The FTX Downfall: updated timeline & market outlook
Today we are going to play a visual guessing game: Beached whale or FTX & Sam Bankman-Fried.
Last Tuesday, I released an article explaining the situation between FTX and Binance. At the time of release, Binance was set to acquire FTX to help fix a ‘liquidity crunch.’ Since then, a lot has happened. Here is an update on the situation and on the broader market.
To understand the situation better and for some background on FTX, I would suggest reading the previous post:
What actually happened
The issues primarily started with FTX sister company, Alameda Research. Alameda used high leverage to invest in risky assets. During the bull market, this strategy played out as risk on assets did quite well. When the market turned, things started to change. Risk assets were hit hard, with the crypto market losing 68% of it's value in just seven months. Being highly levered on these assets, Alameda took a huge hit. As margin calls started coming in, Alameda could not cover their losses. This is where SBF and FTX came in.
Since FTX and Alameda were closely tied, SBF was able to create a back door allowing him to move funds to Alameda while altering the balance sheet to cover it up. FTX had been making microloans using customer funds to help Alameda cover its losses. In total, FTX loaned $10 billion of customer funds to Alameda secured by FTT & Robinhood equity (SBF owned was a 9% owner of Robinhood). At the time, FTX had $16 billion in customer assets meaning that they loaned out more than half of those customer assets to Alameda. For those of you who don't know, this is very illegal.
You may be asking, how is this illegal & how does it differ from other financial institutions lending and investing customer funds such as hedge funds and investment funds? As a hedge fund or an investment fund, you can take positions in coins or assets, they can go up and down, and you can lose customer investments. However, there must be a clear distinction between customer funds and invested capital. SBF co-mingled customer funds with their investment fund, using these funds to cover operating expenses. This is illegal.
In a nutshell: Alameda was over-levered, bad at trading, and stole over half of all FTX customer funds to cover losses.
A short recap of the timeline prior to Nov 9th
July 2022:
SBF was spending a lot of time on capital hill lobbying against Defi, thus lobbying against Binance. In response to this, Binance sold its stake in FTX equity, to which it received $2 billion worth of FTT & USDC.
November 2nd:
Alameda's balance sheet leaked. They had $14 billion in assets against $8 billion in liabilities. Assets included $3.6 billion of FTT, $2.1 billion of FTT collateral, heavy exposure to Solana, Robinhood equity, and many illiquid cryptocurrencies such as SRM and PYTH. This turned some heads.
November 6th:
CZ saw how heavily Alameda and FTX were levered using collateralized FTT and announced that he would liquidate Binance's holdings. To him, the whole situation eerily mirrors the Terra Luna collapse. Initially, Alameda offered to buy Binance's FTT at $22 a token. How would they have paid for this? Most likely with FTX customer funds. Before they could, Binance's announcement had caused a 'run on the bank' at FTX and a 70% selloff of FTT. Given that FTX had loaned out over half of customer funds to Alameda, a liquidity crisis was created.
November 8th:
To avoid another Terra Luna-type situation and further degradation of trust in the crypto market, Binance stepped in, announcing that the two exchanges agreed that Binance would entirely acquire FTX.com, pending due diligence (excluding FTX US).
What happened following Nov 9th
November 9th:
After looking at Alameda's books, Binance decided to pull out of the deal because there was a gross mishandling of customer funds and FTX's finances were an absolute shit show. This furthered the bank run on FTX, and the selloff of FTT exceeded 90%. It took FTX from solvent but illiquid to insolvent & illiquid. In response, SBF tweeted that all would be okay with FTX, but they would be stopping customer withdrawals.
Additionally, the Securities and Exchange Commission and Justice Department announced that they were investigating the cryptocurrency platform FTX following the implosion. For reference, the SEC enforces civil investor-protection laws while the Justice Department prosecutes criminal violations such as fraud.
November 11th:
SBF filed all 134 FTX firms, including Alameda, for Chapter 11 Bankruptcy. At the time of declaration, the combined entities had just $900 million in liquid assets against liabilities upwards of $10 billion. 10-1 leverage. Since filing for bankruptcy, FTX's "assets" are now only valued at $700k.
On the same day, SBF resigned from his position as FTX CEO. His replacement, John Ray III, oversaw Enron's liquidation and would oversee FTX's liquidation and dealing with their over 100,000 creditors. After taking over, he said that he had
"Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.."
It gets worse. It turns out that SBF was doing more than just steeling customer funds to cover Alameda's losses. SBF not only lent $1 billion to himself, but other employees embezzled a total of $600 million (this number may rise as more news comes out).
Contagion
With the financial system being very intertwined, an event like this is bound to cause contagion. Here are firms that have already been affected
Multicoin: Lost over half of its crypto funds capital due to the FTX fallout. When FTX froze withdrawals, Multicoin had 9.7% of its fund's assets in FTX.
FTX Investors: FTX had over $2 billion in institutional investments, many of which have already started to write down their investments.
Singapore investment fund, Temasek, wrote down its $275 million investment.
Sequoya capital wrote down their $210 million investment.
Ontario Teachers Pension Plan will most likely write down their $95 million investment.
Softbank wrote down their $100 million investment.
