An FTX PostMortem
|By Juan Villaverde|
All companies related to FTX have filed for Chapter 11 bankruptcy protection, and customer assets are effectively frozen. Former FTX CEO Sam Bankman-Fried swears his companies have more assets than liabilities, and that he can and will make best efforts to make customers whole.
Problem is, those “assets” are illiquid — meaning they are not readily available to repay customers.
Ultimately, however, this is a story about counterparty risk. And a very familiar one throughout the history of finance.
It takes us back to the collapse of Terra (LUNA, Unrated) and its sister token UST …
UST was an under-reserved algorithmic stablecoin. That means it was pegged 1-to-1 to the U.S. dollar … but there were few assets on deposit to back up this claim.
Under-reserved pegs are common in emerging markets. They generally fail if there is ever a rush to get back to the safety of the underlying asset.
In the case of UST, the promise was to get $1 for every UST token held. That promise failed spectacularly in May.
You see, most crypto hedge funds had exposure to UST back then. Because at a time when USD lending rates were 2%–3% in crypto-land, UST was paying close to 20%.
In a market where interest rates had been forcibly held near zero for a dozen years, it’s hard to overstate the lure of 20% yields. As you would expect, they quickly attracted aton of capital.
Ironically, there were also a lot of investors who recognized the risks inherent in UST’s above-market rates and decided to steer clear.
But herd behavior is a powerful thing, and even the skeptics didn’t want to be left out. So, they lent money to Three Arrows Capital instead, which had a reputation for being run by the smartest traders in crypto land.
What they did not realize, sadly, was Three Arrows Capital’s heavy direct exposure to UST.
This is how, when UST bit the dust, it managed to bring down so many of crypto’s best and brightest — right along with it!
FTX’s Sister Company, Alameda Research,
Was a Major Casualty of the UST Collapse
And it created a monster hole in Alameda’s balance sheet. They needed cash, and fast. So, they made a deposit of FTT tokens on FTX, using them as collateral to borrow billions.
The problem: FTT isn’t liquid. If Alameda suddenly had to sell in order to repay its loan, there wouldn’t be anywhere near enough buyers.
This is what made Binance CEO Changpeng Zhao’s public announcement — that he intended to dump his FTT tokens over a span of time — such a big deal.
In response, panic erupted in the markets.
Everyone rushed for the exits. Before long, falling token prices triggered a margin call on Alameda’s loan … that they couldn’t possibly repay. Thus, the whole house of cards came thundering down.
Was this malicious, or just incompetent? Doesn’t really matter at the end of the day.
Under normal rules, no customer of FTX — even a big institution — would ever be allowed to borrow billions of dollars against collateral as flimsy and illiquid as FTT.
In other words, FTX had to breakits own due diligence rules to permit this transaction in the first place.
However, that exception was allowed because Alameda and FTX are essentially owned by the same people. And in times of crisis, people’s judgement can fail.
This whole saga has folks proclaiming the death of crypto is once again upon us.
And yet, nothing could be further from the truth. In fact, crypto is the SOLUTION to almost everything that went wrong here.
First of all, FTX isn’t crypto. It’s just a company that happens to have custody of crypto assets.
On top of that, the fact that they have control over your money is the polar opposite of what crypto was created to accomplish. Crypto was invented so that only you have custody of your money.
Look, whenever you deposit assets on FTX or Coinbase or Kraken — or any other centralized platform — you’re essentially lending your assets to them.
The entire financial system runs on this premise. The money you have in your bank account has effectively been lent to the U.S. government.
That is, the bank doesn’t actually have the cash you deposited. In its place, it holds government IOUs. Pension funds are no different. Most of that money has been lent out to the government.
Ditto for insurance funds. Hell, even cryptocurrency stablecoins — like USDC — routinely lend the money backing them to the U.S. government.
The only difference between crypto companies and banks and pensions is that the latter have indirect access to the printing press.
Because when the government is unable to pay back the money it owes … it prints the difference.
FTX could not print the difference. And the result was a spectacular collapse.
But printing money causes massive inflation over time. Because it dilutes the purchasing power of your hard-earned savings, it’s really just a backdoor way to default.
The single biggest problem of the current financial system is not greed, stupidity or shortsightedness — although all three are common enough.
The real problem is that you do not own your money.
Cryptocurrency is one of the few ways you can have custody of your own money in this day and age. And it is certainly the easiest. Even gold can’t compete, as most people own it through financial derivatives and have no way to access the metal directly.
As governments keep borrowing without no intention of paying back a single penny, you’ll come to understand what happened with FTX is by no means specific to crypto.
The entire financial system is gravely ill with the same disease.
And crypto will emerge as one of the few ways ordinary people can escape the contagion.
However, it’s too soon to declare the crash is over. We need another week of sideways price action before we can begin to dismiss more downside.
So, until then, stay safe and avoid any rash actions.
P.S. — If you’re interested in more in-depth analysis, check out my Weiss Crypto Portfolio service. You can find out more here.