The typical way I start writing my weekly post is by having a staring contest with a blank Google Doc (if you’re wondering, the doc always wins). But not this week! This week, the post kind of wrote itself.
This past week, FTX went insolvent. It experienced a bank run and had to stop customer withdrawals. The last estimate is that the company is facing a $8 billion shortfall. It is one of the fastest occurring and most spectacular blow-ups of one of the largest private companies ever occurred, and we were all able to see the implosion in near-real time, thanks to Twitter (which makes this a real-world version of the movie Margin Call – great movie btw).
But first, let’s talk about the latest in macro.
The stock market jumped 5% last week
Markets went up because inflation came in less hot than expected. Of particular interest is the core inflation level (the orange bar in the chart below, as that measurement excludes costs of food and energy, which are elevated due to the Ukraine war).
The worst of inflation might be over. But as we discussed elsewhere, the Fed’s favorite measurement is the personal consumption index, which tracks consumer spending, rather than prices of goods and services. The October value for that measurement has not been released yet. But if that comes in hotter than expected, then expect the Fed to continue on its jumbo interest rate hikes.
And now, to FTX…
The collapse of FTX
To understand what happened, we must start at the beginning.
Arbitrage on the Kimchi premium
Sam Bankman-Fried (or SBF) started Alameda Research, a crypto quantitative hedge fund in 2017, to take advantage of the BTC price arbitrage between the US and East Asia – mainly in Japan and South Korea, which at the time experienced a BTC price discrepancy as high as 50% (colloquially called the Kimchi Premium).
After some time, the arbitrage opportunity evaporated. A year or so into Alameda’s existence, SBF set his sights on a larger opportunity: building his own cryptocurrency exchange. He and his team did so by first focusing on the derivatives market. And because the regulatory regime in the US was not keen on this, he moved FTX to Hong Kong, and then to the Bahamas.
Note that there are two FTXs. The one referred to as FTX is the international version, and as of last week, was the second largest crypto exchange in the world. The US version, FTX.US, is much smaller and is a separate entity – more on this later.
Fast forward to about a week ago. Despite its size, the relationship between FTX and Alameda was not clear. On paper, both are different legal entities, and it was unclear if they co-mingled their funds (turned out they did). What was clear over the years is that Alameda acted as a liquidity provider to FTX. It is the counterparty for FTX retail trades.
But let’s not be encumbered with such trivial details just yet. For the better part of 2022, SBF was winning. In January 2022, despite the crypto free fall, FTX was able to raise a $400 million investment, at a $32 billion valuation. Around the same time, FTX.US raised the same amount of money at an $8 billion valuation.
Meanwhile, crypto prices continued to crumble. This triggered cascading failure events beginning in May 2022. First, the Terra/Luna stable coin (a Ponzi scheme) collapsed (this was a $60 billion implosion). Then the crypto hedge fund, 3AC, went bust, burning about $10 billion in the process. This in turn caused multiple bankruptcies in the US: Voyager Digital, BlockFi, and Celsius. Turns out, all these firms lent out to one another…
During this bloodbath, SBF came out as the hero. In June 2022, he bailed out Voyager Digital and BlockFi. To calm the market, he also said that FTX had a $1 billion war chest to bail out other distressed crypto firms.
The bravado worked. The press went as far as comparing SBF to John Pierpont Morgan (founder of J.P. Morgan Bank), who acted as the lender of last resort during the banking panic of 1907 (the Fed was not around back then).
As recently as September, FTX was in talks to raise more funds. SBF’s reputation was at its peak. About 5 weeks ago, Sequoia dropped a 10,000 word piece on its website. In it, the author wrote very effusively about SBF. The page has been an item of parody on Twitter and has since been taken down, but you can find a cached version of the page here. Just to give you a sense of the absurdity, here are a few passages taken from it (feel free to skip them – but if you need a chuckle… facts are indeed stranger than fiction).
