Procyclicality amidst the FTX crisis

During the past few weeks, prices of digital currencies have been continuously plummeting, as a result to the aftershock of the FTX crisis 1; though, how did that crisis even begin?

When an article claiming that FTX’s founder, Sam Bankman-Fried, held billions of dollars’ worth of FTT (FTX’s own cryptocurrency) in the balance sheet of Alameda which is a crypto fund owned by him, appeared online 2 , a sequence of events was triggered, which led to the crypto exchange giant Binance to back up from a deal to purchase FTX 34 , and to eventually sell its $500 million worth of FTT holdings 5 , leaving the world’s second largest cryptocurrency exchange 6 in a financial qualm.

Subsequently, the price of FTT plunged more than 50% in less than a week 7 and continued a downtrend, as around $6 billion had been pulled by FTX investors, in mere three days since the ordeal happened 8.

Consequently, since FTX could not manage the liquidity crisis it found itself in, it filed for Chapter 11 bankruptcy protection in the U.S. 9, though the consequences of that liquidity crisis, still ought to haunt the procedure to its end.

‘What will happen to the approximately $3bn that FTX owes to its largest creditors?’ 10, ‘How will this liquidity crisis expand further upon the crypto market and the broader financial industry?’ ‘Was Binance’s FTT selling what triggered the initial price plunging?’ 11, “Is the price of Bitcoin or Ethereum going to enter a downtrend, or an uptrend?”, “Is this a new Lehman Brothers situation?’.

Frankly, all the above are valid dilemmas, which every financial analyst, regulator, and investor alike would be pondering with at the current period.

Though, similarly to how one cannot see the future before it unfolds, one cannot be naïve enough as to be sure to the accurate prediction of one of the above questions; however, how are they all connected with each other? Or interaffected?

That question is simple to at least navigate through, by the mere application of a term called procyclicality.

But what is it? Procyclicality refers to the proneness of financial variables (Or simply, indicators that express the financial health of an entity) to oscillate around a trend during the economic cycle 12 ; as a rule of thumb, it is entailed that the more increased the phenomenon of procyclicality is, the broader the amplitude of fluctuations 13.

In more technical details, it is only logical to assume that it is difficult to trace where procyclicality originates from; meaning, it is difficult to discern what event triggered the economic trend which it applies to so that the true nature of the trend can be revealed. Practically, one eventually begs to question regarding the FTX Crisis, is the event that triggered the trend in question the bad publicity that promoted distrust and investor anxiety? Or is it the practical liquidity crisis which resulted from the Alameda circumstance?

This uncertainty is interconnected with certain expectations that the financial community has traditionally had; one example of the case, would be The Basel II Framework for international bank regulation, where through its Market Discipline Pillar placed faith to the fact that prices are relied upon to issue timely warning signals 14 , though the result of the Financial Crisis of 2008 showed that market discipline is nullified by other factors (i.e., market risk premiums) 15 , consequently showing that the transition from a neutral to a hostile environment can be precipitous, and that a crisis can be triggered not only by a big event, but also by many smaller ones 16.

Consequently, if one tries to predict the effect of procyclicality upon the current FTX crisis, they will most likely fail, since their findings and measurements of early warning indicators will be price-based 17 , rather than based upon specific financial trends and outlooks (i.e., perhaps big whales had previously shorted bitcoin, and now that it is following a downtrend, those people will profit, gaining from the general crypto crisis, thus actively pushing it to an upward position again. In that case, the trend upon which the follow-up procyclicality will apply into, will be the opportunistic buy out of the low, which will trigger futures and other complex financial events to coincide).

To be frank, procyclicality cannot be measured as having a predestined predisposition towards a down or an uptrend, especially with the events that are currently revolving around the whole FTX crisis, since, to the eyes of the beholder the coast is still cloudy.

However, if one speculation could be said about the overall trend (Whilst still maintaining a neutrality over the price-based bias), it would be perhaps the fact that there is a partial transfer of capital from FTX and any legal or physical entity connected to it, towards the global market (Non-excluding the fact that even Sam Bankman-Fried has stated that the whole order was heavily triggered by him excessively lending to borrowers, without having the necessary collateral assets to cover for it eventually 18 ).

Concluding, to better understand the effect of procyclicality amidst the FTX crisis, one needs to understand that the relevant financial variables range anywhere from profit to sales, to current liabilities to total capital, to the growth rate of current assets, and that their reactions between them and the global market (Remember the transfer of capital) will give away organically the trend which they oscillate around.

Though, when it comes to when that will become obvious, all one can say, is that it is up to each trader to decode the messages; for, that is where true craftmanship will separate the dilettantes from the savants.

Concluding, as a leading investment firm, AAATrade, encourages its investors and traders to be educated and well-informed prior to investing in new products/companies. Therefore, we offer a vast variety of products to invest in, that can fit the profit/risk model of the novice and professional clients, as well as the necessary analysis material for them to base their choices on.