The Crypto Industry has had a rough go of it in 2022, to say the least, and I would like to shed some light on some of the major dominos that have fallen.
2022 has been filled with many extremities including high inflation and the rise of interest rates that many have never seen in their lifetime.
This has led to poor performance across financial sectors, specifically the bond and equity markets, as well as being a contributing factor to the crash of the 2021 Crypto Bull market.
The crash roughly started in December 2021, but the contagion started long before that and spread throughout 2021 and 2022. I will try to do this chronologically but may jump forward and back to make some things absolutely crystal clear.
So here we go! Strap in, and enjoy the ride of the 2021-2022 Crypto contagion that no one truly realized until now.
*Clears throat* We are going to start all the way back in 2020 with rough dates and a lot of introductions, so stay with me and you'll get the picture.
Digital Currency Group (DCG) is a Crypto conglomerate Corporation with many businesses in the industry, including CoinDesk, a notable blockchain news source, Genesis Trading, Crypto’s only prime brokerage (think Fidelity but only for big institutions), and Grayscale, one of the world’s largest digital currency asset managers.
Grayscale had created a Bitcoin Trust Fund called the Grayscale Bitcoin Trust (GBTC) that allows investors to gain exposure to Bitcoin without actually holding it.
One of these investors was Three Arrows Capital (3AC), a hedge fund founded by two MIT graduate traders, Su Zhu and Kyle Davies, that had made money trading Crypto in 2019 and 2020.
Along with other Hedge Funds, they realized that GBTC could be used in arbitrage trading (selling two identical assets in two different markets for a profit) because GBTC was not priced based on the actual price of Bitcoin, but rather the NAV (Net Asset Value).
Therefore, there was a difference in price and better yet for these traders, there was a premium on the GBTC because so many investors wanted it and thus traded at a higher price than the actual spot Bitcoin.
3AC saw this opportunity to make essentially a “risk-free” trade and submitted documentation to own 6.1% of the Grayscale Bitcoin Trust. 3AC took out a loan with Genesis Trading (Genesis) to buy enough Bitcoin that would satisfy the 6.1% ownership.
In order to mint (create) new shares of GBTC, 3AC would then deposit this Bitcoin into the GBTC Trust and wait 6 months before being issued new shares of GBTC.
They would then sell the shares of GBTC to retail or other institutions for a premium since GBTC sold at a premium in much of 2020. To hit this point home, 3AC would buy actual spot Bitcoin and sell GBTC shares for more than they purchased the spot Bitcoin for.
But why did Genesis allow this? Is this fair? Well, Genesis had the incentive to bring in as much Bitcoin as possible into the GBTC Trust because Grayscale would receive 2% of the total AUM in the Trust as fees.
Other Hedge Funds and banks followed this Strategy, like Alameda, which we will learn about soon enough.
In 2021, 3AC used its plentiful amount of GBTC shares as collateral to take out margin loans (allows user to borrow against the value of securities user already owns), to invest in Bitcoin and Ethereum (ETH), which had bull runs and reached All-Time Highs (ATHs) in the summer of 2021.
In November 2021, one of the founders of 3AC, Zhu Su, tweeted that 3AC would no longer invest in ETH and move into Altcoins (more risky alternative coins) to earn higher returns.
At the end of 2021 and the beginning of 2022, they invested $230 million into illiquid (not easily converted into cash) Avalanche (AVAX) coins and started to invest in what the industry calls “ETH killers”(Other blockchains that were created to replace Ethereum).
In March 2022, they became very bullish (invested heavily) in Terra Luna, another ETH Killer blockchain that used an Algorithmic Stablecoin along with their native token.
We will later see what happens to Terra Luna, but the blockchain was very popular during this time and many people thought Terra Luna was a profitable investment that was going to make them rich.
Those people included 3AC and other hedge funds who had been seen as Crypto Trading Gods. They showed their tremendous wealth and confidence by purchasing extravagant yachts and homes.
All the while, the collateral that was supporting all of 3AC’s margin loans with lending desks, GBTC shares, was now at a discount rather than a premium (the price of one share of GBTC < price of one spot Bitcoin).
Therefore, 3AC did not want to pay their loans back because they would take a huge realized loss on their GBTC shares. This began the slow decline for 3AC as they needed a way for GBTC to return to being at a premium or for the trust to convert into an Exchange Traded Fund (ETF).
