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5th December 2022 > > Leverage and correlation II.

Updated: Dec 6, 2022

tl;dr

A look at how the vicious combination of leverage and correlation took out two large players in the last month.


Market Snap








Market Wrap

The leveraged children are out in force again with a big move in the perpetual futures funding rate this weekend. Fear about the liquidity of some of the centralised entities that operate around the crypto space is fuelling this demand to short BTC. More on that below.


Curious Cryptos’ Commentary — Leverage and correlation part 2

There are many thousands of altcoins out there, some of which are outright scams, others are useless, and just a few have a real value proposition.


Centralised cryptocurrency exchange Binance launched its own coin BNB in July 2017 with the earliest recorded price of $0.10 compared to today’s price of $295. If you had been fortunate enough to buy $1,000 of BNB in those early days, your stash is now worth $2.95mm despite the bear market of 2022.


BNB is inextricably linked to the health or otherwise of Binance, but its value does not derive from the exchange. BNB is used to pay gas fees for BSC, the Binance smart chain. BSC is a programmable blockchain, compatible with the Ethereum network that allows developers to build DeFi (decentralised finance) apps using smart contracts.


BNB’s value is dependent on the success of BSC.


Criminal fraudster Sam Bankman-Fried, ex-CEO of FTX the centralised cryptocurrency exchange that recently imploded over just a few days, took note of the value accruing to BNB.FTX launched its own coin, FTT.


Much like BNB, FTT’s price was inextricably linked to the health or otherwise of FTX.


And, er, that’s it.


Or that is mostly it. If you traded on FTX using FTT the fees you paid were reduced. FTT also conferred some voting rights to holders, but I am not sure that ever made any difference.

Holders of FTT, unless they were executing large numbers of high value trades on FTX, were simply speculating on FTX remaining operational. And look how that has turned out.


Alameda Research, the hedge fund part of Bankman-Fried’s pyramid scheme, claimed to have vast quantities of reserves, which it would use to build leverage for its trading positions, some of which were held at FTX.


Alarm bells are ringing already.


But there are two further twists to this tale, one of which when made public caused a selloff in the price of FTT. The second ensured that the pain would be felt by FTX.


On November 2nd, 2022, CoinDesk, in a classic example of a journalist scoop, revealed that $5bn of Alameda’s reserves were in FTT and that these reserves were being used to collateralise a multibillion-dollar position that Alameda had open at FTX.


And that’s your correlation right there.


Over the next few days, those who held funds at FTX tried to withdraw $6bn of those funds, causing a liquidity crisis at FTX, and margin calls on Alameda. Those margin calls were backed by FTT. Selling begets more selling, which is why correlation must never be underestimated.


The collapse of BlockFi is similar in many ways.


BlockFi was one of the largest lenders in the mining industry. Lending always involves leverage, that is just a fact of life.


Miners have clearly had a tough time this year. Some have gone out of business, and others have been furiously selling down their BTC reserves as cash flow from current operations is negative at these prices for BTC.


That is the danger of leverage for the miners – they have become forced sellers of BTC at depressed prices to maintain operations and service the loans they have taken out to invest in mining rigs.


With the prospect of loans going bad, BlockFi would turn to the collateral for those loans to pay off the principal. BlockFi’s lending model was aggressive to say the least. They would make loans for miners to invest in rigs, and those rigs would be the collateral.


And that’s your correlation right there.


With miners going out of business, and a reduced appetite for new entrants to become involved, the elevated price for rigs is, at least temporarily, a thing of the past. Indeed, it has been reported that the average price for an ASIC machine has fallen by 80% since last December.


To make things even more difficult – and pushing correlation to the limit – many of these loans were non-recourse. What that means is that the lender can only use the collateral to pay off the loan, and has no further claim on the borrower, if that collateral is insufficient to pay off the debt.


This is absolutely nuts, it makes no sense. This is the most irresponsible form of lending I know of.


We have recently discussed the contagion effects from the insolvencies we have seen this year.


Until the excessive leverage that built up during the bull run of 2021 has been flushed out, crypto prices have little prospect for recovery.


But once that happens (and it is only possible to know of that in retrospect) then the fear factor will be replaced once more by enthusiasm, and it must be admitted, some greed.

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