Wall Street’s latest ‘market manipulation’ scandal should be a wake-up call for cryptocurrencies

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This week saw the dramatic arrest and criminal indictment of Bill Hwang, the former manager of private hedge fund Archegos Capital Management. You may remember that Archegos blew up last March. The banks that had lent him money for large leveraged trades ended up losing $10 billion dollars.

There’s a fascinating discussion about whether what Hwang did was a full-blown fraud, but I won’t bother trying to top Matt Levine on that front. Instead, I want to focus on the financial mechanics of what Archegos was doing and why it is extremely important for cryptocurrency holders or traders to understand.

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The gist of it is simple: Archegos borrowed a lot of money and used it to buy very large amounts of about 10 different stocks. That purchase itself helped boost the stock, giving Archegos paper profits that it could use to borrow more money, which it then used to buy the same few shares, boosting them further. The leverage game produced incredible results for a time: Hwang reportedly launched Archegos with just $200 million in 2013, but at its peak, the fund’s paper value exceeded $30 billion, a return of 1,400%. in eight years.

But it was a tactic with a limited shelf life. Archegos over time built up absolutely absurd positions in several major stocks. According to the US Securities and Exchange Commission (SEC), Archegos once owned up to 45% of the outstanding shares of Tencent and more than 50% of the shares of ViacomCBS (now Paramount Global). One of the pillars of the fraud case against Hwang is that he lied to banks about these levels when borrowing money. And the way things have developed shows why banks don’t lend often or willingly to this kind of concentration.

ViacomCBS was the pin that popped the Archegos bubble. The stock went from around $35 in January 2021 to nearly $95 in March. I’m speculating, but it seems highly plausible that Archegos’ own aggressive buying (read: alleged market manipulation) contributed to the craze that prompted the sale of new shares. Either way, nearly tripling your money is good!

Except when it’s not. The run-up prompted ViacomCBS executives to issue new shares, which in turn deflated the stock, which fell 30% in three days. With its high levels of concentration and leverage, that 30% drop in a single stock ended up being enough for Archegos to win the world’s worst margin call. With the paper value of his holdings falling against his outstanding credit obligations, Archegos was forced to liquidate, ultimately destroying the entire fund.

See also: What does liquidation mean and how to avoid it?

But, and this is the really important part, there was still not enough to pay off their lenders.

Crucial Warnings

Archegos shows what could happen to any number of crypto assets that are leveraged or backed in a certain way. The key term here is outflow liquidity, and one takeaway is the danger of backing or concentrated holdings in a few assets that can suddenly collapse in a liquidity crisis. In many cryptocurrency ecosystems, token holders are in the same position as the banks that lent to Hwang: they risk getting caught in a token burning around them.

I wrote last week about the potential for a withdrawal from the terraUSD (UST) stablecoin, which, according to the most generous interpretation, is currently “backed” by a single asset, LUNA. Luna’s team is working to diversify that backing to avoid the kind of concentrated risk that destroyed Hwang, but their current goal would take them down to three different assets by adding BTC and AVAX. Hwang ended up being too fragile as he held close to 10 important positions.

Another suggestive parallel here is with the mechanics of crypto valuations in general, particularly when it comes to founders’ rewards, pre-mines, or other large pools of tokens held in relatively static blocks. As many have pointed out, the “market cap” metric touted by many tokens misses quite a bit due to these large allocations, which are essentially not in the market and often never have been. The same could be argued for locks on certain lending and sharing protocols.

See also: Lex Sokolin: The Basics of Crypto’s $2T Market Cap | Opinion

These large blocks of non-tradeable tokens inflate the total market value of the coins in much the same way that Archegos inflated its portfolio. Although pre-mine and stakeout effects are more subtle, they both create a misleading perception of scarcity or demand for an asset. And both, albeit for different reasons, can leave retail investors looking ripped off: If you saw ViacomCBS skyrocket in March of last year and bought it, it ended up being Bill Hwang’s exit liquidity when he torched it from $97 to $48 in just seven days. You could probably have a very therapeutic conversation with a SafeMoon holder.

And let’s not forget the poor banks (God forbid!). Credit Suisse, for example, bore the brunt of Archegos’ lenders’ losses, burning through $4.7 billion. That, in turn, was enough to knock Credit Suisse’s share price down nearly 18% in a matter of days after Archegos’ crash. The bank was already in trouble before this incident and its shares have not recovered in the year since.

Bill Hwang may be a criminal, or he may have simply been playing the Wall Street game according to an unwritten but accepted set of rules; after all, in this day and age, cheating and lying are practically qualifications to work in high finance. Crypto has the distinct advantage of transparency: Hwang couldn’t have caused as much damage if he hadn’t hidden his concentration and leverage levels from him. In most cases, similar behavior by a Layer 1 or other protocol would be much more visible. The question is whether traders and investors are paying enough attention to what’s on the blockchain to prevent a repeat of Archegos, in crypto form.

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