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Briefing | Crypto's crisis

The failure of FTX and Sam Bankman-Fried will leave deep scars

It is harder now to assert that crypto represents the future

[20221119_B]
Nov 17th 2022 | Bogota and Washington, DC
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Nobody in crypto has slept in days. That, at least, is what it feels
like in the never-ending Twitter "spaces" which have been running
since ftx, a Bahamas-based crypto exchange and crown jewel in the
empire of Sam Bankman-Fried, its once-feted founder, filed for
bankruptcy on November 11th. The scattered crypto-community often
comes together in these online forums--they are where people shill
tokens, organise pump and dumps, and occasionally even discuss
exciting innovations. In the days after the fall of ftx and Mr
Bankman-Fried's other firms, including ftx.us, an America-based
exchange, and Alameda Research, a trading firm, they became places
for traders to mourn, former employees to spill the beans and other
exchange operators, including Changpeng Zhao of Binance and Jesse
Powell of Kraken, to try to reassure customers.

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In other words, they are places that now reek of despair--not just
about the billions of dollars that are trapped on a defunct exchange,
but about the architect of the mess. Mr Bankman-Fried was crypto's
golden boy. He studied physics at the Massachusetts Institute of
Technology and was supposed to have learned the craft of marketmaking
and trading at Jane Street, an elite financial firm. It was this,
along with the fact that ftx gobbled up market share after it was
founded in 2019, that attracted investors like Sequoia, considered
one of Silicon Valley's sharpest venture-capital firms, and Temasek,
Singapore's sovereign-wealth fund. Mr Bankman-Fried used his
credentials and newfound wealth--ftx was worth $32bn at its peak in
January--to donate to politicians, push his views on regulation and
buy up competitors. He was supposed to be crypto's future. Instead,
he may have robbed the industry of one.

It was possible to get very rich, very fast in crypto. A certain type
of winner got lucky, bought Lamborghinis and justified their riches
by belligerently asserting that blockchain technology or bitcoin was
the future. Those who disagreed got the now-familiar rejoinder: "Have
fun staying poor." It is tempting to see comeuppance in every scam,
failure or hack that befalls the industry. The failure of ftx is
certainly the closest thing to a death blow it has faced.

Everyone in ftx's orbit has suffered a financial hit, but the real
wound cuts deeper. Mr Bankman-Fried has let down supporters,
embarrassed investors and made fools of politicians. He has also
damaged and exposed flaws in effective altruism, a movement that aims
to safeguard humanity's future, and to which he donated time and
money. The result of the mess will be less sympathetic regulators.
Institutions and punters who embraced crypto will shun the Wild West.

The details of precisely what went wrong at ftx will spill out in
bankruptcy proceedings and possibly criminal ones over the coming
months and years. But the early evidence, in particular a
balance-sheet obtained by the Financial Times, does not make for
pretty reading. In the spreadsheet, which metadata suggest Mr
Bankman-Fried created, ftx appears to hold about $1bn of real money
or money-like assets, including currencies and stablecoins
(crypto-tokens pegged to the dollar), against some $9bn of
liabilities owed to customers. Mr Bankman-Fried claims to hold an
additional $3.5bn in equity or venture investments. Almost everything
else on the balance-sheet--assets claimed to be worth around $5bn--are
either tokens ftx minted itself, had a hand in creating or those
known in the vernacular as "shitcoins", which are not worth the
energy needed to render the pixels on a screen. To add insult to
injury, ftx has since lost most of its liquid assets, worth around
$500m, in a hack that seems to have been orchestrated by an insider.

Astute readers may notice this is not how an exchange should work.
Normal ones hold customer deposits, not a mix of venture investments
and tokens. Then there is an apparent hole in the accounts. In a
grovelling note left in them seemingly by Mr Bankman-Fried, the
writer claims not to have realised $8bn was missing, an amount worth
more than half that deposited in the firm's care. This is put down to
a "poorly labelled" internal account.

