The constant stop-and-start pattern of financial markets in recent months has made it difficult for allocators to deploy capital in any meaningful way for most asset classes. Crypto had mostly been spared from the wild price fluctuations since early July until the rift between Binance and FTX in early November led to panic withdrawals on the latter. This quickly escalated into broader market instability with concerns of potential systemic risk.
The drama around FTX upset what was otherwise an emerging positive setup for crypto as the significant deleveraging in May and June 2022 had left few if any large marginal sellers in this space. But the recent market turbulence and absence of large buyers has left the asset class vulnerable, potentially extending an already long crypto winter.
The bankruptcy proceedings at FTX will now be closely watched, although for the asset class, a lot also still depends on the path of US Federal Reserve interest rates. In our view, it’s still too early for a Fed pivot until inflation truly starts to tip over or we begin to see real weakness in the economic data (i.e. the US housing market stalls or employment starts to turn).
That said, the market seems to have forgotten that outside of the US, many other countries are looking to inject liquidity to support their economies or stimulate them in some way. While a strong USD had made it considerably harder to hold positions in long-duration risk assets, we think this trend looks more vulnerable albeit US economic data still looks comparatively resilient for now.
FTX files for bankruptcy
The relative crypto market stability of recent months was interrupted on November 6 by a run on deposits at one of the largest digital asset exchanges, FTX. This was triggered by Binance’s plans to sell its holdings of ~23M FTT tokens (~US$529M at the time) issued by FTX. Ostensibly, Binance sheltered concerns that FTX’s sister trading firm Alameda Research was holding a large FTT position worth US$5.8B on June 30 alongside $7.4B in loans backed by potentially illiquid assets ($2.2B of which were collateralized by FTT).
Indeed, it has since emerged that FTX potentially has an $8-10B hole in its balance sheet that may be associated with a loan or loans to Alameda pledged with FTT as collateral and using customer deposits. Onchain evidence suggests that transfers of FTT to Alameda occurred during the Terra / Celsius / Three Arrows Capital failures in 2Q22, which indicates the deleveraging effects of those unwinds have continued to reverberate in the market. Margin calls on any outstanding loans were likely triggered as FTT depreciated by ~85% against USD between November 6 and November 10.
FTX co-founder and (former) CEO Sam Bankman-Fried admitted in a tweet that he miscalculated users’ margin differences and that this is at the core of the current solvency issue. The company has since filed for bankruptcy, including FTX Trading Ltd, FTX US, Alameda and 131 additional affiliated companies. But we believe the case may have significant legal complications attached as there is no clear commercial law precedent for crypto plus many transactions took place offshore so it’s unclear what will or won’t be included as part of the process. On the upside, while the situation has contributed to broader market instability, the bankruptcy proceedings may limit the probability of contagion as US courts look for a safe outcome.
Unsurprisingly, this turn of events hasn’t helped investor sentiment towards the asset class. The setback for the industry could come at the cost of an extended crypto winter, in our view. Indeed, investors had already been scaling back their capital deployment due to concerns surrounding the Fed and weak technology stock earnings, even assuming a future recession in the US will be mild.
Now, very likely we will see second order effects arising from FTX’s unraveling as it emerges which counterparties may have lent or interacted with either FTX or Alameda and what those exact liabilities are (1). Moreover, the asset class may feel the effects of the institutional entities that either invested in FTX or who may have funds still locked up on the exchange, as that may have medium-to-long term liquidity implications as well. Already bid-ask spreads have widened as many market makers who had used FTX as a liquidity pool now feel less confident transacting in it.
We believe poor liquidity conditions may last through at least the end of the year. Stablecoin dominance (see chart 1) has risen to a very high 18% of the total crypto market cap, which has itself fallen from ~$1T at the end of October to ~$800B as of November 12.
1. Stablecoin dominance has increased to 18% of total market cap
BTC: Miner risks
Considering the amount of bitcoin being withdrawn from exchanges (see chart 1) at the moment, it’s not surprising that volatility has increased to 66% (based on a 1m rolling window of daily returns). For reference, volatility at the end of June after Celsius/3AC was 77% though the path was far less steep than what was witnessed between November 6 and November 10. Until the unraveling at FTX, bitcoin volatility was actually hovering at a two-year low of 27% as of end-October which was comparatively the same level of volatility as the S&P 500. Moreover, directionally, vol had been rising in the case of US stocks and falling in the case of bitcoin. That said, much of that decline in crypto vol was due to seller exhaustion following the deleveraging in 2Q22 coupled with the absence of any material upside catalysts supporting risk appetite. Consequently, this has shown that there are often few meaningful inferences to draw from such divergences in volatility, especially over such a short time horizon.
