Sentinel species are organisms that are used to detect risks to humans by providing advance warning of danger. In 1895, John Scott Haldane proposed the canary as just such a sentinel species for coal miners.
Canaries are especially well suited to be early detectors of airborne poisons, such as carbon monoxide, as they intake oxygen when they inhale and exhale. The double dose of air combined with their small size and high metabolic rate offers an ideal early warning system for miners.
Canary in the Market
Though canaries have been replaced with electronic warning systems in the mining industry, their use as an early warning system serves as an excellent metaphor and mental model for monitoring financial market risks. While largely forgotten in today’s “AI” and technology-driven market, there were a series of canary deaths in recent times that contain important signals regarding ongoing risks.
In order to explore potential systemic risks that may be signaled by recent market canaries, it is helpful to review a sample of the deaths. While not meant to be an exhaustive list of recent failures, the following chronological list captures the underlying themes behind the market canaries.
June 16, 2023: France is investigating Binance for money laundering.
June 8, 2023: A prominent VC figurehead announced that “If you’re in crypto pivot to AI.” The announcement bookmarked the end of the 2023 VC migration from crypto to AI. Not surprisingly, public and private company AI valuations quickly reached the stratosphere.
June 5, 2023: Binance, a Cayman Island LLC and the world’s largest crypto exchange, along with its founder Changpeng Zhao were accused of misusing investor funds, operating as an unregistered exchange, and violating various U.S. securities laws. The SEC lawsuit listed 13 charges including commingling and diverting customer assets to an entity Zhao owned, Sigma Chain. Of note, Binance accounted for 90% of Bitcoin’s trading volume entering 2023. The importance of this concentration lies in Bitcoin being the foundational crypto asset.
May 1, 2023: First Republic Bank was closed by the California Department of Financial Protection & Innovation and was taken over by the Federal Deposit Insurance Corporation and sold to JP Morgan.
March 17, 2023: Credit Suisse received a lifeline from the Swiss National Bank to enable the company to explore strategic options over the weekend. In a deal brokered by the Swiss government, UBS agreed to take control of Credit Suisse on March 19, 2023.
March 12, 2023: Signature Bank was closed by the New York State Department of Financial Services and taken over by the Federal Deposit Insurance Corporation.
March 10, 2023: Silicon Valley Bank was closed by the California Department of Financial Protection & Innovation and was taken over by the Federal Deposit Insurance Corporation.
December 12, 2022: Sam Bankman-Fried was arrested in the Bahamas after federal prosecutors in New York filed criminal charges. On December 13, 2022, the U.S. Securities and Exchange Commission charged Bankman-Fried with defrauding investors.
November 11, 2022: FTX filed for Chapter 11 bankruptcy protection. Celebrity boosters of FTX were sued in federal court in a class-action lawsuit alleging that false representations were used to dupe investors.
November 9, 2022: Sequoia Capital, a prominent VC firm, wrote down its stake in FTX to $0.
November 2, 2022: CoinDesk published an article and found a significant portion of Alameda Research’s assets, a crypto hedge fund founded by Sam Bankman-Fried, consisted of FTT, a token created by FTX; also founded by Sam Bankman-Fried.
April 27, 2022: A Federal indictment charged Bill Hwang and Patrick Halligan with racketeering conspiracy, securities fraud, and wire fraud offenses in connection with unlawfully manipulating securities and defrauding investment banks and brokerages. Bill Hwang is the founder and head of Archegos Capital Management and Patrick Halligan was the firm’s Chief Financial Officer. Hwang allegedly turned $1.5 billion of capital into a $35 billion portfolio via private derivate bets spread across various Wall Street firms.
March 24, 2021: Wall Street banks began liquidating the positions of Archegos Capital Management, a $36 billion investment firm founded and run by Bill Hwang. Bill Hwang was a seed investor for Cathie Wood’s Ark Invest. The company had amassed massive positions in a few media companies via swaps spread across many Wall Street firms. By the end of the liquidation, Credit Suisse alone had lost nearly $5 billion in its dealings with Archegos.
The Canaries
There are several common themes or risk vectors embedded in the above canary timeline. Of note, the first failure was Archegos which occurred at the same time as the psychological stock market peak of Q1 2021. The first quarter of 2021 featured the blowoff top in meme stocks, cryptos, and “innovation” stocks generally.
