This is the third and final part in our recap of the collapse of FTX. In the first two issues we covered what happened in the weeks leading up to the failure of the exchange and how Alameda Research and FTX became so entangled and fraudulent in the first place.

Today we’ll cover the contagion and fallout throughout the Crypto industry and some lessons learned by Crypto investors and industry insiders.

Leveraged Unwind

The Contagion that we are seeing from the failure of FTX is mainly an unwind of built up debt between Crypto companies. This is acting with a lag as a majority of companies with financial problems were already on the ropes from earlier in the year as a result of the collapse of Luna/Terraform labs and Three Arrows Capital.

The list of Crypto lenders that have so far filed for bankruptcy as a result of these earlier problems include Voyager, Celsius and BlockFi. Gemini’s yield program has halted withdrawals. Nexo has announced that they will exit US markets but have not yet announced financial problems.

If you haven’t already, you should strongly consider whether any of the yield generating accounts at Crypto companies are worth the risk.

 These failures are all a result of counterparties defaulting on loans. Essentially, Crypto hedge funds and other entities took on loans from these lenders during the bull market and have failed to repay this year. To compound this issue towards the end of 2021 and in early 2022 the Crypto lending space was so competitive that loan terms were extremely favorable.

Lenders were growing rapidly and courting new investors. To be successful they needed to grow their loan book at any cost.

Kyle Davies, a co-founder at Three Arrows Capital explained in this interview that his Fund was offered billions of dollars in loaned funds on an uncollateralized basis. Other lenders were making loans on low quality collateral. Some were slow to liquidate loans as collateral value dropped.

This mechanism was a large part of the story of the FTX collapse. It appears that loans from other companies were being taken using FTT tokens and FTX stock as collateral with no plausible way to liquidate those assets anywhere near book value.

This is widely speculated to be the reason why FTX CEO Sam Bankman Fried attempted to bail out insolvent lenders like Voyager and BlockFi earlier this year, to ensure that they did not liquidate his FTT collateral.

This means that the contagion is very different to previous eras of Crypto collapse. It’s not hacks that are causing issues as happened in 2014. It’s not voluntary selling of assets as we saw in 2017 with ICO treasuries. It’s insolvent companies with giant holes in their balance sheets from defaulted loans.

DCG and Genesis

This brings us to the Genesis of all of the leverage in the Crypto industry, Digital Currency Group (DCG) and their subsidiary lending and prime broking service, Genesis. So far Genesis appears to have at least $1.8B owed to creditors. Its parent company DCG is on the hook for $575M that comes due in May next year and another $1.1B owed to Genesis in 2032.

Details are limited and DCG has gone quiet, but it appears that DCG has already committed to backstopping part of the faltering Genesis loan book.

We have no real idea how deep the hole is at Genesis. In early 2021 we learned that their total loans outstanding stood at $3.8B. This had increased by more than 5x since June 2020. It’s not inconceivable that Genesis had $10B in loans owed to it when it halted withdrawals in November. With so much carnage rippling through the industry it’s impossible to know how many of those loans are still performing and how many have defaulted leaving bad debt on the books.

For the first time since its 2013 founding, the DCG empire could be crumbling.

 While you aren’t all that familiar with Genesis as their dealings are mainly with other large Crypto firms, you are definitely familiar with the family of DCG companies. DCG owns Coindesk and Grayscale, which operates the Grayscale Bitcoin Trust. They also hold one of the largest venture portfolios in the industry, with fingers in almost every pie.

Among other things, Genesis loans are used as the counterparty to many yield products throughout the industry. The first shoe to drop was Gemini’s yield program, which simply passes through Genesis loans onto consumers, which is why they were forced to gate withdrawals shortly after Genesis.

Problems at DCG are problems throughout the Crypto asset class.

As the major Crypto prime broker and lending provider, the halting of withdrawals at Genesis is a major problem. Even if the lender can tidy up its books and continue to operate, their pause in normal operations likely means that Credit and business operating loans throughout the industry are much more constricted than normal.

