Welcome back,
In this newsletter, I’m going to try to break down what happened with FTX and how this event will impact the industry. Given the vast amount of information and reporting around FTX, I tried to consolidate as much of these news stories as possible in the piece below.
Please keep in mind, this story will continue to unravel in the coming weeks and months, so what I write is what we know as of today.
I hope you enjoy and see you soon.
-Katja
P.S. As you probably noticed, I’m going to re-work how I do these newsletters and when I post. Please bear with me as I try to figure out the best way to bring you blockchain-related news with the most high quality information. Thank you to everyone who has supported me and Crypto Monkey Blog this far - it truly means a lot.
The downfall of FTX
Background
If you asked me two weeks ago to describe what happened with FTX, I would begin with “the rivalry that went south” between two individuals: Sam Bankman-Fried (“SBF”) and Changpeng Zhao (”CZ”). As of late, I think the narrative has shifted to put more focus on the inner dealings of Alameda and, consequently, FTX. This week’s newsletter will focus on just that.
In 2017, CZ launched Binance and, within eight months, it grew to the largest crypto exchange in the world. Around the same time, SBF co-founded his first company Alameda Research, which started as a quant crypto trading firm, and later became the largest crypto market maker and a hedge-fund. Two years later, SBF launched a crypto derivatives exchange called FTX, which soon developed into one of the largest exchanges, behind Binance.
Some nuances,
Market maker - (typically a large bank or financial institution) ensures there’s enough liquidity in the market so trades can be done seamlessly by buying and selling assets to satisfy the market
Makes money on price spreads as well as charging commissions for providing liquidity to a firm
Hedge fund - pools investor money and bets on various assets (like derivatives and securities)
Maximizes returns while hedging against risk
Makes money on fees and percentage of positive returns
Brokerage - takes customer orders and gets them filled either directly through an exchange or indirectly by “shopping around” the order to other traders
A brokerage is an intermediary between a trader and the market
Makes money on commission fees
Crypto exchange - matches customer buy and sell orders and provides a platform for settlement
A crypto exchange is an intermediary between a trader and other traders
Makes money on trading fees
Bank - distributes money across savers and borrowers (takes in money and lends it out)
Makes money on interest and fees
These entities all function under different regulations (at least in traditional markets), which exist for a variety of reasons like avoiding risk and conflicts of interest. The same regulations do not exist (or barely exist) in the blockchain industry.
Ultimately, this will help underscore what went wrong with FTX and Alameda (more on this throughout the newsletter).
For a brief summary, Alameda,
Was making massive bets
Pledged illiquid assets (with no value) for collateral to finance these bets
Got margin called as markets went down, especially after the Terra-Luna collapse
Leaned on FTX to help it stay afloat as investors demanded their money back
Received money from FTX, only to lose it again
On the other side of the aisle, FTX,
Started as an exchange (serving as a platform for facilitating trades and charging trading fees - basically what Coinbase does now)
Expanded its responsibilities to a brokerage (opening the scope to riskier trades with leveraged positions, which would come out of user wallet funds)
Gave Alameda loans (user wallet funds) to finance Alameda’s risky bets, essentially making FTX into a bank (and exposing it to risk of a bank-run)
Did not have funds to pay back its users once everyone demanded their money back (brought on by Alameda’s leaked balance sheet and CZ’s tweets)
Also worth mentioning now - the entire system functioned through a made-up token (FTT) created by SBF for FTX trading.
An obvious questions, which we still don’t have answers to: Where were regulators, especially ones in the US?
Alongside the platform, SBF also launched FTX Token (”FTT”). FTT served as a utility token providing access to the crypto exchange. By holding FTT, users could gain access to special features and services, like trading discounts and VIP status. From the exchange’s perspective, these tokens can help “lock in” users to the platform through the offered benefits they provide.