Archegos
As the first canary, Archegos shines the spotlight on a primary risk vector, shadow banking. In this instance, the shadow banking activity was with Wall Street banks via swap agreements. The 24x leveraged portfolio that Archegos was able to build in a few stocks was not visible to the markets until the collapse.
In the case of Archegos, as with most of the cases in the canary timeline, the extreme leverage and associated risks were invisible to the public markets. Investors could only infer the potential risks by observing the unusual activity in the underlying securities or investments themselves. This is important to keep in mind when unusual price activity is observed as the price behavior may contain systemic risk signals.
Ark Invest
Interestingly, Bill Hwang seeded Cathie Wood’s Ark Invest. The company’s flagship fund, Ark Innovation (NYSE:ARKK), is the poster child of the Q1 2021 psychological market peak. Given the concentrated strategy employed by Ark and its large positioning in individual companies relative to market liquidity, Ark was able to move its stocks higher in a parabolic fashion. The market impact was similar to that of Bill Hwang’s strategy at Archegos.
Ark Innovation proceeded to collapse by 81% and remains 61% lower today. Common threads connecting the investment strategies of Archegos and Ark Invest include a disregard for valuations, leveraged positions (Ark Invest leverage includes concentrated positions and a large percentage of the float), industry concentration, and executive/founder concentration.
Crypto
Ark Invest is also a large investment backer of the crypto industry. This includes large equity positions in Coinbase, Block, and Tesla. Interestingly, Tesla and Elon Musk were large liquidity suppliers to the crypto industry at the Q1 2021 peak, both directly and promotionally.
The crypto risk vector picked up pace with the failure of FTX, which was essentially a Ponzi scheme supported by leading VC firms, top celebrities, and politicians. Following the FTX scandal and crypto collapse, the failure of Silicon Valley Bank can be viewed as a VC industry risk vector.
VCs
The VC industry displayed clear signs of over concentration, both socially and professionally, via a one-day bank run on Silicon Valley Bank. VCs conducted a bank run on the industry’s primary banking institution. As they have shown to be homogenous, the eagerness to flee Silicon Valley Bank suggests that there are more canaries to come from the VC industry.
Banks
With systemic banking sector risk on the table following the failure of Silicon Valley Bank, Credit Suisse’s failure speaks to the financing connections throughout the above timeline. In fact, Credit Suisse was exposed as the original banking sector canary by losing nearly $5 billion in its shadow banking activities with Archegos. The failure of First Republic, which was focused on wealth management and banking in Silicon Valley and in the VC community, reflects the common financing failure behind the canaries.
More Canaries
Finally, with Binance under investigation and facing charges, pulling on the strings of the largest crypto exchange is highly likely to reveal many more canaries from the crypto and VC industry. The failures to come may be quite large on paper. This is especially the case in light of the leverage that Archegos was able to build in its shadow banking activities with Wall Street banks.
Given the lack of regulation and disclosure, the leverage within crypto shadow banking and private shadow banking generally could turn out to be extraordinary in comparison to that of Archegos. Nonetheless, the canaries are highly likely to be concentrated in the above socio-economic groups, as has been the case to date. As a result, the broad economic impacts are likely to be marginal.
Canary Themes
The following list is my summary of themes or categories which weave throughout the market canaries to date. As these risk vectors are ongoing ripples, they serve as a watchlist of risks to avoid given recent trends. That the VC community quickly rotated to AI from crypto is a red flag for the recent exuberance and hyperinflation in the AI space given the industry’s track record in recent times.
- Shadow banking activities, including crypto and private shadow banking
- VC backed and/or promoted links to “innovation”
- Crime, fraud, and/or questionable business practices
- California / West Coast / technology industry
- Valuation disregard / hyperinflated asset prices
- Highly leveraged, either financially or operationally
- Concentrated positioning and/or lack of diversification across risk vectors
- Deposit or capital run risk / heightened liquidity risk
- Exposure to cryptos
Summary
The market canaries to date share many themes which represent the primary vectors of systemic risk today. Such risk vectors are best avoided if possible. As the scale of the risks is mostly hidden from view via shadow banking activities, one must stay alert to unusual market behavior for signals.
With history as a guide, there are likely many shoes left to drop, canaries in the market as it were. While there remain extremely asymmetric risks, there are also asymmetric rewards as discussed in the recent duration series. Being mindful of both the canaries and the opportunities is necessary to prevent signal loss in the markets.