Perspective on Risk - June 29, 2022 - (Crypto 2/2)
Understand the Market; Are You Over-Concentrated?; Stablecoins Are Not Stable; DeFi Lending Protocols Can Be Raided; Custody and Rehypothecation; Know Your Customer
In the last Perspective on Risk, I gave some background on the recent collapse of the cryptocurrency market. In this post I want to relay a few ‘lessons’ that are probably familiar to many of us, but only emerging in crypto for the first time.
Understand the Market
Marakov and Schoar, in Blockchain Analysis of the Bitcoin Market, “document the transaction volumes and network structure of the main participants, the concentration and regional composition of miners which ensure the integrity of the blockchain ledger, and finally, the ownership concentration of the largest Bitcoin holders.”
Here are some of their findings:
The Crypto Market is HIGHLY Concentrated
We show that the Bitcoin eco-system is still dominated by large and concentrated players.
Bitcoin Mining Is Concentrated
The top 10% of miners control 90% and just 0.1% (about 50 miners) control close to 50% of mining capacity.
Most Bitcoin is Off-Exchange
By the end of 2020 … 5.5 million bitcoins, roughly one-third of Bitcoin in circulation [was held on exchanges]. In contrast, individual investors collectively control 8.5 million bitcoins by the end of 2020. These individual holdings are still highly concentrated: the top 1000 investors control about 3 million BTC and the top 10,000 investors own around 5 million bitcoins. This level of concentration is substantially higher than the wealth concentration of the US population. We also show that these results are not driven by abandoned bitcoin accounts nor the holdings of Satoshi Nakamoto.
90% of Transaction Volume Is Not Tied To Economically Meaningful Activities
We show that the vast majority of Bitcoin transactions between real entities are for trading and speculative purposes.
[I]llegal transactions, scams and gambling together make up less than 3% of volume. The fraction of volume explained by miners is even smaller.
Furthermore, a large fraction of exchange volume consists of cross-exchange flows. The high cross-exchange flows are the consequence of the current market structure.
Haghani and White have a nice explanation why we should all take the size of these purported numbers with a grain of salt, using the metaphor of two antique dealers and a beautiful bowl. Hassan and Ali Finsplain the $50 Billion Rise and Fall of Terra-Luna
The Crypto Network is Dense & Controlled by the Richest Crypto-Billionaires
Zhao founded of Binance, the world’s largest cryptocurrency exchange; Bankman-Fried is the CEO of crypto trading platform FTX; Armstrong and Ehrsam were cofounders of Coinbase; the Winklevoss twins were the cofounders of Gemini
David Gerard suggest the entire crypto market is best modelled as a single entity.1
So, LESSON 1: Know the structure of the market. Bitcoin at least, is much closer to an underwriting and distribution model than it is to traditional trading. A very small number of players are looking to distribute and monetize their assets. They control the supply in circulation.
Are You Over-Concentrated?
In Relative Terms, How Large is The Crypto Market?
The most current figure on Coingecko suggest the market is currently around $985B, down materially from $2.986T on Nov. 11, 2021. For reference, Institutional Investor calculated that the total global investable assets reached $250 Trillion in June of 2021.2
So realize that if you have more than around 1.2% of your investable assets in crypto you are making a bet on the long side.
Stablecoins Are Not Stable
Tether is the largest stablecoin by market cap, at around $67 billion.
Tether’s stablecoin is backed by its reserve assets, the quality of which has been questioned. Tether posts a transparency report giving some limited information on its assets. While the quality of its assets have improved over time, it still holds less than 50% of reserves in UST. A significant, though declining, portion of its assets has been in undisclosed “mostly A2” commercial paper.
Frances Coppola has written extensively about this, and as a result is not very popular in the crypto-shill community. See Tether’s smoke and mirrors for a more thorough discussion. In particular, she notes Tether has an extremely small equity position, and that its terms of service allow it to delay redemptions and withdrawals in the event of illiquidity.
Stablecoins are clearly vulnerable to runs.
DeFi Lending Protocols Can Be Raided
Amy Castor writes about a raid on Solend, a “decentralized” lending platform on the Solana blockchain.3
The whale had deposited a large amount of SOL into Solend in exchange for a “loan” of USDC and USDT, two popular stablecoins, and then disappeared. Make no mistake: this was an exit, not a loan.
They parked 5.7 million SOL (currently worth $170 million) onto the platform to withdraw $108 million in USDC and USDT. The whale then vanished, and would not pay down the loan
The problem was that if the price of SOL dropped below a certain point, the Solend platform would auto-liquidate his funds, selling off a large chunk on a decentralized exchange. This would create cascading liquidations across the books of the decentralized exchanges, potentially driving the price of SOL to zero.
