FTX Bankruptcy Explained!

FTX Bankruptcy Explained!

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Today’s video is sponsored by the Daily Upside, a totally free, high quality daily business and finance newsletter. Visit the link in the description to learn more. A little over a year ago, Sam Bankman Fried told the press that one day he hoped to buy Goldman Sachs and maybe The Chicago Mercantile Exchange.

Of course, the people at Goldman and the CME would have been delighted to hear this at the time, as it was July 2021, and crypto was really hot back then. While many of my regular viewers possibly think that I avoided getting caught up in all of the excitement, but I can’t lie, I too was inspired by Sam Bankman Fried, and while I didn’t end up putting all of my money in crypto (or even advertising Crypto exchanges in my videos), I did buy these New Balance Trainers, hoping to look cool like SBF and that is a shame that I will have to live with for the rest of my life. We all have our crosses to bear. I can only offer my sincerest apologies to anyone who saw me walking around in public wearing them.

It was wrong of me, and I have no excuse. Unfortunately, the people at Goldman Sachs and the CME got some bad news this week. They will have to stay in New York, London and Chicago, and may never get to attend one of those Bored Ape conventions in Miami (that look like so much fun). It is less and less likely that they will get to hang out with Michael Saylor attending parties in El Salvador. As I said, we all have our crosses to bear.

So, Sam Bankman Fried is the owner of FTX the now bankrupt crypto exchange, and Alameda Research, the now bankrupt crypto hedge fund. That is a huge oversimplification of the corporate structure (just to be clear) as according to the FT, the corporate structure looks like this, with each box in that diagram representing a separate corporate entity. It looks like there are around 77 different companies in there, and it is reasonable to believe that the corporate structure may be even more complex than that. The FT is reporting this morning that there are about 130 affiliated companies referenced in the bankruptcy filing. As a contrast, here is a corporate structure diagram of Lehman Brothers – a Global Investment Bank that was over 150 years old - after it was wound up, and as you can see it was a significantly less complex structure.

So anyhow – we have to simplify… Sam Bankman-Fried’s trading firm Alameda Research allegedly owes his crypto exchange FTX 8 - 10 billion dollars after taking loans that were possibly funded by deposits from FTX customers. This is all according to The Wall Street Journal. Both Alameda (the hedge fund) and FTX (the exchange) are controlled by Sam, who issued an apology on Twitter yesterday saying that he “should have done better.” – followed by some legal disclaimers – that don’t look like they were written by an actual lawyer… So, FTX allegedly lent over half of its customer funds to Alameda, who then used those funds to bet on other cryptocurrencies and to help out other crypto firms that have been struggling this year.

Alameda Research, was run by 28-year-old Caroline Ellison – a diehard Harry Potter fan according to the news (and listen, I’m not going to make fun of that – just because I haven’t actually read Harry Potter -It is a children’s book – it’s for children) Look I’m not making any of this up, and I have to warn you, it’s only going to get worse. The venture capital firm Sequoia Capital had a magazine-style article on their website – which has since been deleted – it read like a Dan Brown novel (I’m not sure that these people are big readers) and was titled “Sam Bankman-Fried Has a Savior Complex — And Maybe You Should Too.” Luckily, (before it was deleted) I took some screen shots.

The article describes how when Ellison met up with Sam to learn about what he was doing in the Crypto industry – she was dressed as a “sultry wood nymph”. Who even knows what that would look like. Oh yeah, they included a photo in the article. So, there you go – now you know what a “sultry wood nymph” looks like. You learn a lot on this channel – it’s not just finance.

But, the article is not just sultry wood nymphs (I don’t want to oversell it to you – it was tedious reading), but it goes on to describe how the partners side of the Zoom chat (the investors at Sequoia) lit up when SBF was pitching to them for investment, partners were apparently ”freaking out”. “I love this founder” typed one, “I’m a ten out of ten” pinged another. “Yes”! Exclaimed a third.

They were reacting to the scale of SBF’s vision. The article goes on to say that during the pitch, it was noticed that Sam was playing League of Legends – a video game – I don’t know if this is a children’s game or not – it could be filled with sultry wood nymphs for all I know. But anyhow, the piece goes on to describe how the round raised a billion dollars, which was followed a “meme round” where 420.69 million dollars was raised from 69 investors.

