The FTX Contagion Spreads

The crypto markets entered a second week suffering the aftermath of the FTX debacle that plunged the industry’s market cap by 23%. As of Monday’s close, Bitcoin and Ethereum fell by almost 6% and 11%, respectively. Within the major subcategories, the cryptoassets most affected by the FTX’s bank run this week were Solana, Polygon, and Uniswap, which dipped by 17%, 15%, and 17%, respectively.

Figure 1: Weekly TVL and Price Performance of Major Crypto Categories

Source: 21Shares, Coingecko, DeFi Llama

Key takeaways:

• FTX’s bankruptcy drags BlockFi and Gemini with it
• 75% of last week’s inflows invested in short products
• It’s becoming increasingly more expensive to mine Bitcoin
• The crypto industry to have an Emergency Fund similar to that of the IMF

Spot and Derivatives Markets

Figure 2:

Source: Bloomberg, CoinShares

As seen in the figure above, last week saw inflows to digital asset investment products amounting to $44M, 75% of which are invested in short products, painting a vivid picture of the negative market sentiment on the back of the collapse of FTX and the repercussions that followed.

On-chain Indicators

Figure 3: Bitcoin Average Mining Cost

Source: MacroMicro

The average cost of mining Bitcoin has increased by more than 15%, to exceed the $22K mark, and has now become higher than the spot value of the cryptoasset. This, coupled with the ongoing energy crisis, can forecast the shutdown of many nodes that can neither cover costs nor afford a sharp decline in revenue.

The FTX Debacle: What Happened this Week?

Figure 4: The Convoluted SBF Network

Sam Bankman-Fried and other executives from FTX’s sister company Alameda Research have been invited to a bipartisan hearing later in December held by the U.S. House Financial Services Committee, who have also invited Binance to attend on the back of its intention to acquire FTX before it retreated due to a multi-billion-dollar hole in the balance sheets of the troubled exchange and Alameda Research. Bankruptcy proceedings showed FTX lacked corporate controls and that its financial statements should be deemed untrustworthy due to the absence of accounting and governing practices. The proceedings also indicated that FTX owes $3.1B to its top 50 largest creditors.

FTX’s new CEO Joy Ray III said the exchange was launching a strategic review of its assets. After the filing’s shocking revelations, the securities commission in the Bahamas, where FTX is based, ordered SBF to transfer the exchanges’ assets to a government custodial wallet, for safekeeping. To add salt to the injury, FTX got hacked on Friday and the exploiter converted $600M of ETH to RenBitcoin.

Ring-fencing. The sudden collapse of FTX raised scrutiny of all centralized platforms as technically-competent users flocked to exchanges to withdraw their assets. This heightened cynicism prompted exchanges to share proof-of-reserve balances of their holdings, which a handful of companies have already published while others are still preparing. (You can check out our Dune Dashboard providing real-time coverage of Binance’s published wallet reserves, or Coingecko for a broader aggregation of all PoR balances for exchanges that have conducted it). That said, as non-custodial solutions such as Metamask require much work to improve user experience and help make it more intuitive, relying on intermediaries will still be the theme for the foreseeable future. In that view, Vitalik Buterin - in collaboration with Kraken, Coinbase, and Binance - proposed improvements on the current iteration of Proof of Reserves based on Merkle Trees. Ethereum’s founder suggested that centralized exchanges could leverage zk-SNARK (zero-knowledge succinct non-interactive argument or knowledge) technology to improve on privacy rather than opting to publicize a comprehensive list of wallets and assets that might compromise the operational security of users and entities. The privacy-preserving mechanism would help users validate the platform’s solvency without having unnecessary access to information about other individuals' accounts. Finally, Binance announced the establishment of a recovery fund serving as a backstop that would invest in “projects which are otherwise strong, but in a liquidity crisis” on the back of the FTX collapse. The founder of Binance claims that many players from the space have shown significant interest, without revealing who it might be yet.

Contagion. The extent of the financial crunch became clearer as the FTX Bankruptcy proceedings came to light. The decision revealed the damage incurred to different crypto-native companies overly exposed to the defunct exchange and its affiliated market maker Alameda. Cracks began to appear on November 16 as Genesis halted user withdrawals, redemptions, and the origination of new loans, shortly after announcing a $140M equity infusion from its parent company Digital Currency Group. However, trouble had already been brewing for Genesis as a Wall Street Journal report divulged that the lender had sought to raise a billion dollars in fresh liquidity a day before suspending its operations. Bloomberg disclosed today that the company is on the verge of Bankruptcy after failing to raise funds over the weekend. For context, Genesis started as the first Bitcoin OTC desk in 2013 before becoming the biggest crypto lender. They are tainted as the only full-service primer broker within the industry, which enables a one-stop shop for custody, OTC trading, and a credit facilitator of crypto assets. Therefore, the firm played a pivotal role in onboarding financial institutions and is at the epicenter of the crypto’s capital market. Thus, its collapse would be detrimental to the industry for the following reasons.