[For background - In a crypto exchange, the user deposits funds (lets assume USD) from his or her bank account into the exchange. Trades can be done with USD directly or the USD can be used to buy FTT for trading purposes (allowing for reduced trading fees and other benefits). Typically, traders will not deposit, trade, and withdraw their USD from the exchange within the same day. In fact, many exchanges have a minimum amount of days before allowing withdrawals from the platform (at least in the US). Therefore, most traders will have their money sitting in the exchange, even if they’re not actively using it to trade.]
Occasionally, FTX would also use a portion of its profits to buy back FTT. Therefore, FTT became tied to how well FTX was doing: the higher FTX’s profits, the less FTT in circulation, and the higher the price of FTT. Even though FTT is not a stock in FTX, it ended up behaving like one.
It should be noted that the owners of FTT were highly concentrated, with 10 of the top wallet addresses (accounts), holding 93% of the total (circulating) FTT supply. FTX and Alameda owned the vast majority of FTT tokens (about 90% of total supply) with Binance owning around 7% (of total supply).
Soon after FTX’s inception, Binance made an equity investment into FTX. As CZ said,
“The FTX team has built an innovative crypto trading platform with stunning growth. With their backgrounds as professional traders, we see quite a bit ourselves in the FTX team and believe in their potential in becoming a major player in the crypto derivatives markets… We are pleased to have an excellent partner joining the Binance ecosystem and aim to grow the crypto market together.”
Although the relationship seemed positive at first, it quickly developed into a rivalry, which came down to (allegedly) SBF lobbying regulators against Binance behind closed doors. [I will not go into the rivalry here, but you can read this article for more information.]
Eventually, FTX decided to buy back Binance’s shares of the company. FTX bought those shares for $2.1 billion USD equivalent in cash of BUSD and FTT. Even though Binance (technically) no longer had an equity stake in FTX , it ended up owning a large share of total FTT supply (the “informal equity” as discussed above).
[Where FTX got the money to buy back these shares is currently under investigation.]
The downfall: day-by-day recap
Wednesday, November 2nd
CoinDesk obtained a leaked Alameda Research financial statement. In its report, CoinDesk outlined the assets making up the hedge fund’s balance sheet as of June 2022,
Total assets - $14.6 billion
$5.8 billion FTT
$1.2 billion SOL (Solana’s token)
$3.4 billion unidentified “crypto held”
$2 billion “investments in equity securities”
$134 million in cash
The rest in other ****tokens (Serum, Oxygen, MAPS, and FIDA - all SBF projects)
Total liabilities - $8 billion
$7.4 billion loans
$292 million FTT owed
The rest unidentified by the article
This paragraph from the report, sums up what you’re seeing above,
“That balance sheet is full of FTX – specifically, the FTT token issued by the exchange that grants holders a discount on trading fees on its marketplace. While there is nothing per se untoward or wrong about that, it shows Bankman-Fried’s trading giant Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto. The situation adds to evidence that the ties between FTX and Alameda are unusually close.”
Bottom line: Alameda was heavily tied up with FTT. Although not inherently an issue, it can quickly become a catastrophic one. Like mentioned previously, FTT is technically a liquid asset (can easily be converted to cash at any time). However, the concentration of FTT owned by FTX and Alameda, make it much less liquid, since either entity selling would cause a downward spiral in price.
With Alameda not being able to sell, it faced a few options when it came to obtaining liquidity, something that it needed to do when the markets experienced a downturn and investors started pulling out. However, these alternative ways of increasing Alameda’s liquidity only work during a prospering bull market. See the chart below for a summary,
During bull markets, FTT also does well, just remember its business model,
However, as we’ve all seen over the past several months, 2021 has turned into a deep, bear market, with notable crises around Terra-Luna, 3AC, and Celsius collapses alongside the generally wavering market sentiment. [On the point of Terra-Luna, SBF himself admitted this was a major cause of risky leverage building up at Alameda.]
And now consider what happens on a technical level when a bear market hits and all you have is a made-up coin for collateral,
“The worst case is something like:
You have 100 Customer As who are long Bitcoin on margin: They each have 1 Bitcoin in their accounts and owe you $10,000.
You have 100 Customer Bs who are short Bitcoin on margin: They each have $20,000 in their account and owe you 0.5 Bitcoin.