I worry that we have drifted off from the central point of this video, how did all of this money disappear? Before I get into that, let me tell you quickly about today’s video sponsor – The Daily Upside. If you find yourself sifting through multiple new sources trying to find unbiased and insightful news, the Daily Upside might be the solution to your problem. The Daily Upside is a totally free daily email newsletter, written by a team of financial professionals with real industry experience and is read by over half a million investors every day. It’s become the first thing I read every morning as it is informative, entertaining, and not dumbed down.

They give you the most important news with real analysis. They had an excellent piece on FTX in yesterday’s newsletter which helped me prepare this video. Whether you are a financial professional or just looking for a great source of business news, the daily upside will help. It is totally free to sign up and they send you one information filled email every morning. I can’t recommend it enough.

Sign up using the link in the description below. Ok, so how did things go so wrong so fast? FTX was being valued by its VC investors at $32 billion dollars only a few weeks ago and it appears to be worthless today – it is bankrupt. Well, FTX issues a token called FTT, and this token might seem a bit like stock(or equity ownership) in the exchange, but it’s not. Legally a token like this can’t be too much like equity, or the issuer would get in trouble with the SEC. The FTT token is a bit more like an airline-miles program. If you buy these tokens you don’t get an ownership stake or guaranteed interest payments from FTX like you might with a corporate security.

You instead get perks like discounts on trading. The other feature which is quite important is that FTX has agreed to use a portion of its profits to buy back FTT tokens. And so, this makes the token behave somewhat like stock in FTX, as the more profitable FTX is, the more of these tokens it will buy back, hopefully pushing up the price. So FTT is to a certain extent a bet on FTX’s profits.

(kinda like stock) So, while it is legally not stock – as FTX actually does have real stock – owned by investors like Sequoia, Tiger Global Management, The Ontario Teachers’ Pension Plan and of course Softbank. This FTT token behaves like stock, in that it would be expected to rise and fall with the profitability of the exchange. Alameda – The Hedge Fund – was supposed to have $14.6 billion in assets as of the end of June, but its biggest assets included 3.7 billion dollars’ worth of “unlocked FTT” and its third biggest asset was 2.2 billion dollars’ worth of FTT collateral.

The liabilities side of the balance sheet was dominated by 7.4 billion dollars’ worth of loans. So, this is a problem, as it is almost like a company using its own equity as collateral on a loan. If the company does badly, which is a problem on its own – that is bad, but if the collateral backing its loans is falling in value at the same time, this is a nightmare from a risk perspective. Most risk managers would notice this, but the head of risk at FTX was another teenager who had two years of risk management experience at – (and you can’t make this up)… Credit Suisse… Look, I’m not trying to make jokes about this. I’m essentially just reading out the news to you.

This is what happened… In an appearance on Joe Weisenthals Odd Lots podcast (which is well worth a listen) a few months ago, Sam Bankman-Fried described how value could be created from nothing using tokens. His explanation left Matt Levine who was also a guest on the podcast totally speechless. What SBF described in the interview was eerily similar to what (many suspect) FTX and Alameda were actually engaged in. FTX’s token price was said to be being propped up by Alameda, and Alameda was allegedly using the token as collateral to fund its own trading activities. Sam Bankman-Fried founded Alameda initially to do crypto arbitrage trading, and then he founded FTX afterwards so that he would have a better exchange for Alameda to trade on.

These firms are very tied to each other. The fact that Alameda has a lot of FTX tokens, is not great on its own, as it means that it is illiquid and they might need to sell these tokens down, to cut risk and that would push the price of the token lower. But, that on its own (while not great) is not enough for a run on FTX. The real reason for a run on FTX is if customers believe that FTX lent Alameda a bunch of customer assets and got FTT tokens (its own discount coupons) back in return. In that case a fall in the price of FTT would destabilize FTX – the exchange. So that explains why things were unstable at FTX.

Once word got out what Alamedas balance sheet looked like, CZ, the founder of Binance (a rival exchange) announced on Twitter that he would sell his FTT holdings due to “recent revelations”. Now normally (for obvious reasons) people don’t announce a big trade in advance of doing it (other than (of course) Gordon Brown when he was the UK Chancellor of The Exchequer and sold 401 tons of the UK’s gold reserves (after announcing that he would do it) but that’s another story). CZ’s announcement and selling caused FTT’s price to plummet, and traders then rushed to pull out of FTX, for fear that the firm would collapse. On Tuesday, Binance announced that it had reached a non-binding agreement to bail out FTX by buying the company. Then on Wednesday, Binance announced that it would no longer be buying FTX “as a result of corporate due diligence.” They also cited regulatory investigations and reports of mishandled funds.