BlockFi: The exchange halted withdrawals of customer deposits admitting they had "significant exposure" to Alameda research. They are also laying off more workers as they reportedly are preparing to file for Chapter 11 bankruptcy.
Genesis: The lending arm of the firm announced that they were temporarily suspending redemptions and new loan originations. The unit serves institutional clients with $2.8 billion in total active loans. Genesis disclosed that they had $175 million of locked funds in their FTX trading account.
Gemini: The Winklevoss twin-owned crypto exchange saw $500 million in outflows compared to just $74 million in inflows following the FTX collapse. Given this, they froze withdrawals from their yield product accounts. The exchange claims it has 1:1 backing; however, we will see if that is true in the oncoming weeks.
Galaxy Digital: The crypto focus financial services firm lost $77 million of cash and digital assets tied to the FTX exchange. This news caused Galaxy's stock to drop 22% and a layoff of 20% of their workforce.
Voyager assets: The bankrupt crypto exchange was supposed to be purchased for $1.4 billion by FTX. The deal has since been cancelled, and Voyager is scrambling for a new buyer.
Crypto.com & Gate.io: Following the start of the FTX debacle, Crypto.com sent 320k ETH tokens (82% of reserves) to the crypto exchange Gate.io. The market speculates that the move allowed both exchanges to show proof of reserves to regulators. Crypto.com commented, saying that the funds were sent "by accident" however that seems unlikely as how does one accidentally send $640 million worth of ETH to another exchange? Additionally, the exchange has announced that they had at least $10 million in assets frozen in FTX.
Margin trading: Firms trading crypto on margin will be affected by the FTX crash as it has sent cryptocurrency values down nearly 30%. Depending on their leverage, traders will most likely experience margin calls. Some may default on their loan obligations as a result. Defaults will cause further financial spiralling within the space.
Celebrity endorsements: FTX sponsored many big name celebrities such as Tom Brady, Larry David, Shohei Ohtani, Kevin O’Leary, and the Golden State Warriors organization. Those celebrities + more are now being sued for their part in promoting FTX. The lawsuit states that a part of FTX's scheme was to enlist celebrities "to raise funds and drive American consumers to invest in the YBAs" to keep the exchange afloat. We’ll see if this suit holds up in court.
FTX & Alameda creditors: Firms that had given loans to FTX and Alameda now face the strong possibility of not seeing their funds returned. Depending on what % of their book these loans were, we may see creditors heavily affected. As of right now FTX owes their top 50 creditors a total of $3.1 billion.
Rest of the market: It's still too early to see the full extent of the damage caused to the crypto market by FTX. We have already seen bankruptcy filings by firms heavily invested in FTX, and I believe many more will come. There is much speculation in the market, and many believe that firms are hiding the full extent of the damage they were subject too.
SBF political involvement
Out of all crypto exchange executives, SBF spent the most time on capital hill. He visited the white house on multiple occasions, held many meetings with lawmakers and regulators, and attended not one but two congressional retreats. He even went as far as purchasing a $3 million townhouse just steps from capitol hill, where he hosted happy hours for movers and shakers in both parties.
He also didn't hold back on donations. In the current election cycle, he donated $76 million to the democratic party, spending $12 million alone on getting a referendum on the ballot in California. He was their second biggest donor, and on a late May podcast, he claimed that he would be willing to donate upwards of $1 billion (soft ceiling). It's clear that SBF had an agenda and wasn't afraid to buy his way through it.
His generous donations and political ties have already started to do him well. Since FTX's demise, we've seen puff pieces from the NY Times and Washington Post, with one article claiming "FTX's collapse dooms founders' efforts to prevent another pandemic." Many believe that his slew of donations were attempts to purchase political amnesty and favourable regulatory treatment. We'll see in the upcoming months if that is true.
Industry outlook
As you can tell from my previous articles, I'm a big believer in blockchain technology and the crypto industry. The use cases for the technology are endless, and the industry is here to stay. However, the industry needed a bit of a reality check. Too many investors made their investment decisions solely on the promise of huge returns without an underlying understanding of the technology. As Warren Buffett says, "if you can't understand it, don't do it." It's only when the tide goes out that you learn who's been swimming naked. In this market crash, it's almost as if we're at a nudist beach.
The industry is much like the internet in the dot com crash. In the dot com bubble, money was thrown at just about anyone/anything. The market was hot, and the technology was even hotter. Investors were making huge investments into companies with little to no track record and poor financials, not paying attention potential longevity of businesses and financial due diligence. In 1999, the market cap of 199 internet stocks tracked by Morgan Stanley was a whopping $450 billion. But the total annual sales were only about $21 billion. And their yearly profits? They had collective losses of over $6.2 billion. Greed was at an all-time high and fear at a low, causing irrational investments decision.
When the bubble finally crashed, hundreds of companies went out of business, and investors lost a total of $5 trillion. However, the crash was needed to weed out the weakest companies and to give the industry a reality check. Out of the flames came some of the strongest companies existing today, the likes of Amazon, eBay, and Priceline.
This crash will weed out many cryptocurrencies, and unfortunately, a lot of money will be lost. But out of it will come a handful of strong cryptocurrencies with actual use cases. The lessons learnt and the pain endured will give the industry greater stability in the long run.