Now let's bring in the Macro: Inflation surged 7.5% on an annual basis in February 2022. The Fed now has the obligation to start raising interest rates, which shifts the whole Crypto paradigm and pulls down Crypto yields.
Crypto thrives in a Risk-On environment, or when the Fed Funds rates are low, but does not do well in a Risk-Off environment, or when rates are high or being raised.
But back to Terra Luna because this is when things start getting interesting.
The Terra Luna foundation started to build their Reserves (assets they could hold to make investments and fund the ecosystem) with locked Avalanche tokens as well as 37,863 Bitcoins worth $1.5 billion made through OTC (Over the Counter) swaps with Genesis and 3AC.
Of the $500 million worth of Bitcoin that 3AC sold to Terra Luna, $200 million of the Terra Luna Algo stablecoin was given to 3AC on May 5th.
On May 13th, Terra Luna collapses and shakes the entire industry. Remember when I said a lot of investors believed in Terra Luna, well it all ended up being a huge experiment, and the creator, Do Kwon, did not know if his Algorithmic backed stablecoin was going to work.
All it took was a couple of rumors and for the Algorithmic stablecoin (USTC) to slip below the $1 peg for holders of these Terra Luna tokens (LUNC) to start withdrawing and selling. This created an imbalance in the algorithm and basically crashed the Terra Luna ecosystem and tokens.
Suffice it to say, 3AC was in a predicament with $200 million lost due to USTC going to near $0 and their GBTC shares at a huge discount.
Let’s go back to before the Terra Luna collapse; Bitcoin and ETH were down 60% from ATHs in early 2022. Bitcoin and ETH were a part of the collateral base for 3AC and Alameda as well as Avalanche and Terra Luna tokens, which were down 80% from ATHs.
3AC was in a tough position with billions of illiquid assets on hand that could not be sold for the appropriate price.
What do they do? They borrow and take on as much leverage (using borrowed money) as possible from lending desks, like Voyager and BlockFi, and forge documents to prove they had enough collateral to pay them back.
Instead of owning up to their insolvency (inability to pay debts), they decided to double down on their investments and take the money they should not have been lent to essentially gamble away.
Let's check back in on Grayscale and see what they're up to.
On June 7th, 2022, Grayscale hired Donald B, Verrilli Jr., former solicitor general of the US, as legal counsel to fight the Securities & Exchange Commission (SEC) in the Supreme Court in anticipation that the SEC denies Grayscale’s proposal to convert the GBTC Trust to an ETF.
Once again, many hedge funds and other firms had GBTC as collateral, but at this point in time, GBTC was trading at a discount of -30%. Hence, these firms were only able to access 70% of their collateral in Bitcoin because of the discount on GBTC, which wouldn’t happen if it was an ETF.
Therefore, Grayscale wanted to fix this discount problem on their GBTC by converting it into an ETF.
This would help 3AC, Alameda, and many more players in the space become more solvent and avoid the risk of bankruptcy by unlocking capital locked in the collateral they held with Genesis.
On June 29th, 2022, Grayscale sued the SEC for not allowing the GBTC Trust to convert into a Bitcoin Spot ETF. However, this was just a little too late…
On June 15th, 2022, BlockFi, a Crypto lending company, liquidated 3AC’s margin loans, which was the eventual collapse of 3AC.
3AC was liquidated because they simply couldn’t make payments on their margin loans and used all of the borrowed funds to invest in risky altcoins like Terra Luna which essentially went to $0.
BlockFi had also been partaking in GBTC arbitrage trading as they had sent customer deposited Bitcoin to GBTC or 3AC. Therefore, a large number of BlockFi’s Bitcoins were illiquid. This is no Bueno for BlockFi and eventually caused them to declare Bankruptcy.
Continuing with the 3AC contagion, Genesis lent out $2.36 billion to 3AC but was bailed out by their parent company, DCG.
Voyager, another Crypto lender, gave $660 million in uncollateralized loans to 3AC and was also about to go insolvent( inability to pay debts). However, Alameda came to the rescue and bailed Voyager out with a $200 million cash & USDC loan and a 15,000 Bitcoin loan.
FTX then bails out BlockFi with a $400 million loan. All these bailouts made FTX and Alameda look very solvent and a savior in the Crypto space.
But wasn’t Alameda also arbitrage trading GBTC in 2020 and had GTBC collateral with Genesis which was at a discount along with the other hedge funds? How did they have enough money to bail out these other firms?