How will Genesis Shake Out

Problems at DCG are not the same as problems at smaller Crypto Firms. The company has a wide range of assets that they can sell off to recapitalize the business and can seek outside investment if push comes to shove. There have been rumors about fundraising attempts while an offer to purchase Coindesk for $300M was apparently rejected as too low a bid. The main point is that DCG appears to need additional funding to maintain operations, but it might not be at a crisis point where the whole company is about to go under.

For example, early rumors that the Grayscale Bitcoin Trust could be liquidated seem to be unfounded.

That’s not to say that there aren’t deep problems. It would not be at all surprising if Genesis were sold off or allowed to enter bankruptcy. A sale of Coindesk would not be surprising. The total collapse of DCG and the sale of Grayscale, one of the major revenue sources for the corporate group, would be surprising to say the least.

With all that said, we just don’t know. DCG has been uncharacteristically quiet for weeks and nothing they have said inspires any confidence.

Silvergate

Another institutional Crypto company having problems is Silvergate bank. Silvergate is a US registered and publicly listed bank whose place in the industry was providing banking services to Crypto companies. In 2017 Crypto companies had awful trouble finding reliable banking services who would not close accounts. Silvergate fixed that and gained most of the banking business in the industry.

They claim not to have any exposure to FTX, but they were the banking partner

This opens up two big problems. Firstly, a major part of the FTX story was the dubious banking arrangement, where customers were asked to wire funds to the affiliated hedge fund, Alameda Research, rather than to FTX bank accounts. CEO Sam Bankman-Fried claims that FTX did not have access to banking at the time, but it appears that this practise carried on far longer than could be considered reasonable.

If Silvergate were aware of this arrangement and allowed it to continue, regulators will have some serious questions to ask.

The second and more minor issue is that banking naturally carries significant settlement risk as funds are debited and credited across accounts, sometimes opening up short term loans as settlement finalizes. It doesn’t appear that FTX has left a big gap in Silvergate balances through settlement failures, but it’s a possibility.

The other angle here is that if Silvergate had a major part to play in improper banking for FTX, they could find themselves liable for fines and even clawbacks of funds into the FTX bankruptcy. Members of Congress have already asked for information and it seems likely that a regulatory investigation is coming.

Solana Ecosystem and Wrapped Tokens

It’s no secret that FTX and Alameda had a big role in investing in and guiding the Solana ecosystem. Sam Bankman-Fried and associates had an outsized position in several ecosystem tokens like Serum and Maps. Solana token price has already been cut in half since FTX failed and ecosystem tokens are even more badly down.

The less obvious problem in Solana was that the major wrapped assets were custodied by FTX. Sollet, the wrapped Bitcoin token is currently trading at a 95% discount to Bitcoin. Most traders missed this small but important point as the FTX collapse was happening, but it’s a useful piece of information to keep in mind.

Not all wrapped assets are created equal.

 If you participate in DeFi you no doubt use wrapped assets. They allow you to trade and use assets from one blockchain on a different one or sometimes just provide a different token standard as a wrapper.

The major wrapped assets to be aware of are wBTC and wETH. The differences are important and useful to understand.

In the week after the FTX collapse there was a Twitter joke about wETH having problems. This led the asset to depeg from normal ETH tokens, despite being exchangeable 1 for 1. Articles were written in an attempt to calm panicked sellers of the wrapped token after the joke was reported seriously by Bloomberg.

Types of Wrapped Tokens

Wrapped ETH is a token which places an ERC-20 wrapper around ETH token, allowing it to take advantage of more advanced features of the Ethereum Blockchain. This process is handled entirely by a smart contract. The stash of ETH tokens can be viewed on the blockchain. The total supply of wrapped ETH can be audited in real time to monitor for problems. Nothing can go wrong with this system and funds can’t be stolen unless there is a smart contract exploit.

A big part of what makes wETH extremely safe is that it is self contained in the Ethereum ecosystem.

