Every Time a Bell Rings, a Crypto Clips its Wings | Man Institute


Now that we’re all back at 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 holiday movies. I personally love the 1946 Jimmy Stewart classic, It’s a wonderful life. If you haven’t seen it, the film’s concept involves a man wishing he’d never been born, and then getting a chance to see how the people in his life would have turned out without him. It’s quite a moving movie.

The part of the movie that I kept coming back to is the scene where there is a run on Bedford Falls Savings & Loan, a bank owned by the main character, George Bailey. Depositors in the city rush to the bank to get their money before it’s gone. This run on the bank scenario is one that occurred much more often decades ago, before the FDIC created deposit insurance, but I think it’s also an apt analogy for what happened to FTX.

A 2022 exchange crash through the lens of a 1946 film

FTX, in this analogy, is Savings & Loan. Clients gave them money, and in exchange, they were allowed to place leveraged bets in cryptocurrency on the exchange. In the film, when one of the characters demands that his deposits be returned in full, it is explained to him that his money was not physically in the bank’s safe; most of it was lent to other depositors as loans (mortgages, for example).

Now, imagine if instead of having a lot of small depositors, you had one really big one. To keep with the movie analogy, let’s imagine that someone closely associated with the bank, George Bailey’s Uncle Billy, an employee of the bank, was one of the largest borrowers of cash to speculate on assets. But in this example, unlike in the movie, let’s assume that Uncle Billy’s risk appetite was enormous. let’s say he borrowed $500,000 not for a mortgage but to buy a racehorse, a highly speculative and risky asset. George Bailey (the president of the bank) should have made sure that Uncle Billy had his loan almost fully guaranteed (i.e. have other assets/deposits in the bank that could be sold to cover losses if something happened to his workhorse). races), but did not. that. Maybe he was just trying to give his family good terms. Maybe he was too negligent. we don’t know. But if Uncle Billy’s racehorse breaks a leg and becomes useless, he wouldn’t have enough assets pledged to the bank to cover his expenses. $500,000 loan.

The sell-off of crypto assets created a tailspin for FTX as clients came looking for what was left of their money.

Alameda Research, the hedge fund started by Sam Bankman-Fried (‘SBF’), is, in my opinion, similar to “Uncle Billy” in the FTX debacle. The fund was closely linked to FTX and, along with allegations of fraudulent use of client assets, borrowed massive amounts of money (the amounts are still unclear, which is part of the problem) without being required to file the necessary collateral to cover losses. When cryptocurrencies began to be sold in 2022, and amid the collapse of several other coins and companies, it put Alameda under water in its operations and created an effective “run on the bank” for the rest of FTX clients. By allegedly failing to properly segregate assets for its clients and fail to properly manage collateral accounts for highly leveraged trades, the crypto asset sell-off created a tailspin for FTX as clients came looking for what was left of their money.

A case study on how to (not) manage risk

Fraud allegations aside, the FTX/Alameda Research collapse is, to me, a case study in poor risk management. They did not appear to fully understand or adequately measure the amount of collateral that should be required from their counterparties. SBF apologized to its clients. Figuratively speaking, he took out his pockets to show that they are empty and there is nothing he can do about it, but that was little consolation to investors whose holdings had just fallen to (or close to) zero.

How wide was the crypto asset sell-off that helped this train derail to a crash? The answer is nastier than you may have realized. 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 “best” of them were down -54% (Litecoin). 54% fewer, and he’s the best of the bunch! How scary is that? The worst performer of the group was down 94% (Solana).

Figure 1. Cryptocurrency volatility and withdrawals in 2022

Source: Male FRM; as of December 31, 2022. Financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation to buy or sell.

The volatility levels of crypto assets have been staggering.

The volatility levels of crypto assets have also been staggering. The least volatile of the selection we looked at was Bitcoin, and it had a realized annualized volatility of 62% in 2022. Remember, that’s the less volatile crypto asset in this space we consider. Some of the other cryptocurrencies were experiencing more than 110% annualized volatility. Compare that to a realized volatility for the S&P 500 Index of 24% and its 2022 drawdown of -19%.

Do you have multiple crypto assets? Don’t be fooled into thinking you’re diversified

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

Figure 2. Crypto Correlations, 2021-2022

FRM every time a bell rings Fig2

Source: Male FRM; as of December 31, 2022. Financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation to buy or sell.

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

The problem with these cryptocurrencies is that even having a diversified wallet with the 10 highlighted here would not have been diversified from a risk standpoint.

Often with riskier assets, managers will want to diversify across numerous holdings, rather than accumulate in just one or two. The problem with these cryptocurrencies is that even having a diversified wallet with the 10 highlighted here would not have been diversified from a risk standpoint. If the correlations tend to 1.0, you effectively only have one operation. You may be wondering: does all of this mean that FRM Investment Risk has a resounding “no” when it comes to investing in cryptocurrency? It may come as a surprise to some given the analysis above, but we’re on board with that… with some important caveats.

Although having highly volatile and highly correlated assets without strong risk management and a proper volatility target is a recipe for drawdown, we can accept managers investing in crypto, but only in a small size and with a quantitative focus of reducing the odds. exposures when they become more volatile. In addition, we need to ensure that there is adequate liquidity (can you sell the asset at or near the current price?) and that there are no concerns about operational risk. Managers must have strong risk management around maintaining collateral and stop losses to avoid cash management issues. For more information on this topic, we recommend that you read the articles of our colleagues. crypto guide.

According to e-cryptonews.com, 10,024 cryptocurrencies have been launched as of May 2022. Of those, at least 2,400 (~24%) have already failed, and this does not include all cryptocurrency stores that have closed their doors since May. last year. This makes me wonder about George Bailey’s daughter line in It’s a wonderful life: maybe instead of “every time a bell rings, an angel gets its wings”, it could be updated to version 2022 “every time a bell rings, a cryptocurrency clips its wings”.

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