If you were thinking about these questions, YOU have been following along!
To clear some things up,
- Leverage is using borrowed funds to increase a trading position,
2) A collateralized loan is when a user puts up funds (collateral) to back their borrowing,
3) Liquidating a margin loan occurs if the value of that collateral drops past an agreed-upon level; the user’s collateral will be sold and the lender will use that money to pay off the initial loan, and…
4) all of these institutions mentioned above, besides Terra Luna, were centralized. The decentralized part of Crypto had no examples of crashes or collapses during this time and Decentralized Applications like Uniswap, Aave, and Maker did not lose any funds.
The difference between decentralized and centralized is centralization means there is a central entity that controls the product/service, while decentralization is when there is no central entity and runs permissionless.
Let's take a quick emotional pause and set the tone. I know you saw a bunch of numbers and new names, but let's get the main point across here. The Crypto industry was vulnerable and fragile in the summer of 2022, but we were learning from this as a community.
It didn't matter if you were a hedge fund, institutional investor, retail investor, or someone who had a couple of hundred bucks of Bitcoin; everyone was suffering because prices had crashed dramatically with Bitcoin and Ethereum now down 75% from ATHs as of July 2021.
This price collapse was due to two main events:
- All of that collateral being used to hold up 3AC and other Hedge Fund loans was liquidated and caused selling pressure, and
2) Investors panic-selling their Terra Luna tokens and similar risky tokens.
But why am I telling you this? It’s because of this feeling of mistrust and the feeling that any institution, no matter its prestige or public image, can fall and deceive millions if the risk is not properly managed. This feeling was amplified due to three key entities: SBF, FTX, and Alameda.
First, some context into what each of these words are. SBF is Sam Bankman Fried, a 30-year-old Wizkid out of MIT that made billions arbitrage trading Bitcoin. FTX is a centralized Crypto Exchange that was founded by SBF in 2019 that was used to buy Crypto using Fiat money.
Finally, Alameda is a Hedge Fund also founded by SBF in 2017 that was used to trade Crypto using technical trading methods, including use of leverage, and be a market maker for crypto trades. Another thing to note about leverage is that the technique can increase returns exponentially, but also magnify losses.
Let's jump forward from June 2022 to November 2, 2022, when a CoinDesk reporter published a
FTT is a utility token for the FTX platform that does not entitle users to a part of the platform revenue or represent a share in FTX. Furthermore, it is not backed, nor does it give control over governance decisions or FTX’s treasury.
Essentially, it is a speculative token that does not offer the investor any true benefits.
Anyways, SBF was asked countless times about the conflict of interest between his Hedge Fund and Exchange, but he always noted that there were “walls'' in place to keep the two entities separate.
However, this article suggests that Alameda and FTX were more closely tied together than everyone thought, and Alameda was sitting on $5.82 billion worth of FTT, where $2.16 billion was being used as collateral.
The problem: if these two entities were sharing the same balance sheet and pool of funds, there is a chance that customer deposits from FTX were being misappropriated.
Having a significant amount of a token on your Balance Sheet that was created by your founder is definitely not a “Best Practice” and is risky in itself to use a non-independent asset as collateral.
So why would Alameda have so much FTT on its Balance sheet? We will find out soon enough, but essentially, FTX was able to mint new tokens whenever they wanted and Alameda was indeed very closely tied to FTX.
Let's jump back to May 2022. While the contagion of Terra Luna and 3AC rippled through the industry, Alameda was also hit hard and suffered losses on its GBTC and altcoin positions.
Genesis began to recall the margin loans made to Alameda when its collateral dropped due to Crypto prices declining.
Alameda was not equipped to make these loan payments because Alameda had invested those borrowed funds into investments that were illiquid or no longer easily accessible.
However, unlike 3AC, Alameda was able to receive funds from FTX in the form of ETH and FTT that would be used to pay those Genesis loans.
CEO of Alameda, Caroline Ellison, a 28-year-old Stanford graduate who may or may not have been in a romantic relationship with SBF, would later explain to her staff that Alameda had taken out margin loans and used the money to make venture capital investments and other expenditures, including $72 million worth of Bahamian Real Estate.
After the CoinDesk article was released, ChangPeng Zhao, or CZ, the CEO of rival exchange Binance, became aware of the suspicious Alameda Balance Sheet. Binance had invested early on in FTX and held a substantial amount of FTT.