These sorts of smart contract wrapped tokens are similar to bridged assets. These wrapped tokens also operate by smart contract, but across different blockchains. They feature smart contracts on both blockchains which will custody native tokens and mint wrapped tokens on a different blockchain as requested by users on a 1 for 1 basis. At least that’s what they do when they’re operating properly.

Bridged tokens often break and have security exploits, the technology is extremely complicated and open to hacks.

Bridge exploits are by far the most common DeFi hack, with more than $2.5B stolen from bridges in the last two years.

The final type of wrapped asset is a custodial wrapped asset, which includes the Solana wrapped assets which were custodied by FTX and other more commonly used wrapped assets like wBTC and stETH on Ethereum. wBTC is custodied by BitGo and operated by a DAO, they have fairly good transparency and seem unlikely to suffer problems, but it’s important to be aware that if BitGo goes into bankruptcy, wBTC could have issues. stETH is issued primarily by Lido and is set up in a similar way with similar risks.

The main point is that if you are using wrapped assets, you should understand who holds the custody of the underlying token and whether they are at risk of financial problems.

Solana Wrapped assets are trading at a giant discount and unlikely to be fully convertible. I don’t think there’s a high likelihood that wBTC or stETH have similar issues, but it’s worthwhile being aware that they could have problems. If you’re holding wrapped tokens, know who the counterparty that can unwrap them is and whether or not they are trustworthy and solvent.

Lessons

Here are the big take-aways from all this…

Self Custody

The first and most important lesson out of this giant mess is that every investor in Crypto needs to know how to self-custody their assets. It’s the same lesson that was learned out of the 2014 Mt Gox collapse. It’ll likely be the lesson from the next Crypto crisis.

There is no excuse. Learn how to take custody of your Crypto. Easy self-custody is the major innovation.

There’s a range of options, if you’re only dabbling then use a software wallet like Metamask or Exodus. If you’re a little more serious you’ll want a hardware wallet like a Ledger or a Trezor which are available for less than $100. At the high end it might be worth considering a shared recovery service like Casa.

Whichever way you go, know how to Self Custody. Know how to move your Crypto off an exchange and onto your wallet. Practice doing it so that you can remove your funds when things go poorly.

During the FTX collapse, the people that could remove their Crypto the day that things started looking bad kept their coins. Others lost theirs.

Know Your Counterparty

The firms in the Crypto industry are not like banks or stock exchanges. They don’t have anywhere near the same regulatory scrutiny. They don’t have the same insurance. They don’t do the same audits.

This isn’t the wild west, but it’s still close.

If you’re giving your money or your Crypto over to an exchange or custodian know your counterparty. Know their counterparty. Read the terms of service and see what the risks are. The most surprising failure out of the FTX collapse was Gemini Earn closing down. They weren’t exposed to FTX but they used Genesis who suffered losses in the FTX collapse.

As a general rule, if you’re earning yield then your Crypto is being lent out. At the moment most of the yield products are closed down or bankrupt, but keep this in mind for next time. It doesn’t even have to be your chosen custodian that has problems, this industry is small and most firms have exposure to a wide range of counter-parties.

Always gauge whether the risk associated with the yield you’re getting is worth it. During this cycle plenty of investors lost their entire investment because they were chasing 10% yields. When the next bear market starts, your first thought should be whether you still want exposure to lending firms.

Know what you own

Not all Crypto assets are created equal. If you’re dabbling in altcoins and DeFi, know how the tokens you own are connected to the larger ecosystem.

As we already covered, wrapped assets have unique risks and that needs to be recognized. Ecosystem tokens, that is altcoins within a broader protocol should be viewed as having a strong correlation to the ecosystem they live in.

Problems in one place can easily spread.

Understanding how these tokens move together and how problems in one part can affect other parts is vital as the Crypto token ecosystems get more and more interlinked.

