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#40 The Contagion Vectors of the FTX debacle
We were this close 🤏 to writing an upbeat newsletter: Polygon, Instagram, JPMorgan...But then everything blew up.
The Contagion Vectors of the FTX Debacle
Time flies in crypto. If you swap "years" for "hours" in this quote from Marvin, the Paranoid Android from The Hitchhiker's Guide to the Galaxy, you get a glimpse of what crypto has been like in recent weeks.
“The first ten million years were the worst," said Marvin, "and the second ten million years, they were the worst too. The third ten million years I didn't enjoy at all. After that, I went into a bit of a decline.”
In the last few weeks, FTX has exploded, and somehow it keeps exploding.
We were this close 🤏 to writing an upbeat newsletter. Prices were giving us a break, and there was a regular stream of good news about technology and adoption. JPMorgan had completed an experiment with tokenized assets transactions using DeFi, Ethereum had gone deflationary, Instagram announced tools for NFT creators… Everything looked as it should: small rays of light piercing the gloomy backdrop of the global macro economy. And then everything blew up most unexpectedly.
There are already dozens of recollections of the events circulating. Our favorite, of course, is ours: you can read it here:
We considered the text finished on Friday, just when FTX declared bankruptcy. But the news kept breaking, so we’ll make the quickest possible summary to have a common ground.
On November 2nd, Ian Allison (bless hum) published an article about Alameda's balance sheet, indicating that FTX's sister company may be full of black smoke.
Caroline Ellison, CEO of Alameda, responded quickly by saying that the article was inaccurate and that Alameda had at least another $10B.
Changpeng Zhao, Binance founder and CEO admitted that his exchange was behind an FTT selloff that caused the price of this token to crash.
Suspecting a possible contagion, investors began to withdraw funds from FTX massively.
Sam Bankman-Fried published a tweet (already deleted) that said something along the lines of…
However, FTX began to block fund withdrawals, which set off all the alarms.
Exchanges do not have the power to re-invest their clients' funds and should therefore have no problem redeeming deposits. If FTX could not afford to let users withdraw funds, there had to be some customer capital mismanagement.
When we all thought this was a bloody battle of egos between two billionaires, Sam surprised us with a chilling revelation: CZ, and he had reached a non-binding agreement for Binance to acquire FTX. The agreement confirmed the worst: FTX was insolvent and had lost its clients' money.
The story could end here, but we are only halfway there.
As many predicted, the agreement did not come to fruition. After looking at FTX accounts, Binance yelled, “retreat.” Sam was alone.
Sam then announced the filing for Chapter 11: the most common bankruptcy procedure. SBF stepped down as CEO and was replaced by John J. Ray III, the man behind Enron's chapter 11. And some uncomfortable truths emerged in the Chapter 11 documentation:
The number of FTX creditors exceeded 100,000
FTX’s assets ranged between $10 and $50 billion.
So did their liabilities: $10-50 billion.
Over 130 companies in the group’s organizational chart will be involved in the liquidation. See below.
Compared to FTX, Lehman Brothers' structure at the time of its bankruptcy looks like an elementary school kid's lesson plan.
Over the next few hours, chaos grew. Rumors emerged of empty offices, flights to Argentina, disgruntled employees peddling influence, and depictions of the management team as a college dorm full of sex and personal favors. But in the middle of this hot mess, two stories seemed particularly feasible and worrying.
One indicated that SBF could have designed a “back door” to FTX's software to make transactions invisible to internal and external auditors.
Another, confirmed informally by internal FTX staff, indicated that FTX desktop and web applications may have been substituted by malware that enabled hackers to seize funds from desperate customers. The numbers are yet to be confirmed, but there are rumors of over $500M stolen. A hack comparable to the largest DeFi thefts ever
From this point on, making a linear account of the events is impossible. At this moment, the formula “sh*t + fan” comes into play, and the story shoots off in countless directions. We have a more elegant name for this, though: we call it “contagion vectors”:
Investors in FTX. FTX was one of the most reputable companies in crypto and one of the pillars on which the industry was building its foundations. In just two years, it had raised more than $1.8 billion in funding rounds from a long list of investors at a valuation of $32 billion. The list includes crypto-natives, such as Coinbase Capital, Circle, Pantera, or Paradigm. But in some other cases, they were unsuspecting normies, such as the Ontario Teachers Pension Fund. This could be a powerful reason for many more traditional investors to stay away from crypto indefinitely.
