Weekly Update

Who Backstops Cryptocurrencies?

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Published November 11, 2022


For the first time in awhile the usual market suspects of inflation and the Fed’s assault on the stock and bond markets took a backseat for a couple of days. When interest rates rise sharply as they have this year, investors find out who was overly leveraged and caught without a seat in the market’s cakewalk. This week, we found out that cryptocurrency exchange FTX was the latest one without a seat. As usually happens with these things, the sudden collapse of Sam Bankman-Fried’s FTX was a huge shock to investors with the ripple effects unknown. Sure, we were aware that the crypto space was a little dodgy. Frauds and missing bitcoin balances were somewhat regular occurrences, supporting those who looked with skepticism on the wild west nature of the ‘asset’. But this week that all ratcheted up bigtime when the wunderkind of the crypto world was found to be seriously deficient in managing his business. Making things even more dramatic was the proverbial tap-dance on the grave by FTX’s biggest rival, Binance’s founder and original FTX investor, Changpeng Zhao (known as ‘CZ’, naturally).

A few days ago, CZ caught wind that Mr. Bankman-Fried might be saying untoward things about Binance to U.S. regulators. Not surprisingly, this annoyed CZ to the point that he told the world he was going to unload his substantial holdings in the cryptocurrency used by FTX’s business (an FTX-created currency called FTT). The mere mention of this massive sale sent the FTT token price reeling. That caused a bit of an old-fashioned bank run.

The cryptocurrency world prides itself on being a sort of alternative currency universe. The true believers distrust the central banks of the world and hope that crypto ultimately becomes so widely used it offers a real alternative currency system, unregulated by any one government or entity. In that universe are game-worlds, markets in digital goods, and even real estate transactions using only cryptocurrencies. This decentralization of regulation, if you will, is a core feature of the crypto universe. There is no single authority to step in and backstop a run on the system. Instead, you have a sort of incestuous collection of private entities that cooperatively help each other out – creating their own alternative economy and backstopping each other, in effect.

But human nature intervenes, competition gets heated, and people choose power over some altruistic vision. A handful of very powerful entities emerge. One of those entities maybe plays against the unstated cooperative rules of the universe. And some amount of dislocation ensues. So, CZ tells the world he’s dumping his FTX crypto tokens, sending the price of that token reeling, this causes (further?) financial strain on FTX which appears to be way overleveraged and relying on its FTT as a core asset. As the FTT token plummets in value, CZ steps in offering to buy FTX and stop their bleeding. A day later, he backs away saying that FTX’s finances are such a mess that he’s no longer interested. Throughout this debacle, every cryptocurrency is plummeting – that’s bitcoin and ether(ium) as the most known variants, but also the dogecoin that Elon Musk likes to tout. It’s all crashing down.

BITCOIN to US dollar

To be accurate, bitcoin is still worth more than it was even in late-2020. But for those viewing bitcoin as an alternative currency, such volatility and striking drop in value make it hard to have much confidence in it as a store of value. Stable it is not. Coinbase, the company that makes a market in cryptocurrencies, has seen its share price fall by 85% since its well-timed IPO in the heady days of 2021 (bottom chart above).

Besides watching this market wreck occur, what does it mean for the broader market? Maybe something, maybe not much. If nothing else, cryptocurrencies are a risk asset with broad enough participation to believe that the failure of FTX will, in turn, damage other companies. The failure of FTX clearly hit the stock market this week, taking the wind out of a nascent post-election rally widely expected on Wall Street. The election delivered the expected gridlock, the market’s favorite election result. But stocks tumbled more than -2% on the FTX news because there will be ripple effects from such a major player being taken down. And no one knows where those ripples will show up – as it always is when the music stops and we discover who had overindulged on cheap money.

Nevertheless, these things do not likely impact the business of Caterpillar or Honeywell, or Deere, or almost all the other companies that have impressed investors with their recent business results. And cryptocurrency will likely find its footing, someone will scoop up the remains of FTX on the cheap, and the alternative currency will emerge stronger for the experience – or so we will undoubtedly hear in the coming months. Ask any country, developing and managing a currency is very, very hard. It takes many, many iterations for investors and markets to develop the confidence required to make the currency a long-term success. Which is why we scoff at the occasional shots hurled at the U.S. dollar. The world’s reserve currency did not gain that status overnight. It took generations.


Market Update

This week was supposed to be about the midterm elections and a hoped-for post-election bounce for stocks, something that has happened after every midterm election for decades. Investors tried to get ahead of that bounce by pushing stock indexes up Monday and Tuesday. A +1.3% gain Monday and +0.6% lift Tuesday recovered some of the prior week’s lost ground. That was all undone Wednesday as election results were not conclusive in delivering the hoped-for government gridlock scenario. But the real damage Wednesday came when word of a meltdown in crypto-exchange company FTX surfaced. The plunge in cryptocurrency prices and unknown ripple effects of the company’s implosion unnerved investors. Stocks gave back the entirety of Monday and Tuesday’s gains in a -2% losing session. While investors worried about possible contagion effects from FTX, we got a fresh inflation report that completely changed the mood. The report came in below expectations showing that inflation has perhaps peaked and begun moderating. Investors read the report as being exactly what the Fed needs to see in order to tap the brakes on rate hikes. Stocks soared +5% or more while interest rates slid. The momentum carried over into a +0.9% rise Friday. Adding to the cheer was a surprise announcement from China of relaxing Covid restrictions.

A +5.89% gain for the S&P 500 (SPY) this week brought the index back to a visit with its long-term resistance around 4000. The Nasdaq (QQQ) popped higher by +8.80%. Smallcap stocks  (IWM) gained +4.60%.

Warm wishes and until next week.