Proof of Solvency

While my advice would be to not have any tokens on any exchange or with any custodian at the moment, that’s not practical for everyone and people do need to trade sometimes. Ryan Sean Adams at Bankless has coined a phrase that I think explains how to think of exchanges at the moment:

Think of an exchange like a public restroom. Go in, do your business, and get out.

This isn’t the period where you want to hold assets on an exchange without a good reason. We’re heading into Christmas which is historically a low liquidity period. While a lot of insolvent firms have been flushed out, it feels decidedly like there are more shoes to drop.

While Binance has performed a proof of reserves there are numerous problems with their approach and some weird activity on their order books has left traders nervous. It’s unthinkable that Binance could be insolvent, but I wouldn’t want to have any funds there at the moment.

Kraken is the exchange that has the longest history of doing proof of reserves. Their CEO has recently been pointing out problems with other firms auditing, including Binance. He has also been advocating self custody.

If you need to keep assets on an exchange, Kraken appears to be safer than most, but their CEO is telling you not to keep your assets on any exchange.

Coinbase is the other big exchange. They’re publicly listed. They’re rigorously audited. Does that mean they’re safe? No. Do I trust them not to have problems? No. But they’re also safer than most.

There should be no real reason to keep a lot of Crypto assets on an exchange at the moment. If you plan on doing so, make sure you know how to get them off the exchange in a hurry.

Watch out for the next blowups

This all could be over. It also might not be. The blow ups in the first half of this year were fast and destructive. Luna and Three Arrows Capital blew up and took out huge chunks of the industry overnight.

This time around the blow ups are slow and large.

Genesis looks like it’s going to take December off and then come back and talk to creditors next year. Their parent company DCG is a multi-billion dollar behemoth. If they are going to blow up they are going to do it slowly. It takes forever to unwind an entity as large as Genesis.

The good news if you don’t have exposure to any of the already bankrupt firms is that most of them have already gone through the period where they sold off all of their assets in a fire sale. FTX was the poster boy for this phenomenon, ending their life with zero Bitcoin on their balance sheet, despite billions in Bitcoin owed to customers.

If more things explode, there likely won’t be a fire sale of coins rushing to market.

I fully expect there to be at least two additional offshore exchanges blow up in the next 6 months. I don’t expect them to have a large amount of assets to sell off, but things could get weird and an exchange blowing up will impact the price of tokens.

The Tail Risk is still out there

The Stablecoins are the biggest question mark still left on the board. After years of assurances, we still haven’t seen Tether’s books with any real certainty. Circle recently canceled its public market debut and will no longer be providing public financial reports. The less said about Binance USD the better and the other more minor stablecoins are plagued with questions.

Stablecoins are not dollars in a bank. If you want US dollars, own US dollars.

US short term government treasuries are currently yielding almost 4%. Bank accounts have insurance. There’s really no reason to be holding a large amount of stablecoins in this environment unless you’re using them in DeFi.

I don’t want to bet against Tether. Shorting Tether is the widowmaker trade in Crypto. Even if you’re right, your counterparty will likely be insolvent and won’t pay out.

I don’t even really think that Tether will fail in this cycle, but it’s a tail risk to be wary of.

Stick around for the next cycle

The biggest takeaway from all of this is that Crypto isn’t going anywhere. Bitcoin isn’t dead.

If you’re here already, stick around. Fortunes are made in bear markets and collected in bull markets. Learn about the space. Hone your strategies. Figure out what you want to own and why. Get ready to deploy funds when the Crypto winter is waning.

The Federal Reserve can’t stop printing money forever

Today’s post is from contributing analyst Scott Hill. To receive further updates of this series and our overall investment thesis for digital assets (even in this climate), subscribe to the Bombthrower mailing list. 

Last week we covered the collapse of FTX as it happened but there’s a lot more to the story. How did FTX grow from a tiny Hong Kong bucket shop into a top three Crypto exchange over the course of just a few years? What was Alameda research and were they ever legitimate? Most importantly, how exactly does an exchange lose track of up to $10 billion worth of customer deposits?

