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Cryptography Diaries: “Crash Course” in Cryptography in Custody

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FTX(FTT-USD) filed for Chapter 11 bankruptcy on Friday, Nov. 11 after a series of revelations regarding the company’s financial stability triggered a liquidity event when investors quickly attempted to withdraw their funds. The The crash affected more than 5 million customers worldwide, including retail clients and hedge funds who are now stuck trying to recover their funds after FTX halted withdrawals. But it’s not just FTX customers who are affected – the FTX crash shook the entire crypto industry and spurred pullbacks from other exchanges and a broader crypto price crash. Since early November, Bitcoin has fallen around 20% to below $17,000 (as of November 15). Ethereum also fell over 24% to $1,250 during the same period. But is this harming the long-term viability of the crypto industry? Probably not – most long-term crypto investors realize that this has little to do with the asset class itself and has more to do with how and where crypto is invested. Rather than damaging the legitimacy of the crypto industry, this event will likely help reshape how regulators view the crypto industry and also reshape how investors choose to invest in crypto by guard duty. Some takeaways are below:

CRYPTO Index, BIT, ETH YTD Returns So Far in 2022, Percentage

Crypto Price Falls This Year (Author)

Crypto exchanges and platforms do not offer the same protections as a bank account or brokerage account. Although the FTX incident was highly publicized, it is not the first time an incident like this has occurred. In May, Terra Luna (LUNC-USD) crashed, drawing attention to “unsecured algorithmic stablecoins”. In June, Celsius Network (CEL-USD), a crypto credit company, froze withdrawals and later filed for bankruptcy owing approximately $4.7 billion to its customers. 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 compounded by the fact that there were very few regulations in place to protect customers against liquidity events and bankruptcies, including proof of reserves or insurance protections (unlike banks/ traditional brokerage firms). For example, the FDIC (Federal Deposit Insurance Corporation) insures $250,000 per depositor, per insured bank. Similarly, the SIPC (Securities Investor Protection Corporation) insures up to $500,000, which includes a $250,000 cash limit. Moreover, it is difficult to protect investors who use offshore platforms like FTX, especially when attracted by celebrities or high yields.

Higher yields are sometimes too good to be true. Investors who purchased TerraUSD (UST-USD) were attracted by a 20% return earned by buying UST and lending it to a platform called Anchor. Similarly, Celsius and FTX both offered high staking returns on some coins that were in the double-digit percentage range. But staking can be both unsustainable and risky, since deposits are loaned out to other borrowers – and at such high returns, it’s easy for the amount of deposits to exceed the amount of borrowings.

As an alternative to exchanges, investors can likely explore one of two crypto investing methods. At one extreme, some buy-and-hold investors may choose to hold cryptocurrencies 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 retaining custody of their own crypto holdings. Some investors eventually abandoned 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 executing short-term trades on Scholarships.

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

Investors who prefer the ease of crypto trading may be more likely to use US-based exchanges like Coinbase (PIECE OF MONEY) that are subject to some regulatory oversight.Coinbase, for example, is a publicly traded company in the United States that is supervised by the SEC. Like any public company, Coinbase publishes annual audited financial statements, which makes it easier for customers to do their due diligence compared to offshore exchanges like FTX that also have strong ties to trading platforms. Coinbase also stores assets offline and holds customer assets 1:1, meaning the company does not use customer funds for business purposes such as lending or trading. This means that in the event of a liquidity event, customers 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 remove them at any time of the day? Is the exchange closely tied 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.

Conclusion

While the FTX crash was obviously a shock to the broader crypto market, the event highlights several key regulatory and custody issues. When market volatility subsides, investors will likely become 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 (CRYPTO) Index is the underlying index of the Invesco Alerian Galaxy Crypto Economy (SATO) ETF.

Disclosure: © Alerian 2022. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided for general information only and should not be considered investment advice. Alerian employees are prohibited from holding individual MLPs. For more information about Alerian and to view our full disclaimer, please visit Disclaimer | Alien.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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#Cryptography #Diaries #Crash #Cryptography #Custody #crypto strategy

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