CZ went to Twitter to notify his followers that Binance would sell $2.1 billion worth of FTT due to suspicious activity between Alameda and FTX.
In her tweet that has now been deleted, Caroline Ellison offered to OTC buy all of Binance’s FTT holdings for $22 per token, leading to speculation that Alameda may have had loans that would have otherwise been liquidated if the price of FTT fell below $22.
CZ did not entertain this offer, which put the market into panic mode. A sell-off of FTT and other tokens on FTX began as net outflows of $451.1 million were withdrawn from FTX days after the article was published.
On November 8, 2022, FTX paused withdrawals and CZ shared that Binance would enter into a strategic transaction with FTX through a non-binding Letter of Intent to fully acquire FTX and help cover its liquidity crunch.
The industry was in shock as the second-largest Crypto exchange was now set to be acquired.
Things got even crazier a day after the proposed acquisition when CZ decided to walk away from the transaction after conducting due diligence and uncovering FTX was insolvent.
During this whole period, SBF was tweeting about “protecting consumers” and how “users’ funds are FINE”, but in reality, FTX did not have enough money for customers to withdraw from. A few days later on November 11, 2022, SBF stepped down as CEO and FTX declared bankruptcy.
But HOW? FTX and SBF were saviors, bailing out all of the other firms in the industry; how could they be suddenly bankrupt?
The following will dive into these questions in more detail but simply put: SBF created FTX on a house of cards and fooled the entire industry with his altruistic persona.
To recap, SBF was noted as a Crypto Genius, and many thought of him as the face of Crypto after appearing on the Forbes cover and being seen with celebrity endorsements and experienced investors.
FTX gained worldwide recognition and was considered a trusted exchange to execute trades and hold users' funds. But as I told you before, it does not matter how well-perceived someone is, they can still do very bad things.
In the case of SBF, we now know that he was playing life like a video game and trying to level up his “life score” by using funds to buy whatever he wanted to make himself seem more powerful, including a $1 billion personal loan from FTX.
How did he do this? Let’s dig a little deeper with the help of Nansen.ai’s report titled, “
Alameda and FTX owned the vast majority of the total FTT supply from the very beginning, meaning:
- The actual circulating supply (how much FTT is in the open market) is low when compared to the total supply
- Prices can be easily influenced to move up (or down) with small amounts of FTT
- Since both Alameda and FTX held the majority of FTT supply, if one entity is forced to sell its FTT holdings, then the other entity may consequently take a huge hit to its balance sheet
Out of the 350 million (m) total supply of FTT, 280m of it was controlled by FTX (~80%) and out of the 59.3m tokens for seed and private rounds, around 27m (or roughly 46%) ended up with Alameda, where almost all the total FTT token supply had to go through Alameda at some point in its distribution.
Therefore, Alameda had a direct role in the development of FTT, and the entities were connected from FTX’s inception.
The initial success of Alameda, FTX, and FTT led to a rise in the value of Alameda’s balance sheet during the 2020-2021 bull market with FTT reaching ATHs in the summer of 2021.
The high value in Alameda’s FTT position was most likely used as collateral by Alameda to borrow from Genesis and other lending desks.
As previously mentioned, the borrowed funds were used to make illiquid investments causing FTT to become a central weakness for Alameda if the price of FTT decreased too much.
Effectively, Alameda was in a leveraged long position, where they were borrowing funds using their high-value FTT position that they needed to stay high (long) or else their loans would be recalled.
This strategy worked perfectly in a bull market when prices were at ATHs.
But remember that huge Crypto crash in May/June that caused Terra Luna, 3AC, and a bunch more firms to collapse…. Well right around that time, liquidity quickly started to dry up as borrowing rates & margin calls increased, and creditors started to recall their loans due to general market conditions worsening.
Given that significant portions of Alameda’s balance sheet had consisted of illiquid assets, Alameda was on the brink of a liquidity crunch (in need of cash) as the rest of the Crypto industry was crumbling.
Due to the control SBF had over both FTX and Alameda, he knew that if Alameda declared bankruptcy, then an FTT liquidation would occur and cause the price to fall dramatically.
We believe the margin call for Alameda’s FTT position was $22, therefore, if the price of FTT fell below $22 and Alameda did not make payments to meet the margin level, then lending desks would have no option but to sell the FTT collateral.