Most of this material is still an educated guess, but the guessers are out there putting together clues from private discussions which have been leaked, the bankruptcy proceedings and first hand dealings shared on Crypto Twitter.

It’s worth noting that there is a whole deep state angle to this story.

I won’t go into it in this article because so little is known (see endnote – ed.)

What we do know is mostly confined to the fact that FTX CEO Sam Bankman-Fried (SBF) was the second largest donor to Democrat political campaigns since 2019. His Co-CEO for part of the FTX Empire, Ryan Salame, was a top 10 donor to the Republican party in the same period.

Sam Bankman-Fried met with SEC Chairman Gary Gensler seeking a “no action” letter on an enforcement matter in April, shortly before SBF began pushing the DCCPA, a bill which the Crypto industry mainly saw as a subtle crackdown on DeFi wrapped in a reasonable sounding regulatory framework.

The biggest question mark is the identity of FTX CTO and co-founder Garry Wang. The man is a ghost with very little online presence and only a handful of photos. Famed short seller Marc Cohodes is under the impression that Wang is a state actor for the CCP.

These questions are important and interesting, but they don’t make for a useful article because of the complete absence of detail.

Alameda Research

Alameda Research, the market maker or crypto hedge fund founded by SBF in Hong Kong during the bull run of 2017 is the start of the rot. The official story is that the firm was formed from a team of young hotshots who learned to trade at Jane Street, a notoriously secretive global market maker which trades more than $10 trillion in securities volume each year.

In January 2018 as Bitcoin was collapsing, Alameda research were performing the Japan arbitrage trade. They purchased Bitcoin in the US, moved it onto Japanese exchanges and cashed in on the gap between markets. The spread was often as wide as 10%. SBF claimed the firm made $10M on the arbitrage over the course of several weeks.

This was a complicated trade. Japanese capital controls are strict with only Japanese nationals allowed to hold bank accounts, making it extremely difficult to get the money out of Japan and requiring a reasonable level of sophistication and corporate legitimacy to pull off.

Following the Japan arbitrage, Alameda went after the “Kimchi Premium”. This was the same type of arbitrage trade, with Bitcoin on South Korean exchanges worth up to 20% more than Bitcoin on US exchanges. The capital controls were tighter, the ability to set up corporate infrastructure in the nation was more restricted and Bitcoin was in the middle of collapsing making trading the asset much more risky.

Some people are suggesting that Alameda lost $10 million on the Kimchi Premium trade, but no one really knows whether any of this story is even true.

I’m deeply skeptical of this entire backstory given what we have now seen about how careful SBF is with his public image.

It’s entirely possible that this whole story was a fabrication to paint the picture of a boy genius trader with a Jane Street pedigree striking out on his own in Crypto land.

Completely Absurd Fundraising

In early 2018, Alameda Research established headquarters in Hong Kong. While SBF was a complete unknown to Crypto insiders at the time, Alameda Research was making a name for itself, frequently up the top of the Bitmex trading leaderboard.

Crypto markets in 2018 were very different to the last few years. While 2017 had seen a burst of activity during Bitcoin’s bull run, volumes were still tiny and there were very few professional firms taking the asset class seriously.

It’s completely plausible that in the absence of professional market makers, Alameda Research could have done very well. It also seems likely that the edge that such a small team had would have disappeared quickly as the market became more professional. Alameda Research only had a handful of employees. Nowhere near enough to build and execute a sophistical algorithmic market making strategy, such as those employed at Jane Street.

In December 2019 an investment pitch deck for Alameda Research circulated among Crypto insiders. The firm was seeking to raise $200 million in debt funding and was offering 15% payments on the debt. The pitch itself made ridiculous claims about the firm’s edge and was riddled with red flags.

“High Returns with no risk – These loans have no downside”

Insiders that viewed the pitch deck were confused. The whispers within the industry were that this firm was highly profitable yet they seemed desperate to raise $200 million. Most stayed away and it’s unclear whether or not the fundraising was successful.

