Who would win in a fight, a trillion lions or the Sun?
My thoughts on the events surrounding FTX's insolvency, Binance's strengthened market position, and the industry's future
The bigger you are, the harder you fall
The past week has been interesting and at the same time infuriating, with crypto big boys SBF (henceforth referred to as Sam) and CZ going head-to-head. In the end, FTX didn’t stand a chance. So, what’s happened?
First, CoinDesk published the combined balance sheet of a subset of Alameda Research’s entities, which raised suspicions that Alameda had borrowed FTT without collateral / received a large allocation for providing market making services, and used the tokens to acquire loans from other institutions. Then, CZ announced that Binance would sell its FTT holdings as a risk management procedure, which accelerated fear in the market, ultimately leading to a bank run on FTX. Over USD 1bn of deposits have been pulled out from the exchange during the past 7 days, of which ~USD 600m were withdrawn in the past 72 hours. And remember, these are only the withdrawals that have been processed.
I was quite certain that Alameda and other FTX affiliates would have the necessary funds to defend the FTT price such that Alameda wouldn’t get margin called as a result of collateral value dropping, but it turns out that back when the bear market began, Alameda likely blew up, leaving a speculated ~USD 10bn hole in its balance sheet. To cover the liabilities, Alameda probably borrowed FTX customers’ funds and consequently, when the bank run started, it didn’t have enough assets that it could use to defend the FTT price, even though the circulating token supply was extremely limited, with Alameda holding ~70% of the FDV (based on Alameda’s balance sheet and the FTT price as at June 2022). What is more, it seems that Binance had already been selling its FTT holdings prior to CZ’s announcement, something that had been unnoticed by the market. In hindsight, the bank run was probably net positive for the industry since otherwise, Alameda could have utilised even more FTX customers’ funds to defend against sell pressure deriving from Binance, hoping for things to stabilise in the long run.
Nevertheless, the defending of FTT’s price was unsuccessful and instead, Sam contacted CZ which ended in Binance signing a non-binding LOI to acquire FTX. When the deal was preliminarily announced, I was sceptical of it being finalised due to: 1) the relationship between FTX and Alameda, and their balance sheet structures as it wouldn’t have been rational for Binance to purchase a vast amount of liabilities and a dead customer base; and 2) regulatory obstacles—historically, similar deals have been shut down by anti-competitive authorities and Binance’s past with regulators didn’t provide any help. As I’m writing this, Binance has already withdrawn from the deal and it seems that Sam is currently contacting every remotely potential buyer on the market, while simultaneously trying to put together an emergency funding package.
Do as I say, not as I do
U.S. inflation slowed in October, which is positive news since it should give the Fed some breathing room with respect to interest-rate hikes. However, macro conditions become irrelevant if FTX’s bankruptcy creates systematic risk. On the one hand, several lenders connected to Alameda might become insolvent, which could kick off a chain reaction of bankruptcies, spreading unsystematic risk across the industry. On the other hand, ideally, losses could be contained within a few individual lenders. Based on Binance’s response following its due diligence into FTX, the former scenario seems more likely. The situation is made worse by CeFi lenders already facing headwinds from a reduction in the size of the Fed’s balance sheet, the implosion of Terra, and the bankruptcy of 3AC. Whatever the near-term future looks like for lenders, I’m hoping that retail trader repayments are prioritised since their trust in the space has to be maintained in order for crypto to reach mainstream adoption and relatively speaking, they usually have the most to lose.
I have three main takeaways from the FTX / Celsius / BlockFi / 3AC events: 1) the principal-agent problem is especially strong in crypto and will always be present when financial assets are controlled by corporations where decision making is concentrated across a few leaders and thus to function properly, they need to be extremely transparent and/or appropriately regulated; 2) even though not yet perfected, DeFi has proven itself in challenging market conditions, as protocols that are properly built prevent unsystematic risk from spreading across the market (a great example of this is Alameda paying its DeFi debt to Abracadabra before its CeFi debt because protocols show no mercy when it comes to liquidations and the position was public); and 3) humans are inherently profit-seekers, willing to utilise any opportunity to their advantage and consequently, during the previous bull market, investment decisions in crypto could largely be summed up as; “is this idea interesting enough for it to catch mainstream attention”, instead of the focus being on safety and long-term benefits, resulting in opaque systems that have led us to the price action we’re seeing today. Knower crystallises this notion well:
“With FTX removed from the picture, crypto is facing a make-or-break moment. The systems that ruined us weren’t the fault of crypto, they were the result of bad businesses and individuals capitalising on crypto. There’s nothing inherently evil or insidious about Bitcoin or cryptography, so why did everything go so south? In the midst of the bull market, we allowed some bad apples to fill us with intrigue and we didn’t do anything about it because we were making so much easy money. Now that the music has stopped and no one is dancing, we’re all a little confused.”