Sequoia and Wintermute are among the companies that have disclosed their exposure to the crisis and have admitted that they are already scratching their investment in FTX off their balance sheets.
Clients of all sizes. The most significant proportion of victims on that list of 100,000 creditors is likely to be retail customers. But among FTX users, top-tier companies also managed their operations using FTX. Until a solution emerges, their funds are locked along with all other customers' funds. According to The Block, venture firm Multicoin Capital could have 10% of its Master Fund assets locked on the platform. The hedge fund Galois Capital has also confirmed that half of its assets have been trapped indefinitely in FTX. Genesis has admitted to having $175M locked up.
Invested companies. Alameda and FTX were active investors in the Web 3 space and beyond. Their impact on the companies they invested in went further than mere financial support; their reputation and credibility permeated the companies they invested in. Only in recent weeks had they announced their participation in the Lens and Aptos protocol. In recent months they had also become the saviors of companies in trouble, such as Blockfi, which is back in the mud after being rescued by a line of credit from FTX in June. Another notorious case was its commitment to the Solana ecosystem, which has fallen by -40% since the crisis began and barely survives under suspicions about its viability. But the effect is felt outside the crypto walls as well. FTX owned 8% of Robinhood, and rumors were circulating that SBF could eventually acquire the entire company. As a result, Robinhood shares have fallen to August 2021 levels.
Of course, the real damage extends far beyond first and second-degree victims. The entire crypto ecosystem is under scrutiny and suspicion, and FTX will likely come up in political and regulator speeches for months and years. But all crypto is tainted now. BTC and ETH prices dropped immediately (the crisis erupted just hours before another Fed rate announcement), and Coinbase shares plunged, as did shares of other crypto-closers like Microstrategy, Silvergate, or Marathon. Digital.
Probably the most significant damage, however, is intangible. The whole industry is demoralized after seeing a flagship sink.
We wouldn't want to sound naive and downplay the impact of FTX's collapse, but ending this article on such a sad note wouldn't be honest. FTX dies, but crypto doesn't. The sector, which was already struggling, probably now has more obstacles to overcome before regaining credibility and luster. But in the same way, ENRON did not kill the energy industry or Lehman Brothers banking sector, and crypto is much more than its bad apples.
There are still some of us who think like this
Obviously, two-faced Sam had to be the subject of today’s INTERPOLATIONs.
We asked Dall-E to draw a "two-faced man with curly hair, one side is good the other side is evil digital art"
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⬡ Six Angles
We select six topics to illustrate the very different angles crypto can be approached from. We could choose dozens, but six is the atomic number of carbon… and otherwise we’d be writing for ages.
1. TradFi | JPMorgan completes a pilot program using DeFi
This was going to be the main topic of the week. A piece of news that goes straight to the heart of finance and crypto nerds. Project Guardian, a pilot program led by MAS (Monetary Authority of Singapore), has completed its latest experiment. On this occasion, MAS coordinated with JPMorgan, DBS Bank, and SBI Digital Asset Holdings to exchange tokenized coins and bonds.
It’s not! Listen!
Three top financial institutions completed a pilot program using DeFi. We are used to seeing banks talk about DLT and blockchain technology, which are two ways of saying “a version of crypto but without the parts that bother us.” TradFi institutions already have their blockchains, but they are private, making them nothing more than a weird database within their systems.
