Risklessly Weighted, Asset Like Substances
Vol #105: November 10th, 2022
We’ve taken the second leg down.
That’s not to say there isn’t another one coming; the market beast has more lives than a cat and legs than a centipede.
But the crypto ecosystem has taken a generational credibility hit. The outspoken golden boy of this market cycle, Sam Bankman-Fried, was compared to Warren Buffet and JP Morgan mere weeks ago. He turned out to be a lot more like Bernie Madoff, and stands accused of personally wiring $4 billion in customer funds to cover a loss at his hedge fund.
If you’re reading The Till, you’ve probably been bombarded with a dozen different analyses of the situation. If you want the best run down in financial journalism, catch up on Matt Levine’s last two columns. (CZ SBF’ed SBF, and FTX Had a Death Spiral).
The long and short of the story is that Sam owns (owned?) two companies, a hedge fund and a crypto exchange, who both have asteroid size holes in their balance sheets. The hedge fund was leaning on a virtuous circle of credit facilitated through a token (FTT) manufactured by the exchange FTX. This fueled their pillaging of decentralized finance, and made Alameda synonymous with the Jolly Roger.
Alameda got this FTT for essentially free, because they were tightly linked to the founding of FTX. They were the lynch pin liquidity provider that created enough depth for flow to transact there, and bootstrap FTX to the third largest exchange position. “Built by traders for traders”, was Alameda establishing a venue where they could play many of their profitable games in market making, yield farming, and generally fleecing unregulated retail customers a few pennies at a time.
In “traditional finance” the place where you trade is distinct from the place that holds your money. The CBOE and NYSE don’t open accounts for customers (retail or institutional), they have broker dealer members who hold customer funds and transact on their behalf. Everyone is all very highly regulated, and except for MF Global, keep the customer funds segregated and properly accounted for.
Traders thought they were coming to FTX for spot trading, perpetual futures, and contorted realized vol products. To get access to this playground they deposited assets like Bitcoin, Ethereum, and US Dollars. The customers were in fact the product, and FTX was providing a toy in exchange for their digital and fiat assets.
For an ephemeral halcyon moment, this worked quite well for all parties concerned. FTX was a popular institutional platform- even my venue of choice for Harvested Digital Asset Management (funds are safu, thankfully). There were small gripes about trade execution (wink wink Brad Katsuyama), but they listed interesting products to trade and provided useful features like cross chain bridges and stablecoin fungibility. FTX was increasingly becoming a blockchain prime broker with direct market access.
Holding customer deposits is more like a banking business than an exchange operation, and a good way for banks to make money is to lend their deposits out. At peak crypto mania, traders on FTX could get up to 100x leverage. Providing customers leverage, means lending them money to buy more of an asset than the balance in their account would typically afford them. Trading firms could keep exposure to tokens they liked, and short futures of tokens they didn’t like (or were scorched earth yield farming1) all while maintaining relatively small balances on the exchange.
Alameda was a customer of the exchange like any other. But instead of funding the account from their allegedly brimming coffers, they used over $6B worth of FTT as collateral to borrow the other assets that FTX had on the books. Two flavors of FTT were Alameda’s #1 and #3 assets. FTX as a company, now had a leveraged bet on itself via the token price of FTT, and the powder is dry and in place for a bank run.
The vanguards of decentralized ledger technology praise its transparency and trustless nature. Ironically it was the work of good old real world fourth estate sleuthing that exposed the balance sheet of the fund. Last weekend Coindesk published a report, which triggered some very public de-risking by rival exchange Binance. They were ironically the first investor in FTX, and also held a sizable position in FTT tokens, $500m of which they were putting up for sale. This caused the price of FTT to stumble. (CZ is rumored to have made about 20x his money on the deal, putting in $100M in 2019 and then bought out for $2B in June 2021.)
Matt Levine encapsulates how the spark gets lit:
The reason for a run on FTX is if you think that FTX loaned Alameda a bunch of customer assets and got back FTT in exchange. If that’s the case, then a crash in the price of FTT will destabilize FTX. If you’re worried about that, you should take your money out of FTX before the crash. If everyone is worried about that, they will all take their money out of FTX. But FTX doesn’t have their money; it has FTT, and a loan to Alameda. If they all take their money out, that’s a bank run.
When the great ones fall, the world revels in schadenfreude. As I frequently disclaim, I’m not a psychologist, but there’s something that makes the vast majority of us feel just a little bit better when the seemingly invincible are rapidly grounded. Both Sam and I come from the world of prop trading, so I’m used to my peers making oodles more money than me. But $26 billion before age 30? C’mon.
Market participants who last year were told to have fun staying poor by the newly-moneyed Bored Apes, can now tip their green visors once again to GAAP principles. Even Brian Armstrong can sleep well (in his $133 million house) because Coinbase’s public company handcuffs require audited disclosures.