Three things in life are certain: death, taxes, and Binance not taking Ls
Okay, let’s focus on Binance for a moment. Even though CZ came out and said this wasn’t a victory for the company, I think otherwise. Yes, the industry has taken a massive hit as confidence in crypto has decreased and many investors have lost a substantial share of their wealth, both horrible outcomes. Moreover, regulation will tighten (not necessarily a throughly negative incident), and the market will bleed in the near- to medium-term. Nevertheless, whatever CZ’s underlying intentions were, Binance’s robustness and devotement to continuous development have been rewarded with a notably strengthened market position. Below, I’ve listed two themes that I think will drive the growth of the CEX market in the long-term and reinforce Binance’s dominant position.
Accelerating crypto penetration and regulatory clarity driving further market growth, with Binance well-positioned to benefit
The aggregate yearly CEX trading volume is currently ~USD 89tn, down ~17% YoY. However, trading volume is correlated with market capitalisation / volatility and once the economic landscape improves, volume growth can be expected to return closer to the largest CEX’s spot volume 2018–2022 CAGR of ~133%.
Retail traders hold ~0.3% of their wealth in crypto assets, in contrast to the ~25% that is held in equities. The shallow penetration indicates that there is headroom for growth. Institutional trading is also set to increase. ~57% of hedge funds investing in crypto have <1% of their AUM within the sector, while ~29% of the funds that aren’t currently invested, plan to do so in the coming years.
In the next few years, crypto retail trading will likely be sanctioned in new geographical locations such as Hong Kong and regulatory clarity is anticipated to increase in 2023, hopefully in a way that restores the general population’s confidence in crypto at an accelerated pace, enabling new institutional and retail traders to enter the industry. Both trader types are mostly onboarded through CEXs, widening the customer base.
Traders choose a CEX mainly based on five key criteria: 1) liquidity, security, and reliability; 2) cost structure; 3) number of assets covered, breadth of product types, and trading tools; 4) regulatory compliance; and 5) brand awareness.
Top exchanges have a defensible market position because they can leverage their scale to outperform smaller competitors across the five key criteria and consequently, the industry is consolidating. ~15 notable exchanges have ceased operations during the summer of 2022.
With FTX added to the list of bankrupt CEXs, there aren’t many competitors that are able to challenge Binance and thus, it is well-positioned to increase its market share. Moreover, following FTX’s insolvency, Binance was one of the first exchanges to push for transparency and started advocating for Merkle Tree proof-of-reserves, which could improve its position in the regulatory compliance category, maybe even earning some goodwill from regulators when things cool down.
Unlike pure exchange tokens that have a limited set of use cases and a trivial value-accruing mechanism, BNB offers real utility
In comparison to pure exchange tokens issued by the vast majority of CEXs and that in general only offer discounts on the issuing CEX’s services together with arbitrary airdrops, BNB also enables holders to use the BNB Chain as well as applications within the chain’s ecosystem, which gives BNB intrinsic value.
Meanwhile, the sole value-accruing mechanism utilised by pure exchange tokens is a buy-and-burn system, which is akin to a dividend payment but since no actual cash is transferred to token holders, for them to gain monetarily, new buyers must enter the system. In theory, these tokens provide utility to high-frequency traders who are new to the space due to the notable fee discount they can receive, but as seen with FTT, organic demand for these tokens can be low.
Where do we go from here
Imagine you were a person who doesn’t interact with crypto daily. One day you check your preferred news source and see that another crypto company has blown up, with most of its customers scrambling to get their money back and the whole market is in turmoil. How would you react?
Following the events surrounding FTX, an average person’s confidence in crypto has decreased, if not outright evaporated, and even seasoned investors are considering leaving the space. Many have lost a substantial amount of their funds and the worst might be yet to come if default contagion commences.
It will take some time for trust to be restored and for markets to stabilise but I’m hopeful that the industry emerges from this stronger than ever due to deadweight having been dropped and optimistically, CEX regulation will be drafted / modified in a way that doesn’t hinder innovation and is beneficial for all market participants, ultimately leading to increased crypto penetration.
Hopefully your bags haven’t taken massive damage during this week’s events and you managed to dodge any potential trapped funds on FTX. Don’t hesitate to shoot me a message on Twitter (@0x___Brick) if you’re feeling down, my DMs are always open.
“I will not lose, for even in defeat, there is a valuable lesson learned, so it evens up for me” — Jay–Z