Crypto Crisis: Why Adequate Risk Management Matters!

Over the past couple of weeks, the investment community has watched the unraveling of a number of global markets. What’s happening in both the bond and equities market from a fundamental standpoint is quite digestible, however, what has occurred over the past few weeks with respect to crypto can be a bit more complex in nature. In this piece, we seek to provide an insight into capital structures, insolvency, and the industry's lack of risk management so our network can make sense of the recent crypto crisis, and better understand the inherent risks in a disruptive asset.

To kick things off, we need to start on the first floor, that is capital structures. When a company needs to raise money to fund operations, capital expenditures or acquisitions, it can be financed through various financial instruments, which fall either into the debt or equity buckets. Debt, as we know, is money provided by a lender to a company or entity, which must then be repaid with interest. Equity, on the other hand, represents capital paid in exchange for ownership of a company or business. When looking at a capital structure, equity is typically the most junior, meaning in the event of a sale or liquidation, equity holders cannot receive payment until all of the more senior portions of the capital structure are paid, i.e. bondholders.

Overview of Capital Structure

Source: Corporate Finance Institute

Now, it’s important to understand what a financially sound company looks like. With respect to a company’s creditworthiness, a business that takes on debt must be able to service the debt according to a predetermined payment schedule. To do that, the business needs to make sure that its current cash on hand plus cash flows from operations are greater than the periodic repayments. Additionally, lenders may include restrictive covenants on a borrower’s operations and finances to mitigate risks.

If a company is unable to service the debt borrowed plus additional interest accrued, and or breaks covenants in place, the company will have to negotiate new terms with the lending party, or be forced into bankruptcy. In even more severe situations, as we’ve seen with the recent crypto crisis and resulting drawdown, companies could be deemed insolvent and be forced to prepare for bankruptcy immediately.

To segue, crypto as an asset class has blossomed before our very eyes and has shown to have both positive and negative effects on society. While many are bullish on the long-term prospects of the adoption of the asset class, the increasingly large number of crypto hacks coupled with a growing list of failing blockchain projects show why risks must not be overlooked. Unbeknownst to many industry participants, there are deep nuances with respect to the different platforms and protocols that have unfortunately crippled the growing industry.

Protocol Risks = Technology Risks: Includes the risks associated with failures of various crypto projects, i.e., protocols such as Bitcoin, Ethereum, and Terra.

To touch upon the tip of the iceberg from a recent cryptocurrency collapse, Terra Network, a blockchain protocol and payment platform used for algorithmic stablecoins suffered a dramatic collapse, and with it, $60 billion of value was erased.¹ Since Terra was developed to be interoperable with other protocols, meaning other projects could interact and work in tandem with it, when it collapsed, not only did every protocol it was engaged with suffer collateral damage, but the rest of the industry felt the pain in the form of various liquidity crises.

For example, at its peak, Terra held 80,000 bitcoins, which the company was forced to liquidate in a failed attempt to protect the protocol. Unfortunately, when a well-known crypto company liquidates approximately 33% of an asset’s avg daily volume, trade bots and signals triggered a cataclysmic reaction, ultimately putting immense downward pressure on the price of bitcoin, and costing investors billions in losses.²

Platform Risks = Transparency Risks: Includes the risk associated with the failures of the institution participating in crypto services, i.e., platforms such as Celsius Network, BlockFi, and CoinFlex.

A little after a month after Terra collapsed, more stress was added to the crypto system as Celsius Network, an interest-earning platform which offers high-yield products on crypto, paused withdrawals, facing a liquidity crunch of its own. Similar to traditional banks, Celsius offered customers yield in exchange for holding their assets (coins). The yields on these assets, however, are vastly different from the yields offered by banks. Whereas you would be lucky to earn a few hundred bps on assets deployed in a traditional checking account, Decentralized Finance (or Defi) platforms such as Celsius offered customers yields that would have every bank risk management team in a frenzy, some upwards of 2000 bps. As we were all taught in Finance 101, higher yields often come with higher risk. Celsius moving away from providing short-term loans to market makers and traders, to deploying capital into higher yielding strategies offered by Defi lending protocols increased the risk profile of the platform immensely.

