Every time a bell rings, a crypto clips its wings | institute of man

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Now that everything was back to work after a festive holiday season, I couldn’t help but think of the ongoing crypto saga through the lens of one of my favorite Christmas movies. Personally, I love Jimmy Stewart’s 1946 classic, Its a Wonderful Life. If you haven’t seen it, the concept of the film involves a man who wishes he had never been born, then has the opportunity to observe how the people in his life would have turned out without him. It’s a pretty touching movie.

The part of the film that I kept coming back to is the scene where there is a run on the Bedford Falls Savings & Loan, a bank owned by the main character, George Bailey. City depositors are rushing to the bank to withdraw their money before it’s all gone. This run-on-the-bank scenario is one that happened far more frequently decades ago, before the FDIC created deposit insurance, but I think it’s also an apt analogy for what happened to FTX.

A 2022 swap collapse through the lens of a 1946 film

FTX, in this analogy, is savings and lending. Clients gave them money and in return they were allowed to make leveraged bets on cryptocurrencies on the exchange. In the film, when one of the characters asks for the full refund of his deposits, he explained to him that his money was not physically in the bank’s safe; most of it was lent to other depositors in the form of loans (mortgages, for example).

Now imagine if instead of having many small depositors, you had one very large one. To keep the movie analogy, let’s imagine someone close to George Baileys bank Uncle Billy, a bank clerk was one of the biggest borrowers of money to speculate on assets. But in this example, unlike the movie, let’s assume that Uncle Billy’s appetite for risk was enormous. Let’s say he borrowed $500,000 not for a mortgage but to buy a racehorse, a very speculative and risky asset. George Bailey (the president of the bank) should have ensured that Uncle Billy had his loan almost fully secured (i.e. had other assets/deposits in the bank which could be sold to cover the losses if anything happened to his racehorse), but he didn’t. Maybe he was just trying to give a family member good terms. Perhaps he was grossly negligent. We do not know. But if Uncle Billy’s racehorse breaks a leg and becomes worthless, he wouldn’t have enough assets pledged in the bank to cover his $500,000 loan.

The sale of the crypto assets created a free fall for FTX as customers came for what was left of their money.

Alameda Research, the hedge fund started by Sam Bankman-Fried (SBF), looks in my opinion like Uncle Billy in the FTX debacle. The fund was closely tied to FTX and alongside allegations of fraudulent use of client assets, it borrowed huge sums of money (amounts are still unclear, which is part of the problem) without being held accountable. to provide the necessary guarantees to cover the losses. When cryptocurrencies started selling off in 2022, and amid the collapse of several other coins and businesses, it put Alameda underwater on its transactions and created an effective run on the bank for the rest. FTX customers. By not properly segregating their clients’ assets and not properly managing collateral accounts for high leverage trades, the sale of crypto assets created a tailspin for FTX as clients came for what their money was left.

A case study on how (not) to manage risk

Fraud allegations aside, the FTX/Alameda Research bankruptcy is, for me, a textbook case of poor risk management. They apparently did not fully understand or even correctly measure the amount of collateral their counterparties should be required to hold. SBF has apologized to its customers. Figuratively, he pulled out his pockets to show that they are empty and there is nothing he can do about it, but that was no consolation for investors who had just seen their holdings drop to (or nearly) zero. .

How big was the crypto asset selloff that helped this train on track to a wreck? The answer is meaner than you would have imagined. Looking at a selection of cryptocurrencies that have been some of the largest and most liquid over the past two years (Figure 1), we can see that the top one saw a drawdown of -54% (Litecoin ). Down 54% and it’s the best of the bunch! How scary is that? The worst performer of the group was down 94% (Solana).

Figure 1. Crypto Volatility and Withdrawals in 2022

Source: Man FRM; as of December 31, 2022. The financial instruments mentioned are indicative. The contents of this material should not be construed as a recommendation for their purchase or sale.

Volatility levels for crypto assets have been astounding.

Volatility levels for crypto assets have also been astonishing. The least volatile of the selection we looked at was Bitcoin, and it had an annualized realized volatility of 62% in 2022. Remember, this is the least volatile crypto asset in this space that we have considered. Some of the other cryptocurrencies were achieving annualized volatility of over 110%. Compare that to a realized volatility for the S&P 500 of 24% and its 2022 decline of -19%.

Do you have multiple crypto assets? Don’t fool yourself into thinking you’re diverse

As if the volatility and huge declines weren’t hard enough to bear, we noticed that the crypto space has become much more correlated in 2022 compared to 2021 (Figure 2).

Figure 2. Crypto Correlations, 2021-2022

Source: Man FRM; as of December 31, 2022. The financial instruments mentioned are indicative. The contents of this material should not be construed as a recommendation for their purchase or sale.

The average pairwise correlation of the 10 cryptocurrencies we observed in 2021 was 0.45 positively correlated on average, but not overly correlated. Fast forward to 2022, and that average pairwise correlation jumps to a much more correlated 0.73. The range of correlations between these assets has also changed over the past two years. In 2021, the two least correlated currencies had a correlation of 0.16 (Decentraland and Avalanche) and the highest was 0.74 (Bitcoin and Litecoin), a fairly wide range which implies that some of these assets were not not as correlated as others. In 2022, this range narrowed to the point where the lowest correlation was 0.60 (Cosmos and Ripple) and the highest was 0.90 (Bitcoin and Ethereum).

The problem with these cryptocurrencies is that even holding a diversified portfolio with the 10 elements highlighted here would not have been diversified from a risk perspective.

Often, with riskier assets, managers will want to be diversified across many holdings, rather than piling on just one or two. The problem with these cryptocurrencies is that even holding a diversified portfolio with the 10 elements highlighted here would not have been diversified from a risk perspective. If the correlations tend towards 1.0, you have effectively only obtained one trade. You might be wondering: does all of this mean that FRM Investment Risk has a hard no when it comes to investing in crypto? This may come as a surprise to some given the previous analysis, but we agree with a few major caveats.

Even though holding highly volatile and highly correlated assets without strong risk management and proper volatility targeting is a recipe for the draw, we can accept managers investing in crypto, but only in a small size and with a quantitative approach consisting of reducing exposures when they become more volatile. . Additionally, we need to ensure that there is appropriate liquidity (can you sell the asset at or near the current mark?) and that there are no operational risk issues. Managers need to have strong risk management around maintaining collateral and stop-losses to avoid cash management issues. To learn more about this topic, we encourage you to read our colleagues’ guide to crypto.

According to e-cryptonews.com, 10,024 cryptocurrencies had been launched up to May 2022. Of these, at least 2,400 (~24%) have already failed and this does not include all the crypto shops that closed since May last year. It makes me wonder about the line from George Baileys daughter in Its a Wonderful Life: maybe instead of every time a bell rings an angel takes her wings, it could be updated to the 2022 version every time a bell rings, a crypto clips its wings.

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