Explainer: What Really Happened at Crypto Exchange FTX?
Moneylife Digital Team 19 November 2022
When the US$32bn (billion) crypto exchange FTX filed for chapter 11 bankruptcy in the US, inviting investigations by regulatory authorities and the justice department, the entire crypto world was plunged into a panic. FTX and its associate, the trading firm Alameda Research, both founded by Sam Bankman-Fried (@SBF_FTX), are understood to have made huge losses and 'unauthorised transactions', losing billions of dollars of customers’ and investors’ money. There are reports of massive fraud when customer money with FTX, a crypto exchange, was diverted to fund losses of Alameda, the trading arm. What really happened?
According to a report from Vox, the downfall of FTX is not a typical story of crypto's volatility or investor risk-taking; it did not crumble due to bad luck but—what now appears to be—unsustainable layers of deception. "On the surface, FTX appeared to be thriving—in the past year, it made several high-profile acquisitions and bailed out other failing crypto companies.
In reality, it was drowning in debt. At least US$1bn in customer funds is reportedly missing. The stunning contrast between image and reality has resulted in Mr Bankman-Fried facing a reputational fall from grace swifter than any in recent memory."
The report describes the FTX founder as someone who 'made his riches through cryptocurrency arbitrage—buying coins for a lower price on one crypto exchange, then quickly selling them for a higher price on a different exchange'. "He convinced a few fellow effective altruistic friends to help in this arbitrage model and founded his trading firm, Alameda Research. By 2019, it was turning enough profit that Bankman-Fried launched his own crypto exchange, FTX. Part of FTX's draw for investors was that it allowed riskier trades than other exchanges; it allowed people to make highly leveraged bets—at least until 2021 when it reduced the amount of leverage it offered clients. (Mr) Bankman-Fried was quickly branded as a brilliant disruptor in crypto. That year, at the age of 29, he was worth US$22.5bn," Vox says.
Over the years, marquee investors like BlackRock, Sequoia Capital, Tiger Global Management, Insight Partners, SoftBank and Temasek, among others, invested money in FTX.
However, 2022, especially the second half, proved to be too much for Mr Bankman-Fried and FTX. In August, a US bank regulator ordered FTX to halt what is known as 'false and deceptive' claims about whether funds at the company are insured by the government.
When FTX was floundering in early November, Binance, the world's largest crypto exchange, took a U-turn on acquiring FTX, saying it was backing out of the deal after reviewing the company's finances, leading to a further fall in major cryptocurrencies. FTX admitted that 'unauthorised transactions' have drained hundreds of millions of dollars from its wallets. Reports claimed the amount could be as high as US$600mn (million).
Jason Choi, a tech investor, who claims to have witnessed the rise and fall of FTX, alleges that Alameda Research, a trading firm, and hedge fund, founded by Mr Bankman-Fried, was trading billions of dollars from FTX accounts and leveraging the exchange's native token as collateral.
In a series of tweets, he also alleges, "In the early days, Alameda being a heavy portion of FTX's volumes was an open secret. Employees told me Alameda has an exclusive application programming interface (API) key that allows faster access than any user - offering a systematic way to profit off clients."
"Alameda pledging illiquid collateral to borrow money to finance bets, which get margin called as markets went down this year, leading to the theft of FTX user funds to put out fires. This means liquid reserves on FTX were likely lower in amount than user deposits - but chances are this hole was manageable given enough time as more of FTX and Alameda's illiquid assets get vested over the years," he says.
Mr Choi also shares an example of how both Alameda and FTX created 'great looking assets' through the illusion of a large and diversified balance sheet to fund directional bets.
"Let us say Alameda funds a semi-incubated project at a US$10mn (million) 'fully diluted valuation' (price of the token total number of tokens ever to be issued) with US$2mn. FTX then lists the token on its exchange but only releases 1% of the total tokens to the market. As markets are thin, Alameda can prop up prices using a few million dollars to create a 'fake' fully diluted valuation of say, US$1bn. Suddenly, US$2mn is US$200mn on 'paper'. This is an open secret for what industry insiders call 'Sam coins'. By doing this, Alameda creates the illusion of a large plus diversified balance sheet, which it could then borrow against to fund directional bets. FTX also lists swaps contracts for 'Sam coins', which means Alameda can short to lock in profits on unvested tokens," he says.
According to Mr Choi, the story of Alameda and FTX can best be summarised by Mr Bankman-Fried's philosophy of betting big. "Every major decision they have made is related to acquiring more leverage - via deceptive fundraises, financial engineering, and ultimately, outright fraud, as we will see below."
Here is the link to all tweets from Mr Choi on the FTX episode... https://threadreaderapp.com/thread/1592502785873825794.html
Meanwhile, Kelsey Piper from Vox interviewed the ex-CEO of FTX and published the conversation that took place through Twitter. He wrote, "(Mr) Bankman-Fried has maintained that FTX has never invested the deposits of crypto account holders on the exchange. I pressed him on that point via Twitter, and while he continued to insist that FTX did not directly use account money in this way, he said that Alameda — which he also owns — had borrowed far more money from FTX's balance sheet for investments than he had realised, which ultimately left FTX vulnerable to the crypto equivalent of a bank run."
Mr Bankman-Fried, in a series of tweets (after the Vox interview), accepted that they got 'overconfident and careless'. "Once upon a time--a month ago--FTX was a valuable enterprise. FTX had about US$10bn - US$15bn of daily volume and roughly US$1bn of annual revenue. US$40b of equity value. And we were held as paragons of running an effective company. I was on the cover of every magazine, and FTX was the darling of Silicon Valley. We got overconfident and careless. And problems were brewing. Larger than I realised."
"That so many people in different industries are rocked by a single person's financial ruin illuminates the magnitude of influence billionaires have. It also shows why that influence needs serious, careful examination. How much credence can we give to a sales pitch?" the report from Vox says.
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