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Crypto Exchanges Have a Problem Affecting Crypto Markets

Jeff Dorman, CFA
Nov 4, 2019
What happened this week in the Crypto markets?
A Bad Week For Banking
The Crypto exchanges are having substantial problems. Bank of America was subject to a short lived cyber attack on Tuesday when  all bank branches, debit cards, ATMs and customer service centers went down for over two hours.  Capital One also had 'technical difficulties' on Friday, and banks from Italy and other small provinces in Europe dealt with what is rumored to be the same group of cyber hackers. Meanwhile, there was yet another bank run in rural China (Yichuan Bank), Lebanese banks still haven’t opened their doors back to customers, and Argentina is right back to restricting capital flow abroad. Oh, and the Fed is now injecting almost as much money into the US banking system each week than it did during the peak of the financial crisis, while the ECB defends negative interest rates for the sake of jobs.
Public trust is rapidly waning in relation to trusted third-party money custodians, and they all seem to be failing in patches as macro economic conditions deteriorate.  Digital assets may not be the solution to these problems just yet, but the technology continues to evolve and mature giving people another choice when there was previously none available. While Libra, Facebook's monster project, continues to be battered from all sides of government and banking, China has responded with a digital token of their own (DCEP), which is set to roll out a lot sooner than many originally anticipated.  
Banks aren’t going away, but it’s safe to say neither are Digital Assets.  Pandora's box as a metaphor is usually taken in a negative context - but this may be the rare positive one.  Bitcoin opened up the advent of a seismic shift in how the world utilizes the digital world, and it is much too late to go back now. And so, we continue to forage further into the unknown.
Digital World Of Crypto Exchanges Have a Problem Affecting Crypto Markets

Market Manipulation & Crypto Exchanges

In September, the crypto markets fell over 20% in a single hour.
In October, the crypto markets rose over 40% in a single day.

Most participants in this space can state with confidence to a friend, parent, or colleague that Bitcoin will be significantly higher than its current price one year from today. However, it is much more difficult to pinpoint an accurate short term price for an asset so volatile and unpredictable. News that we may think matters often does not yet and events that we think should not matter sometimes have large effects. 
Volatility itself isn’t a bad thing, as most sophisticated investors have learned how to manage risk in all types of environments.  But as more market participants enter crypto, and as existing investors become more savvy, the source of some of this volatility is becoming more clear -- Exchanges.
Most crypto exchanges are unregulated, and the majority are not domiciled in the U.S.  In fact, many have now chosen to block U.S. customers altogether rather than comply with certain, and often vaguely understood rules.  Even those who are willing to adhere to U.S. regulations are still waiting to figure out what that even means due to ambiguous laws surrounding the regulation of crypto assets.  In the meantime, the crowded business model of crypto exchanges has been sparked by low barriers to entry and lack of consequences.

Last week, the headlines for Crypto Exchanges were not pretty:

  • On Thursday afternoon, Coinbase Pro, the third-largest “legitimate” Bitcoin spot exchange by volume in the industry, suddenly went down -- and stayed down for 75 minutes.
  • At the same time (and possibly as a result of), Deribit, the largest exchange for Bitcoin and Ethereum options, experienced a malfunction of its flagship BTC perpetual swap contract, causing the price of the contract to drop 15%.  This generated $1.3 million in user losses, which Deribit reimbursed almost immediately.
  • On Friday, BitMex, one of largest crypto derivative exchanges in crypto, accidentally released the email addresses of tens of thousands of its users.
  • Over the weekend, a new Asian-based exchange, FTX, was hit with a 150 million lawsuit in California court, with charges stemming from market manipulation, racketeering, unlicensed securities sale and more.
Surprisingly, these events had little to no effect on price or user response.  It’s possible this is because market participants are used to these types of events.  It’s also possible that the market is maturing and is now sufficiently diversified to withstand these types of market attacks.  Regardless, it demonstrates a clear need for those that will adhere to regulation, even if that takes years. By then, it’s anyone’s guess as to what the crypto market construct will look like.  We may see decentralized exchanges finally gain market share and adoption, eliminating the need for centralized middle-men altogether. Or we may see the current crop of regulated marketplaces like Bakkt and the CME dominate further.  We may even see today’s financial incumbents buy or build their way into this marketplace, since they already understand how to navigate the regulatory environment. For now, however, the takeaway is that the majority of volume and manipulation is happening on unregulated exchanges.  These risks can be mitigated with proper planning and due diligence -- but they clearly aren’t going away.
On the bright side, crypto exchanges have been extremely profitable, as the majority of crypto unicorns have come from the Exchange space.  They have also been the most innovative creators of valuable digital assets outside of Bitcoin, as many exchanges have issued tokens that are part quasi-equity, part utility token (i.e. BNB, KCS, FTT, FLEX, HT).  Lastly, the introduction of crypto derivatives, while clearly flawed thus far in execution, can have incredibly long-lasting positive effects, as businesses who want to use Bitcoin and other digital assets can now do so with confidence given their abilities to hedge and navigate price volatility (see a great example involving Ray Dalio and Chicken McNuggets).
Despite all of their flaws, exchanges are clearly creating value for equity investors, token holders and crypto-native businesses.
Crypto Exchanges Are Creating Value For Equity Investors

