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Market Commentary

Lessons of 2022 | TWIC

Dave Weisberger

Dave Weisberger

January 05, 2023

Reflecting on 2022 and the lessons we SHOULD learn from the year’s events, I thought about some of my father’s favorite expressions.  If there is an afterlife, my dad is probably “up there” furious with the stupidity exhibited in crypto markets last year.  He was pretty famous among our family and his friends for what we called “Artie-isms”:  expressions that explained his cynical but realistic views on how the world worked.  

There are at least three of his expressions that were routinely ignored, with disastrous results:

  1. “If someone offers you something for free, put BOTH hands on your wallet”

  2. “If you take a risk, make sure you are getting paid well enough to make it worth it”

AND, most important:

  1. ”NEVER bet more than you can afford to lose”

Thinking back on 2022’s catastrophes, all relate directly to violations of his wisdom. The Terra/Luna debacle was fueled by investors reaching for the 18% yield on Anchor Protocol by staking (depositing) what they thought was a STABLECOIN (UST).  Unfortunately that “free” 18% turned out to be very expensive when UST turned out to be less than stable.   At the same time investors in the LUNA token, assuming that the UST money machine would grow indefinitely, were wiped out entirely.  The wreckage of this event was enormous, with billions of dollars of capital destroyed, creating losses for many of the largest risk taking firms in the industry.  At the time, it wasn’t clear how much collateral damage was created, but it turned out to be catastrophic, setting in motion a chain of events that played out over the rest of the year. 

It’s worth noting that my inherent suspicion of “free” money or schemes that purport to deliver risk free returns above the market kept me from considering investing in either Luna or the UST staking scheme.  To me, the idea of an algorithmic stablecoin seems too much like a perpetual motion or magic money machine, so I avoid them.  In this case, I asked my co-founder Ian what he thought about Luna/UST and he repeatedly told me that the circular nature of a stablecoin backed by a token created almost exclusively to be collateral for such a coin didn’t make sense. 

Ever since “Basis” I have thought the notion of “algorithmic” stablecoins was flawed, as the concept relies upon liquidity demands never being greater than previously anticipated.  Sadly, the history of quantitative finance has many examples where liquidity demands overwhelm what is available, and that is exactly what happened to Luna.  While there were critics of Terra/Luna that pointed out the vulnerability, the crypto investing community didn’t take them seriously, in part because the founder of Terra Labs, Do Kwon, used his social media fame to belittle them. 

Unfortunately, his fame and the “star studded” lineup of supporters left many less knowledgeable investors holding the bag, while many intermediaries & leveraged traders also suffered massive losses, which had impacts upon other players including the majority of the crypto lending firms.

Lending firms such as Voyager, Celsius & other centralized lenders ultimately failed a few months after Luna blew up, after loans they had made went bad.  In their case, the “free money” warning was also true, but the issues went beyond that.  Investors in these firms had little to no idea of the risks those firms were taking in order to be in position to offer the yields they paid.  If, for example, Voyager had TOLD investors they were making under collateralized loans to crypto hedge funds that used enormous leverage, I am certain MANY of their investors would have pulled their funds from them or not invested in the first place.   My guess is Voyager’s management agreed, which is why they never disclosed what they were doing.   In short, investors took unknown risks, while not getting paid nearly enough to compensate them for that risk.   The same is likely true for Celsius and other lenders; investors in those platforms thought that such firms were agents who actively managed lending risk by requiring appropriate collateral. In retrospect, this was not the case, and investors took much more risk than they were getting paid to take.

Moving to the third and most important rule, (not betting more than one can afford to lose), there were many examples during the year.  Every leg down was exacerbated by forced selling of collateral, necessitated by traders using too much leverage.   Over and over, we’ve seen crypto speculators wiped out by taking excess leverage because they insisted on betting more than they can afford.   One could even argue such leverage has been a feature of the crypto markets, exacerbating volatility to both upside and down.  FTX/Alameda, however, took this to a new (destructive) level.

While the disastrous impact upon FTX’s clients (and the industry) was caused by outright THEFT of those client assets, the reason they stole the money was because their management team violated the third rule.  At this point, it is pretty clear that Alameda bet everything they had early in the year and became insolvent no later than Q2.  However, instead of closing down Alameda when it became insolvent they kept on gambling, betting what they AND THEIR CLIENTS could not afford to lose.  Blog posts about doubling down and plea deals have made this point pretty clear, but the real question one must ask in retrospect is HOW none of this was examined during due diligence. 

FTX announced a capital raise in January and was working on a fresh raise in July and none of the investors or potential investors questioned the revenue breakdown between Alameda and FTX exchange operations.   Had they done so, and been shown the real books and records, the risk profile of Alameda, along with the comingling of funds would have been shown.   Both would have waived huge red flags that went unseen until the bitter end in November… 

So, where does this leave the crypto industry as we enter 2023?  First, it’s important to recognize that Bitcoin is still hovering just below the previous cycle’s ATH and is still 4x the price it fell to on the pandemic panic in March of 2020.  Second, whatever one thinks of ETH, the merge is now ancient history and the network is functioning well.   Third, multiple layer one protocols continue to build, while layer 2 solutions for many verticals are also being built.  The potential use cases for the technology continue to expand and the number of talented professionals in the industry continues to grow.  In simple terms, the long term potential is undiminished.

That said, there is a crisis in confidence at the moment, with many firms either out of business or severely impacted by their assets being stolen.  Confidence in the entire venture capital industry has been shaken by the startling lack of diligence and faith that regulators can do anything to prevent these malicious actions is low. 

The best way forward is for the industry to work with the new Congress to push the regulators to focus on what matters instead of their petty politics of control.   That would mean enacting rules to protect client assets by oversight of crypto custodians (while making those assets “senior” in default scenarios).  It would mean rules and oversight of crypto exchanges & other institutions that handle client funds to force full risk disclosures, promote fair market access and best execution and stop misleading marketing.  All of this can be accomplished without crushing innovation or preventing crypto markets from offering self custody.

Lastly, while people are not focussed on it at the moment, 2022’s events should trigger a review of the “accredited investor” rules that prevent average investors from making informed decisions while, at the same time, provide a competitive moat to the VC industry.  That oligopoly has access to the most profitable early investments on the basis that they are best equipped to evaluate them, but the absurdity of that idea was in full display with FTX as even CURSORY due diligence would have exposed the scheme.  

As it’s a new year, I will end this note on the hopeful thought that SBF will go to prison for a long time and the incoming Congress helps prod the regulators towards sensible rule making.   Let’s hope for a better year.

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