The story of crypto in 2022 has been a crash course in why regulation exists. It’s not because Gary Gensler has actually proposed anything like a sensible framework, but because the very lack of clarity has allowed for two major crises to unfold. First we had the LUNA ecosystem unravel and take out some of the largest funds and protocols in the space, and now we have a major centralized exchange going bankrupt with customer deposits trading OTC at 20, 15, 10 cents on the dollar.
There are many good reasons why distributed ledger and blockchain technology represent an important step forward in financial markets. Whether it’s empowering remittances or facilitating permissionless transactions, when done properly tokenization can be very powerful.
The double edged sword of permissionless access, is that truly anyone can interact with a protocol. This of course means there’s a lot of snake oil out there. Coins get copy/pasted into existence for meme value, and DOGE is the #6 coin by market cap today. If 96% of public companies have negative returns over their lifetime, imagine what the number is for coins?
For crypto markets to mature, there needs to be a credit facility. This basic financial innovation is the lifeblood of economies. (See how public equities react when the Federal Reserve changes the cost of credit.) But for credit to exist, there needs to be some evaluation of its worthiness.
Fortunately, this is not a new concept! We’ve seen this movie before!
If the Great Financial Crisis taught us one thing, it’s that banks need to be transparent and disciplined about their holdings and reserve requirements. Bank runs are brutal for the economy, wiping out depositors and destroying the good faith that greases the wheels of production.
After the dust of 2007-2009 cleared, global financial leaders sat down and created a framework called Basel III. Reacting to the subprime mortgage crisis, they sought to design a framework that could accurately measure the value of assets held by a bank. US Treasuries are quite pristine, “NINJA” loans in Glengarry Highlands that are 90 days past due - no so much.
This calculation of “Risk Weighted Assets” was very important for banks, because it determined how much cash they had to keep on hand. The more they had to keep, the less productive they could be elsewhere. This is something Sam and Alameda knew very well, and exploited. FTT and USDC are not the same.
When this regulation finally trickled down to us lowly options market participants, we bristled at the changes. Listed equity options were not top of mind when the rules were created, so there were some quirky calculations. Short options required lots of capital, and there was no way to offset them with long options - i.e. a short put spread was just a short put. This meant the business of clearing options got more expensive, and Merrill Pro’s bosses at Bank of America started to get more interested in the returns on auto loans.
While those were frustrating kinks to work through, ultimately the purpose was to guarantee that our trading capital was there when we needed it. When you’re in the business of trading, you are always looking to be as efficient as possible, so most of your money is going to be sitting capitalizing your positions. If we went to pull out some capital to pay bonuses and BAML couldn’t cut a check because they’d lent their last dollars out to another client/competitor in exchange for monopoly money, we’d be pretty righteously angry.
When the banks got government bailouts in 2008, thousands descended on Zuccotti Park to Occupy Wall Street. Satoshi himself points to this crisis as the original sin that spawned the need for Bitcoin, with the first block including an encrypted message referencing the UK’s second round of bailouts.
The grift of FTX is far greater than what any Wall Street CEO was accused of by their worst enemies. Misappropriating customer funds directly for personal gain is fraud and theft. Sam is going to spend a lot of time in court. There’s a decent chance he ends up behind bars. Fortunately for him, fellow huckster Martin Shkreli recently told Do Kwon of LUNA infamy, that “jail isn’t that bad.” This is surreal.
Anyone tangentially related to the industry is reeling because of the massive scale and future repercussions. Very smart, seasoned investors lost their shirts because of this. I feel deeply sorry for anyone who had their funds stolen from them. This is a burn that will permanently turn many away from the industry, and prevent still others from approaching it.
The knock on effects are wide. FTX was a major sponsor of the Solana ecosystem, which has incubated many interesting projects, particularly in the trading space due to its scalable and high throughput validation architecture. Sam just pulled the ultimate rug.
While it will cause many purists to bristle, the unfettered capitalist pillaging and fraud perpetuated by those vaunted as the best and brightest is exactly why we can’t have nice things. For crypto projects to work credibly, there needs to be some framework that compels honesty.
Perhaps there is room for a decentralized solution that solves for the mistakes and inflexibility of the current regime. Ari Pine at Digital Gamma suggests this might be an avenue for existing products like CME bitcoin futures and options to grab market share from professionals who tested the waters offshore. Either way, the answer can’t be nothing. Regulation is coming.
Alameda had a long history of predatory “anti-social” behavior. They would invest in protocols at the earliest stages in exchange for tokens issued at a fraction of a penny. When the protocols went live, the token values would soar, often fueled by retail buyers (“exit liquidity”) who didn’t get privileged access. Alameda would viciously sell their tokens at inflated prices, and box out smaller participants to scoop the majority of token rewards only to ultimately dump those too. Rather than actually supporting projects, they were simply in it for a smash and grab quick buck.