First, Genesis is a subsidiary of Digital Currency Group (DCG), which owns sizable companies such as Grayscale, amongst others. If DCG is the indebted entity to Genesis, it raises the possibility that DCG could liquidate its GBTC trust and sell either part of its ~633K BTC (3.24% of total supply) fund, or its 3M ETH fund, adding pressure to the market. Grayscale refused to provide a proof-of-reserve of its balances in the wake of scrutiny due to security reasons; however, Coinbase has since published a report of the fund’s assets held in their custody to alleviate the concerns. Second, Genesis serves as the counterparty for many centralized companies, as they power their yield programs by lending out the user-deposited assets to native financial institutions for an interest that gets partially distributed back to those users. This impact is already being felt as Gemini halted its earn program, while Circle saw its Circle-yield program (fixed-income product) drop to 0% due to its reliance on Genesis. Therefore, the failure of Genesis would dry up liquidity across the ecosystem. It is worth noting that Gemini asserted today that it is in talks with DCG and Genesis to assess all options for reopening redemptions for its Earn product. Similarly, the market maker B2C2 has offered to step in and buy Genesis's outstanding loans, so this is a development we will closely monitor.

As discussed last week, the Solana ecosystem is taking a significant hit as many of the struggling VCs and Funds who had deep ties with FTX were also significantly exposed to SOL-based tokens. First, Solana’s TVL (akin to assets under management) dropped to a staggering $330M as of November 22, losing almost up to $700M in assets’ value over the past two weeks. In addition, OKex, Bybit, and Crypto.com all announced they would terminate support for USDT and USDC on the Solana chain. Binance took the same decision; however, they have since re-enabled Solana-based USDT deposits. The rationale behind this move is still a mystery since the founder of Circle, Jeremy Allaire, emphasized that USDC was functioning as intended on top of Solana. Thus, the exchange’s motivation remains unclear. However, it can be argued that some platforms are taking precautionary measures to mitigate the Solana ecosystem exposure to FTX. Tether also announced that it performed a cross-chain swap of $1B USDT from Solana to Ethereum. Although they didn’t provide further explanation, it could be driven by the fact that the firm follows where the user demand goes. Native protocols didn’t go unscathed either, as the GameFi StarAtlas project publicized it lost half of its cash runway as it was stuck on FTX, while the prime brokerage protocol Oxygen and Maps revealed they held 95% of their token’s total circulating supplies at FTX.

The financial turmoil also extended to venture funding and the broader crypto space as a wrath of companies acknowledged their exposure to FTX and Alameda:

• Multicoin Capital reportedly has almost ~860M of assets stuck at the exchange.
• Jump crypto, the crypto arm of the trading giant, was rumored to be unwinding its operations due to its exposure to FTX, which the firm subsequently denied.
• BlockFi paused its withdrawals and expectedly discussed filing for bankruptcy since it was recently acquired by FTX in the wake of the Celsius collapse.
• Galois Capital and Ikigai VC funds also caught up as their capital was trapped at FTX with the former losing close to $100M.
• Chainalysis confirmed as one of the creditors owed money by the exchange with an undisclosed amount as of yet.
• Sino Capital were deeply tied with FTX beyond just equity investments, holding mid seven figure positions in SOL ecosystem tokens like Serum, Oxygen and Jet protocol
• The lender Vauld announced $10M were stuck on the exchange.
• TradFi giants such as Bank of America, Circle, JPMorgan Chase Bank, Wells Fargo, Silvergate Bank were also exposed to FTX as creditors and market down their investments.
• LayerZero fully bought out Alameda/FTX of all their equity positions, leaving the protocol’s finances in a better position.
• Liquid Global, An FTX-owned exchange, paused withdrawals, then proceeded to halt all trading.
• Lending platform Salt halted withdrawals and deposits.

What to expect?

Potential Insolvency of DCG and/or Genesis: As discussed in the report, Digital currency Group is the owner of the asset manager Grayscale as well as the prime broker Genesis. If the latter fails to raise enough funds in due time, the firm will have to resort to declaring bankruptcy. The ramification of this step would be the restructuring or liquidating of the manager’s assets in order to fill in the almost $1.5B hole if DCG is indeed the entity in debt. Things don’t look bright for the troubled lender as Binance has reportedly stepped away from the deal due to conflicts of interest with Genesis's business model.

FTX Hacker Amplifying Selling Pressure: The unknown entity identified for siphoning more than $600M of assets, amidst the chaos of last week, off the FTX exchange still has close to $200M worth of ETH. The hacker’s on-chain activity showed that he’s on the move as recently swapped millions of ETH into renBTC last Sunday, potentially preparing to unwrap first into Bitcoin, then launder the assets through some of the available mixer solutions that would have deeper liquidity than the sanctioned Tornado Cash that lives on the Ethereum network

Short-Term Decimation of the Solana ecosystem: As liquidity dries up on the alternative Layer1, critical DeFi service providers have demonstrated their readiness to step away from the embattled ecosystem. Tether’s decision to migrate more than a billion dollars of its USDT stablecoin to Ethereum and the exchanges reluctance in accepting deposits of native USDT on Solana is signifying that more problems could in sight for the network.