Unpeeling the FTX Onion
What the hell is this mess? What do we do? Part II in a series coming to grips with Crypto, DeFi, and Shenanigans
Image credit: Bloomberg
As you probably could have guessed, I spend a fair bit of time reading about the unfolding train wreck that is the FTX bankruptcy and the broader unraveling of the crypto universe. I have discussed before my feeling[1] of Schadenfreude, but what I feel when I read many post-mortems and “WTF happened at FTX?” stories is a feeling best described by Jacobim Mugatu. I feel like I am taking crazy pills. I feel like I am being gaslit. On a recent episode of Bloomberg’s Odd Lots, cohost Tracy Alloway said “I don't know, it feels like the speculative mania kind of reached almost its purest form when it comes to crypto. Like this is about making money with pretend money that we have created. That's what it feels like to me.” I feel like I am taking crazy pills, because I vividly remember screaming this sentiment in my internal monologue whenever I encountered any talk of crypto.[2] But now, it seems, this has become self-evident ex-post. If you took one step back during the craze—what is obvious now was obvious then. That is, if you weren’t actively putting scales into your eyes. You did not need to wait for a Damascene moment—the truth was always there to see. In the instance of FTX, you could have listened to Sam Bankman-Fried’s own words on a now-infamous episode of Odd Lots.[3] What is clear is that FTX and similar actors were, at best, creating a financial system that existed purely for speculation which was a giant house of cards.
You should read or listen to the whole thing—it is nuts. In the episode, SBF describes “yield-farming” using an instructive[4] metaphor of a “box.” In this metaphor you put money into a “box” in exchange for a token[5] that “promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens.” It’s cool, no? The idea is that these tokens have value from these ill-defined governance rights and represent some kind of claim on the money in the box. Hence the more money there is in the box, the more value in the token, right? SBF then goes on to talk about “yields” and “multiples” on the value in the box. Except there is no value in the box. There are assets in the form of the money or crypto “assets” in the box, but the box contains offsetting liabilities too because you can always redeem the token for your money, I guess. When pressed, SBF concedes there is normatively no value here, but that from a descriptive perspective there is an observable market value. OK fair, whatever, but if you “invest” in something you know has no normative value—you are not investing even if it has a market price. But the more people “invest” in this thing with no real value, the more return the early investors see on their value in the market. This isn’t a new idea; that concept was popularized by financial engineering pioneer, Carlo “Charles” Ponzi. But hey, you can lose money being right all the time on the short side, so SBF was justified when he asked “like you're kind of the guy calling and saying, no, this thing's actually worthless, but in what sense are you right?” Well, you are right when the music stops. And right now, FTX as a major holder of these boxes has $1.7mm in crypto assets and $151.5mm in liabilities.[6] So, uh… the music stopped somewhere.
So what was FTX even doing? On the surface it was an exchange for crypto “assets” like these tokens that made money the normal way an exchange does. That’s fine, even if the assets on it are kind of scammy and people shouldn’t really buy them. But this is not the FTX story—enter Alameda Research, SBF’s proprietary trading firm.[7] Alameda functioned as a major market-maker on FTX—that’s fine, lots of prop-traders function as market makers. Except Alameda was also controlled by SBF & co; he held 90% of its equity and cofounder Gary Wang held the other 10%. The positive gloss on this is that Alameda was providing early liquidity on FTX until things got going and the training wheels could come off. But the order of events and the link between the two entities suggests that rather than Alameda stepping in to provide liquidity for FTX—FTX was created to provide a captive pool of traders for Alameda to make money from. Beyond normal activities that would entail, it appears that Alameda was using its privileged position[8] in a host of ways including front-running tokens about to list on FTX. Black Edge[9] or not, Alameda was making money on delta-neutral strategies[10] until they decided to take massive directional bets too. Eventually a bunch of these positions blew up when the prices of these “assets” imploded and Alameda found itself in a very deep hole. They tried to fill this hole by borrowing $10b from FTX[11] in margin loans secured with FTT and other tokens.[12] Now, anyone can take a margin loan, but usually these loans come with a lot of conditions. You have to post a lot more value in securities than money you borrow. You have to borrow it from someone else. That someone else can’t just take that money out of brokerage accounts of their customers, and those securities have to be real. They can’t be thinly-traded non-securities you hold so much of that you can easily manipulate their price. None of these conditions held for this transaction. Without these risk precautions both borrower and lender would find themselves in a very precarious place—this is obviously compounded when the lender and the borrower are the same entity. So if there is an other person who could affect the value of the collateral securities decides that he wants to dump his holdings to screw you—you are, indeed, screwed. And that happened when Changpeng Zhao of Binance decided he had had enough of SBF. So things blew up and the marks rushed to get their money back. But the money was gone. After the blow-up a lot more was revealed—and a lot of it is mind-blowingly stupid and likely criminal.
