Q9 Weekly | FTX Freefall

11 November 2022

Q9 Capital: www.q9capital.com

FTX Freefall

• FTX and Alameda empire collapses
• Indications FTX used client funds in ways they weren’t supposed to
• Fallout heats up, contagion spreads, markets sell off

The FTX liquidity crisis and collapse has rocked crypto markets in recent days.

Following a rumour that sparked a confidence crisis and a “bank run” at FTX, the world’s second largest crypto exchange was hit with $6bn in withdrawals in the 72-hours before Tuesday morning. The venue did not have the funds to meet the surge in withdrawals and customers were frozen out of their accounts.

The company is now insolvent and is seeking a $9.4bn rescue package after Binance walked away from a possible bailout, stating “the issues are beyond our control or ability to help”. Equity backers such as Sequoia have marked their investments down to zero (the firm was valued at $32bn earlier this year) and the chances of a white knight rescue are slim.

Massive questions are now being asked about the firms use of client assets, the depth of the ensuing contagion, how this could be allowed to happen, and whether criminal activity took place.

Bitcoin was born in 2008 as a direct response to the global financial crisis. Ironically, the crypto industry it spawned may now be experiencing its own “Lehman moment”. If the Lehman analogy holds true, Terra/Luna maps to Bear Stearns’. If FTX is the Lehman Brothers of this story, there is likely more to run. BlockFi has already suspended its operations and others will certainly follow suit over the coming days and weeks.

The event is attracting the gaze of global regulatory bodies. FTX is being investigated by the DOJ and the SEC, the company’s assets have been frozen by the Bahamas securities regulator, and the Japanese regulators have ordered it to suspend its operations there.

Bank man, fried

As for SBF himself, he witnessed his entire $16bn personal wealth evaporate, marking the biggest one-day wealth collapse for an individual on record, and he is no longer a billionaire.

Source: Bloomberg Article from April

Here’s a list from Forbes highlighting the other major investors set to lose big, including the Ontario Teachers Pension Fund, Temaskek and Paradigm — and here’s the cap table from August:

Source: Forbes

A Simple Twist of FTT

As the market sold off, the biggest pain was seen in “Sam tokens” that Alameda had positions in such as Solana and (obviously) FTT. Bitcoin reached a two-year low and ended the week at $17.5k, down -13%. ETH fell -15% to $1.3k. The market cap of all-crypto fell to $0.9tln.

Trading platforms dYdX, Crypto.com, OKX and others have restricted SOL trades. Concerns are also being raised about next-gen blockchains Sui and Aptos, which SBF backed.

FTT, SOL, ETH, BTC Return, 5 Days (vs USD)

Source: TradingView

However, the market cap of stablecoins has not declined, a sign that there has been no major fiat offramp.

Market Cap of USDC, 5 Days

Source: TradingView

How Did the Collapse Unfold?

SBF’s woes began on Nov 2nd, when CoinDesk revealed that his prop trading shop, Alameda Research, was full of tokens FTX prints out of thin air, called FTT. The note revealed that of Alameda’s $14.6bn in assets, nearly $6bn was in FTT with $2.16bn of it as collateral against loans.

The rest of the assets were equally abysmal — $1b+ of SOL, $2b+ of other illiquid altcoins (SRM, MAPS, OXY, and FIDA), and $2b of “investment in equity securities”.

The FTT tokens are used by traders to access benefits such as reduced trading fees and earn a yield when FTX buys them back periodically using a portion of the revenue it generates through trading commissions. Effectively they are a similar concept to air miles with the airline buying a portion back from you at regular intervals.

Last year, CZ sold his equity stake in FTX back to SBF (Binance originally seeded FTX), who paid for it partially with these FTT tokens. However, after the CoinDesk report emerged, CZ revealed on Twitter that Binance held $580mn in FTT — and that he was selling everything.

Alameda CEO, Caroline Ellison, then attempted to mitigate the situation and further signal confidence with an offer to buy all of CZ’s FTT at $22 (at the time trading ~$23). But CZ was not a taker.

This caused a massive confidence crisis in both FTX and FTT and everyone ran. FTX saw around $6bn in withdrawals in 72-hours and was unable to meet the redemptions. The selling action spread to other tokens that Alameda was known to have large positions in. These included SOL and MATIC. FTT’s value fell from $22 to $5.

Binance then launched a deal to rescue FTX, but backed out (to nobody’s surprise) a day later, citing concerns about FTX’s business practices, alleged mishandling of customer funds, and reported investigations by US regulators… FTX now limps on to find other potential buyers.

FTX.US (a separate entity) announced today it may halt trading on its platform in a few days.

This story is far from over. News of more scandals at FTX will emerge over the coming days and weeks. Former employees are leaking information citing ongoing harassment and death threats due to the exchange’s solvency issues. Twitter is also awash with very severe rumours.

