The Naked Coin

We are finally being forced to clear out our workstations as hot-desking enters a more permanent and rule-laden phase. Sifting through the detritus of time, a colleague found a decade-old photograph from a long-forgotten Investment Week Fund Manager of the Year awards dinner.

I was about six stones heavier in those days and when I look at the photograph it’s quite a shock. I will be keeping it as a deterrent from gorging on gluten-free cakes. When I think back, I don’t remember worrying too much about my weight. I used to look at a mirror, suck in my stomach and see a thin person. This carried on until a doctor bluntly told me I was close to being designated morbidly obese (how rude) about five years ago. This shook me out of my complacency/denial.

I suspect 1 million investors in cryptocurrencies and non-fungible tokens may be having a ‘Coombs’ moment this week after the collapse of FTX, the world’s third-largest cryptocurrency exchange, likely wiped out their holdings. As well as matching buyers and sellers and executing customer trades, the Bahamas-based exchange acted like a bank, holding both dollar and crypto-denominated client assets. It also offered its customers loans secured on their assets (margin lending).

FTX had a huge crypto trading company hanging off it as well. Alameda Research was really the heart of the tangled FTX web. It was the business that founder Sam Bankman-Fried created to make quantitative-driven crypto investments on his own book; essentially an algo-trading machine for digital currencies. FTX was founded to improve trading liquidity in crypto and make it easier for Alameda to operate. And so Alameda was at the heart of things in the end: when Bankman-Fried’s empire was crumbling, FTX loaned about $10 billion of client cash to Alameda. FTX held a total of roughly $16bn in client funds, so it lent more than half to itself. Not only that, but about 40% of Alameda’s assets were FTT, a crypto token that is a kind of quasi equity in FTX itself.

It wasn’t enough and Alameda has now foundered along with FTX and there’s a hole in the exchange’s accounts big enough to drive a convoy through. This is complex stuff, but sometimes the best red flags are the simplest: be careful trusting a bank/exchange that is based in a tax haven solely to avoid regulation.

Heavy debts, light assets

It’s not just investors and depositors in FTX that have taken a hit. The blow-up is so big that it caused a huge downdraught in all crypto markets. The skulduggery involved, whether or not it’s proven illegal in the end, casts a storm cloud over the whole industry.

Long-time readers of this blog – or listeners of our podcast The Sharpe End  – will know I have been a bit rude about the whole crypto cohort in the past. So please give me this one moment of smug satisfaction. Anyone want a digital cartoon of a monkey, rights to Jack Dorsey’s first tweet, or a bag of Dogeycoin right now? Looking at the prices, not really.

OK I’ve got the ‘I told you so’ out of the way, so I can get serious. I firmly believe more will unravel. Why? There is no intrinsic value to any of these currencies. And unless you are Mark Zuckerberg, NFTs in your Meta lounge still seem fantastical at the moment.

For me, crypto is extremely fragile because there’s no income from them and, unlike commodities such as gold and copper, no natural demand by industry or artisans. With no income to generate a base value there’s no natural floor to crypto prices beyond faith that someone else will pay to take it off your hands. An ironic state of affairs for a ‘trust-less’ financial system.

The crypto industry has ‘solved’ that problem by offering investors interest for holding their crypto assets with exchanges/depositors. However, this income is provided by lending out that crypto to leveraged traders. So it’s made the system even wobblier, while many investors likely have no idea of the risks they are taking on. At least 37 crypto exchanges have failed since 2010, and FTX won’t be anywhere near the last. It hasn’t stopped true believers. Yet, combined with higher interest rates now on offer in ‘old finance’ and lots of people nursing big losses during a worldwide cost of living squeeze, crypto must be looking less attractive to the masses.

Over the last few years, crypto benefited from being young, hyped and trendy. Many people suffering from FOMO (Fear of Missing Out) leapt on the rocket ship, flinging emojis left and right. Now they might be suffering from GMOF – Get Me Out First.

Will it spread to vanilla assets?

While it’s easy to see contagion from FTX across the crypto world, what could it mean for more mainstream assets? Could we see a sub-prime-mortgage-type crisis bringing down all markets?

At the moment this seems unlikely, however, we need to be vigilant. It’s hard to know for certain just how much money has been sunk into crypto because it’s so opaque. The UK government estimated that globally there was about $930bn (£781bn) in June, down from a peak of $3 trillion in November 2021. Prices have slumped a great deal in the past six months too. Many mainstream investment banks and asset managers have dabbled in this area over the past couple of years, but my sense is that it’s too small to cause systemic risk and suck liquidity out of credit markets.

How could it happen though? Our old friend Larry Leverage. If some huge hedge fund or other financial institution is holding crypto assets as security on loans – like FTX did with its customers and its trading arm Alameda – the recent price slumps could cause them to close out the loans, causing business failures and ripple effects across other asset classes. As I said, this is a low-probability event, but we cannot be complacent.

There could be a positive outcome from this. The public markets in vanilla securities might just once again feel like the safest way to store value and create growth. Perhaps all that money chasing crypto comes back to equity and credit markets, attracted by lower valuations and better expected returns than a year ago. Add all the cash balances out there on the sidelines and there could be FOMO in regular assets.

So what have I learnt from this?

1. When celebrities back any investment – avoid
2. When a company advertises during half time of the Super Bowl – avoid
3. Shiny new investments that promise to democratise capitalism – avoid
4. Stick to what you understand
5. Never forget points one to four

Just as I saw a thin person in the mirror, many investors in crypto see Lambos but own Ladas.