Rare Respite as Financial Markets Rally

The crypto market rallied through out the week, with market cap finally breaking back above $1T during the weekend. 

Source: CoinGecko

The market have largely retraced the dips which started 2 weeks ago following the release of the latest US CPI numbers and subsequent rate hike announcement. 

Source: MarketWatch

The crypto recovery came in lockstep with broader equity market rallies, as major equity indices all posted gains in the past week.

Source: CoinGecko

Both BTC and ETH rebounded strongly, up 4.6% and 9.4% respectively compared to 7 days ago. As at time of writing, BTC and ETH are now trading around the $21.5k and $1.2k levels. 

Is the Worse Over?

The crypto market sustained its rally across the weekend, likely buoyed by positive US Initial Jobless Claims Data released on Friday (24 June), which showed that the US labor market remained tight despite the Fed’s monetary tightening measures. However, the rate hike does seem to be having an effect in terms of slowing the economy, with latest manufacturing, housing and retail sales data showing contractions.

The Fed, and other central bank’s monetary tightening measures don’t seem to be anywhere near the end however, with Chairman Jerome Powell last week reaffirming to Congress the Fed’s resolve to combat inflation, which remains stubbornly high. Notably, Fed Governor Bowman has said she supports another 75 bps hike in July, followed by a few more 50 bps hikes during the next few subsequent meetings.

In the same testimony to Congress last week, Chairman Powell had said that the possibility of a soft landing, i.e. moderating inflation without a recession, will be “very challenging”, and that recession is a possibility.

 Source: Societe Generale, via Bloomberg

With hawkish monetary policies to remain, Societe Generale last week released a report that the S&P 500 may tumble as much as 40% more before hitting bottom at a range of 2,900 - 3,150, judging from trends based on stock market returns from previous bear market bottoms. The S&P 500 closed last week at 3,913.65.

In the shorter term, Arthur Hayes, in his latest blogpost “Floaters”, called out the weekend of the 4th of July, a long weekend for Americans, as a “likely candidate to host the final showdown between panic sellers and a bidless market”. With volumes typically low over the weekend and inability for Americans to deposit fresh fiat funds into their trading accounts over the holidays, this may be the “perfect setup for yet another major crypto dump”.

Crypto Lending Companies Looking for Bailouts

The fallout from Three Arrows Capital’s (3AC) implosion continues, as its effects ripple across the industry. Particularly badly hit were centralized crypto lenders, many of which either had exposure to 3AC, or held underlying assets which were badly affected by 3AC’s collapse. With bad debts piling up, many had to quickly seek new financing before spiraling into insolvency. We take a look at some of the most prominent companies that have made the news thus far.

Celsius

Beleaguered crypto lending company Celsius, which earlier on 13 June paused all withdrawals until further notice amidst swirling rumors of insolvency, seem to have become a target for acquisition. 

After what appears to be the insolvency of @CelsiusNetwork and mindful of the repercussions for their retail investors & the crypto community, Nexo has extended a formal offer to acquire qualifying assets of @CelsiusNetwork after their withdrawal freeze. https://t.co/JFtKTHRLcY

— Nexo (@Nexo) June 13, 2022

On the same day, Celsius announced that it was freezing withdrawals, rival firm Nexo had already announced their intent to acquire certain remaining qualifying assets of Celsius. Reports have indicated that Celsius have hired Citigroup, law firm Akin Gump Strauss Hauer & Feld LLP, as well as advisory firm Alvarez & Marsal to advise on possible solutions and next steps for the firm, with a bankruptcy filing possibly on the horizon if restructuring / financing solutions don’t pan out. 

Late last week, further reports emerged that Goldman Sachs seems to be looking to raise $2 billion from investors to buy up Celsius’ assets at potentially big discounts in the event of a bankruptcy filing. 

While all this has been rumbling on, reminiscent of last January’s Wall Street Bets Gamestop Short Squeeze saga, a small #CelsiusShortSqueeze movement seems to have formed amongst retail investors on Crypto Twitter (where else).

Source: CoinGecko

Dubbing themselves the #CELARMY, the group are buying up $CEL to keep the price above the psychological level of $1, in an attempt to squeeze CEL shorts mainly on CEXes, while hoping to profit handsomely if Celsius pulls off a meteoric comeback. While $CEL did stay above $1 for most of last week (though whether that has anything to do with this movement is debatable), it seems they may be running out of steam now as the price of $CEL fell back down to $0.80.

BlockFi

While BlockFi seems to still be operating its services as advertised, it has not stopped a spate of bad news coming out as competitor Celsius imploded. Earlier this month, there were reports circulating that the company was looking to raise a down round with a reduction in valuation from $3B to $1B. This was followed by an announcement the following week that the company was laying off 20% of its staff following a “dramatic shift in macroeconomic conditions”.

Today @BlockFi signed a term sheet with @FTX_Official to secure a $250M revolving credit facility providing us with access to capital that further bolsters our balance sheet and platform strength.

— Zac Prince (@BlockFiZac) June 21, 2022

Last week, BlockFi reached an agreement for a $250M credit line from FTX to bolster the platform’s financial position. Crucially, the facility will be subordinate to all client balances, meaning that in the event of insolvency, clients of BlockFi will be repaid before FTX. However later in the week, it appeared that one of BlockFi’s long-time venture investors, Morgan Creek Capital, was seeking a separate financing arrangement through an equity sale instead. Their disagreement with the FTX deal seems to be the presence of an option within the credit line for FTX to acquire BlockFi at “essentially zero cost”, presumably in the event BlockFi is unable to service the credit line. This deal appears to be a long shot, as formal agreement between BlockFi and FTX looks to be signed in days.

