Teneo Restructuring is set to handle 3AC BVI assets as it unwinds its liabilities.
But where does this leave the crypto market? Well there are better managed firms that are opportunistically waiting to scoop up struggling entities at severe discounts.
SBF & FTX: A Knight in Shining Armour or A Wolf in Sheep’s Clothing?
FTX and Alameda Research, both founded by Sam Bankman-Fried (“SBF”), have hinted at several prospective acquisitions.
A Forbes article states:
1/ Voyager: Alameda Research indirectly holds 22,681,260 common shares of Voyager ("Common Shares"), representing approximately 11.56% of the outstanding Common and Variable Voting Shares.
Alameda Research has further extended a USDC-based credit facility with an aggregate principal amount of $200 million. The second revolving credit facility is for 15,000 BTC. Voyager will only use the credit facilities if needed to safeguard customer assets.
The credit facilities will expire on Dec. 31, 2024, and will have an annual interest rate of 5% payable on maturity. Certainly a nice little earner for Alameda during a bear market.
2/ BlockFi: BlockFi is one of the crypto industries largest lenders.
SBF has extended a $250 million “line of credit” to the struggling crypto lender, which would effectively wipe out all shareholders and venture investors by allowing FTX to buy the company at essentially zero price.
Morgan Creek (A BlockFi early investor), Managing Partner stated:
“If FTX were to exercise the option, it would wipe out all of BlockFi’s existing equity shareholders, including management and employees with stock options, as well as all equity investors in the company’s previous venture rounds”.
Zac Prince (BlockFi CEO) confirmed that BlockFi signed a term sheet with FTX to secure a $250M revolving credit facility. So seeing how this one plays out could be interesting.
3/ Robinhood: Robinhood is a trading and investment application. SBF owns a 7.6% stake in the investment platform on May 2, 2022 for $648.3m.
There is speculation of a potential takeover of Robinhood, however nothing formal has been announced. The trading platform is an attractive target with $6.1 billion in cash, albeit with longer term liabilities of $12 billion. But in the short term landscape cash is king.
Up to now SBF has been protecting the blockchain ecosystem with tightly controlled short-term loans that give breathing space to distressed lenders like Voyager and BlockFi to which Robinhood doesn’t fit that category, yet.
4/ Bitvo: FTX has agreed to acquire Bitvo, a Canadian crypto asset trading platform to further the FTX expansion across the entirety of Canada. This entry into the Canadian market is timely as Binance pulls out of Ontario due to regulation.
5/ Embed Financial Technologies (“Embed”): FTX will acquire Embed as part of a deal aimed at “enhancing” the company’s US stock offering.
FTX US president Brett Harrison says the acquisition of the clearing firm will provide the technology and infrastructure to facilitate the crypto exchange’s US stock offering.
This hawkish activity from FTX will likely be the first of many takeovers to come as crypto companies and projects struggle to find the runway to continue operating. Those with strong value propositions will remain prime targets for those cash rich companies, like FTX. We touched on the crypto M&A activity in the May’22 OriginsNFT report, which referenced PWC who highlighted that crypto M&A activity increased from $1.1B in 2020, to $55B in 2021.
An Opportunity for Other CEXs
Centralized crypto exchanges tend to do well provided they manage their working capital properly. With significant volume and a percentage earned off each trade they have a decent revenue stream, provided volume remains at a reasonable level.
1/ Binance: Binance is by far the largest exchange by volume, offering the widest range of tradable assets and currencies.
Binance Labs has invested in and incubated hundreds of projects. Its portfolio includes 1inch, Audius, Axie Infinity, Dune Analytics, Elrond, Injective, Polygon, Optimism, The Sandbox and STEPN.
Although more recently it has indicated an intent to diversify out of crypto with target acquisitions within the media industry (e.g. failed attempt for Forbes) to bolster crypto education. This strategic direction of expanding its reach should help steady the ship in challenging economic times when risk on assets don’t fair as well.
Binance CEO Changpeng Zhao (“CZ”) said that:
"as Web 3 and blockchain technologies move forward and the crypto market comes of age we know that media is an essential element to build widespread consumer understanding and education. We look forward to bolstering Forbes’ Digital initiatives, as they evolve into a next level investment insights platform."
2/ Coinbase: Coinbase maintains similar levels of trading volume to FTX with a user friendly platform, but limited offering. The recent strategic decisions to deliver an NFT market place hasn’t performed well. The share price plummeted 75% before Goldman downgraded its rating. The BTC holdings also decreased while Binance increased its BTC reserves.
While the recent performance has not been as strong as the other exchanges, it still holds a reasonable war chest and provided it makes the right strategic decisions could acquire some struggling smaller crypto companies.
DEX Acquisition Season
We could see more DEXs rise and acquire innovative crypto tech companies. While the media is distracted with the larger volumes of activity in the wider crypto space, NFTs have been ramping up in M&A activity.
Uniswap recently acquired Genie, a NFT marketplace aggregator. Could this lead to a new decentralized NFT market place to compete with both Looksrare and Opensea? Or could this mean a new series of crypto power houses acquiring smaller entities with strong value propositions? Opensea recently acquired a similar NFT aggregator, Gem to improve its Professional NFT trader experience, but volume has dropped significantly and is not doing as well as 2021.
Yuga Labs also acquired Cryptopunks and Meebits from Larva Labs, amending the licensing rights to be more friendly to holders. The rights permit holders to spin off their own NFT collections based on particular apes, or to sign their apes with major record labels. In fact we saw Eminem and Snoop Dogg feature their apes in their latest music video.
Could we see the likes of Yuga Labs rise to the same size as other brands like Disney? There’s a long way to go but it’s moving in the right direction and will depend on whether the web2.0 counterparts jump on the web3.0 “bandwagon” early enough.
Regardless, this will likely be the start of more NFT M&A activity over the coming months and years, as more collections are deemed complimentary to existing brands and acquired under the same collection umbrella.
Where Do We Go From Here?
More dominos will likely fall - possibly the smaller exchanges and crypto lenders who are over leveraged and unable to pay their short term debts. Their debtors could push their own credit limits and stretch their working capital cycle to the limits, either way some will file for bankruptcy and working capital will be strained.
Some will be rescued by those who have better managed their war chests. After all, cash is king during economic downturn, which is where we can see the likes of FTX excelling.
Ultimately, none of these crypto companies want contagion to take effect, but there’s only so much capital that can be deployed before there’s none left to deploy. Do you try plug a sinking ship, with founders making statements like “Deploying more capital - steady lads” or do we let the failing organizations fall by the way side to make space for better structured, more innovative alternatives?
Being smart, potentially ruthless, about when and where to allocate capital will mean many companies will see their demise, similar to the internet boom in the 1990s. But from the ashes the next tech giants could spawn to rival their web2.0 counterparts.
There are lessons to be learned. There’s a lack of transparency for these centralized crypto lenders, which acts as a bull case for DeFi whereby all counter-parties and the size of the loans are viewable on chain. There is proof of asset and an automated unwinding of liabilities so as not to require a pause on withdrawals.
It is going to be a bumpy, and exciting ride. So buckle up and grab your popcorn as we enter uncharted territory for the crypto industry.
At OriginsNFT we leverage data-driven decision making, educational resources, and proprietary analytics to remain ahead of the curve with respect to blockchain tech and specifically NFTs. To find out more, please visit our website or Twitter.
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