You have loaned 50 of the Customer As’ Bitcoins to the Customer Bs, and $1 million of the Customer Bs’ dollars to the Customer As. You keep the other 50 Bitcoins and $1 million as collateral.
Your accounts show that you owe clients 100 Bitcoins and $2 million, and that they owe you back 50 Bitcoins and $1 million, and you have 50 Bitcoins and $1 million on hand, so everything balances.
You have one Customer C who says ‘hi I would like to borrow 50 Bitcoins and $1 million, I will secure that loan with 150,000 FTT, each of which is worth $20.’
You say ‘sure, sounds good,’ and hand over all your collateral.
Now you have 150,000 of FTT, worth $3 million, as collateral (and no Bitcoins or dollars).
Your accounts show that you owe clients 100 Bitcoins and $2 million and 150,000 FTT, and they owe you back 100 Bitcoins and $2 million, and you have 150,000 FTT of collateral, so everything balances.
But then if the value of FTT drops to zero, you have nothing. You have no Bitcoins to give to the customers to whom you owe Bitcoins, no dollars to give to the customers to whom you owe dollars. You just have to call up Customer C and say ‘hey we need all those dollars and Bitcoins back.’ But Customer C will not want to give you back all those valuable dollars and Bitcoins in exchange for now-worthless FTT.
Not only was FTT made-up by FTX, but this token was heavily correlated with the business itself (pseudo-equity stake). This equates to a bank lending money against its own stock, which as Matt Levine points out is “very dark magic” and possibly illegal.
[Was this a liquidity or solvency crisis? See this Bloomberg article and this newsletter for more information. For more on what went wrong, see this Forbes article.]
A lingering question: Why was FTX so invested in helping Alameda? I think for two reasons, 1) (most importantly) if Alameda failed, it would be forced to sell its FTT holdings, which would also take down FTX, and 2) the personal connections that existed between the leadership of the two entities.
[This discussion mainly focused on qualitative evidence that has come out of reports and investigations. For on-chain data analysis, see Nansen’s deep-dive into the transactions leading up to FTX and Alameda’s collapse. If you’re still interested in more of the high-level analysis, I would recommend reading Matt Levine on Bloomberg.]
Sunday, November 6th
Naturally, the CEO of Alameda, Caroline Ellison, had to respond to these claims,
Very few actually bought that argument. Most notable of the skeptics, CZ decided to sell off his FTT holdings after seeing the news around Alameda,
CZ’s tweets triggered an industry-wide response and a wave of $5 billion worth of withdrawal requests hit FTX, which caused the price of FTT to plummet.
Did CZ know how much of an impact his tweet would have? We won’t ever know the real answer to this question. My best guess is that he wanted to hurt SBF’s reputation (and company), but he didn’t realize how badly positioned FTX was.
Monday, November 7th
The following day, Caroline, CEO of Alameda, tweeted the following,
This fueled the fire by suggesting that 1) FTT was worth exactly that (no matter what the market decided) and 2) once FTT broke through that level, there would be liquidations. SBF tried to put out some of the flames by first tweeting, “FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries).” He later deleted this tweet, but it will likely come back to haunt him during the ongoing investigations.
Tuesday, November 8th
In the background of all the reassurances to users, SBF was shopping around FTX to other companies. It seemed like Binance had stepped up to take the charge and rescue FTX before users got hurt.
At this point, FTX also halted the continual and incoming withdrawal requests.
Wednesday, November 9th
Just 24 hours later, Binance backed out of the deal.
As CZ explained, Binance could not go through with the acquisition because of the following reasons -
FTX had a large financial hole with millions of dollars missing and accusations of misappropriation of user funds
FTX regulatory investigations made it a highly risky and undesirable acquisition
Binance would not gain many new users (high overlap between the companies and Binance had greater reach across geographies)
Binance had more advanced technologies than FTX
All legitimate reasons, but only the first can be crowned the winner. Just take a look at (the now leaked) balance sheet FTX sent around during the acquisition talks,
As Mark Levine put it,
“It’s an Excel file full of the howling of ghosts and the shrieking of tortured souls. If you look too long at that spreadsheet, you will go insane.”
