FTX Spotlight & 2023 Outlook
FTX Update
What’s Happening
Many of you have been tracking this in real-time, so we won’t cover the full spectacle play-by-play, but we’re encouraged by several developments since our last writing:
- SBF is likely going to jail for a very long time - SBF was successfully extradited to the U.S. and has now been charged by the SEC with defrauding investors. Specifically the SEC cites “defendant concealed his diversion of FTX customers’ funds to crypto trading firm Alameda Research while raising more than $1.8B from investors”.
- SBF’s main co-conspirators have folded - FTX co-founder Gary Wang and former Alameda Research CEO Caroline Ellison have both pleaded guilty to fraud and are cooperating with the SEC in the case against SBF.
- MSM & politicians have changed their tune - Despite initially sympathizing with SBF, mainstream media and politicians pretty quickly came around to acknowledging that SBF intentionally and illegally commingled customer funds. Unlike in the past, the narrative has largely not been about crypto being inherently corrupt or evil. House Financial Services Committee Chairman, Patrick McHenry, went so far as to tell his fellow Representatives in the opening FTX hearing, “we have to separate out the bad actions of an individual from the good created by an industry and an innovation”.
- The FTX bankruptcy process is going surprisingly well - Restructuring legend John J. Ray III (of Enron bankruptcy) was quickly appointed interim CEO of FTX and has already recovered over $5.5b in assets: $1.7billion of cash, $3.5billion of crypto assets and $300M of securities. He’s also exploring the sale of FTX business assets like Ledger X and Embed, and even considering restarting FTX (likely to help market it for sale or monetize the recovered FTT). Already a secondary market for FTX creditor claims has emerged, with prices ranging from $0.15-$0.20 on the dollar. While nowhere near full recovery, a market emerging with some optimism for partial recovery this quickly is encouraging.
- Crypto markets have held up shockingly well - while global crypto market cap declined by more than 60% after the Terra collapse, FTX at most caused a 25% drop in global crypto market cap. As of this writing, those losses have been almost entirely recouped and markets sit only 2% below their 11/4/22 (just before FTX collapse) watermark.
Where it Goes From Here
The FTX saga is far from over, but its curse of uncertainty seems to be fading. The biggest areas we’re watching now are whether any more dominos are left to fall and how we make sure impending regulation gives clarity and guardrails to opaque centralized actors while not snuffing out decentralized ecosystems.
Genesis, DCG, & Gemini
What’s Happening
Late Thursday evening, one of crypto’s largest centralized lenders, Genesis Global Capital, filed for voluntary Chapter 11 bankruptcy, revealing it owed a total of $3.6B to over 50 different creditors. To understand why this matters and how it relates to DCG, GBTC, Gemini, BlockFi, FTX and industry at large, it’s helpful to start with a who’s who, beginning with DCG.
Digital Currency Group (“DCG”): owner of Genesis, Grayscale, a large venture portfolio, and a handful of operating businesses like CoinDesk. DCG has a lot of businesses, but by far the most important are Genesis and Grayscale.
Genesis Global Capital: the institutional lending arm of DCG that filed for Ch. 11 on 1/19/23. As it turns out, the bulk of its loan book was to borrowers like Three Arrows Capital ($2.4B), Alameda Research, and other now-defunct debtors. But where was the money that Genesis was lending out actually coming from? A variety of parties, but their largest partner was Gemini Earn.
Gemini: US-based centralized crypto exchange (“CEX”) run by the Winklevoss twins. Gemini’s exchange appears to be solvent, while its Gemini Earn program, which offered customers 6.9% APY, is now owed roughly $765.9M by Genesis. How did this happen? Gemini was (legally) depositing customer funds with Genesis in exchange for some interest rate, say (6.9+x)%. When working correctly, Gemini’s Earn customers got their 6.9%, Gemini pocketed spread x%, and Genesis was able to loan at some even higher rate to borrowers like Three Arrows Capital.
If it’s starting to look like this…
Three Arrows Capital (“3AC”): Singapore-based hedge fund which, at its height, had an alleged $10B assets under management. 3AC imploded in June 2022 following the collapse of Terra Luna, leaving Genesis with a $2.3B hole on its balance sheet. But why was 3AC betting so big on Terra Luna? As it turns out, the aggressive bet on Terra Luna most likely an attempt to “make it all back” after having already lost big nearly a year earlier on none other than..DGC’s Grayscale Bitcoin Trust (GBTC).
