Krypto has an incest problem

Last year, the failures of crypto issuer Terra ricocheted across the crypto ecosystem, eventually claiming FTX, a giant in the space. This examination of court records shows how exposures to millions—if not billions—of dollars worth among companies like Three Arrows Capital, Voyager and Celsius allowed a ripple to turn into a tsunami.

It’s well known that crypto companies are tightly intertwined, but privately held firms like FTX usually don’t have to reveal their financial secrets. That changed when they were placed in the transparent fish tank in Chapter 11 bankruptcy.

The figures show a network that was interlocked, if not outright incestuous. That made the system less resilient overall. Legally unraveling the mess is going to be a long and expensive process, and spell bad news for those hoping for their money back. Regulators have already set themselves the task of ensuring that it does not happen again.

On January 30, FTX’s sister trading firm, Alameda Research, sought to recover about $446 million it had transferred to bankrupt lender Voyager Digital. Voyager and its creditors declined, saying Alameda’s “unfair and fraudulent conduct” had cost them over $114 million.

But that’s just the start of the charting of finances among crypto companies — including hedge fund Three Arrows Capital (3AC), Genesis and lenders Celsius and BlockFi — now in bankruptcy proceedings. (Genesis, like CoinDesk, is a subsidiary of Digital Currency Group).

After the TerraUSD stablecoin and Luna token collapsed, 3AC suffered around $200 million in losses, and was the first casualty to herald another crypto winter, a collapse that made further waves.

They all had relationships with the FTX empire too – even before Bankman-Fried rode in to save the sector after 3AC. As of July 5, Voyager was owed $377 million by Alameda. Around the time it filed for bankruptcy in November, BlockFi, also the target of Bankman-Fried’s white-knight deals, said it had $355 million in crypto frozen on FTX, plus $671 million in loans to Alameda.

Celsius also had an FTX exposure of billions. According to an investigative report, as of April, the lender had borrowed $1.5 billion in stablecoins from FTX and had over $2.5 billion in assets on the platform. Alameda also posted about $520 million of FTX’s original token FTT to Celsius — which was meant to back $814 million in loans, but whose value collapsed when the exchange did. Genesis owed $226 million and is reported in FTX’s bankruptcy filings as the largest unsecured creditor of FTX.com and its affiliates.

The smaller companies also lent to each other. As of July 5, Voyager reported a $17.5 million exposure to another bankrupt Genesis entity. Celsius has also sought to recover the $7.7 million it transferred to Voyager in the three months before it itself collapsed on July 13.

Meanwhile, 56 million shares of Robinhood, bought by FTX founders Sam Bankman-Fried and Gary Wang with the help of a loan from Alameda, sit in Emergent Fidelity, a shell company created specifically for the purpose, which has filed for bankruptcy in Antigua and the U.S. Around $600 million of its assets are now caught up in a complex legal battle between liquidators, the Department of Justice, FTX and BlockFi.

Regulators care about this kind of interconnection in finance because it makes the overall system less resilient and reliable.

In 2008, the failure of Lehman Brothers spread worldwide thanks to complex and opaque transactions. Standard-setters now measure coherence to determine whether a bank is too big to fail; too many assets and liabilities within the financial system and you have to issue additional capital.

So far, the crypto contagion has not spread further; with a few exceptions, such as Silvergate Capital, the sector is fairly well demarcated from conventional finance. But the pattern is used to justify regulation.

“The crypto-asset market is highly interconnected, which could lead to rapid contagion and the spread of stress among crypto-asset market participants,” the international standard-setter Financial Stability Board said in a consultation in October, where it proposed sweeping new standards for the sector.

Banks have tough laws on ownership, capital requirements and reuse of funds; crypto companies, at most, self-imposed norms that seem to be frequently violated. Celsius breached its own credit limits with major customers such as 3AC and Alameda, according to a court-appointed investigator; Bankman-Fried’s statement that FTX did not invest customer funds now does not seem credible. Alameda itself was able to borrow from FTX far beyond FTX’s client limit.

But beyond the financial risks is the practicality: When the mess hits the fan, intertwined companies are much harder to wind up.

If a large company goes bankrupt — such as Enron in 2001 — it’s not uncommon for others in the market to feel a second-order ripple, bankruptcy expert Mark Shapiro told CoinDesk — but crypto may be different.

“It doesn’t happen very often where you see this level of different companies connecting with each other,” said Shapiro, a partner in law firm Shearman & Sterling’s New York practice.

“All these companies were more interconnected than people probably could have appreciated,” he said, describing the crypto-euro as the biggest “domino effect” since Lehman Brothers.

US law already views with suspicion any transaction made up to three months before a bankruptcy, and any transaction deemed to be a fraudulent intermediary can also be repaid. Now, several judges in separate courts in New York, Delaware and New Jersey must sort through the complex web of transactions and decide what belongs to whom.

Tough luck for any customer waiting for their money, says Shapiro.

“Anything to do with FTX will take a while,” he said. Victims of Bernie Madoff’s Ponzi scheme had to wait around a decade for a solution; this may be similar.

Infographic by Sage D. Young

DIRECTION (February 17, 14:45 UTC): Gives full name to Mark Shapiro’s law firm Shearman & Sterling.