A few highlights -
$8 billion entry titled “hidden, poorly internally labeled ‘fiat@’ account”
Before the crash, FTX held $19.6 billion of assets
$12.2 billion of that came from tokens FTX had made up, including FTT, SRM, and MAPS [for more on the made-up tokens, I highly recommend reading this article on Bloomberg]
An additional $2.3 billion came from SOL, a token FTX did not make up but had close associations with
The remaining $5.1 billion was in illiquid venture investments, cash, crypto, and Robinhood stock (making up about $580 million of that remainder)
Overall, a disaster of a balance sheet. After seeing this, it’s really not a surprise why no one wanted to buy out FTX.
[ Here’s a chart to visualize these numbers.]
Friday, November 11th
Only nine days after the initial CoinDesk article, FTX, Alameda, and 130 subsidiary entities filed for Chapter 11 bankruptcy, SBF resigned as the CEO of FTX, and an estimated $8 to 10 billion of customer funds are still missing.
John Ray III, who helped manage Enron after its 2001 collapse, stepped in for SBF to sort out internal matters as the bankruptcy unravels. In Ray’s own words,
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”
[For a short breakdown of the filing, see this Bloomberg article or this video.]
In addition to Ray’s investigation, the Securities and Exchange Commission (SEC) has also launched a probe into the matter. Congressional hearings have also started to take place with more on the way. The main goals are to figure out,
What went wrong?
How it happened so quickly?
Will users be made whole again?
SBF is currently in the Bahamas “under supervision” of the government.
Weekend, November 12th - 13th
Only 24 hours after the bankruptcy filing, a mysterious hack drained FTX wallets (users’ funds) of $477 million in crypto assets. The following day, another transfer of about $280 million (newly minted) FTT and ETH was taken from FTX wallets. Nothing has been confirmed on this front, but it does seem like the Bahamian government had something to do with authorizing these transactions.
Impact on the industry
It’s highly unlikely this incident will cause the contagion to spread to other financial systems. However, it will have large effects for individuals who lost their money as well as the industry as a whole.
The individuals mentioned above include individual traders and investors as well as companies that backed FTX and Alameda. Without taking into account the missing billions of dollars of individual funds, FTX also sank nearly $2 billion of investors’ money, affecting firms like Sequoia Capital, Lightspeed Venture Partners, BlackRock, Thoma Bravo, Paradigm, among others. Expanding this even further, organizations like Ontario Teachers', one of Canada's largest pension funds with nearly $250 billion in assets under management, had to write off its $95 million investment in FTX.
This has two major consequences in the short-term, 1) companies rushing to reassure their users to prevent them from withdrawing funds and 2) cascading effects continuing to ripple through the ecosystem. On the second point, large consolidations are expected to happen. Just see the wide reach (investments) that Alameda and FTX had,
In the long-term, bringing back trust entails increasing transparency through -
Individual firm efforts: issuing proof of reserves, wallet addresses, and audits
Industry-wide efforts: industry standards
Government efforts: regulations
Looking ahead
I see three major shifts happening in the space, which fall in line with the three long-term tracks above,
On a firm level, companies will make their tools easier to use and allow for a freer interaction with the whole ecosystem. Some industry players will push harder for more investment in decentralized projects and to move away from centralized entities (like FTX and Alameda).
On an industry level, companies will collaborate and develop industry standards to keep one another accountable. Since the blockchain industry continues to build for something better and grows through industry network effects, it would make sense for these same companies to make sure an operating standard is kept and protected.
On a government level, regulations will become a focal point for the upcoming months and years. The focus of regulations will also shift from a narrow focus on KYC/AML to reserves and user assets, wallet security, customer dispute handling, among others.
Overall, these efforts need to aim to make the system more neutral, secure, compliant, and easy to protect users and their funds. FTX’s widespread fraud and theft of user funds set the industry back several years, but it did not destroy it.