What the hell happened to FTX?
The unfolding FTX implosion keeps getting worse
The first in a multi-part series on the rise, fall and fallout of Sam Bankman-Fried and his cryptocurrency empire. This post describes the events so far. The next post discusses the causes and consequences. The final post talks about the conclusions we can draw.
In hindsight there were a lot of red flags 🚩🚩🚩
In late 2018/early 2019 a small hedge fund named Alameda Research was seeking to borrow money from investors by promising HIGH RETURNS WITH NO RISK and no downside. [🚩] Here is Zhu Su of famously well-managed firm Three Arrows Capital expressing some skepticism about the pitch at the time:
Alameda had been able to put up apparently very impressive profits arbitraging the growing but still underdeveloped cryptocurrency markets — though no one knew exactly where their initial capital came from [🚩]. Later that year Alameda launched a new cryptocurrency exchange called FTX where Alameda would (at least initially) be the principal market maker. That’s an uncomfortable arrangement — it meant Alameda was taking the opposite side of FTX’s users’ trades [🚩].
Trading on an exchange that does its own market making is like playing poker with your cards turned up and politely asking your opponent not to look. FTX knew lots of things about its user’s trades/positions (margin price, stop losses, etc) that Alameda should not have had access to and it was also rumored to give Alameda a special high-speed access that allowed them to front-run user’s trades. In theory if there was a commercial firewall between the two businesses they could operate separately but in practice FTX and Alameda were never really separate entities. For years users deposited money on FTX by just wiring it to Alameda [🚩].1
Everyone knew this was a little bit sus, but by crypto standards it didn’t necessarily stand out. And FTX was able to offer very tight pricing, a uniquely forgiving liquidation engine and an extremely wide range of margin and derivative products surprisingly quickly. FTX captured share by offering the products and services that other exchanges saw as too risky [🚩]. They also invested in hundreds of startups throughout the crypto industry, usually with the side requirement that those projects custody their treasuries on FTX [🚩].
FTX quickly grew enormous. They sponsored stadiums and superbowl ads [🚩]. In their last round they raised $420M dollars from 69 investors to make sure everyone knew they didn’t take the money too seriously [🚩]. Founder Sam Bankman-Fried (SBF) became famous for his wealth, generosity and ostensibly spartan lifestyle. He was vegan and drove a used Toyota Corolla. He was the second largest political donor on the left, a major advocate for effective altruism and an outspoken supporter of tighter crypto regulation. People compared him to famous financiers like JP Morgan and Warren Buffet. He was on magazine covers.
Slowly at first, then all at once
Alameda built its reputation and initial business on market making — smoothing out the inefficiencies of an illiquid market for a small premium rather than making a directional bet on the underlying asset. But as the crypto market matured and more competition emerged this easy edge dried up. At this time Alameda seemed to shift from being market neutral to being directionally long. Here is Sam Trabucco (at the time co-CEO of Alameda) tweeting about gambling on Dogecoin [🚩] in April 2021 or Caroline Ellison (the other co-CEO of Alameda at the time) tweeting about going 'balls long' [🚩] the month before. It was a simpler time.
During this period FTX and Alameda made a habit of issuing tokens with one important feature in common: they kept most of the token for themselves. Tokens like FTT, OXY, MAPS, SRM and FIDA all traded on FTX, so they had a price — but that price wasn’t very meaningful because FTX/Alameda never actually released most of the supply of the tokens onto the market. Instead Alameda used their illiquid holdings as collateral for enormous loans [🚩].
Imagine issuing yourself a billion tokens, selling one of them to someone for $1 and then using the rest to secure a $500M loan. In one sense the loan is over-collateralized (you put up almost 999M tokens each worth ~$1) and in another sense no it is not over-collateralized of course it is not over-collateralized! The collateral is entirely made up! You might be able to sell $1-2 more dollars worth before the market notices what you are up to but you would not be able to raise the $500M needed to pay off your debt. That debt may as well be unsecured. That is how Alameda was borrowing billions to go 'balls long' on Dogecoin.
This all became apparent earlier this month when someone leaked a partial Alameda Research balance sheet to Coindesk and people noticed that Alameda was counting billions of magic beans as assets against billions of actual dollars in liabilities [🚩]. That made everyone worried about Alameda’s solvency which made everyone worried about FTX’s solvency which made everyone rush to withdraw their funds from FTX before they froze withdrawals, which they very quickly did. FTX found themselves at the center of a bank run. SBF assured everyone that customer funds were safe and that FTX was facing a liquidity crunch, not a solvency crisis.