“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.” This is how current FTX CEO, John J. Ray sets the table in FTX’s bankruptcy filing. And to put a finer point on it, this dude unwound Enron. Let that sink in. Here are a few highlights of FTX’s boundless cupidity and moronism. The level of misappropriation of funds is pretty wild; Alameda “loaned” SBF $1b. Corporate funds were used to buy real estate and other stuff for employees without any real oversight or documentation. They racked up an outstanding payable to Margaritaville to the tune of $55 grand. Their oversight for expenses seemed to be an open Slack channel with authorization granted through emoji reactions.[13] FTX tried to function like a bank, but the folks there didn’t really bother writing down what money there was or whom it belonged to—even a street loan shark or bookie does that. None of this was viewed as a problem by the firm’s/firms’[14] auditor—an auditor Ray has never heard of but does boast a Metaverse HQ.[15] Compounding all this malfeasance ex ante, a bunch of people and entities appear to have looted the firm(s) of assets after the declaration of bankruptcy. Yet worse, this appears to have happened with the connivance or even participation of Bahamian regulators.
It is clear that regulators need to step in here, as do the criminal authorities. It is beyond doubt that existing rules and laws have been broken. Furthermore the Bahamians need to get their act together. The folks in Nassau should hew to the values expressed by the pre-1973 motto of "Expulsis piratis, restituta commercia"[16] and arrest SBF and prepare him for extradition to the US. This started as one level of scam that is probably not illegal and snowballed into several levels that almost certainly are. Regardless of what happens next there are a few people who need to face justice.
This comes to the thorny issue of how regulators should move forward. But before we leap to establishing a new regulatory regime for Crypto and DeFi I think we should take a step back and ask what regulations are for and why SBF was such an outspoken proponent of regulation of this space. To take on the first issue—regulations exist to protect ordinary people and their money from people who would take advantage. SBF and his ilk are clearly the wolves we must protect against. But SBF wanted a regulatory regime to use as a tool to further fleece sheep even more unwitting than those he already did. On the “box” episode of Odd Lots he said “I do think this is the thing that makes me the [most] bullish about like crypto asset pricing is just the amount of money that isn't able to access it today or able to, that isn't accessing it today, you know, one way or another, but directly could be, and very well might start doing so over the next few years.” Here the Ponzi Schemer is arguing that the greatest case for the appreciation of his assets is that there are many more Greater Fools just waiting to further inflate prices. The thing he identifies[17] as stopping them is the lack of a regulatory framework. Lacking an applicable framework, most institutional investors[18] were effectively barred from investing in the space. In this instance a lack of regulation was what protected the greatest number of investors and kept this cancer from metastasizing throughout the greater financial system. A lack of regulation likely stopped some banks from filling their balance sheets with FTT style junk and retail investors from piling into crypto ETF products. SBF is almost explicitly calling for regulation as a fig-leaf to open the gates to even more money to flow into crypto—almost explicitly to pump its market value. So, maybe instead of granting this fig leaf that would legitimize this meshuges—we should just let it burn and punish those who were outright frauds. This leaves a lot of people with some serious losses—but in gambling in this space they took on knowable risks chasing outlandish returns. That toothpaste is well and truly out of the tube—what remains is trying to limit the damage schemes like this can do in the future. Speculation is a feature of the financial system, and we have a host of regulations that limit its activities, even in legitimate cases. To wit, it is illegal to trade onion futures because it is very easy to manipulate onion prices.[19] But at the end of the day—people need onions; they do not need SBF’s magic box and similar schemes. If we can deny onion speculation[20] the legitimacy of regulation, we ought to deny it to this.
[1] Immense and slightly smug feeling to be exact.
[2] Sometimes out-loud to myself as I listened to Odd Lots episodes about Crypto and DeFi.
[3] Seriously, it turns out to be worse than what he said but even when FTX was going at full flank it was manifestly sketchy.
[4] Even more instructive than he thought, and not in a “well as it turns out” way. Matt Levine saw right through it.
[5] Read: unlicensed, unregistered non-security.
[6] I don’t know how much of this is to do with the “boxes,” but nor does anyone else. More on that later.
[7] People call it a hedge fund—this is the latest instance of a profound abuse of that term. Hedge funds classically defined are more than just big pools of money that do whatever. And usually they have investors, as far as I can tell Alameda does/did not. These people were not good at record keeping. Or they were good at not record keeping. Jury’s out… metaphorically. The jury hasn’t been empanelled yet.
[8]IE being indistinct from the exchange itself.
[9] IE cheating.
[10] That is to say, strategies that don’t rely on movements in underlying prices.
[11] Which it bears repeating was not a different organization run by different people.
[12] Non-security, non-money invented by SBF.
[13] I cannot wait to find out what emojis they used… I hope it was 🔥 or 💯. Probably should be 🤡.
[14] This issue is vague.
[15] You really cannot make this shit up.
[16] Latin for “Pirates expelled, commerce restored.” This motto features on a very cool Blue Ensign defaced with the arms of the Crown Colony of the Bahama Islands which was replaced when the archipelago achieved full independence in 1973 after about a decade of home rule dominated by a clique of white businessmen know as the “Bay Street Boys,” which will sound like an off-brand boy band to some readers but to others may evoke a crew of RBC MDs named “Gord” and “Hugh” getting plastered at the Granite after playing shinny against “some boys from Osler’s.” IYKYK.
[17] Correctly, I may add.
[18] Who invest the money of normal people and pension funds.
[19] Seriously, read about it. It is a wild story.
[20] I guess you can engage in all the OTC onion speculation you want, but normals can’t use exchange traded instruments.
