The Fall of FTX Explained

Short summary: FTX lent $10bn of client funds to their trading arm Alameda research, which used it for very high-risk crypto bets (leveraged crypto speculation). Alameda lost a lot of this money as crypto prices fell. Investors found out about this & tried to withdraw $8bn from FTX. FTX didn't have it. FTX filed for bankruptcy.

Long story goes thus:

Meet the main characters

Sam Bankman-Fried, also known by his initials SBF, is a 2014 MIT physics graduate who made some millions from buying Bitcoin in one market and selling it in another one at a higher price, profiting from the price difference. Something called Bitcoin arbitrage .

In 2017, SBF founded a crypto research and trading firm called Alameda research whose CEO, Caroline Ellison, is also an MIT alum and dated SBF in the past. Alameda research is also sort of a hedge fund.

Also in 2017, Changpeng Zhao, commonly known as "CZ" founded a cryptocurrency exchange called Binance.

In 2019, SBF launched FTX, a crypto exchange. A week ago, FTX was the 2nd largest exchange behind Binance. FTX's native token is called FTT. FTT allows owners to enjoy lower trading fees and access a slew of perks on the FTX exchange like using the tokens as collateral to trade derivatives.

Also in 2019, Binance invested as a shareholder in FTX.?In 2021, Binance decided to sell its FTX investment. As part of the sale, Binance agreed to take $2B of FTT.

Cut to the year 2022

The Fed has been increasing interest rates. Investors have been selling down their crypto positions. Cryptocurrency prices have nosedived and not a lot of people are trading crypto (crypto trading volume is low).

On November 6th, CZ announced on Twitter that he's going to sell Binance's $2bn FTT stash due to unspecified recent revelations.

This is bad news for anyone holding FTT. $2bn of selling pressure would crush the price. So FTT holders start to panic sell. Nobody wants to buy FTT because it's too risky, a whale is about to dump and everyone wants to sell. This causes FTT price to drop 15-20% overnight.

Caroline came out and said Alameda will "happily" buy the FTT token at $22 apiece to reduce the market impact of the sale. It seems CZ did not take her up on the offer

Let's go back a bit. What could the unspecified revelations have been?

This is what I've found so far in the public domain

Alameda research had $14bn in assets and about $7bn in liabilities, which indicates that they have enough assets to cover their debt (a good thing). However, Coindesk revealed the week before CZ announced the FTT sale that $5.8 billion out of $14.6 billion ?of assets on Alameda's balance sheet were in FTT.

This simply means Alameda research borrowed money and used FTT tokens as the collateral for those loans. This would be like a company borrowing money and using its shares as collateral for that loan.

Collaterals are the lenders' safety net if a borrower is unable to repay a loan. If a debtor is unable to pay a loan, the lender can sell the collateral to get their money. If a company is about to default on its loans, they are probably in a bad financial position, which will cause its share price to fall significantly. A great illustration of this was the real estate giant, Evergrande Group, which saw its share price drop over 90% in 2021 when rumors came out that it could default on its loans.

So, if a company uses its shares as collateral, its lender will not be able to recover its money in full if they try to sell those shares in a default. Thus, no sensible lender will accept a company's shares as collateral for a loan. But this is essentially what Alameda research did. Took loans to make crypto trades and used FTT as collateral. Remember Alameda research and FTX were founded by the same person.

There is speculation that CZ found out about this and announced the FTT sale to make the FTT price plummet and force Alameda to file for bankruptcy. But if Alameda goes down, so does FTX.

Why would FTX go down with Alameda?

The Wall Street Journal reports that of $16bn in customer assets FTX had, they "loaned" $10bn to Alameda research. Alameda probably suffered great losses in any of the several crypto meltdowns that happened this year and could have gone bankrupt. Instead of allowing them to fail, FTX gave them more than half of its customers' trading money to bail them out.

Why didn't FTX allow Alameda to fail?

