Material and commentaries published in the past may or may not be helpful in analyzing current economic or financial market activity. Please note publishing date when reviewing materials.  Please email [email protected] for our current thoughts or to reach an advisor.

 

It Isn’t Over Till It’s Over

Robert Eisenbeis, Ph.D.
Fri Nov 25, 2022

The collapse of the cryptocurrency exchange FTX — the third largest of such exchanges — on the heels of significant price declines in the value of many cryptocurrencies (Bitcoin, for example, has lost 70% of its value from its high on November 10, 2021) highlights what many have known for some time: that cryptocurrencies and related entities are very risky, speculative activities that are largely unregulated. Some have called the industry the “Wild West,” and rightly so.

 

It Isn’t Over Till It’s Over by Robert Eisenbeis, Ph.D.

 


At present, there are over 9,300 cryptocurrencies in existence, and they operate internationally in hyperspace, that implies over 40 million possible exchange rates if one wanted to convert from one currency to another. This is compared with 180 government-sponsored currencies in the world, requiring about 15,000 exchange rates.

The crypto industry has expanded and is now quite complex. It includes issuers, exchanges, specialized hedge funds, banks, and securities firms, plus crypto-based investment vehicles such as ETFs. While some skeptics, Jamie Dimon among them, have voiced reservations about cryptocurrencies, at the same time their firms, including JPMorganChase, Morgan Stanley, and Goldman Sachs, have quietly entered various aspects of the cryptocurrency business. Even the Federal Reserve Bank of New York has created a 12-week pilot program based upon a digital dollar-based blockchain system involving participants like BNY Mellon, Citi, HSBC, Mastercard, PNC Bank, TD Bank, Truist, U.S. Bank, and Wells Fargo. Whether the events surrounding FTX will chill this project remains to be seen.

The collapse of FTX is one in a series of recent failures in the cryptocurrency industry, beginning with the collapse in May of the crypto firm Terra, which spilled over into significant price declines for both Bitcoin and Ethereum, two of the largest cryptocurrency entities. Terra’s collapse was followed by the collapse of Three Arrows Capital, a crypto hedge fund, and the collapse of the Voyager exchange.

The problems in FTX were triggered by an article in CoinDesk, the digital news site that follows the crypto industry, questioning the finances of FTX. The article resulted in a run on both FTX and its cryptocurrency FTT, as well as on other cryptocurrencies. The run that occurred in early November, and that continues to this day, exposed five separate potential problems contributing to FTX’s failure. First, FTX was an international conglomerate, headquartered most recently in the Bahamas but with more than 130 subsidiaries and affiliates headquartered in many countries. The bankruptcy filing in the US notes that FTX’s business were essentially conducted in four “silos” — a venture capital arm; a hedge fund that traded cryptocurrencies for profit; and two exchanges, one for operations in the US and one for operations internationally. Its business model was complex, lacked transparency, involved multiple corporate entities, had few if any internal controls, and was filled with self-dealing, as explained by the
Wall Street Journal on November 19.

Second, the firm’s value was based upon the value of its FTX exchange, which utilized a centralized custodian of the cryptocurrencies that traded on the exchange. Third, the firm had a venture-capital and trading-firm affiliate, Alameda Research, that made loans to many insiders of the firm based upon its holdings of FTT, the company’s crypto token. FTX provided loans and FTT tokens to Alameda to prop it up when Alameda began to experience financial problems.

Third, the firm lacked effective regulatory oversight to protect the interests of investors and clients from the culpable self-dealing of FTX and Alameda, which seems to have surprised everyone was the reach of its subsidiaries around the world.

Fourth, FTX operated as a centralized exchange that maintained its own electronic order book and held crypto assets and reserves on a centralized computer system which was subject to misuse. It is important to realize that cryptocurrencies are not physical assets but are instead simply electronic records stored in digital files. Like all cryptocurrencies, FTT had no intrinsic value other than what people would be willing to pay at any given moment. Value was based upon trust rather than substance.

Fifth, a substantial portion of the firm’s assets were in the form of its own cryptocurrency, FTT. It was like listing your own personal IOUs as an asset on your balance sheet.

Many of FTX’s activities are reminiscent of fraudulent practices at Enron that reflected deeply flawed corporate governance — issues not inherently related to cryptocurrencies. Other problems are related to its cryptocurrency dealings, where much of FTX’s market value was based upon its own liabilities that were reported as assets on its balance sheet. Those liabilities required the trust of market participants to maintain value and proved to be the source of significant liquidity problems when trust vanished.

Indeed, for a variety of reasons, liquidity problems have continued to plague market participants way beyond FTX into the Thanksgiving week. The Bahamian securities regulator ordered the transfer of all digital assets of FTX Digital Markets Ltd, a Bahama subsidiary of FTX, to a digital wallet controlled by the regulator. It is reported that the regulator then converted all the FTT tokens to Ethereum. The amount was reportedly somewhere between $477 and $500 million, and this sale and subsequent sales have depressed prices of Ethereum and subsequently of Bitcoin when owners of Ethereum converted funds to Bitcoin. Losses have been experienced by many different parties, including Tiger Global, the Ontario Teachers’ Pension Plan, and Sequoia Capital, totaling some $347 million. The FTX bankruptcy also resulted in a reported $3 billion in losses. The fallout is likely to continue. Whether the crypto industry survives the loss of confidence remains to be seen. What we know is that it isn’t over till it’s over.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist

Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.


 

Sign up for our FREE Cumberland Market Commentaries

 


Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.