In messages published by Vox, an online publication, Mr Bankman-Fried
said ftx had directed customers to send money directly to Alameda but
never checked it got passed along (Mr Bankman-Fried has since tweeted
he thought the messages were private). This does not tally with what
Caroline Ellison, chief executive of Alameda and reputedly a former
girlfriend of Mr Bankman-Fried, is reported to have mentioned on a
call with colleagues on November 9th. According to the Wall Street
Journal, Ms Ellison said that she and Mr Bankman-Fried knew of a
decision to move ftx customer funds to Alameda. Since Mr
Bankman-Fried resigned from ftx on November 11th, the firm has
declined to comment, but on November 16th the new boss issued a
statement pointing out Mr Bankman-Fried has no role at ftx or Alameda
and does not speak on the firms' behalf.

To the moon...and beyond

The balance-sheet of Alameda--information about which has been
reported by CoinDesk, a news website--appears similarly full of holes.
It shows the trading firm owed $8bn in loans and that its assets
again consisted largely of tokens created by ftx. Combining the two
balance-sheets in a rough calculation, it appears that before things
went south, Mr Bankman-Fried's firms had taken in around $14bn of
deposits, borrowed $8bn and raised almost $2bn of equity capital from
investors. His firms gave back $5bn to those savvy enough to run away
fast, and probably hold around $5.7bn in equity and venture
investments plus $1bn in cash. This means a hole of perhaps somewhere
between $4bn and $12bn, depending on how much of Alameda's debt is
owed to ftx. Mr Bankman-Fried insisted on November 15th that the
trading firm's problem was liquidity, not solvency, because it held
lots of illiquid but valuable assets. But the balance-sheets appear
to have exposed what Mr Bankman-Fried counts as a valuable asset.

How did Alameda lose so much money? It was clearly using leverage. In
April last year a former employee tweeted the firm was taking long
positions on crypto assets based on "narrative market-drivers", such
as Elon Musk's tweets. Presumably such leveraged positions worked
well until November last year, when crypto prices peaked, at which
point things went downhill. Transactions that occur on a blockchain
are public, meaning it is possible to look for evidence of when
Alameda appears to have needed to tap ftx's customer funds.
Nansen.ai, a blockchain-explorer company, has identified wallets
belonging to the firms. Analysis of them cannot provide a complete
picture. Both firms could create new wallets on a whim; many
transactions were directed through other trading firms, muddying the
trail. Still, the wallets suggest Alameda blew up over the summer at
the same time as other crypto firms, such as Three Arrows Capital, a
hedge fund, and Voyager, a lending platform--and that Mr Bankman-Fried
bailed out Alameda by lending it customer funds.

The idea Alameda blew up in May or June may help explain why Mr
Bankman-Fried swooped to rescue firms like Voyager. He may not, as
was thought at the time, have considered himself the next John
Pierpont Morgan, a banker who saved the American financial system in
1907. Instead, he may have been backed into a corner. Alameda is
reported to have borrowed money from Voyager. If the lending platform
had been liquidated it would have exacerbated problems at his fund.

The only way out would have been to bet big or raise money. According
to reports, Mr Bankman-Fried has been trying to raise capital since
the summer. He flew to Abu Dhabi two weeks ago in an apparent attempt
to drum up interest. When his problems became acute, he called
Sequoia and other early investors. He even tried Binance, owned by
his great rival, Mr Zhao.

There is also more cynical speculation about what happened. One
suggestion is that Mr Bankman-Fried may have used customer funds not
just as a solution to a problem. Perhaps Alameda had been relying on 
ftx as its piggy-bank all along: depositing the exchange's own tokens
as collateral in order to move more reliably valuable crypto, like
bitcoin or ether or stablecoins, to Alameda for trading purposes.

[20221119_B]

It is a view which Mr Bankman-Fried's words appear to support, if not
insurmountably prove. In an interview with Bloomberg, a news website,
he described how to build a token in order to borrow against it. He
suggested making the number of tokens traded low relative to the
number issued, thus making it easier to pump up the market
capitalisation. For a token in theory worth $20m, "Maybe there hasn't
been $20m that has flowed into it yet". But "You can ...finance this,
right? You put X token in a borrow-lending protocol and borrow
dollars with it." Mr Bankman-Fried then described how, once these
tokens have been deposited as collateral for a loan in exchange for
dollars, "If you think it's worth less than two-thirds of that, you
could even just put some in there, take the dollars out. Never...give
the dollars back." He gave this description of borrowing real dollars
he would never give back against a low-float, imaginary token on
April 25th--two months before Three Arrows Capital was liquidated, and
Alameda's problems seem to have started.