This did nothing to help the situation… On Wednesday, SBF tweeted that he mistakenly believed that FTX customers had plenty of liquidity earlier this week to facilitate withdrawals. He was not aware of leverage within the FTX system. He said that he could not have gotten it more wrong. In many ways you would think that this record keeping problem is the sort of thing that blockchain could solve.

But anyhow… Crypto exchanges are in many ways more like broker dealers than they are like traditional exchanges. Exchanges match traders, allowing them to execute orders with each other, while brokerages transact with their clients directly. A lot of FTX’s business is in perpetual futures, where traders trade a derivative on the cryptocurrencies often with leverage. A crypto exchange thus needs to come up with the money to lend to their customers.

FTX might have borrowed that money from Alameda – the affiliated hedge fund, or they might have borrowed it from their other customers. Once an exchange is borrowing and lending money like that, the business is a lot like a bank. And if all of the people they have borrowed money from demand to be paid back at once, they have a bank run on their hands. SBF was claiming yesterday that FTX was illiquid, but not insolvent, and he was shopping around for a multibillion-dollar cash infusion to bridge any cash flow gaps. A liquidity problem is when a firm has enough money, but can’t access it quickly enough.

The classic example would be a savings and loan bank, where all of the depositors want their money back at once, but the bank has lent a lot of it out to home buyers or local businesses. The money is there, it just can’t be accessed quickly enough to be returned to depositors. A solvency problem is when a firm has simply lost the money. These two things can have some overlap, as a run on a bank – which might be a liquidity problem, is most often caused by the bank customers worrying about the bank’s solvency. Liquidity problems can turn into solvency problems, as if a firm is forced to sell assets quickly to meet a liquidity problem, their selling can push the price of those assets down. The selling pressure pushes the value of the assets below the value of the liabilities and now a liquidity problem has become a solvency problem.

No matter how you look at it though, a liquidity problem is something that is easier dealt with than a solvency problem, as if you can find a way of buying enough time to sell your assets slowly and at a fair price, you can pay everyone back what you owe them. The Panic of 1907 is a famous example of a financial crisis caused by banks lending to speculators who lost money, there were bank runs that spread throughout the nation, and the financier J.P. Morgan famously lent his own funds to prevent a complete financial collapse. Only a few months ago Sam Bankman Fried was being compared to JP Morgan for his offers to bail out struggling crypto businesses.

That is not what people are referring to him as any more… If the issue at FTX is just a liquidity problem, then someone could in theory step in and rescue the situation. In Banking the Federal reserve is required to lend freely against good collateral at a penalty rate in such situations. The lending should ease the liquidity problem, and the penalty rate means that the bank is punished financially for getting itself in such a position. Warren Buffett famously provided capital to Goldman Sachs during the credit crunch in 2008. Berkshire Hathaway bought $5 billion of preferred shares that paid a 10% dividend. Buffett also got warrants allowing him to buy an additional US$5 billion of common stock at US$115 per share.

The day after that deal was announced, Goldman Sachs was able to sell $5.75 billion in stock to the public who now had faith that the firm was well capitalized- it was in safe hands. So, this type of bailout, whether done by the Federal Reserve or someone like Warren Buffett (in traditional finance), is usually very expensive for the troubled financial institution and financially attractive to the firm doing the bail out. So if Binance had bought out FTX a few days ago, it wouldn’t have been surprising if the price had been close to zero.

The difficulty for a crypto exchange in a situation like this is that there are going to be fewer people interested in getting involved. We shouldn’t expect Warren Buffett to be stepping in. Sequoia Capital have announced that they will be marking their investment of over 210 million dollars down to zero. Apparently over the last few days, mentioning the number 420 is now taboo in their offices, and turning up to the office dressed as a wood nymph is a firing offence.

If FTX actually has an $10 billion hole in its balance sheet, you wouldn’t really expect anyone to get involved, other than possibly someone who has so much crypto exposure, that spending $8b is worth it to stabilize their other assets (It would appear that Binance is not on that list) Binance’s behavior in this case would in more normal situations, possibly draw some regulatory attention, but the way Binance is structured, it is not even clear who would have regulatory jurisdiction over them. CZ has not even disclosed where the main exchange is located. SBF as of yesterday was claiming that FTX US – The US based exchange was 100% liquid.