As a side note, BlockFi had simultaneously raised deposit rates slightly while implementing a $25 fee for withdrawals last week, possibly in a bid to stem withdrawal demand and reduce withdrawal pressure from the platform. 

Others

Toronto-listed crypto broker Voyager Digital (VOYG) signed a term sheet with Alameda Research (yes, it’s Sam again) to secure a revolving line of credit for $200M worth of USDC / cash, as well as 15,000 BTC. The broker said it will only utilize the credit line to safeguard customer assets. The broker concurrently disclosed that it had exposure to 3AC amounting to $350M of USDC and 15,250 BTC. Following this, Voyager also slashed its daily withdrawal limit from $25,000 to $10,000, and a max total of 20 withdrawals in a day.

Other than those already mentioned above, the list of parties affected by the 3AC fall-out has been helpfully compiled here by @mattysino. 

this is the panda pic.twitter.com/Q9DalCG9R0

— Matthew Graham (@mattysino) June 26, 2022

Our Thoughts

Bailouts (and insolvencies) are difficult to navigate, though for these companies with legal entities, the Absolute Priority Rule (APR) and Priority of Claims (POR) “Waterfall” is pretty clearly defined in the Bankruptcy Code. 

Source: WallStreetPrep

The biggest question for customers / depositors is where do they fall in the POR Waterfall in the event of platform insolvency, and unfortunately it’s pretty much up for every company to define. While this information is not public for all platforms, Coinbase in its 10-Q filing has stated that customers “could be treated as our general unsecured creditors” in the event of bankruptcy proceedings. Unfortunately this places them at the bottom of priority debtors just before equity-holders.

Taken in this context, the FTX credit line for BlockFi seems to be the most advantageous / generous to BlockFi’s customers, as it subordinates FTX’s debt to theirs. Indeed reports have mentioned that while there were other financing options on the table, only FTX was willing to agree to this arrangement, putting them more at risk in the event of insolvency. While there may well be other debtors which are higher on the priority list, this is a good sign for customers that at least the credit line was done in good faith to protect their assets (or share of assets if BlockFi goes under). 

On the other hand, equity-holders only get paid after debtors, and therein sits crypto’s biggest boogiemen - VC funds, who are in the most precarious state. In the event of bankruptcy, it is unlikely that they will see anything back on their initial investment. Such is the nature of VC funding though, and even the best VCs see investee companies fail on a regular basis. However it is unlikely many will shed tears for the VCs, as they’ve likely seen their initial investments balloon during the bull market as BlockFi reached $3B in valuation at peak (though there might not have been the possibility to exit). FTX’s deal (rightly so) will not bail out the VCs, and could wipe them out instead, which explains the effort by Morgan Creek to seek an alternative.

In any case, we seem to be in the make-or-break moment for firms affected by the 3AC implosion now. Either secure enough runway to carry on, or wrap things up now in the hopes that customers can still be made (almost) whole. 

Ultimately, the whole event and fall-out only served to highlight the weaknesses of existing centralized crypto savings / lending platforms, which emerged in droves during the bull market, and haven’t had to face a bear market up to now, much less a full credit cycle. Such platforms often offered depositors barely believable rates with no lock-in, but literally functioned just like any tradfi lender. During a bull market as long as crypto prices remained high and there was no need to make margin calls to borrowers, while depositors were happy to leave their assets on the platform and accumulate paper gains. However once bear market hit, rapidly shrinking asset prices, frequent margin calls, and mounting withdrawal pressures quickly plunged these platforms into crisis. It’s clear now that in order to generate outsized gains to attract customers, there were definitely flaws in the product design, and whatever risk management measures taken were clearly insufficient. It may have been more prudent to take a more sustainable longer term approach to what are marketed as “savings products”, instead of a mad dash for short term gains.

Finally, this saga has also highlighted the resiliency of on-chain true DeFi protocols. While we may often bemoan the capital inefficiencies of the prevailing over-collateralized lending model, it has its merits when it comes to unwinding positions, and liquidity providers can be sure that their stake in the pool (minus impermanent loss) will always be there. While large liquidations on-chain may cause its own cascade issues (see last week’s Solend debacle), that’s not a flaw in the lending protocol itself but rather the overall on-chain liquidity for a particular token. It’s a risk that will continue to be reduced as DeFi protocols gain more adoption and on-chain liquidity improves.

From a broader macro perspective we’re definitely not out of the woods yet, with monetary tightening policies still to continue. This means that there may well be still more pain to come in the crypto market unless we see inflation come down significantly in the next few months (or unemployment goes through the roof). It also means platforms which may not yet surfaced as being at-risk may only be dead-man-walking until the next big dip. Do take the appropriate risk management measures for your fund, and remember that ultimately “not your keys, not your coins”. 

Upcoming Economic Data Release

Monday, June 27: US Pending Home Sales

Tuesday, June 28: US Consumer Board (CB) Consumer Confidence

Wednesday, June 29: US Q1 GDP (Final), US Crude Oil Inventories, China Manufacturing PMI

Thursday, June 30: UK Q1 GDP (Final), Germany Unemployment Change

Friday, July 1: German Manufacturing PMI

Note: We will be taking a break for the next two weeks (Weeks of July 4th and 11th) to prepare the Q2 quarterly report. Normal market update will resume on the week of June 18th.