2. BTC withdrawals from top 5 exchanges
Meanwhile, as we’ve discussed throughout 2022, the combination of increasing hashrate (pushing up the difficulty as a result), rising energy costs and now weaker bitcoin prices has led to increasingly stressed economic conditions for bitcoin miners. The average cost of electricity per kWh in the US is currently around ~US$0.10, meaning the only US operators capable of mining profitably are either running the newest, most efficient hardware (Antminer S19 XP with a breakeven electricity cost of ~US$0.12 per kWH), or have access to marginally cheaper energy. Even in states with access to lower energy prices, such as Texas (~US$0.08 per kWh), operators are unable to mine profitably with hardware released prior to May 2020 (Antminer S19; breakeven electricity cost of ~US$0.09 per kWH).
Given these conditions, one of the world’s largest bitcoin mining firms, Core Scientific, announced early in 4Q22 in an SEC filing that they were halting all debt financing payments. The company stated that they anticipated existing cash resources would be depleted by the end of 2022 or sooner. This came just a week after the company raised their electricity rates (for the second time in just the past few months) for their hosting customers to ~US$0.10 per kWh. The company continued to liquidate its BTC reserves in October and as of October 31 held only 62 BTC in their reserves – liquidating 2,285 BTC during the month of October.
While it is encouraging that a large public miner like Core was able to liquidate over 2,000 BTC without much meaningful market impact, we believe it is unlikely that we’ve seen the last of bitcoin miner capitulation. Many operators have been amending and extending their outstanding debt contracts in an effort to stay afloat long enough for the variables impacting profitability to improve. Absent a near-term increase in the price of bitcoin, material declines in hashrate (and in turn difficulty), and/or declines energy prices, it’s possible that more operators will be forced to shut down in the coming months – particularly in light of stressed crypto market conditions. As a result, we would expect the mining industry to consolidate in the year ahead as more well-capitalized players acquire hardware and capacity at attractive prices.
Table 1. Public bitcoin mining sales in October
BTC mined (Oct 2022)
BTC reserve balance
(As of date)
Source: Public disclosures and SEC filings
ETH loses support
Ether had its first deflationary month on record because of a mid-October increase in activity associated with an ETH-based token project called XEN Crypto. Specifically, free mints on the protocol (so long as gas fees were paid) drove a massive spike in network traffic concentrated between October 8 and October 26 that caused ETH’s burn rate to increase. However, the project’s economics have been met with some criticism and at one point, someone took advantage of a loophole to recursively mint XEN 17k times at zero cost. A daily average of 1875 ETH were burned in October leaving ETH with a negative annualized supply growth rate of -0.07% last month.
3. ETH negative supply growth
Although XEN wasn’t the only source of the traffic uptick (there was some increased NFT market activity, a rise in the DeFi pulse index and the launch of Fidelity's Ethereum Index Fund as well), it seems unlikely that this is part of a larger deflationary trend. What it does show is that it doesn’t necessarily take much to see usage of the Ethereum network rise alongside interest in a particular dapp or project.
That said, supportive technical factors are unlikely to help any digital asset much in the face of the fallout at FTX. This is visible in the steep retracement in the ETH/BTC cross – often a barometer of investor crypto risk sentiment – in early November, suggesting a retrenchment of the risk exposure that investors were previously taking in October. At that time, the short squeeze in US stocks alongside the reduction of speculative ETH longs post-Merge (mid-September) had helped the pair climb higher. That had coincided with a change in the fundamental narrative for Ethereum working in its favor. With the recent proliferation of alternative layer-1 blockchains, the marketplace for L1s has become saturated, leading many in the crypto community to question the need for additional blockspace.
4. ETH/BTC gives back October’s gains
The unfortunate events surrounding FTX have undoubtedly damaged investor confidence in the digital asset class. Remediation will take time, and very likely this could extend crypto winter by several more months, perhaps through the end of 2023 in our view. Truthfully, it was going to be a challenging market regardless, as traditional risk assets still need to reckon with the high likelihood of a US recession in 1H23. Moreover, policy tightening in the US has made inflation in the rest of the world worse off. The stronger USD has made it difficult to hold long positions in crypto or other long-duration risk assets. Seeing the USD break that trend after October’s inflation print may have given US stock markets a helpful catalyst for a rally into year-end, but we still believe it’s unlikely that this will be sustainable into early 2023.