As a large holder of FTT, FTX would see its FTT holdings crushed. With lending desks like Genesis now recalling their loans to Alameda, SBF decided to send FTX Customer Deposits to Alameda to satisfy their outstanding loan payments.
Again, this was due to Alameda’s illiquid investments in Terra Luna, GBTC, and others. In return for customer deposits, Alameda deposited as much as ~$4 billion worth of FTT on FTX as collateral between early June and July with the majority being sent during the 3AC collapse.
SBF was able to move customer deposits without external auditors knowing due to a “Backdoor” software protocol and bespoke accounting practices SBF created in his FTX exchange that would not alert anyone when funds were lent out, like to Alameda.
But why did FTX bail out Voyager and BlockFi during this time? It was because those entities were holding millions of FTT, and other tokens related to FTX.
Therefore, if he let those firms go bankrupt, those tokens would have been liquidated and the price of FTT, among others, would decrease and cause FTX to go insolvent.
Instead of owning up to their highly leveraged positions and declaring bankruptcy, Alameda and FTX decided to double down and acquire all these firms to stay solvent long enough to make all of the money back.
It solidified FTX’s image as a solvent and responsible institution, which helped FTT's price stay above $22 for the rest of the summer and kept people from digging too much into the two entities.
To reiterate, FTX and Alameda still had leveraged positions outstanding with FTT as the collateral with a margin call of about $22.
SBF used customer deposits to cover up the liquidity crunch in the meantime while attempting to make the loss whole with the funds Alameda had available.
However, Alameda was not able to make up for those losses in time even with the continued help from FTX before the November 2nd article was released.
Although the November 2nd article exposed Alameda and FTX to the public, it was the overleveraged positions (more debt than collateral), using FTT as collateral, and investments in illiquid and risky tokens that were the true downfall for both firms.
However, the true contagion started with the GBTC arbitrage trade that 3AC, Alameda, and many other firms participated in during 2020 which was mentioned earlier.
The fallout from these three entities (SBF, FTX, and Alameda) has shaken the Crypto industry and has made long-time enthusiasts question their loyalty to such a selfish industry.
Millions of regular people held billions of dollars in FTX as a safe and trusted haven, which SBF took advantage of and used to prop up his own self-esteem.
Unlike most other fraudsters who have stayed silent after committing their crime, SBF sought out attention including being interviewed at the New York Times (NYT) Dealbook Conference.
He was asked multiple times during the NYT interview as well as interviews with the Wall Street Journal and Good Morning America if he knew about the misappropriation of Customer Deposits to Alameda which he squeamishly deflected to the excuse that customers with Margin accounts allowed FTX to use their digital assets to lend out to Alameda.
Essentially, SBF is making the excuse that somewhere in the Terms of Service it gives FTX the ability to lend out customer digital assets if the customer uses a margin account and that is why customer deposits were sent to Alameda.
But what about the regular customers who never allowed FTX to lend out their digital assets? The Terms of Service, seen below, clearly state that none of the digital assets in a customer’s account are owned or may be loaned out to FTX.
Throughout these interviews, he was visibly uncomfortable and tried to answer the interviewer’s questions without actually answering the questions at all.
He has continued to seek attention through interviews, but when the hard questions like, “where did all the money go?” were asked, he bounced around two answers: “I don’t know” and “I don’t know what to say”.
@CoffeeZilla, a famous Crypto investigator, had the chance to interview SBF over a Twitter space and drilled SBF on the Terms of Service question.
CoffeeZilla was finally able to get SBF to admit that he was treating all customers equally when it comes to withdrawals, even though there were supposed to be two separate pools of funds for regular and margin account customers.
Therefore, SBF admitted that FTX was commingling customer funds and was not fulfilling their obligations of the Terms of Service, which is no doubt FRAUD. Why is it fraud?
Because SBF did not follow the Terms of Service that customers agreed to and rather “loaned” (stole) customer digital assets, which they never approved. This is why SBF will go to jail for a very long time.
All I can say is that I am still committed to this technology, and I will keep writing so more people can be informed about the diverse applications of Blockchain.
Bad actors should not represent our industry when there are thousands of intelligent innovators building sophisticated and beneficial applications for the masses.
For every SBF, there is a Vitalik Buetrin, a Brian Armstrong, a Balaji Srinivasan, and many more lesser-known people fighting for financial freedom. Thank you for reading and I hope you enjoyed it!
- 72099.ETH