It is this kind of public theorising that has made some even more
suspicious. Regulators and law-enforcement agencies, including the
Department of Justice and the Securities and Exchange Commission are
investigating, along with authorities in the Bahamas. Mr
Bankman-Fried may be flown to America for questioning; Congress plans
to force him to testify in December about what went wrong. In
crypto-forums, thousands of conspiracy theories are being traded.

Still, the theory for which there is most evidence is the one Ms
Ellison seemed to outline to Alameda's staff on November 9th: that
the trading firm had taken on leverage and was struggling to meet its
liabilities in the summer, at which point the decision was taken to
move over customer funds from ftx. The tale is one that makes plain
why regulators tend to split up these kinds of firms in the world of
traditional finance. Retail brokers, which take in customers'
deposits and hold their assets, are segregated from exchanges, the
venue in which customers trade assets, which are in turn segregated
from marketmaking firms, such as banks and hedge funds.

ftx was an offshore exchange which, like Binance and others, had
studiously avoided locating itself in a strict regulatory regime.
(Its American counterpart, ftx.us, has also filed for bankruptcy, but
seemed to face fewer problems redeeming customer assets.) Thus its
blow-up is not straightforwardly the fault of poor American
regulation. Nevertheless, Alesia Haas of Coinbase, another crypto
exchange, argues a lack of regulatory clarity in America "pushed
volumes offshore", meaning more American customers will end up hurt
by ftx's implosion. She argues that rules making it clear how and
where digital-asset exchanges ought to be registered would help.
There are several bills floating around Congress that would do just
that. They will surely have fresh impetus now.

[20221119_B]

The events also reveal just how interconnected crypto is, and the
vulnerability this brings. When one large project (the Terra-Luna
stablecoin system) blew up in the summer, it was enough to bring down
a hedge fund and two lending platforms, which was in turn enough to
bankrupt one of crypto's biggest exchanges. This dynamic has been
supercharged by the failure of ftx, which already seems to have taken
out three smaller exchanges, aax, BlockFi and Liquid, as well as a
lending platform, Genesis. Other exchanges faced enormous withdrawals
(see chart 2). Given that it took around six months for the fallout
of the summer's blow-up to hit ftx, the stage is now set for more
blow-ups.

The bigger question the events raise is whether crypto is a cause for
which it is worth fighting. ftx is just the latest and biggest in a
long line of multi-billion dollar projects, businesses and funds that
have gone spectacularly bust. Hacks and scams are commonplace. "Why
bother with any of this?" is a reasonable question. It is an
indictment that, almost 14 years after bitcoin was created, there are
only a handful of use cases for crypto, such as firms paying workers
in countries suffering from hyperinflation, like Argentina, or
efficient decentralised exchanges and lending tools. Even these seem
at present to offer only moderate improvements over more
old-fashioned forms of finance.

Diamond hands

Among the developers who work on the software powering the Ethereum
blockchain, or those building applications on top of it, the promise
of crypto has never seemed greater. In October, at a crypto
conference in Colombia, Danny Ryan, an Ethereum developer, pleaded
with the audience to work on functions and applications other than
those related to finance. And that is the direction many are taking,
especially now that efficient, scalable blockchains are beginning to
emerge. Stani Kulechov, the creator of Aave, a decentralised-lending
protocol, is building a social-media platform that would allow people
to port their followers from application to application, thus
allowing them to quit a platform without losing clout. The Gitcoin
platform allows people to vote on grants to be distributed to
so-called public-goods projects, like open-source software.

Much of crypto is just a casino--and thus high-octane, shiny and
tempting. Mr Bankman-Fried positioned himself as the champion for the
less dubious end of the industry. But it is now clear he actually ran
one of the most dubious casinos of all. With his empire in ruins,
crypto advocates must hope it is the underlying technology's turn to
shine. #

Listen to Money Talks, our podcast on markets, the economy and
business, which this week discussed the rise and fall of Sam
Bankman-Fried and the future of crypto.

This article appeared in the Briefing section of the print edition
under the headline "Hold on for dear life"

Briefing November 19th 2022

  * Indonesia is poised for a boom--politics permitting
  * The failure of FTX and Sam Bankman-Fried will leave deep scars
  * What Sam Bankman-Fried's downfall means for effective altruism

Crypto's downfallCrypto's downfall

From the November 19th 2022 edition

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