FTX Collapse – the end of Crypto?

Welcome to Finance and Fury. Todays episode – full summary and implications on the FTX collapse – some time has passed since the initial news of the collapse emerged, new information keeps coming out – longer episode as there is a lot to unpack

1. But if you weren’t aware – the second largest crypto exchange, FTX filed for bankruptcy on the 11^th of November – but the story is much deeper than that – Lot to unpack – try to do so in a succinct way as there are many movies pieces, between fraud, the Ukraine, political donations and regulators turning a blind eye

First – will introduce the players –

2. Samuel Bankman-Fried– will either call him Sam or SBF – up until a few weeks ago, he was the richest 30yo on earth with an estimated net worth of $10 billion
3. How did he get rich – Comes from a family of academics – both his parents are professors at Stanford Law school and are heavily politically connected, with his mother being the co-founder of Mind the Gap – a political fundraising organisation for the Democrats
   1. Sam went to MIT – graduated with a degree in physics and went to work where all the money for someone with a physics degree – quantitate trading in 2014
4. At the end of 2017 – he left a role at Jane Street Capital and founded Alameda Research – a crypto hedge fund
   1. At his time at Jane Street, he met his future GF Caroline Ellison – who became the CEO of Alameda Research at the start of 2018 – her industry experience? 19 months as a junior trader
   2. Other people beyond his GF were friends he met at MIT or Jane Street – inner circle of 10 people – some weird reports started coming out a few weeks ago saying they all dated one another and lived together – this aside
5. In 2019 – FTX was created by Sam – this was effectively a Derivatives exchange – A crypto exchange is a place to store and trade crypto
   1. Sam stated that he wanted to create FTX to offer more complex trades to individuals – such as options and derivative positions, and tokenised stocks that track the real value of other companies – Other exchanges didn’t offer this – so Sam saw a gap in the market and opened an exchange adjacent to Alameda research
   2. To establish this exchange, he received around $2bn in start-up funds – reports that some of this money came from Blackrock, Softbank and other hedge funds – but most of the money is in the dark – no body really knows where the money came from
      1. One that we do know about that invested later is Sequoia capital – $210m invested –
   3. FTX issued a token as well – called FTT – not stock in FTX or equity ownership – legally, these tokens cannot form part of ownership of the issuer would get into trouble with the SEC
      1. Work as a perk scheme – with discount on trading – but also, as part of this agreement – FTX agreed to use a portion of their profits to buy back FTT tokens – this can make it perform somewhat like a share in a company as it is linked to the profitability of the company, in conjunction with share buybacks – the more profitable, the more tokens it will purchase, pushing prices up
   4. So as a quick recap – Sam had Alameda Research which acted as a hedge fund, trading cryptos and tokens, he also had an exchange that other people stored their crypto on and often traded on using leverage and derivative positions, and finally FTX issued a token called FTT which would rise and fall based on the buy backs
   5. FTX continued to rise over the next two years – had over 100 affiliate companies in a complex web of counter party risk – either companies that were bought up over this time period, created by Sam or lent money too by Alameda research
      1. Sam’s wealth and fame grew massively over this time period – with promotions by major stars, Stef Curry, Tom Brady, Larry David – had sponsorship deals with stadiums and racing cars – they received equity in FTX for this
      2. Around this time – stated that he wanted to buy out Goldman Sacs – a company with $1.5 trillion in assets – had some ambitions
      3. Sam was on top of the world – on the cover of Forbes, hanging out with Bill Clinton and Tony Blair, mainly because they becoming heavily politically involved, partnering with the WEF – for which his Aunt is a key person
      4. Built the infrastructure for Ukraine to receive donations in Crypto – where any donations would be transferred back into Fiat currency at the national bank of Ukraine – for which there is no trail of receipts where the money really went
      5. Personally, Sam and others within FTX made large political donations – Sam to Dems around $50m (second largest individual donor), another Sam involved who was the Ex-Co-CEO donated $23m to Republicans – buying up both sides with political favours whilst also lobbying for regulation for crypto exchanges – Why would a founder and owner of a crypto exchange want regulation on their own industry?
         1. This is where things started to unravel as these actions did not endear him to some of his fellow crypto billionaires and exchange owners
         2. Rather than being part of the diehard ethos of most of the crypto community – being decentralisation – SBF was pushing for the opposite – For the US government to establish a brokerage like licencing system – who would lose out from this? All other exchanges along with competitors trying to start up

• Common practice – lobby a government to create barriers to entry for your competition once you become a dominate market force

