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Crypto Logs: Crypto ‘Crash Course’ On Custody

Crypto Currency Exchange Binance Drops Plans to Acquire Competitor FTX

Michael M. Santiago/Getty Images News

FTX (FTT-USD) filed for Chapter 11 bankruptcy on Friday, November 11 after a series of revelations about the company’s financial stability caused a liquidity event as investors quickly tried to withdraw their funds. The collapse affected more than 5 million customers worldwide, including retail customers and hedge funds who are now stuck trying to restore their funds after FTX stopped withdrawals. But it’s not just FTX’s customers who are affected – the FTX crash shook the entire crypto industry, spurring withdrawals from other exchanges and a broader collapse in crypto prices. Since early November, Bitcoin has fallen about 20% to below $17,000 (as of November 15). Ethereum also fell by more than 24% to $1,250 during the same period. But does this harm the long-term viability of the crypto industry? Probably not – most long-term crypto investors realize this has little to do with the asset class itself and more to do with how and where crypto is invested. Rather than harming the legitimacy of the crypto industry, this event is likely to help reshape the way regulators look at the crypto industry and also reshape the way investors choose to invest in crypto based on conservation . A few key takeaways are below:

CRYPTO Index, BIT, ETH YTD returns so far in 2022, in percentage terms

Downturn in Crypto prices this year (Writer)

Crypto exchanges and platforms do not offer the same protection as a bank account or brokerage account. Although the FTX incident was highly publicized, it is not the first time such an incident has happened. In May, Terra Luna (LUNC-USD) collapsed, bringing attention to “uncollateralized algorithmic stablecoins.” In June, Celsius Network (CEL-USD), a crypto-lending company, froze withdrawals and later filed for bankruptcy owing approximately $4.7 billion to its clients. In July, crypto brokerage Voyager Digital (OTCPK: VYGVQ ) filed for Chapter 11 bankruptcy with $1.3 billion in crypto assets. All of these incidents were exacerbated by the fact that there were very few regulations in place to protect clients from liquidity events and bankruptcies, including proof of reserves or insurance protection (unlike with traditional banks/brokerage firms). For example, the FDIC (Federal Deposit Insurance Corporation) insures $250,000 per depositor, per insured bank. Likewise, the SIPC (Securities Investor Protection Corporation) insures up to $500,000, which includes a $250,000 limit for cash. Moreover, it is difficult to protect investors who use offshore platforms like FTX, especially when they are attracted by celebrities or high returns.

Higher returns are sometimes too good to be true. Investors who bought TerraUSD (UST-USD) were attracted to a 20% return earned by buying UST and lending it to a platform called Anchor. Likewise, Celsius and FTX both offered high return yields on certain coins that were in the double-digit percentage range. But strike can be both unsustainable and risky, as deposits are lent to other borrowers – and at such high yields, it is easy for the amount of deposits to exceed the amount of loans.

As an alternative to exchanges, investors can probably explore one of two methods of investing in crypto. At one extreme, some buy-and-hold investors may choose to hold crypto through crypto wallets rather than tying up funds in an exchange. Before the crypto industry became more popular, investors originally bought crypto and stored it in wallets where they had a private key. This gave them the advantage of maintaining oversight of their own crypto holdings. Some investors eventually moved away from this method because it was easy to lose your private key (there is no help desk or password recovery system) and also more convenient for short-term trading on exchanges.

At the other extreme, some investors looking to participate in the crypto asset class performance may choose to gain indirect access through crypto funds. Futures-based ETFs such as the ProShares Bitcoin Strategy ETF (BITO) have almost perfect correlation with Bitcoin, but hold futures contracts instead of actual bitcoins. Similarly, crypto-stock ETFs such as the Invesco Alerian Galaxy Crypto Economy ETF (SATO) hold shares of companies operating in the crypto-economy, along with some exposure to the Grayscale Bitcoin Trust (OTC:GBTC). GBTC stores assets in offline or “cold” storage with a custodian (meaning assets are less vulnerable to a cyber attack) and does not lend or borrow the underlying assets (reducing the risk of a liquidity event).

Investors who prefer the convenience of crypto exchanges may be more inclined to use US-based exchanges like Coinbase (COIN) that have some regulatory oversight.Coinbase, for example, is a publicly traded company in the US that is overseen by the SEC. Like any public company, Coinbase releases audited annual financial statements, making it easier for customers to conduct due diligence compared to foreign exchanges such as FTX that also have close ties to trading platforms. Coinbase also stores assets offline and holds client assets 1:1, meaning the company does not use client funds for commercial purposes such as lending or trading. This means that in the event of a liquidity event, clients must be able to withdraw their funds at any time of the day. These are important factors for clients to consider when using an exchange – How are my assets stored? Can I withdraw them at any time of the day? Is the exchange closely linked to a lender or does it operate on its own? By asking these questions, clients can better understand the risk behind certain platforms and exchanges.

Bottom line

While the FTX crash was obviously a shock to the broader crypto market, the event highlights several key issues regarding regulation and custodianship. When market volatility settles in, investors are likely to be more wary of offshore crypto exchanges and explore other methods of investing in crypto, including private wallets, crypto ETFs, or US-based exchanges.

The Alerian Galaxy Global Cryptocurrency-focused Blockchain Equity, Trusts and ETPs Index (CRYPTO) is the underlying index for the Invesco Alerian Galaxy Crypto Economy ETF (SATO).

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Editor’s note: The summary bullets for this article were selected by Seeking Alpha editors.

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