Miner Equity Will Help Crypto

While exchanges had a tough week, miners are shining brightly. Two of the largest global mining operations, Canaan Creative and Bitmain, both filed for IPOs last week. While these attempts to access traditional equity investors fell short last year, there is reason to believe that they will be successful this time around.
Our friend, Paul Kremsky at DRW / Cumberland, summed it up nicely (paraphrasing):  “It will be really interesting, and beneficial, to have publicly traded mining companies. That could prove to be a nice hedge to a long BTC position, plus you will have legitimate, liquid options contracts on the equity.”  This will give non-crypto investors more access to this growing asset class, and will also give crypto investors additional ways to express their views. 

Notable Movers and Shakers

Market exhaustion is a normal occurrence; it does not discriminate and is a psychological condition of any asset class. Bitcoin is not immune to the natural order of the ‘living, breathing’ market, as it finished the week down 4% after last week’s double digit rally. While there was no news that caused a move lower, there was news across the broader market:
  • Chinese tokens rallied early in the week as a result of comments made by Chinese President Xi Jinping October 25th promoting the use of blockchain technology for future technological innovations: BTM (+47%, -20%), IOST (+32%, +10%), NEO (+17%, -4%), NULS (+35%, +9%), ONT (+20%, -8%), QTUM (+19%, -9%), TRX (+20%, +3%), and VET (+29%, -6%) all experienced sharp buyside interest during the first half of the week, before crashing back to earth when Beijing urged investors that President Jinping’s comments about blockchain technology doesn’t extend to cryptocurrencies (peak, close). The price action across the sector suggests that speculation, not legitimate buy-side interest, led the short lived rally.
  • Decred (DCR) revamped their off-chain proof of stake governance platform (dubbed Politeia) last week, with a complete frontend overhaul to the UX/UI of the system. Decred is unique in its use of a hybrid PoW/PoS model, utilizing on-chain consensus (PoW) for validating blocks in combination with off-chain governance (PoS) for proposals and treasury allocation. The revamped governance tool was well received, with DCR finishing the week up 43%.

What We’re Reading this Week

Following comments made by China’s President early last week, Chinese investors began to drive up the price of shares in blockchain-related firms and potentially the price of Bitcoin. According to reports, Chinese brokerages received notices from the Shanghai Stock Exchange last Monday asking listed companies to “not make any exaggerated claims or create vicious hype”. State media is encouraging investors to remain “rational” and not take the support for blockchain technology as in-kind support for digital assets.
Last week the SEC issued a no-action letter to Paxos for settling equity securities on a permissioned and private blockchain. Paxos’ initial clients to transact on the settlement service will be Credit Suisse and Société Générale. The system will allow two parties to bilaterally settle trades with each other instantly, marking a huge update on the current systems which are decades old. Paxos, which worked on the product for the last two years, plans to reach out to a number of additional companies with the no-action letter in hand. 
The race is on to reach the US equity markets among mining giants Canaan Creative and Bitmain. After Canaan Creative quietly filed a registration statement early last week, Bitmain did the same although their listing hardly flew under the radar. Once Bitmain’s listing intentions were announced, it became public that it had ousted its co-CEO Micree Zhan and Jihan Wu, the other co-CEO, would be heading up the company through the listing process. The potential for these companies to debut on US stock exchanges is a milestone for digital assets as it will be another way investors can indirectly gain exposure to digital assets. 
CoinList, the startup which spun out of AngelList that helps token projects raise capital, closed a $10m round of venture funding last week. The round included participation from Twitter CEO Jack Dorsey, Polychain Capital and Collaborative Fund. Along with the new fundraising round, CoinList also announced the launch of CoinList Trade, a secondary cryptocurrency trading venue for digital assets. The progression is only natural for CoinList which will boast a regulated and compliant exchange for US investors. 
Recent unrest and inflation in Argentina has led to an increased demand for the US Dollar. Last week the government reduced the amount of USD a person can purchase from $10,000 to $200. As an alternative means of protecting their cash, Argentinians have looked to alternatives such as Bitcoin to protect their capital. However, later in the week, the government also banned the purchase of Bitcoin with credit cards on Argentinian exchanges. The government claims the restrictions are all to protect the country’s foreign exchange reserves and are dependent on $57b of funding from the International Monetary Fund. 
And That’s Our Two Satoshis! 
Thanks for reading everyone!   
Questions or comments, just let us know.  
The Arca Portfolio Management Team
Jeff Dorman, CFA - Chief Investment Officer
Katie Talati - Head of Research
Hassan Bassiri, CFA - PM / Analyst
Sasha Fleyshman -  Trader  
Wes Hansen -  Head of Trading & Operations
To learn more or talk to us about investing in digital assets and cryptocurrency
call us now at (424) 289-8068.

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