Web Designers

Much of this centres around the interconnected web of the web connecting Sam’s trading business Alameda Research, its relationship with FTX and the use of client funds. FTX lent billions of dollars’ worth of customer assets to fund risky bets by its affiliated trading firm, Alameda Research.

This is a massive no no. It shouldn’t be doing anything with those assets. They should just be sitting there so people can use them. An exchange shouldn’t have problems returning its customers deposits. In traditional markets, brokers must keep client funds segregated from other company assets. Crypto should be no different.

All in all, FTX had $16bn in customer assets, so it lent more than half of its customer funds to Alameda. Alameda also took out $1.5bn of additional loans from other financial firms (who likely aren’t seeing this back). If this is correct, this will rank as one of the largest financial frauds of all time.

SBF tweeted on Monday: “FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries).” He later deleted the tweet. He had believed in the run-up to the crisis that the exchange had 24-times average daily withdrawals of US dollar liquidity available. This turned out not to be true.

It is possible that SBF was eager to prop up Three Arrows, Voyager etc because Alameda and his other companies were exposed to them and needed to use client funds to plug the massive black hole. It is also likely FTX and Alameda were wash-trading the FTT token to maintain its lofty valuation. Much of this is opinion, not fact — but we’ll find out the details soon.

The web of interconnectedness is going to take a long time to unwind. The corporate structure shenanigans are out of this world (see below). Figuring out what’s actually gone on at FTX, Alameda and other related entities will be very tricky.

Source: FT

The SEC’s post-mortem diagram of Lehman’s corporate structure looks a model of simplicity in comparison.

Source: FT

Bankman-Fried on Thursday said he plans to wind down trading at Alameda.

The CZar of Crypto

The collapse of SBF’s empire leaves Binance dominant. CZ is now the top dog, with the world’s biggest crypto exchange, and the winner by KO in the public war between him and SBF. The Binance x FTX conflict has been brewing since 2019 — here’s a thread detailing the complete history of the spat.

CZ alleged as he sold FTT: “We won’t support people who lobby against other industry players behind their backs”. SBF later addressed a “particular sparring partner” on Twitter: “Well played, you won.”

Binance will not now come to FTX’s help. There’s no need to pay for FTX customers because many of them will migrate to Binance anyway, and FTX doesn’t have technology that Binance needs.

However, the optics of massive centralization in a business that’s supposed to be about decentralization will make Binance look bad. Binance’s dominance will attract more regulatory scrutiny and possible anti-trust action.

Binance’s Increasing Share of Crypto Trading Volumes

Source: Reuters

Down, But Not Out

This event is a massive black eye for crypto. The damage here is huge. Jesse Powell, CEO of Kraken, summarises the fallout in this great thread.

Tom Brady and other super wealthy investors lost big money in FTX’s collapse. But more importantly, so have mum and pop investors and regular savers sucked in by eye watering returns and the opportunity to improve their lives. They may never see part of their life-savings again.

SBF marketed himself as the friendly face of crypto, who was engaging with regulators, celebrities and blue-chip investors. He was sponsoring sports teams and currying favour with politicians. Last year he even told the Financial Times he might one day buy Goldman Sachs. Many people are rightly shocked by the event. Regulators will now look at FTX’s unforeseen failure as a lesson that even crypto groups that appear well-run and responsive are liable to implode.

The opaque nature and the lack of transparency around FTX/Alameda is not an isolated issue — as highlighted by Celsius, Three Arrows Capital, Voyager Digital and many others throughout the Summer.

The crypto industry will need to change. Proponents have suggested Proof of Reserve products as a solution to future trust issues. DeFi also has a future. Decentralised exchanges ran as clockwork this week and are shielded from the obvious conflicts and greed of CeFi players. Regulation and investor protection rules also needs to emerge quickly. But we cannot rely on governments to save crypto — the industry needs to be better at weeding out bad actors.

Crypto has obvious vast potential — but for it to be sustainable and to ultimately thrive as an integral part of the global financial services ecosystem, incumbents need to change how they operate and include more robust regulatory compliance, risk management procedures and transparency about how client funds are being used.

While the FTX fallout will certainly cause short-term volatility, in the longer term, the digital asset industry will rebound to build a better and more transparent future for financial services and other key sectors. Q9, as always, remains committed to its mission to drive the next generation of capital markets with performance, security and compliance at its core.

In the News…

• Twitter will allow users to buy and sell NFTs through tweets
• El Salvador President denies storing Bitcoin on FTX
• Bored Ape Yacht Club NFT prices fall after FTX sinks crypto market
• Thoma Bravo leads $70mn fundraise for blockchain intelligence firm TRM Labs
• Amazon becomes first company ever to lose $1tn in stock value
• Meta’s metaverse division reports $3.67bn quarterly loss