This time, participants used an Aave Arc fork running on Polygon. Arc is Aave’s institutional platform. It allows the creation of whitelists, which opens the door for banks to comply with their KYC and AML obligations, an obligatory for them to enter DeFi. And Polygon, as we have seen so many times lately, is that scalability solution for those who want to use the closest thing to Ethereum for a reasonable price.
For the first time, a bank like JPMorgan has interacted directly with decentralized finance. It has indeed done so in a way that, in theory, violates many of the principles of DeFi, but today more than ever, it is clear that we need to find a meeting point between the two sides: Trad and De. We want to revolutionize finance, but we must also know how to behave like adults from time to time.
2. Technology | Polygon continues to score
If you are looking for something to believe in, there is a project that insists on giving signs of good health.
Polygon is one of the hottest projects in crypto lately. They have scored quite a few major headlines with their collaborations with Reddit and Facebook / Instagram (and previously, Disney and Starbucks), while they remain one of the most exciting infrastructures for crypto-first projects too, like Lens, and they develop one of the most anticipated L2 innovation, their zk rollup. And all while seducing the big banks.
Some other key metrics are much flatter compared to the network's popularity boost, to be fair. For example, wallet count has grown thanks to the success of Reddit's NFTs, but indicators like TVL, number of transactions, or revenue are underwhelming.
3. Ethereum | Ether Goes Deflationary
Ether has gone deflationary while all eyes were on FTX. One of the most desired consequences of the consensus mechanism change has already borne fruit. Bitcoin is "sound money" due to its predictability. Ether is described as ultrasound money because it has found a formula for the negative emission of the token.
The negative inflation rate means ether's net supply has declined by 5,598 since Ethereum transitioned to a proof-of-stake (PoS) consensus mechanism of verifying transactions from a proof-of-work (PoW) mechanism on Sept. 15. Ether's supply would have increased by nearly 670,000 had Ethereum continued to use the PoW mechanism. Ether Turns Deflationary as Amount of ETH Burned Spikes Amid FTX-Induced Market Volatility
4. Self-regulation | Proof of reserves
Another consequence of the FTX debacle is the predictable reaction of regulators. Many politicians, especially in the US, have already started throwing stones at the ecosystem, often without distinguishing what’s centralized from what’s decentralized. “The recent collapse of FTX is a loud warning bell that cryptocurrencies can fail,” says Senator Sherrod Brown. But cryptocurrencies did not fail; a group of very dishonest people did.
Meanwhile, the industry is looking for ways to self-regulate. In response to their clients' reasonable doubts, many centralized exchanges have announced that they will begin to publish “proofs of reserves”: irrefutable evidence, supported by validating on-chain information, of the state of their balances. Binance leads the way, and many others (like Kucoin or OKX) have announced that they will follow suit.
5. NFTs | Tools for creators on Instagram
What could have been the most bullish news of the month in crypto has drowned in doom and gloom. Instagram recently announced the development of new tools for the creation and sale of NFTs on its platform, based on the technology of Arweave (decentralized hosting) and Polygon (Ethereum scalability solution). A tremendous accolade to the concept of NFTs and a potential rush of adoption comparable to Reddit's NFTs.
"Accessibility is still one of the biggest hurdles to onboarding new users to Web3, and making this process easier, faster, cheaper, and more approachable will have an immense impact." Polygon Studios CEO Ryan Wyatt told Decrypt. Meta's Instagram Plans NFT Minting, Trading Tools
6. Web 2 | What will become of crypto-Twitter under Elon's mandate?
The Musk effect has already made a strong entrance on Twitter. And so far, it hasn’t been for the better. His $8 profile validation experiment has had some catastrophic side effects. We can imagine that Elon is worried about other more pressing problems (verified profiles, loss of advertisers, mass layoffs followed by some regret…). Still, a few ideas on his table might affect CT (crypto Twitter). Twitter is the most important media outlet for crypto, as the FTX crisis has shown. Musk’s Twitter has been involved in plans for crypto bots, a native Twitter wallet, advertising, and many other issues that would significantly affect the platform. This is how they summarize it in NFT Now.