Grayscale Bitcoin Trust (“GBTC"): Here the story comes full circle. GBTC is an investment product created by Grayscale (subsidiary of Digital Currency Group) in 2013 to give institutional investors, pension funds, or other tax-advantaged accounts legal exposure to Bitcoin. Those investors can’t hold BTC directly, but they can hold an investment product whose sole mandate is to hold BTC for them. So in exchange for a 2% annual fee, investors give Grayscale BTC or USD and receive shares in GBTC, a security that the investors can actually hold. After a mandatory 6-month lock-up period, those shares become tradeable on the open market but can never be redeemed for actual BTC. This creates a strange dynamic where, if there’s more demand for liquid exposure to BTC than there are “unlocked” shares of GBTC, shares of GBTC will trade at a premium to the Net Asset Value (NAV) of the underlying BTC held in the trust.
For years the GBTC dynamics above meant that, so long as the premium held, putting BTC or USD into the GBTC trust, holding the shares for 6-month lock-up, and then selling those shares once unlocked = easy money! Groups like 3AC, BlockFi, Celsius certainly thought so and were happy to borrow from Genesis to repeat this trade over and over.
And the music stops. For a variety of reasons, the premium eroded and eventually on 2/24/21, GBTC began trading at a discount to NAV (see below). Investors now had other ways to access BTC directly or more cheaply, and the illiquid 6-month lock meant that dynamics reversed: holders like Three Arrows Capital, BlockFi, and Celsius who had used leverage to go long BTC via GBTC were now going to unlock at an increasingly painful loss. Depending on the maturity of their loans, many of which were originated by Genesis lending, all of these players were now secretly scrambling to make back their losses with even riskier bets like Terra Luna.
The infamous GBTC Trade, which inverted and went negative on 2/24/21 and has remained negative since
In May of 2022, Terra collapsed, bringing down 3AC and over 60% of the global crypto market cap with it. In addition to borrowing $2.3B from Genesis, 3AC was the primary debtor of Voyager, which was also forced to file for bankruptcy protection in July 2022. Meanwhile, Alameda Research was revealed in Voyager’s bankruptcy to have defaulted on nearly $400M, revealed in Celsius’ bankruptcy to have defaulted on $12M, and revealed in BlockFi’s bankruptcy to have defaulted on $680M – now it becomes clearer why FTX was trying to swoop in last summer as the “white night” to save CeFi lenders.
Where it Goes From Here
DCG is now attempting to monetize some of its healthy assets, like Coindesk and likely parts of the $500M DCG venture portfolio. From there we’ll see if a buyer comes in for Genesis or whether DCG is forced to carve up all of its businesses and transfer custody of the Grayscale Trust to someone else. Over time, we believe the GBTC discount will dissolve but, until then, there may be more insolvent debtors that emerge.
Ultimately, much of this saga could have been avoided had i) institutions been able to hold BTC directly or via a spot ETF (both of which have been denied by the SEC), or ii) had these loans been on-chain, over-collateralized, and auto-liquidating (DeFi protocols like Compound, Aave, and Maker all liquidated counterparties throughout 2022 with little interruption). Beyond that, the clear takeaways seem to be:
- Be wary of easy yield - Dig in to find out where the yield is actually coming from and assume that it won’t last as long as you think.
- Be wary of leverage - Debt can be healthy when financing lasting value, less so when amplifying risky returns. For the creditor, outsourcing the underwriting of your loan book, like Gemini’s Earn program did with Genesis, should be treated as multiplying risk (not just adding risk).
- Be especially skeptical if 1 & 2 are combined in weird ways - see Three Arrows Capital death spiral above.
- Watch out for market participants that ignore 1-3. Since we don't trade on margin or chase easy yield, the most important thing we can be doing for our partners is do our best to avoid these players.
V. Market Update & Outlook
As of this writing, crypto markets seem to be looking up! BTC is +28% on the year, ETH +33%, and we’re even getting texts from non-industry friends asking “Is crypto back?”. We won’t complain about a healthy dose of optimism for 2023, but we’re also not calling the bear market done so easily. Instead we’re taking stock of developer adoption, consumer adoption, and institutional adoption and then looking out at what the state of the industry means for the year ahead.
Developer Adoption
Global active developers contributing to crypto crossed 20,000 in 2022. Despite total crypto market cap declining in value over 70% from its peak in November 2021 to its trough in November 2022, total crypto developers were still up +5% YoY for 2022 and only down -11% from all time highs. Full-time developers finished the year at +8% YoY growth, which is meaningful given full-time devs contributed roughly 76% of code commits. Global crypto market cap as of December had returned to 2018 levels, but in the background, monthly active developers had increased +297%.