He was lying.
Chaos and confusion
What happened next was chaotic. SBF announced that FTX had sold itself to Binance (presumably for a pittance) and that customers would be made whole but almost immediately after seeing the books Binance announced they would not be following through with the acquisition because of mismanaged customer funds. FTX was not a solvent bank with a liquidity problem. They were a smoking crater ~$8B wide.
FTX filed for Chapter 11 bankruptcy, SBF stepped down as CEO and all its assets were frozen — at least in theory. In practice a hacker (probably an FTX insider) managed to steal hundreds of millions of dollars worth worth of crypto and swap them around in various channels until they ended up with ~241k ETH (~$291M at time of writing), making them the 36th largest holder of Ethereum and raising all sorts of interesting questions if they decide to start staking.
Bahamian accounts were also still able to withdraw from their accounts, supposedly because of a local Bahamian law (FTX is based out of the Bahamas). FTX users scrambled to sell their account balances to local Bahamian users or buy fake Bahamian identities to verify with. Bahamian authorities later denied that those withdrawals were legal but did acknowledge having seized some funds after FTX had formally declared bankruptcy. Was that a legitimate seizure? A bureaucratic mistake? A bribe? A backdoor for SBF? Still unclear.2
What was almost immediately clear was that FTX/Alameda was not just a badly run business but an explicitly criminal one. Not only had Alameda been given visibility into the stop-losses and liquidation thresholds of FTX users and special high-speed access to front run them with, they were also exempt from liquidation. Alameda knew the exact prices that would liquidate FTX users and had no liquidation price for themselves. FTX just let Alameda run up as much risk as they liked, as though they had infinite collateral. Worse yet, the missing ~$8B didn’t just come from credulous investors and crypto lenders who had made loans against foolish collateral. FTX had stolen user deposits and loaned them to Alameda to gamble with.
When the market started unwinding as Terra/Luna collapsed the value of Alameda’s assets fell faster than the rest of the market for the same reasons they had climbed more quickly: low liquidity. Alameda needed the price of those tokens to stay up (so their loans wouldn’t be recalled) but they were the only real buyers in the market. So they sold everything else they had buying worthless tokens like FTT trying to keep the loans afloat. When they ran out of assets to sell, they stole assets from FTX users and sold those, too. When they ran out of those assets, too, they tried to sell themselves to Binance (essentially for free) and Binance said, 'lol no.'
… but wait, there’s more!
There were other red flags, too. The executive leadership of FTX and Alameda were mostly made up of a group of friends and romantic partners living together as a polycule [🚩] in a $40M Bahamian mansion called 'The Orchid' [🚩]. SBF had a habit of using off-label stimulants while trading [🚩] and was also weirdly bad at League of Legends [🚩] despite having famously played it a great deal, including during both fundraising calls for FTX [🚩] and while it filed for bankruptcy [🚩]. The only known photo of his co-founder Gary Wang is the photo of the back of his head on the FTX team page [🚩]. CEO of Alameda Research Caroline Ellison gave interviews where she said she used only elementary school arithmetic in her job and didn’t believe in using stop losses on trades [🚩].
There is just too much for me to cover even in a multi-part series. If you are interested in more detail here is a thoughtful (if speculative) description of what probably went down at Alameda. Here is an hour long podcast from an FTX employee about what the implosion looked like from the inside. Here is an 82 part chronological timeline of events and here is a longform theory of how FTX’s liquidation engine might actually have worked (and why it failed). Or just wait for the movie! SBF invited Michael Lewis (author of the Big Short) to embed himself with the Alameda team for the last six months and he is already shopping the screenplay to Hollywood studios [🚩].
The first in a multi-part series on the rise, fall and fallout of Sam Bankman-Fried and his cryptocurrency empire. This post describes the events themselves. The next post discusses the causes and consequences. The final post talks about the conclusions we can draw.
In literary circles this is known as foreshadowing.
One theory is that the hack was the Bahamian government (or someone in it) deciding that the remaining funds were sufficiently valuable to be worth seizing even if the rest of the financial world objected. If so that will be an interesting test of Ethereum’s sovereignty!