9. What was happening behind the scenes – The practice was that FTX would lend user funds to Alameda Research, who would then bet on other cryptos and to invest in other crypto and invest in different projects
   1. Remember – FTX was an exchange where users would deposit their funds – in simplistic terms, think of it as a broker you give money to – but then this broker takes your money without your authority and gives it to another company where they make very risky trades with it – the estimates are that $10bn of user funds were lent to Alameda research
      14. And their financials were not healthy – During this time period – Alameda Research’s main asset was the FTT token, with a balance sheet of $14.6bn in assets at 30 June – $3.7bn in unlocked FTT, plus $2.5bn of FTT collateral – plus they had $7.4bn in loans to other entities – this means their actual equity was only $1bn
   2. This is due to the FTT tokens valuations being controlled in part by Sam and Alameda research through wash trading with yourself to jack the price up – Sam described this practice on a podcast where value could be created out of nothing – wasn’t exactly a secret –
      1. You increase the capital price – then you use this as collateral – can borrow funds off this or use it as collateral in trading other leveraged positions – so FTT tokens were being propped up by Alameda and then Alameda used collateral to get loans and fund trading activities
      2. The discovery of this is what blew the company up – come back to this – just remember that the biggest holder is Alameda and due to this, they are illiquid – i.e. not being heavily traded as they are a store of collateral
   3. Beyond this – What was going on is that the money that people stored on FTX was being lent on to Alameda Research to trade with – Remember that $10bn in loans were given
      1. Both of these practices are a big no no – even in their terms of service, FTX said that they would not do this – not only is it illegal, it is a problem, as it is a company using their own equity as collateral on a loan – this is bad, but when their own equity starts to drop, this becomes a nightmare form a risk management position

How could it get this way – This whole time, there was no oversight – no board of directors, just Sam, his GF CEO and a few of their friends – The head of risk management was another teenager who only had two years of risk management experience at Credit Suisse – a firm that if you google Credit Suisse and the letter r…it would auto complete with risk management failure

12. But it appears that some regulatory authorities were aware of this – in a leaked email – Regulators in the form of the SEC appeared to have looked into the practices of FTX and they were given a no action relief notice – this essentially means that the regulators know you are doing something wrong, but give you a free pass –
    1. How could this be? One answer is the political donations made by the two Sam’s – another is that the head of the SEC – the entity responsible for regulations is Gary Gensler, Glenn Ellison – Caroline’s dad (the CEO of Alameda research) worked together, Where Glenn is Gary’s former boss – and they were good friends
    2. If this is true – It helps to explain the reason that FTX was given a no action relief notice rather than legal action being taken – remember at the time this was looked into, the exchange hadn’t collapsed

This brings us to the start of the collapse – 2022 hasn’t been a kind year for many assets – Crypto has seen the largest declines of any asset class in a risk off market – with BTC being down just over 70%, compared to the ASX sitting at around break even with dividend income

13. FTT tokens lost around 50% of their value, going from $50 to around $25 from November last year to the start of November this year – Remember that these tokens are the underpinning for Sam’s whole operation – they were collateral and in part, what incentivised users continue holding their funds in FTX
    6. Remember the balance sheet of Alameda Research – $6.2bn of their collateral was in FTT – so this is now worth around $3bn – on which $7.4bn was borrowed
    7. plus, they took around $10bn of user funds and used these to trade with – so assuming a similar loss margin, they could have been left with $5m of assets whilst still owing $10bn back to FTX to pay back the user funds they took –
14. The straw that broke the camels back comes from a tweet from the CEO of their largest competitor – Binance – Changpeng Zhao (CZ for short) – crypto community loves their acronyms
    1. The start of the final stage of collapse is on November 6^th – CZ tweeted that they would be dumping their FTT tokens due to ‘revelations that have come to light’ – normally people don’t announce large trades before they do them – you trade first, so the market doesn’t move ahead of you
       1. He held around $2bn of FTT by this point, as he was also an early investor in FTX, where he invested $100m to later be bought out by Sam for FTT tokens for $2bn
    2. SBF fired back – stating that their competitors are lying, FTX is fine and their assets are fine
    3. But what these revelations were likely the balance sheet or that someone figured out that they were using users funds and were now insolvent, not just illiquid
    4. Some suspect that CZ’s tweet was an opportunity to blow up his competitors – may well be, I suspect that CZ wouldn’t want crypto to be regulated, so the fact that Sam was pushing for this to happen may have upset CZ, so this may be his motive – doesn’t really matter at this point
       1. As a side note, by no way is Binance clear – criminal investigations ongoing with them as well in regards to money laundering and criminal activity financing – such as allowing Iranian firms trade $8bn despite sanctions
    5. But with the tweet from CZ – saw a massive withdrawal off the exchange by users of FTX – around $6bn was requested to be withdrawn over a 3 day period
       1. The FTT token dropped around 80% in value over 2 days from the 8^th to the 10^th of November – These tokens have low liquidity – so dumping these would have major issues as the price drops massively rather quickly in a low liquidity environment – sitting at around $1.5 today – a 94% drop from just two weeks ago
       2. Sam called CZ – and they came to a deal that Binance would buy FTX – but two days later they backed out of this deal
       3. On FTX’s balance sheet they had $9bn in loans and only around $1bn in liquid assets – basically 10% covered – let alone the shambles that was Alameda’s balance sheet
          1. Backing out of this deal makes sense – multibillion dollar hole in the company – not just a liquidity problem but one of solvency – Bailouts work in times of illiquidity – i.e. if a company has assets at hand but can’t liquidate them to cover funding needs – 2008 bank bailouts are an example – where central banks issued funds at a penalty rate – Also warren buffet with Goldman Sachs – the people or entity doing the bail out can make a lot of money, as did Buffet – but in a scenario where the fund is bankrupt, purchasing assets in them is almost a guaranteed loss making venture
       4. But as FTX was both illiquid and involvement – The issue when it came to the withdrawals is that they didn’t have the redemption request for their users – so they stopped withdrawals
       5. By the 11^th of November – FTX and Alameda filed for Chapter 11 – sending all crypto markets crashing – $152 billion of market cap gone – And a company (FTX) that was valued at $32bn just a few months ago was no worth nothing
    6. Where did any remaining money go?
       1. $1 to 2 billion of user funds just that was transferred from FTX to Alameda disappeared – they just don’t know where it is – liquidator revealed in a sworn declaration submitted in bankruptcy court that a subsidiary of FTX had lent $1 billion to Bankman-Fried
       2. On the same day, FTX they said that all the remaining liquidity they had in users accounts, around $600m was hacked and the money drained from users accounts overnight – Sam is a trustworthy guy, so I’m sure it was just some Russian hackers – whoever hacked this, moved into Ethereum