During that same time and amid plenty of market chop, we’ve seen over 5x growth in monthly active developers on Ethereum, Cosmos, Polkadot, Solana, and Polygon. In 2022 alone, we saw over 61,000 new developers write open-source crypto code, the highest ever for any single year in the industry’s history.
The Ethereum Merge in September 2022 was the single most significant developer achievement in crypto of the last several years. Following the Merge, and despite the FTX saga, Ethereum developers deployed over 4.6m smart contracts in Q4, a 453% jump Q/Q that brought quarterly smart contracts deployed near what we saw in DeFi Summer 2021. Web3 developer platform Alchemy’s recent Q4 Report highlights that developers are learning to build “smarter and faster” too, with 433% Y/Y growth in SDK requests, over 10x Y/Y growth in enhanced API requests, and over 10x increase in NFT API requests. It may not be reflected in current prices, but developers are continuing to build in the background.
Ethereum’s momentum is exciting, but developer activity from Top 200 networks outside of ETH and BTC was up even more (+12% Y/Y) as purpose-built blockchains continue to flourish. Solana, despite its close reputational ties with FTX, saw its web3-developer package downloads grow from 87k weekly downloads in December 2021 to 420k in the first week of December 2022.
Finally, zooming in on some of the emerging sub-300 developer ecosystems that make up much of that Top 200 growth, below are some of the consolidated highlights in Y/Y developer growth and emerging networks that we're watching closely:
Consumer Adoption
NFTs
In our October letter, we highlighted that Q3 NFT trading volume (in both USD and ETH) was already down more than -60% Q/Q. Our opinion then and now remains that the NFT landscape will continue to evolve and that a less exuberant market will encourage more experiments, better product market fit, and more use-cases built for everyday people (not just collectors and not just for art). In Q4, Total NFT Marketplace Volume ($$) did stabilize, and we even saw modest M/M growth return in December 2022.
Dollar volume tells part of the story but can be heavily skewed by luxury NFT sales or events. Looking at the monthly spike in January 2022 USD volume (above), for example, most of that surge was due to the Bored Ape Otherside Land Sale that month. Looking at Total Number of Transactions (below), though, we see that despite USD volume falling -85% from Q1-Q4 2022, Total Number of Transactions in that period fell by only -17.5%. Luxury NFTs sales are down, but broader activity has held up remarkably well.
As NFT royalty debates heat up and new marketplaces emerge, we’re also seeing the dominance of OpenSea wane, with Blur breaking through meaningfully over the last several months.
OpenSea is no longer the only game in town, high-end collectible art is no longer the only on-ramp, and, as we’ll see below, the NFT standard is going beyond art to help bring real world assets to the blockchain.
Real World Assets (RWA)
The tokenization of fungible and non-fungible real world assets represents one of the most promising on-ramps for mass adoption emerging in crypto right now. The vision is to unlock consumer and institutional liquidity for real world assets by representing those assets on-chain in a legally compliant, secure, programmable, and enforceable way. In III. Deal Highlights, we highlighted Centrifuge, which will be centerstage in the real world assets ecosystem this year as it helps consumers tokenize and borrow against invoices, mortgages, or other real assets. But this trend isn’t limited to crypto-native companies. In November, DBS Bank, JP Morgan, and SBI Digital Asset Holding executed their first on-chain RWA transactions. Only a few months earlier, Societe Generale tokenized AAA-rated French home loans that could be used to borrow up to 30M DAI, the overcollateralized stablecoin of DeFi stalwart MakerDAO.
Stablecoins
Stablecoins are one of the most meaningful example of real world assets hiding in plain sight. Already, they occupy nearly 1/10th of the global crypto market cap. At a high-level, there are currently three main types of stablecoins representing real world “monies” on chain:
- Fiat-collateralized Stablecoins (Centralized)
- Crypto over-collateralized Stablecoins (Decentralized)
- Algorithmic Stablecoins
Though algorithmic stablecoin disasters like Terra/Luna dominate the news, over 90% of all stablecoin supply is fiat-collateralized, with the bulk of this value being held in U.S. dollar-backed Circle (USDC) and Tether (USDT).
