Digital Dives
We’ll get back to our regular bi-weekly cadence for Digital Dives going forward, but I wanted to get this one out to coincide with the anniversary discussed below. In addition, last week marked the 15th year since the collapse of Lehman Brothers. I’d be curious to get your thoughts on how that incident could also be placed in context of the crypto meltdown of 2022. Do many of the themes seem familiar across the crises?
Roger Lowenstein’s “When Genius Failed: The Rise and Fall of Long-Term Capital Management” is one of my favourite finance books and is often considered “required reading” for any youngster looking to enter the space. If you’re unfamiliar, LTCM was a hedge fund established in 1994, celebrated for being managed by several Nobel Prize-winning economists and renowned Wall Street traders, whose sophisticated strategies promised significant returns. The group even launched with a splashy initial capital raise of $1.25B, including considerable investments from the major financial houses and $100M of partner capital. However, its dramatic collapse in 1998 uncovered some indispensable lessons, which I think are relevant to the crypto contagion of last year as well. These are two seemingly different events, but with many common underlying premises.
The value of $1,000 invested in LTCM, the Dow Jones Industrial Average, and U.S. Treasuries:
To commemorate the 25th anniversary of the group’s implosion, Marc Rubenstein (whose Net Interest is also compulsory reading, in my opinion) wrote an account of the events surrounding the demise of the high-profile hedge fund. He acknowledges the common rationales cited for the fund’s collapse. Namely, overreliance on models and excessive leverage. However, the former bank analyst’s perspective on the disintegration emphasizes a lack of diversification and endogenous risk. You could say that the same pitfalls that brought down Long-Term Capital Management also played a part in the downfall of digital asset markets in 2022.
Crypto prices ended 2021 with a Q4 blowoff top, which led to a precipitous decline as the calendar flipped and the market began to brace for the first interest rate increases since before the pandemic. Prior thereto, rates sat at zero which had helped catalyze a dramatic rise in the values of “long duration” risky assets like BTC and tech stocks. The former had been used increasingly as collateral across the digital asset ecosystem, so when its price fell, the solvency of many projects and companies was brought into question.
The price performance of the Nasdaq 100 (LHS) and Bitcoin (RHS) in late 2021 and early 2022:
In August 1998, Russia devalued the Rouble and defaulted on its debt, leading to a broad-based market sentiment shift. This caused a liquidity crisis that severely impacted LTCM's $100B+ portfolio, which had become a major supplier of index volatility to investment banks, was active in mortgage-backed securities and had dabbled in emerging markets such as Russia. The fund had several strategies, and this may have given the illusion of diversification. However, its balance sheet was considerably exposed to a single risk factor. “If liquidity became more valuable (as it did following the crisis) its short positions would increase in price relative to its long positions.”
As he often does, Marc Rubenstein highlights another, less talked about exposure – endogenous risk – a hazard brought upon by the interaction of market participants. LTCM’s bank counterparties saw that it was in trouble, so they marked their OTC derivatives in an overly punitive fashion, which would accelerate the company’s eventual demise, but also make it easier to trade out of the assets once collected in insolvency.
As the fund’s losses mounted, the brokerage houses begun to doubt its ability to meet margin calls, but they were unable to force a liquidation for fear that such action would precipitate a crisis. Many copycat funds had put on similar trades and thus had also been extended margin from the major trading desks. A fire sale may have caused huge losses among LTCM’s counterparties and potentially even a systemic crisis in the event of a bank run if depositors got spooked.
On September 23rd, 1998, members of the New York Federal Reserve organised a rescue package through which a consortium of leading investment and commercial banks, including LTCM's major creditors, would inject $3.5B into the fund and take over its management, in exchange for 90% of its equity. The financial institutions booked significant trading losses when they reported Q3 results, and several executives departed their respective firms.
The crypto ecosystem was also plagued by a lack of diversification and endogenous risks, which exposed considerable leverage. The algorithmic stablecoin, UST depegged and eventually the once-popular Terra/Luna ecosystem was shattered. This generated significant losses for many participants and margin loans were called. A major hedge fund was made insolvent (there are any similarities to the LTCM case here as well). However, there is no Fed in crypto (yet), so the deleveraging had to work itself through the system naturally. Platforms which had effectively acted as banks, borrowing retail deposits in exchange for yield, found themselves with capital shortfalls as the losses compounded. They gated withdrawals, but most entered receivership. As the counterparty casualties piled up, not even the most private of balance sheets could avoid a reckoning. Alleged comingling of assets from a major exchange and its non-arm’s length hedge fund were exposed and again the market tumbled lower. There are many pending criminal cases across the space.
The flow of savings/capital and risk/losses in the case of LTCM and the 2022 Crypto Crisis:
As with LTCM, we can see that a lack of diversification and endogenous risks were catalyzed by an external shock to bring about last year’s crypto meltdown, the key difference being a coordinated bailout. It will be interesting to see how the digital asset ecosystem moves on from this. In the case of Long-Term Capital Management, the Fed’s actions have been criticized. They used their power to protect the banks and their customers, perhaps seeding a moral hazard problem by encouraging excessive risk taking. Some even believe this set the Great Financial Crisis in motion.
Maybe the turmoil of 2022 will reinforce a sense of accountability in crypto. We’ve seen considerable leverage leave the markets, but a ravenous appetite for risk and margin remains. As more traditional financial operators engage with digital assets, it’s possible that their cultures of risk management and regulatory oversight will bring some discernment to the space. Further, blockchain technology does provide considerable transparency advantages compared to the current system, which helps enforce accountability. However, as Rubenstein remarks: “Twenty five years on, the story of LTCM still resonates. At one level an Icarus tale of hubris, it is more usefully a case study in how markets work. Finance is rich with such stories…”
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