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Cryo Crypto:
Frozen Funds, Bankruptcy & Conflict

Crypto Contagion...
Conceived in the wake of the Great Recession, crypto's vision, as pioneered by Satoshi Nakamoto, involved stabilizing economies by doing away with inflation and enhancing trust in financial systems. Despite decentralization's intentions of preventing institutions from flirting with insolvency by taking excessive risks, 2022 saw a host of crypto firms go bust. The first wave of crypto bankruptcies was set into motion in May by the collapse of the algorithmic stablecoin terraUSD (UST) and its sister token luna in what has been described as a bank run. TerraUSD’s breakdown rippled through the crypto industry, shuttering firms exposed to UST. With heavy exposure to terraUSD, crypto hedge fund Three Arrows Capital (3AC) filed for bankruptcy on July 1. That same day, crypto lender Voyager Digital halted all customer withdrawals. Days later, Voyager filed for bankruptcy after 3AC defaulted on a crypto loan worth over $650 million. On July 14, after freezing customer withdrawals, crypto lender Celsius Network filed for bankruptcy as another casualty of the breakdown in UST and luna. Since its insolvency, Celsius has been accused of using investor money and customer deposits to prop up its own token, while two of its founders made millions selling them.

Frozen Withdrawals
The stunning meltdown of crypto exchange FTX in November sent further shockwaves through the cryptosphere. FTX, which had stepped in during the UST and luna collapse to keep some crypto firms afloat, received customer withdrawals of about $6 billion in just 72 hours. In response, FTX suspended all client withdrawals on November 10, before filing for bankruptcy the next day. Founders and executives of FTX and its affiliated crypto hedge fund, Alameda Research, have since been charged with fraud on an historic scale. Accusations describe how FTX artificially boosted their balance sheet by manipulating the price of FTT, an exchange token issued by FTX; and misappropriated hundreds of millions of dollars of FTX customer funds to cover losses incurred by their crypto hedge fund. The same day that FTX halted customer withdrawals, crypto lender BlockFi followed suit, announcing it would also terminate withdrawals. BlockFi would file for bankruptcy itself some two weeks later as it had relied on a $400 million credit facility from FTX after the bankruptcies of Voyager and Celsius. In December, one of the biggest publicly traded crypto mining companies in the US, Core Scientific also filed for bankruptcy, citing a $7 million unpaid debt from Celsius as one of its headwinds. Large crypto lender Genesis filed for bankruptcy in January after halting customer withdrawals in November. Genesis was hit by the collapse of 3AC, who owed Genesis $1.2 billion in unpaid debt. The final blow for Genesis came from its exposure to FTX.

Regulatory Heat
Crypto lenders and exchanges, acting as banks of the crypto world, boomed during the pandemic, attracting customers with double-digit rates in return for their crypto deposits. However, since then, not only have crypto firms dealt with a liquidity crunch, but they are also facing challenges from regulators. The SEC has asserted that many crypto products are actually securities that should be registered with the agency. This year, the SEC has already made several complaints against firms it has accused of selling unregistered securities, including the crypto firms Genesis, Gemini, and Nexo. Crypto firm Kraken is the latest to settle SEC charges of offering an unregistered security. Kraken paid $30 million to settle the charges and decided to stop offering their staking-as-a-service program in the US, which advertised annual returns of up to 21 percent. In 2022, the SEC brought several similar actions against crypto firms, including BlockFi, which subsequently decided to register the offering in question.

Crypto Conflicts
The SEC has been warning of the dangers of crypto assets, increasing their oversight of products deemed to be securities that fall under their jurisdiction. Of the 11 charges the SEC has made so far this year, five have been crypto-related. In 2022, the SEC made 13 crypto-related charges, which compares with just three charges brought in 2021. Last year, in addition to selling unregistered securities, the SEC made accusations of crypto price manipulation, crypto insider-trading, and other fraudulent investment offerings. Of the three Ponzi scheme charges made by the SEC in 2022, two were crypto-related. The SEC also charged Kim Kardashian for promoting a crypto asset as an investment without disclosing she had been paid to do so as required by securities laws.

Gensler’s Refrain
SEC chair Gary Gensler has described the business models of many crypto firms as “rife with conflicts” and has referred to crypto as a “largely a noncompliant field”. He has said that crypto firms need to “disentangle” bundled products. For instance, Gensler has said, ““we don’t let the New York Stock Exchange also run a hedge fund and trade on the exchange; why would we do it here?”. This refers to the practice of offering both exchange services as well as market making services, profiting by taking the other side of a customer trade in addition to any transaction fees. Gensler has also expressed concerns that crypto firms do not properly segregate customer’s assets, often commingling client funds with their businesses.

Crypto Winter…
Considering that crypto was meant to exist outside of the traditional finance system, and that the creators and proponents of crypto assets often cite issues of trust with markets, it may seem ironic to contemplate seemingly widespread fraud and conflicts of interest present in the cryptosphere. All of the breaches of trust and conflicts of interest that crypto proponents may perceive as commonplace in traditional markets seem to exist at least as much within the digital asset space - misappropriation of client funds, market manipulations, frauds and Ponzi schemes. Some conflicts that do not exist in traditional markets are only present in crypto, such as providing services both as an exchange and a market maker. Crypto is rooted in mistrust of the banking system stemming from the 2008 Financial Crisis when angst against big banks reached a fever pitch. Therefore, it may seem especially ironic that much of the recent turmoil in crypto resulted from what were essentially bank runs.

February 15, 2023

Markets Demystified is published the first and third Wednesdays of each month, and explores how stock market investing can relate to personal finance.

Thanks for Reading!

Jonathon Oden
Owner | Aesop Advisor LLC

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