While fiat-backed stables are not as privacy-preserving, permissionless, or severed from traditional finance as crypto-native decentralized stablecoins like DAI, we believe demand for U.S. dollar-collateralized stablecoins will continue to grow as countries like Argentina, Turkey, Venezuela and others fail to quell double (even triple) digit inflation. To give one recent example, earlier this month following the resignation of its Economy Minister, Argentinian crypto exchanges reported 3x as many inflows to stablecoins as “consumers were looking to hedge against a potential devaluation”. Around the world, over 35 countries have current annual inflation of above 10% (see below).
The IMF reports over 35 countries with annual inflation of > 10%
In a moment where U.S. dollar dominance and continued ability to borrow are increasingly at risk, we’re optimistic that audited USD-collateralized stablecoins may be a bright spot in crypto's relationship with U.S. politicians and regulators. Just this month, Circle became the first stablecoin issuer to tap a Big Four auditor, Deloitte, and we expect other fully-collateralized stablecoin issuers to follow suit in 2023. As Messari co-founder Ryan Selkis puts it, “stablecoins should be our leading export”.
Institutional Adoption
Institutions continue to use the bear market to build partnerships (AWS & Avalanche), launch crypto research efforts (Visa on Ethereum), and explore new use cases (Fidelity in the metaverse). Below are some highlights since our October letter:
- AWS to partner with Avalanche to help bring blockchain to enterprises and institutions (Jan 11, 2023)
- Twitter and Stripe to launch purchasable “coins”; non-crypto to start (Jan 10, 2023)
- Square Enix, the maker of Final Fantasy, reiterated its commitment to building web3 games (Jan 1, 2023)
- SK tech giant LG Electronics now lets users buy, sell, or trade digital art from their TV (Jan 5, 2023)
- Fidelity filed 3 new trademark applications to offer web3 products in the metaverse (Dec 27, 2022)
- Visa is working on a new solution for crypto auto-payments using Account Abstraction (Dec 21, 2022)
- PayPal and MetaMask to allow new MM users to buy crypto using PayPal (Dec 15, 2022)
- Reddit NFTs minted by users surpassed 5 million in December (Dec 12, 2022)
- Apple will allow users in EU to download software from outside of its AppStore by 2024 (Dec 12, 2022)
- Warner Music Group is partnering with Polygon to release new music and collectibles (Dec 6, 2022)
- Starbucks is launching a blockchain loyalty program called Odyssey (Dec 8, 2022)
- Stripe launched an embeddable and customizable fiat-to-crypto on-ramp (Dec 1, 2022)
- Messaging app Telegram launched it’s own blockchain and sold $50M+ of usernames (Dec 2, 2022)
- Formula One announced a partnership with OpenSea for a Racing NFT Marketplace (Nov 3, 2022)
2023 Market Outlook
2023 is a year to continue investing in the projects, protocols, and teams that will shape the next era of crypto innovation. In bear markets, VCs give a lot of airtime to lower valuations, which this vintage of the Fund should certainly see. In our last letter, we added, “Even more important than valuations coming down is that the space has been largely de-noised. The tourists have left. The froth is gone. And largely who remains are gritty founders building for the right reason: long-term value creation.” Indeed, Q4 crypto venture was down to its lowest level in over two years. The large crossover funds have left the space (for now), taking fair-weathered or mercenary founders along with them.
For crypto, we’ve now entered the stage where two things will happen. First, great teams that were working on the wrong businesses (but didn’t realize they were working on the wrong businesses because they launched/raised in the up-only markets of 2020/2021) will run out of cash and wind down. This will be painful for them as well as most 2020 and 2021 vintage funds but ultimately healthy for the industry. It’s much harder to build the wrong business in hard times. Second, great teams will now be more likely to build lasting, meaningful, and venture backable businesses that aren’t reliant on exuberant 0% interest rate environments, lazy diligence, or cowboy leverage. These are the business that will build strong foundations during the bear and position themselves to win over years to come.
Of course, then there’s macro. The yield curve is still inverted. Jobs are strong, but real wages continue to decrease. CPI came in with a headline deflationary print earlier this month causing markets to rally, but hasn’t Fed Chair Jerome Powell said in the past that he’ll stay hawkish if he sees premature market optimism? The consumer is still strong, but new car purchases are down…Is this a bull-run or a bull-trap?
There are a lot of cross-currents, all dynamically swirling in real-time. We don't claim to know exactly what macro will do. Where we do maintain conviction is that crypto will be a major component empowering the future users of a global economy. Whether viewed as digital money, composable software, immutable speech, or simply the financial substrate of the internet, crypto innovations like Bitcoin, DeFi, NFTs, and DAOs cannot be uninvented.