What does this mean for crypto markets at large – mostly a lack of confidence and contagion risks –

1. Many other companies affected – reducing confidence in markets, making people hesitant to invest further funds, lowering demand
   1. Other traditional finance companies not so much – Galois capital had around half of their capital on FTX
   2. Ontario’s Teachers pension fund invested around $100m into FTX – but this has around $220bn, so $100m isn’t much to write off
2. BlockFi – Digital asset lending platform, initially paused client withdrawals but likely Heading to bankrupty – partially due to FTX providing BlockFi a $250m loan to help cover their losses with the decline of the crypto markets at large over the last year
   1. Contagion between each of the 130 companies linked to FTX ownership – estimated liabilities are in the range of $50bn from the bankruptcy filings

In short, this seems to be a massive case of fraud – as there are recordings that others, such as Caroline knew this was going on

1. Comparing this to other collapses from Fraud – Bernie Madoff – half of his direct investors lost around $32bn
2. Enron – around $24bn
3. But market cap of crypto much smaller than share and bond markets by a magnitude – so this has a larger impact on the market
4. Now comes the calls for more regulation – something that SBF wanted anyway – Department of justice is involved – if he is jailed for fraud will come down to how far his political donations got him along with his families leverage
5. Congress has an open case into this, but Maxine Waters is in charge – an 84 year old who has been in politics for 32 years – she was probably the most technically savvy to look into these charges, not that she received any money in the form of donations

Lessons –

1. Firstly, not to store your crypto on exchanges – crypto exchanges act more like broker dealers than traditional exchanges – easy option, but a risky one, as if the exchange goes down, they can take your funds with them
   1. Traditional exchanges match traders allowing them to execute orders with one another –
   2. Brokerages – transact directly with clients directly and hold funds for clients
   3. A lot of FTX’s business was in futures – where people were trading a derivative on crypto, often with leverage – hence FTX would need to come up with the funds to lend to their investors
   4. To do this, they could have borrowed funds back off Alameda, their other customers or simply created lines of credits with banks or other lenders
   5. Cold wallets – just remember your passwords
2. Secondly – lesson of something too good to be true –
   1. To incentivise people to use TFX, they were offering terms that were too good to be true
   2. 2019 promotional document stating that they will pay a 15% annualised rate of return on funds deposited with FTX and in this promotion that there is no downside, as they guarantee full payment of the principal and interest – Enforceable under US law – even though they were operating in the Bahamas, under commonwealth law –
3. Thirdly – this is probably not the end of the story – lots of additional companies may go down as contagion spreads –
   1. Not the first to go down – collapse of Terra and Luna, Celsius Network, Voyager, three arrows capital –
   2. There are many more tied up with FTX – BlockFi will likely go bankrupt
   3. Highlight problems in systems with no checks in place – done episodes on bubbles in the past – like the Mississippi bubble – similar foundations to the share market in the early days where speculation was rife
4. Fourthly – more regulation probably coming and industry takeover from major financial institutions
   1. In the end, this collapse could have the result that Sam was after all alone – the irony of someone doing something at the very least immoral to illegal in any other regulated market, whilst campaigning for regulation is a little funny