Unfortunately, as the many factors plaguing crypto unraveled, negative sentiment towards the platform’s perceived risk is what caused mass outflows, akin to a bank run. In this instance, customers were pulling liquidity out faster than others were willing to put at risk, putting the platform in a very precarious position – that is, exuberant yield obligations owed to customers in the face of billions of dollars in outflows. Similar to many other liquidity crunches seen around the industry, Celsius announced that it would be pausing all transactions to move assets away from the platform. This “temporary” freeze on assets, unfortunately, is looking to be a bit more permanent as the platform is rumored to be insolvent. Even worse, this is not an isolated issue in the crypto crisis, as many other platforms are experiencing the same potential fate.

To tie this back to the discussion on capital structures, as companies fail to service their obligations, more and more will be deemed insolvent. In this case, we may see the rise of bankruptcy proceedings. If companies such as Celsius are to file bankruptcy, a few things could happen.

Chapter 7 = Liquidation: In this instance, the company ceases all operations and assets are sold off then distributed per a distribution waterfall (diagram below).

Chapter 11 = Restructuring: In this instance, the company’s equity holders are wiped out and creditors take control.

In the event of Celsius, it is a bit ambiguous how deposits will be treated. It has been reported that the current frozen deposits will be treated as assets, which in the event of liquidation will be sold at a significant discount at auction to the highest bidder. In essence wiping out not only the depositors, but likely leaving investors with little to nothing. As of this week, it has been reported that Goldman Sachs is the front runner looking to raise $2 billion to buy up distressed assets from Celsius.²

Another platform, BlockFi, which as of a year ago sought a valuation of approximately $5 billion, is currently facing a liquidity and valuation crisis of its own. In this instance, investors of BlockFi are scrambling to protect and/or recoup their equity investments. One proposed situation included the likes of Sam Bankman-Fried and his crypto exchange FTX. To save the distressed platform, FTX proposed a credit line of $250 million to help keep BlockFi afloat. The key caveat to this proposal is it included the option for FTX to buy BlockFi, which would effectively wipe out all of the company’s existing shareholders, including the multiple venture equity investors, as well as management and employee stock options.³ Unlike other proposed bailouts, FTX’s was reportedly the only one that would not subordinate client assets in the cap table, meaning in the event of liquidation, client assets would be protected.

All in all, the state of crypto has become rather perplexing for traditional investors. While the growth prospects for the industry are incredibly enticing, crypto protocols have become too intertwined, and platforms have operated freely with little oversight. While many have previously sought the asset as an inflation hedge, the recent crypto crisis shows that we’re now in a risk-off environment and the inflation hedge isn’t working for the stablecoins that are decoupling. On top of this, the increasing disparity between industry insiders and naïve participants in the sector will surely prompt a risk management overhaul, and we support the move away from the status quo. In order to protect all participants, many believe crypto needs to move away from the wild, wild west mentality and into a more regulated environment. For investors looking to retreat to low volatility strategies, some strategies such as global macro, multi-strategy, and equity market neutral are becoming increasingly important. Those investing in high-yielding crypto and looking to replicate a stable income stream may be interested in private credit strategies backed by managers who have navigated multiple market drawdowns and have risk management teams in place to prevent meltdowns such as that experienced the past couple of months.

Sources:

1. Bloomberg, June 2022. "Crypto Terra Explainer"
2. Coindesk, June 2022. "Opaque Platforms and Intertwined Protocols Pose Big Risk to Crypto"
3. Coindesk, June 2022. "GS Raising Funds to Buy Celsius Assets"
4. Coindesk, June 2022. "Morgan Creek trying to counter FTX BlockFi Bailout"