Launch of FTX

FTX was founded in May 2019 but had very little volume until the following year when they established the regulatory status to allow US customers to trade. FTX later acquired Blockfolio to obtain additional US licensing and the bones of a trading app. Even with this boost in volume, FTX was considered an unfavorable exchange to make markets for among established industry participants.

The presumption was that Alameda Research was an embedded market maker that was given an unfair advantage on the platform and rival firms stayed clear.

At the time SBF was still the CEO of both companies. There were claims of a separation of the firms, but it was known that they both operated out of the same offices in Hong Kong. It was rumored that Alameda had full access to customer position data and would hunt for liquidations.

FTX was seen as a shady offshore bucket shop.

By early 2021 little had changed in the industry perception of FTX, but volume was growing. In January SBF was busy arguing on Twitter, leading to the infamous “I’ll buy as much Solana as  you have, right now, at $3” tweet. He was not taken seriously until later that year when this huge Solana bet seemed to pay off.

FTX gains Legitimacy

By the middle of 2021, with Crypto in a raging bull market and FTX capturing significant market share, the exchange became too large to ignore. A big part of the story was China putting in place another round of Crypto bans in September which forced many major Crypto traders and market makers to find new venues to trade.

Zhu Su, founder of disgraced Crypto Hedge fund Three Arrows Capital said recently that he had moved his fund’s trading from Huobi and Okex to FTX and Binance in the wake of the China ban.

FTX gave them extremely favorable terms.

A big reason that firms began to feel comfortable with FTX was the splashy fundraising FTX was able to pull off. Market participants assumed that among the billions of dollars of venture capital money that had been invested in FTX, someone had done basic due diligence on the firm. We now know that during these heady days of free money SBF was demanding investment commitments quickly from VCs or he would move on to the next phone call.

There was a giant line of VCs desperate to get into an FTX round.

The July fundraising list was a who’s who of Silicon Valley VC. Led by Sequoia, the round included Softbank, Temasek and VanEck. Apparently none of these firms insisted on even the most basic corporate controls, like installing a board of directors. A later round included a strategic investment from Blackrock. FTX was a blue ribbon investment.

They all needed Crypto exposure now and FTX was the hottest Crypto startup in town.

The other piece of the puzzle was that trading firms were now making money on FTX, when before they were simply getting their positions hunted by Alameda. Leverage was handed out in ample servings. Compliance was lax. Payouts were quick. It seemed to most that FTX had moved on from its shady beginnings to become a legitimate venue for market makers to use.

Tokens

A giant part of understanding exactly what went down at FTX is understanding the Tokens they had launched or partnered with. In 2019 FTX launched FTT, an Ethereum ecosystem token which represented a cut of exchange fees and offered discounts to traders for holding it. It was the same model that Binance launched their token with in 2017. Tokens would be bought out of the market with a portion of exchange profits on a regular basis, delivering a return to investors.

A huge portion of FTT tokens were held on the FTX balance sheet as an asset.

Even more egregious were the Solana ecosystem tokens which FTX helped launch. The leaked balance sheet showed that FTX had large holdings of Serum, Maps and Oxy.

It showed Serum tokens marked as a $2.2 billion asset. Available market cap at the time was less than $500 million.

We don’t know for sure, but it seems likely that loans were taken out backed by FTT and other minor tokens.

Essentially, it seems that SBF invented his own currency from this air and then took out US dollar loans against it from anyone that would offer. 

We haven’t heard from any major Crypto lender about whether or not they took FTT as collateral. We may never hear an admission on that point. What we do know is that Solana DeFi, where SBF had significant influence, largely took these minor tokens as collateral for loans on much more generous terms than seems reasonable now.

And why wouldn’t Crypto lenders offer loans to FTX on whatever collateral was offered? FTX was the fastest growing exchange in industry history. It had prestigious investors. Its CEO was throwing around cash on advertising and political donations. Surely FTX was profitable enough to service their loans.

So what happened to the money?