It is not obvious to me how believable that is. Of course, influencers who advertised for FTX have been very quick to claim that they only encouraged their audiences to put their money in the US entity. In todays news, FTX’s former head of institutional sales has been quoted as saying that only 10% of FTX’s $8.8 billion dollars in customer funds were backed by liquid assets. Venture capital funds like Sequoia who valued the firm at $32 billion dollars (plus a wood nymph) a few months ago, will have lost a lot of money in this. It seems likely that customer funds are compromised too, as I don’t know how an 8 billion dollar balance sheet hole could have developed without the exchange lending out customer funds.

Reuters are reporting that FTX lent customer funds to Alameda Research after it was hit hard by the failures of Three Arrows Capital and Voyager in May this year. It seems likely to me that things went wrong around that time (although I have no evidence), as a few strange things happened over the summer, like some of the big finance youtubers (who took advertising money from FTX) advised their audience to keep their crypto at FTX rather than in cold wallets. This is surprising advice, and it caused some controversy in the comments sections of those videos. The videos were quickly taken down, many were removed within hours due to viewer anger.

Around the same time, Brett Harrisson, the president of FTX US got in trouble with US regulators for a tweet that contained misleading claims that funds held at FTX were FDIC insured. So, it might be reasonable based on this unethical (and possibly criminal) behavior that went on, to think there were problems in the magical forest around this time, and that FTX really needed their customers to leave their money on the exchange. But this is of course just guesswork. The US justice department and US regulators are now investigating relationships between FTX and Alameda, including whether customer funds may have been misused.

If customer funds have been lent out, then unless SBF succeeds in finding a buyer (which seems less and less likely right now), FTX customers seem like they will lose a substantial part of their funds. FTX marketed itself to retail customers, even encouraging people to deposit their paychecks into their FTX accounts. Some of these people are likely to suffer financial hardship as a result. Sam Bankman Fried often claimed that it was his goal to give everything away, and it would appear that he has possibly achieved that goal at record pace. BlockFi a digital assets lending platform, paused client withdrawals yesterday saying that it could not operate its business as usual because of the “lack of clarity on the status” of FTX and Alameda.

FTX had bailed out BlockFi during the crypto crisis earlier this year, extending it a $250mn loan. The collapse all comes less than a month after FTX was poised to carry out a series C funding round matching its $32bn valuation from January. I have sympathy for some of the people who were lured into depositing their funds at FTX and may not get them back.

Once again, a lot of influencers can be blamed for accepting highly paid adverts to promote this as an investment to their audiences – followed by the “This is not financial advice disclaimer. To some of the big institutions who lost money in this I have some advice as to how to improve your process. You could start by casually asking founders what their favorite book is.

If the answer is Harry Potter, The Cat in The Hat, or the very Hungry Caterpillar, and they are playing a video game while chatting with you, you really only have yourself to blame. Maybe you shouldn’t write breathless articles about investing in meme capital raises of $420 million dollars split between 69 investors. Look, I realize I can be criticized too, I clearly have had a book of fairy stories on my desk for this whole video, but, it was written by the Nobel Prize winning poet W.B. Yeats, and I was using it to research this video, as I figured it might explain what a “Sultry Wood Nymph” is, and whether it is reasonable to trust one with your money. SBF (who there is no reason to believe is a “sultry wood nymph”) is alleged to have cashed out investments in FTX from the likes of Sequoia and then invested that money back into the very venture capital firms that provided the investment.

I’m starting to wonder if when we look back on this period of time, people will see meme number investments (420 and 69) as the lepers bell warning people to keep a safe distance. Who knows though… I would hate to be the investor relations person at Sequoia, charged with answering the phone and explaining to investors that “it seemed like a good idea at the time” because it just didn’t. The ongoing crisis at FTX and Blockfi, and before that, Celsius, Voyager, Three Arrows Capital, Terra and Luna (the list keeps going), has less to do with cryptocurrency overall (which I am by no means a believer in) but instead it highlights the problems in financial systems where there are no checks and balances in place. If you found this video interesting, you should watch my video on John Law and The Mississippi Bubble which describes the birth of the modern financial system, how it went wrong almost right away, and all of the lessons that were learned from the early mistakes. A lot of what happened back then is not unlike what we are seeing today.

Don’t forget to check out our sponsor The Daily Upside, by clicking on the link in the video description, it’s a great newsletter that I can firmly recommend. Talk to you soon, bye.

2022-11-16 07:22

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