The whale essentially sold a huge amount of SOL for a two highly liquid assets — at a substantial discount, granted, but that amount of SOL would have crashed the market otherwise.
Solend Labs made a bad loan and overpaid for the SOL. To fix this, they came up with a solution: set up a sham DAO4 and conduct a sham vote to take over the whale’s account and sell the coins over the counter (OTC) to avoid crashing the market. “Code is law” only applies until the big boys might lose money.
Anonymity makes recovery a bitch.
Custody and Rehypothecation
In traditional lending, one might pledge assets in order to get a loan (think about pledging your house to secure a mortgage). In crypto, that may not be the case; on needs to read the fine print carefully.
As an example, Frances Coppola dove into the Celsius legal agreements. She finds that you aren’t pledging coins to Celsius, you are instead doing a repo (sale and repurchase agreement) with Celsius.
[T]here is full title transfer here, too. So you no longer own the coins you deposit. Contrary to the impression given in Celsius's blogpost, any coins in cold storage are not held in custody for you, but for Celsius.
Celsius, of course, lends out your crypto making it virtually impossible to redeem in event of default. You are essentially an unsecured creditor.
Here is a link to the 1st post in her little bird thread on this.
Know Your Customer
KYC seems to be the absolute anthesis of the decentralized, anonymous crypto-currency vision adopted early on. Still, there have been some significant advancements in this area. Regulations are being passed that require KYC akin to what is seen in traditional finance. For instance:
Starting on June 27, 2022, Coinbase will require users from the Netherlands to provide KYC data if they plan to send crypto to a wallet off the Coinbase platform.
Coinbase says the new rules are being applied because the company must comply with local regulations. The 1977 Sanctions Act coupled with the Money Laundering and Terrorist Financing Prevention Act (Wwft) requires virtual asset service providers (VASPs) to provide KYC data on outgoing transactions involving non-custodial and third-party wallets.5
Forrestor has produced Key Trends Impacting Anti-Money Laundering For Cryptocurrencies.
Early fintech companies didn’t capture the true identity of crypto payment parties. Cryptocurrency payments were initially used for malicious activities, such as ransomware payments and dark web transactions. Many VASPs6, including cryptocurrency exchanges such as Binance, Coinbase, or Gemini, never made earnest efforts to collect and verify the true identity of customers and may have lacked monitoring capabilities, meaning that cryptocurrency could be used for money-laundering activities without being detected.
Regulatory mandates are now clearer and deeper. Most regulators have increased their scrutiny of cryptocurrency payments. The Office of Foreign Assets Control (OFAC) has issued notices, and the Financial Action Task Force (FATF) has released reports and guidelines on the risk-based approach that countries and companies should apply to virtual assets (VAs) and operations of VASPs. FATF also clarified that the “travel rule,” which mandates that FIs must capture and transmit payee and beneficiary information in a chain of payments to aid with potential forensics and investigation, applies to cryptocurrency transactions. FATF recommends that VASPs follow know-your-customer (KYC) and know-your-business-partners (counterparty intelligence) guidelines on persons and the FIs and VASPs with which they conduct transactions. These changes, combined with the fact that regulators are cracking down on cryptocurrency compliance, demands stronger AML-for-crypto capabilities.
In addition to the traditional risks of structuring and layering, they cite the unique risks of “Mixers, tumblers, and chain-hopping.”
Mixers and tumblers are VASPs, usually wallet providers, that, despite being regulated in some countries, materially allow money launderers to: 1) perform transfers to VASPs in jurisdictions outside of the area where the customer lives or conducts business; 2) mix funds from multiple, including illegal, sources into multiple outgoing payments; 3) perform chain-hopping, which is making rapid transactions and converting funds between multiple cryptocurrencies, including privacy-strong ones such as Monero, to hide money-laundering activities; and 4) withdrawing VAs from a VASP immediately to private wallets, often without investment returns.
Hears hoping you either enjoyed or at least tolerated this brief diversion. We’ll get back to regularly scheduled programing soon.
Gerard, The crypto market as a single unified scam, Attack of the 50 Foot Blockchain Attack of the 50 Foot Blockchain
Chung, Global Investable Assets Reach Record $250 Trillion, Institutional Investor
DAO is an acronym for Decentralized Autonomous Organization; essentially the governance protocol for the chain.
Virtual Asset Service Providers