Written by: Jonah Van Bourg, Global Head of Cumberland Trading
There are two ways to tell the story of 2022.
The first way, the generally accepted narrative, says that a BTC selloff lit a fuse, LUNA was the detonation, and the rest of the year was fallout.
A decline in BTC of around 40% between January and May dragged LUNA down from $125 to $75. The selloff in LUNA caused UST to de-peg, which in turn vaporized LUNA to $0. A few months later, we learned that one of the largest funds in crypto was deep underwater, subsequently going broke. That, in turn, inflicted lethal wounds to the lenders. And though we wouldn't find out for months, it also put Alameda deep in the red, and when FTX tried to bail them out, the exchange went insolvent as well.
All those cumulative losses trace back to the LUNA/UST collapse.
All of those things happened. It's a true story, but with the wrong lesson.
Here's another way to tell the same story.
In 2021, some funds made directional bets in crypto, which were wildly profitable. They used those profits to make larger bets. Solana profits rolled into LUNA and AVAX bets, and when those paid off, the profit rolled into NEAR, FTM, and ONE. The only take-profits were the ones used to roll into a higher beta, smaller market cap. While crypto's overall market cap rallied from $600b to $3t, most crypto fund's AUM did much more than a 5x. Lenders scrambled to gain market share, a race to see who could create the largest loan book the fastest. Dreams of IPOs danced through founders' heads. Caution be damned.
And then something happened. The fact that it was LUNA/UST doesn't really matter...when the market is systematically taking as much risk as possible, and laying its risk out to lenders, it doesn't matter what ends the party, because it's going to end eventually. LUNA just ended up being the one to turn off the lights.
The problem was not that risk was available. Risk is always available, and as long as there is incentive to take risk, traders and investors will do so. What was severely lacking in the crypto industry this year were risk controls.
Risk is intrinsic to trading, but unchecked risk is a cardinal sin. In general, it's the trader's job to find the trade, and it's the risk manager's job to place sensible limits on the trade. The organization's job is to empower the risk managers.
Generally, the firms which were able to weather the storm in 2022 were the ones that came from established institutions, and it's not because they had larger balance sheets. It was because they understood the core tenants of risk management and likely had dedicated risk managers.
Trade sizing is not the only vector here. If an entity is lending assets into the market, counterparty risk is unavoidable. That's one of the reasons borrowers pay interest. However, time and time again this year, we saw lenders concentrate their entire fortunes on one counterparty. Likewise, we saw trading firms and venture firms bet their entire futures on a single exchange, a bet which seemed like a 99% certainty. With every decision, firms should be considering the absolute worst-case scenario, and asking the question: "If this occurs, do we survive?"
Warren Buffet's famous quote applies here: “You don't find out who's been swimming naked until the tide goes out”. This year, unfortunately, the tide has been going out since the beginning of April, and observers have been shocked at the lack of bathing suits. It's only obvious in retrospect which firms didn't have strong risk controls, or even worse, which firms had none.
It bears repeating: market volatility doesn't bring down trading desks; poor risk management does.
Here's a confession. I am max bullish on crypto. Five years ago, I bet my career on this space, then toughed it out through the 2018-19 bear market, the March 2020 crash, and I'm a few weeks away from surviving 2022. From a thesis standpoint, I am so bullish that it hurts. So the question becomes: when you're that bullish, what do you do?
In crypto, we like to say "WAGMI." But as we've seen this year, unfortunately, not everyone is going to make it. Anyone who is fundamentally bullish on this technology should have one goal: make it. Don't blow up.
There are many ways to blow up in crypto, but most of them fall into two categories: leverage and concentration. We express our max bullish stance by taking the steps to ensure that, when the crypto utopia arrives, we are a part of it. The worst-case scenario would be seeing the thesis play out but not being a part of it. This affects our decisions on how to trade and who to partner with, and every decision we make is with a time horizon of the next decade, not the next year.
As an industry, we have to get past this cycle of "Bad news happens, someone goes down, speculation abounds at contagion effects, self-fulfilling prophecy manifests the next wave." Because as much as we like the coins, this market will get hit by negative catalysts, and if the infrastructure providers (like lenders and exchanges) in particular do not have strong risk practices, we will end up in the contagion cul-de-sac again and again.
The truth is, none of what happened in 2022 was a crypto-specific phenomenon. TradFi had its own "does this industry even have risk managers?" moment in 2008, and the direct result was Dodd-Frank. Regulation in crypto to prevent another FTX is most likely coming, and we shouldn't be afraid of it; instead, we should strive to work with regulators to establish responsible guardrails for the industry.
A final point. 2022 was the direct result of 2021. Last year's sharp rally had the unintended consequence of rewarding the most aggressive risk-takers with the largest balance sheet and the biggest soapbox. The market treated some folks as if they were saviors when really, they were just irresponsibly long. 2023 will be the direct result of 2022, so we do expect to see a more careful approach to risk, and at Cumberland hope to help build a more resilient market.
Read Part 3 of our Year in Review series, “Emerging Narratives for 2023.”
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