Crypto Logs: Crypto “Crash Course” on Custody

11/17/22 | Roxanna Islam, CFA, CAIA

FTX filed for Chapter 11 bankruptcy on Friday, November 11 after a series of revelations regarding the company’s financial stability triggered a liquidity event when investors were rapidly attempting to withdraw their funds. The crash affected more than 5 million customers globally including retail customers and hedge funds that are now stuck trying to recover their funds after FTX halted withdrawals. But it isn’t just FTX’s customers which are affected—the FTX crash shook the entire crypto industry and stimulated withdrawals from other exchanges and a broader collapse in crypto prices. Since early November, Bitcoin fell approximately 20% to under $17,000 (as of November 15). Ethereum also fell over 24% to $1,250 during that same time period. But does this hurt 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 has more to do with how and where crypto is invested. Rather than hurt the legitimacy of the crypto industry, this event will likely help reshape the way regulators look at the crypto industry and also reshape the way investors choose to invest in crypto based on custody. A few key takeaways are below:

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Crypto exchanges and platforms do not offer the same protections as a bank account or brokerage account. While the FTX incident has been highly publicized, this isn’t the first time an incident like this has happened. In May, Terra Luna crashed, bringing attention to “uncollateralized algorithmic stablecoins.” In June, Celsius Network, a crypto lending company, froze withdrawals and later filed for bankruptcy owing approximately $4.7 billion to its customers. In July, crypto brokerage Voyager Digital filed for Chapter 11 bankruptcy with $1.3 billion in crypto assets. All of these incidents were worsened by the fact that there were very few regulations in place to protect customers from liquidity events and bankruptcies, including proof of reserves or insurance protections (unlike with traditional banks/brokerage firms). For example, the FDIC (Federal Deposit Insurance Corporation) insures $250,000 per depositer, per insured bank. Similarly, the SIPC (Securities Investor Protection Corporation) insures up to $500,000, which includes a $250,000 limit for cash. Additionally, it’s difficult to protect investors who are using offshore platforms like FTX especially when they are attracted by celebrity endorsements or high staking yields.

Higher yields are sometimes too good to be true. Investors who bought TerraUSD (UST) were attracted to a 20% yield which was earned by buying UST and lending it to a platform called Anchor. Similarly, Celsius and FTX both offered high staking yields on certain coins that were in the double-digit percent range. But staking can be both unsustainable and risky since deposits are lent out to other borrowers—and at such high yields it is easy for the amount of deposits to exceed the amount of borrowings.

As an alternative to exchanges, investors may likely explore one of two methods for investing on crypto. On one extreme, some buy-and-hold investors may choose to hold crypto through crypto wallets rather than tie up funds in an exchange. Before the crypto industry grew more popular, investors originally bought crypto and stored it in wallets where they had a private key. This gave them the benefit of maintaining custody 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 to execute short-term trade on exchanges.

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

Investors who prefer the ease of crypto exchanges may be more likely to use U.S. based exchanges like Coinbase which have some regulatory oversight. Coinbase (COIN), for example, is a publicly traded company within the U.S. which has oversight by the SEC. Like any public company, Coinbase releases audited annual financials, which makes it easier for customers to perform due diligence on compared to offshore exchanges like FTX who also have close ties to trading platforms. Coinbase also stores assets offline and holds client assets 1:1, meaning that the company does not use customer funds for commercial purposes like lending or trading. This means that in the case of a liquidity event, clients should 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 has obviously been a shock to the broader crypto market, the event brings to light several key issues regarding regulation and custody. When the market volatility settles, investors will likely be more wary of offshore crypto exchanges and explore other methods of investing in crypto including private wallets, crypto ETFs, or U.S.-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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