Jacob Stein

Nov 12, 2022

The FTX Meltdown

If you own any cryptocurrency at the time of writing, don't check your wallet, cause it won't look too good. In the past few days, a series of events has brought the crypto industry to its knees. Sam Bankman-Fried (SBF), was the golden boy of crypto because of his commitment to the earn-to-give philosophy and effectivw altruism. He has also spent a small fortune on lobbying on the industry's behalf in Congress. In short, he embodied what most people hoped the crypto industry could become. He now more closely resembles Elizabeth Holmes. Let's begin exploring this wild story.

The story starts with Binance and its founder, Changpeng Zhao (CZ). Binance is the world's largest cryptocurrency exchange, and now probably the ostensible front-runner of the industry. In May 2019, SBF began working on FTX, another crypto exchange platform. Hoping to keep his enemies closer, CZ made a small investment in FTX in the form of $FTT, FTX's native cryptocurrency token. SBF did a great job scaling FTX, so much so that Binance's original investment grew to upwards of $2 billion.

SBF also founded a quantitative trading firm called Alameda Research Group, which dealt primarily in crypto. Alameda's CEO is a woman named Caroline Ellison, who also happens to be SBF's love interest. Alameda and FTX have been inextricably tied since Alameda's inception, with Alameda holding a sizable position in $FTT. Like most crypto hedge funds, Alameda did not fare too well when LUNA crashed, losing billions of dollars worth of investments in the Terra ecosystem, and losing even more in the industry crash that followed. Unknown at the time, Alameda no longer had enough liquidity to pay back its investors, but more on that later.

At the start of November 2022, Binance decided to do some investment book-keeping and CoinDesk reported that a large portion of Alameda's holdings were in FTX's native token. This made CZ think that FTX was propped up largely by investments in Alameda that were then used to buy $FTT. This spooked CZ, so he announced on Twitter that Binance would be selling its stake in FTX, worth roughly $2 billion. The announcement and sell-off precipitated a large dip in $FTT's price, which precipitated an even greater sell-off as people tried to close their positions. FTX shut down all withdrawals from the platform, citing a lack of liquidity. Well, such a measure begs the question, where is all the liquidity? It turns out that SBF loaned billions of dollars to Alameda, which had no money because of the LUNA crash. This loan was then invested in risky positions, including $FTT. We know that $FTT nosedived, so Alameda effectively lost most of the money loaned by SBF. It also makes sense that these two groups would be in cahoots, given that FTX was managed by a group of ten romantically involved nerds holed up in a penthouse/office in the Bahamas. So at this point: Binance liquidates its investment in FTX because it seems propped up by investor funds used to buy $FTT in Alameda --> This announcement triggers a huge bank run on FTX, which is then forced to lock withdrawals --> FTX has no liquidity because it lent $FTT to Alameda, the value of which plummeted because of Binance's sell-off and the subsequent bank run.

This is where it gets even crazier. Binance explores the possibility of saving FTX by providing liquidity. This almost makes it look like CZ torpedoed FTX by closing his position so he could buy out his competition at a discount. Anyways, Binance began auditing FTX's financial records, and noticed a black hole on their sheet conveniently equivalent in size to the loan given to Alameda. CZ was originally concerned that Alameda was propping up FTX, and now sees that FTX is propping up Alameda. A system in which two different entities are both trying to prop each other up is not a very safe one. As any logical investor would do, Binance pulls out of the acquisition deal, essentially leaving FTX and all its investors out to dry.

If you think it can't get any worse, well, it does. Late last night (November 11th), it was reported that FTX's wallets were being drained. The FTX Telegram reported that the websites and app was hijacked, and the wallets were being drained. There is speculation that FTX is moving remaining liquidity into cold wallets until FTX's bankruptcy is processed, but it could also be a hack. Alternatively, there are reports that SBF built a backdoor into FTX without his employees' knowledge, so he could also be making a run for it. Ultimately, what little liquidity remained in FTX is now gone, so investors are really screwed.

So, to summarize: Binance invests early in a potential rival, FTX --> FTX grows very quickly, becomes Binance's competitor --> CZ sees that SBF's hedge fund largely consists of $FTT, meaning that FTX may be propped up with investor money from Alemeda --> CZ liquidates his position, triggering a sell-off of $FTT --> FTX had loaned investor funds from the platform to Alameda in the form of $FTT to cover losses from the LUNA crash --> The crash from the Binance sell-off kills the size of FTX's loan, so FTX and Alameda both have no liquidity --> Binance explores buying out FTX, but withdraws after seeing the faulty loan structure --> SBF or a hacker has taken off with the remaining FTX liquidity, leaving investors holding the bag --> The crypto industry takes an enormous blow, shaking trust across the board.

When the Theranos fiasco unfolded in 2016 and the dust settled, Elizabeth Holmes had defrauded investors out of around $600 million. SBF and buddies in the Bahamas created losses upwards of $6 billion, additionally obliterating billions of dollars in market capitalization in the subsequent crash. It is interesting to speculate that CZ may have anticipated FTX's downfall, but not its faulty loan to Alameda. Assuming CZ knew this, he could have sold his position to buy out his only competitor at a discount. If this was the case, though, it is certainly not a net positive for Binance because of the enormous damage to the industry. On the other hand, if anyone saw that FTX was propped up by a hedge fund founded by the same guy, they would be right to exit their position. In either case, the investors are the ones taking the loss. It will be interesting to see if SBF is penalized for his incompetence. Even more damaging is the reputation damage to the industry (assuming it had one in the first place). All the sketchy institutions are facing somewhat of a reckoning in this winter. Personally, I am hoping that short-term projects with no long-term value are eventually phased out. This will hopefully open the door for more substantive, legitimate, and thought out ventures that have a genuinely impactful agenda. Until then, I doubt FTX will be the worst meltdown we have the pleasure of witnessing.