The leak
Fast forward to November 1st 2022, CoinDesk published a review of a leaked balance sheet of Alameda Research. It revealed that much of the net equity (the difference between its assets and liabilities) in Alameda’s balance sheet comprised FTX’s token, FTT (which was printed-out-of-thin-air digital money).
Three days later, on November 4th, a newsletter further questioned the solvency of Alameda. In it, the author compared what Alameda/FTX were doing to Celsius, which also blew up because it traded its users’ funds. In short, Alameda, using FTX, created money out of thin air by pumping FTT token price, carried out wash trades to generate trading volume to support FTT’s price, and used said tokens as collateral to borrow leverage for trading.
There are several problems with this:
- If the liabilities are USD and assets are tokens, Alameda’s assets are depreciating rapidly in this current environment. That is bad.
- And if the assets are largely your own token (FTT), the degradation of FTX’s business will depress the value of these tokens. That is doubly bad.
- And if the total value of the FTT tokens held far exceeds the total market value that is being openly traded, you will not be able to sell without further depressing the price. This is triply bad.
- And if your primary competitor gets wind of this? Game over.
Enter CZ
Changpen Zhao (or CZ) is the CEO of Binance, the largest crypto exchange in the world. It was one of the first investors in FTX when it was founded in 2019.
But as FTX became larger, competition between FTX and Binance became heated. Binance then exited its FTX investments sometime in 2021.
Four tweets to kill your competitor
On November 6th, a couple of days after the aforementioned leak, CZ tweeted that they would dump FTX’s token FTT. This was the start to four tweets that led to the death spiral.
- 16 minutes later, the CEO of Alameda research tweeted that they’re willing to buy the tokens at $22 per token (in an attempt to support the price and prevent a bank run).
- That same afternoon, SBF reiterated that everything is fine. This was a untrue. WSJ later reported FTX was hit with about $5 billion in withdrawals that day.
- Tech news sites reported that FTX was slowing down withdrawals.
- Two days later, on November 8th, SBF reassured users that FTX.US is separate and is not facing a liquidity crisis.
- That same day, both CZ and SBF announced that Binance might be bailing out FTX (it signed a non binding letter of intent, pending due diligence. In other words, a free option to look under the hood).
- The next day, November 9th, WSJ reported that Binance pulled out. “Sad day. Tried, but ?” — CZ
- On November 11th, FTX and all its affiliates (including FTX.US and Alameda Research) filed for bankruptcy. SBF stepped down as CEO and will be replaced by John Jay Ray III, who was Enron’s lawyer.
What exactly happened?
It’s still unclear what exactly happened. It’s possible that during the period when SBF was rescuing other firms, Alameda Research likely became insolvent as well, and the rescue attempt was to paper over its own losses. It’s also an open question as to the source of funds for these rescues. Whatever the case maybe, it is now reported that to cover the hole in its balance sheet, FTX sent users’ funds, to the tune of $10 billion, which is more than half of its customers’ assets, to Alameda to keep it solvent.
CZ’s tweets triggered a bank run. In the weekend of November 5th, FTX saw $5 billion in outflows, and contrary to SBF’s tweets (some are now deleted), the exchange ran out of cash and had to freeze withdrawals. But by then, the death spiral had begun. The value of the FTT token was in a free fall. The house of cards collapsed.
The story is not fully written yet. As of this writing, the other shoe is still dropping:
- BlockFi, which was in the process of being rescued by FTX, is suspending withdrawals again. Rumor has it that the only reason that FTX ‘rescued’ BlockFi is to move customers’ funds to FTX’s custody.
- Voyager Digital is still insolvent and is reentering its Chapter 11 restructuring again, now that FTX itself is bankrupt.
- US regulators are probing FTX.
- There are reports of FTX being hacked.
- SBF apparently built a “backdoor” to FTX’s accounting software to enable him to change financial records and move funds without alerting others.
- FTX is custodian for large crypto institutions. Some may become insolvent in the coming days. One has already revealed that half of its capital is stuck in FTX.