When FTX blew up there was a balance sheet hole of somewhere between $6-10 billion. It was reported as “missing customer funds” but judging from recent public comments made by SBF it seems more likely that there was a complex web of loans and cross company funding arrangements than just straight up theft of customer assets.

An underreported part of this story which fills in a key gap is that the offshore FTX entity apparently didn’t have its own bank account. Wires to the offshore exchange would go directly into a bank account held by Alameda Research. It seems that FTX didn’t secretly transfer customer funds to its associated hedge fund, it probably didn’t even make loans between companies.

The most likely explanation is that Alameda Research just had direct access to customer funds  which were wired to them.

While shocking, it wouldn’t be as egregious if the FTX terms didn’t explicitly say that assets were held on trust for customers. FTX wasn’t supposed to touch customer funds once they were deposited. Maybe that’s the whole point, that SBF was relying on some bizarre technicality or legal fiction to convince himself that he had the right to deal with customer assets. Did I mention that both of his parents are compliance lawyers, with one a leading expert on tax havens.

If there’s anyone that could access the advice to set up a complex piece of legal fiction entitling him to pilfer customer funds in a defensible way, it’s SBF.

Liquidations

That only explains how Alameda Research got access to customer funds, but how did they lose the funds? Alameda Research is a market maker primarily and was the key integrated market maker on FTX. Among other things that gave Alameda the ability to purchase liquidated positions of customers, likely at a huge discount.

In a bull market this is a hugely advantaged position to be in. Say Bitcoin drops 5% in an hour and longs get liquidated, Alameda was able to purchase those long Bitcoin positions and then resell them later, after the liquidation cascade was over and price had recovered.

Alameda was exempt from liquidation on FTX, so they could hold underwater positions for as long as they wanted without being forced to close them.
In a bear market, Alameda would likely accumulate underwater positions that they couldn’t get out of without incurring a large loss. Other market makers will generally sell a liquidated position off as soon as possible, to avoid being liquidated themselves. This doesn’t appear to be a check and balance that was in place for Alameda’s operations on FTX.

Another key feature of the leverage trading offered at FTX was cross asset collateral. Essentially this means that leverage was offered on the entire portfolio of a customer. There wasn’t a segregation of collateral, users could simply offer up a mixed list of tokens and take margin loans against the whole pie. This included FTT and Serum at much more generous collateral ratios than other exchanges offered.

Whatever low quality collateral you had, FTX would take it, and it seems that it would end up on Alameda’s books when a customer was liquidated.

Luna Eclipse

In a collapsing market, this lack of controls over Alameda is potentially disastrous. Luna had the most high profile collapse in the history of Crypto tokens in May this year, losing 99.7% of its value in a week before getting as close to absolute zero as possible. FTX and Binance were the major venues for trading the Luna collapse. Traders bought the dip on leverage all the way down.

It seems likely that Alameda took all of those liquidated positions onto their own balance sheet.

Luna started its collapse at around $90. The following week it was at essentially zero. There is no way that Alameda could have sold off all of those liquidated customer positions as the token collapsed. This type of liquidation transaction is known as “toxic flow” and is a surefire way to bankrupt a market maker.

If FTX’s famously specialized liquidation engine simply meant that customer positions were shunted onto the Alameda balance sheet to be cleared at a later date, then the amount of toxic flow from junk tokens in the last year would build up quickly.

This seems to be the only way the size of the hole makes any sense.

Other Problems

If we assume that Luna blew a giant hole in the balance sheets within the FTX empire then what happened next makes a whole lot more sense. SBF went on a buying spree as Crypto lenders collapsed, backstopping insolvent firms and being proclaimed as Crypto’s JP Morgan.

In the cold light of day a more likely explanation than wanting to save the industry is wanting to save himself.

If insolvent Crypto lenders like Voyager and Celsius had given loans to FTX, taking FTT and other minor tokens as collateral then those tokens would be seized and sold into the market during a bankruptcy, cratering the price and liquidating FTX loans with other lenders. Don’t forget, for tokens like Serum, FTX held and likely pledged as collateral more than the entire free float on the market.

