By Kelvin Lee, Alonso Munoz
A preface: Like many, we have been cautiously monitoring and tracking crypto over the last decade. We seem to understand that the underlying technology has the potential to make our world more efficient, but to what extent? How many of you reading this article use your “crypto” to pay for your groceries? Or do you use your credit card?
As capital allocators, crypto has been a frustrating, fascinating, and disappointing asset class. Our approach has been “wait and see”, while warning of the inefficiencies and lack of transparency. In July of this year, we wrote about the cons of allocating “crypto” to 401(k)’s and retirement accounts, and after the FTX debacle, our position is even more clear. Is crypto the future? Only time will tell. If you ask around this week, the answer is likely a resounding “probably not”. If you are curious to learn more, we highly recommend Bloomberg’s “The Crypto Story”, written by one of the most articulate and thought-provoking writers in the financial industry, Matt Levine.
Let’s get to it: Here’s a money-making idea. Let’s sell my signature to investors for, let’s say, $100. Yes, they’re inherently worthless, but we’ll get the NFL and famous influencers to market it as a great and exciting investment. As more and more people buy signatures, the price continues to go up, making everyone happy. Best part is, when people give us cash for signatures, we can pocket it! And should any of our investors want out of their signatures, we’ll just give them cash from any new investors. Sounds amazing, right? What we’re describing is commonly known as a Ponzi scheme. For most “crypto” investments, there’s no real underlying asset, so value is pretty much demand driven. This creates not only a flourishing field for fraud, but a complete house of cards built on the price of a, brace yourself, useless coin. This leads us to Sam Bankman Fried who will likely displace Bernie Madoff for the most infamous scheme of the 21st century.
What the FTX Happened?
Here’s the brief rundown of how FTX, Sam Bankman Fried’s (SBF) crypto exchange crashed. Two weeks ago, a Coindesk report showed that $5.8 billion out of $14.6 billion of assets on Alameda Research’s balance sheet was tied to FTX’s crypto token, FTT. Alameda Research is SBF’s crypto hedge fund and, as reports show, was being supported by FTX’s customer funds through loans collateralized by FTT. As a response, CZ, CEO of the largest crypto exchange, Binance, tweeted that Binance would sell off its entire FTT holdings. The news correspondingly tanked FTT’s price by 90% and sparked a market wide panic of withdrawals from FTX, which they couldn’t cover (a classic “run on the bank” scenario). And this is where we’re at today; customers who can’t withdraw their assets, an insolvent exchange under an SEC probe, and the fall of Sam Bankman- Fried’s fortune from $15.6 billion to under $1 billion.
Ok, that’s a lot, and while it may make sense for the crypto millionaires out there, lets break down the news.
Let’s first understand what FTX is. It’s a crypto exchange, it’s in the business of facilitating trades for crypto currencies and products. That’s simple if you think of FTX like a bank that simply holds deposits until you withdraw them for a fee. However, FTX also functions as a brokerage where you can use leveraged products to get more exposure, and potentially increase your returns. And sometimes that leverage is 20 to 1, where you can use $100 of a customer’s cash to buy $2,000 of bitcoin. This is where the trouble starts. Where does that extra money get borrowed from? Well, your customers, financial backers or maybe an affiliated hedge fund. Either way, you introduce liquidity risk since your constantly moving assets around. You lend customer 1’s BTC’s deposit somewhere else, likely to customer 2 who is leveraged long. And when customer 1 wants their BTC back, you must get it back from customer 2 or borrow it again. This constant borrowing becomes a hurdle when everyone is making withdrawals. You can’t deliver assets you don’t have, and boom, that’s a liquidity crisis.
FTT, FTX’s own crypto token, then adds gasoline to the fire. FTT works like a stock for FTX and generally moves relative to FTT’s performance, but like most crypto currencies, isn’t tied to an asset and its value is pretty much what people agree on, which makes it highly volatile. That volatility is an issue, especially when the exchange is trading customer deposits for FTT. If a customer wants to make their withdrawal and FTX secretly traded their money already for FTT, they need to sell some FTT to fund the withdrawal. More withdrawals, means more FTT needs to be sold which means a lowered FTT price. Customers realized that FTX couldn’t sell enough of FTT to get their money back. And there’s the liquidity problem again. Withdrawal from FTX hurts FTT which lowers the value of FTX’s holdings and their ability to pay back customers, which causes more customers to withdraw.
Alameda Research
Alameda research is SBF’s crypto hedge fund and has been the white knight for other crypto exchanges like Voyager Digital. But there is an inherent problem with bailing out failed exchanges and businesses, they are usually BAD deals (think Lehman Brothers). Voyager Digital filed for bankruptcy and Alameda research suffered heavy losses. What was SBF’s response? Prop up Alameda with customer assets through FTT. Alameda received billions of FTX’s customers assets to cover their risky betting business by using FTT as collateral for the loans (which, as we mentioned before, is a terrible idea). So here we have an empire built on overexposed leverage that is subject to the whims of one token. That’s risk, and that’s what caused Binance to sell FTT and start the downward spiral of fear and lower prices, the negative feedback loop.
What’s next?
Well, Binance offered to buyout FTX, but after seeing their balance sheet and the more than $6 billion gap between assets and liabilities, decided to take a hard pass (speaking of balance sheets, accounting and audits for FTX were done by Prager Metis, “the first ever CPA firm in the metaverse”). Skepticism of Binance is also growing, as a Bloomberg Report on Friday showed that 40% of assets are kept in its own native token. SBF needs, ironically, his own white knight to bail out his customers, and the number of players there are slim. Even less likely is help from some of FTX’s initial backers (industry “titans”): Sequoia Capital, BlackRock Inc., and Tiger Global Management. Did some of the most sophisticated investors in the world perform any due diligence, or where they enamored by the prospects of market domination and sky-high returns? What does SBF mean for crypto as a whole? He has certainly tarnished the credibility of most crypto exchanges, and perhaps the crypto ecosystem. As always, the retail investor is the most harmed, and least talked about. What does all this mean for the likes of Bitcoin? No one really knows. Our Bitcoin price target sits comfortably under 10k. We can only hope for the next iteration of Michael Lewis’s “The Big Short” to break this crisis down in a digestible format we can all enjoy.
To contact the author of this story:
Kelvin Lee at kelvin@hamiltoncapllc.com
To contact the editor responsible for this story:
Alonso Munoz at alonso@hamiltoncapllc.com