FTX gave money that customers deposited on the exchange for trading purposes to Alameda to make high-risk crypto trades and make profit. While crypto prices were soaring, that arrangement was profitable. But as crypto prices crashed, so did Alameda's money and by extension, FTX's customer assets.

"A rising tide floats all boats.?Only when the tide goes out do you discover who's been swimming naked" -?Warren Buffett

Apart from the conflict of interest in the relationship between SBF and Caroline, if FTX had let Alameda go bankrupt, all Alameda's FTT tokens would have been liquidated in bankruptcy court. As we learned, Alameda has billions of FTT tokens. So that would have caused FTT tokens to fall significantly in value.

Also, if Alameda went bankrupt, FTX would have lost some of their customer's funds that they gave Alameda to use for trading purposes. This would have been terrible for FTX, so they bailed Alameda out to avoid this and in hopes that Alameda could make more profitable trades, recover lost funds and repay the "loan".

Now that we know what the unspecified revelations could have been, let's go back to November 7th.

24 hours after CZ's tweet, FTX had not shown financial strength. This feels like the "steady lads" moment right before Luna collapsed.

FTX customers start withdrawing funds en masse in case it collapses like Celsius, Blockfi, Voyager, and Luna all did this year. FTX saw billions of withdrawals. They didn't have the cash to give customers, so they paused withdrawals.

This rush to the exits reportedly forced SBF and his team to begin frantically shopping for an acquisition partner, approaching a?variety of potential partners ?before Binance entered the picture.

On November 8th, CZ tweeted that Binance signed a non-binding agreement to acquire FTX to bail them out of their liquidity issues. CZ pulled out of the deal the next day after they saw FTX's books.

Conclusion

FTX promised users that it?would not speculate ?with cryptocurrencies held in their accounts. If that policy was followed, there should have been no need to pause withdrawals. As we know, that was not the case.

Now

FTX's legal team has quit. SBF has resigned as CEO. The SEC is investigating FTX and FTX has filed for bankruptcy.

Customers have been unable to withdraw funds and the FTX trading app is reportedly no longer working. It was reported that FTX got "hacked" for $600 million after they filed for bankruptcy. Was this really a hack or were the founders getting some money out?

This has caused another crypto crash with most crypto prices falling anywhere from 15% to over 50%. Companies that invested funds with FTX will likely face similar liquidity concerns. Coinbase and Robinhood saw their share price fall over 10%.

Coinbase's share price fell out of fears they had exposure to FTX or they were running a similar model, Coinbase has released statements saying they do not. Robinhood shares fell because SBF is a large investor in Robinhood and will need to sell a lot of shares to cover his liabilities.

We are yet to see how many businesses will be affected by this (the contagion). In time, this will become clearer.

FTX attracted investors like BlackRock, Ontario Teachers' Pension Fund, Sequoia, Paradigm, Tiger Global, SoftBank, and many more. Sequoia has already written down its $213 million?investment in FTX to $0. So, a lot of capital will be destroyed by this.

The billion-dollar question is where did all the money go?

Some of the money went to Alameda who, as we know, borrowed money to trade crypto (leveraged trading). The thing with trading with leverage is if the trade is profitable, you can magnify your profit many folds but if it's not, you can lose more money than you invested. Alameda probably lost more money than it invested.

Some of the money also went into illiquid investments (assets that cannot easily be sold to get cash). The Financial Times received a copy of FTX's balance sheet dated Thursday, November 10, which shows FTX had only $900mn of liquid assets (assets it can easily sell to get cash), despite having $9bn of liabilities.

The balance sheet shows FTX has over $8bn in illiquid assets including in Twitter, and something called TRUMPLOSE (was that a bet that Trump loses something or a donation to the Democratic party to ensure Trump loses? nobody knows). Some of those assets may be worthless today, others may be worth significantly less than what was originally invested.

Moral lessons according to CZ

1. Never use a token you created as collateral.
2. Don’t borrow if you run a crypto business. Crypto is too volatile to use borrowed funds to trade. You can easily magnify your losses

End credits

SBF is the son of 2 Stanford Law professors