All of this isn’t to say that funds didn’t go missing in other ways though.

According to the Bankruptcy filings, FTX had loaned more than $1 billion to SBF individually and $2.3 billion to his investment company, Paper Bird Inc. There were also 9 figure loans to other executives and Bahamas real estate purchased by SBF’s parents and associates worth $300 million. There are even suggestions that the $420 million meme fundraise in October 2021 basically just ended up in the pocket of SBF, rather than productively invested in the company.

It seems like the FTX balance sheet was used as a slush fund for SBF.

None of this in any way can add up to $6-10 billion in stolen customer funds and it’s unlikely that the mechanism was brazen theft. The scenario outlined above, poor trading controls at Alameda creating bad debt within the corporate structure and a CEO that was scrambling to keep the empire afloat, is far more likely. This also casts a new light on the “generous terms” offered to other major market participants in 2021.

Taking VC money

What if Alameda’s goal wasn’t to make money, but to lose money to other traders in a perverse growth hack used to attract the next round of “smart money” investors?

After all, at best Alameda had been making a few hundred million from trading over the course of its existence and likely much less than that. As spreads closed with more market makers flooding into the asset class it’s much easier to take money from Sequoia and Softbank than it is to make money trading.

Running an unprofitable casino is a terrible business, but selling an unprofitable casino that looks extremely busy to a private investor is a fantastic business.

This part of the story seems like the inevitable end state of the 2010s dominance of Venture Capital and private investing. After a decade of easy money, low interest loans and an insatiable appetite for tech investments we were bound to see someone game the system. In 2021 VCs were not doing diligence, they were shoving newly raised funds into startups as fast as possible. Venture capital firms invested $643 billion in 2021. Almost double the pace of 2020 and five times as much as was committed in 2012.

For context, noted scam company Theranos raised $1.4 billion over 13 years. FTX raised $1.8 billion in only 3 years.

The entire story of the growth of FTX is a story of the driving forces of tech stock investing being applied to Crypto and fintech. The problem is that when a social media company blows up, users just lose their photos and social graph. When a fintech or Crypto company blows up, customers lose their funds and lives are ruined.

A big part of the problem with FTX was that tech growth hacking and the infinite pot of VC money was applied to financial services with little regard for the safety of users. No one did the diligence. The regulators were asleep at the wheel.

“Grow fast and break things” isn’t an appropriate model for the financial sector.

We Have Questions…

This article mostly dealt with how FTX managed to grow so fast and then blow up so spectacularly but it didn’t touch on the why. As stated in the introduction, there are some major question marks about state entanglement, potential involvement of intelligence operatives and the corruption of captured regulators are all major open questions that I just don’t have answers to.

Was FTX a plant to bring down the Crypto industry and justify tighter regulation?

Was FTX a front for money flowing from Crypto traders and Tech VCs into Democrat coffers?

Why is the mainstream media reporting on this event as if SBF is just a failed entrepreneur who dreamed too big, rather than a fraud who appropriated customer funds?

Who was behind the success of FTX? Who is Gary Wang?

We likely won’t ever get satisfactory answers to these questions. The family political links between major characters in this story are deeply suspicious. As one Crypto Twitter account that has been covering the news relentlessly said:

“This FTX fiasco is *really* doing its best to confirm every single conspiracy theory anyone has ever had about anything.”

Next week in the conclusion of this three part article I’ll cover some of the fallout surrounding the FTX collapse that is important to understand and the lessons being learned by the industry in its attempt to rebuild.

Endnote

[A good place to start down the deep state rabbit hole in all this is Mathew Crawford’s  ‘A Grand Unified Theory of FTX’ – which I printed off to read and it clocks in around 65 pages – markjr]

Today’s post is from contributing analyst Scott Hill. To receive further updates of this series and our overall investment thesis for digital assets (even in this climate), subscribe to the Bombthrower mailing list.