A spectacular fall

1—A spectacular fall

We're doing something a little differently today because the situation warrants it. That situation is of course the "spectacular fall of FTX and Sam Bankman-Fried", which will be the focus of this entire issue:

"Last week Sam Bankman-Fried was the most important person in crypto. The floppy-haired 30-year-old former billionaire, who goes by 'sbf', is the founder of FTX, which was then the industry's third-largest exchange. When crypto prices collapsed earlier this year he swooped in with loans for Voyager and BlockFi, providing the crypto-lending ventures hundreds of millions of dollars, and snapped up assets from Three Arrows, a distressed crypto hedge fund. Many compared him to John Pierpont Morgan, the banker who saved the American financial system in 1907.
...
Oh, how the mighty have fallen. After rumours that FTX might be insufficiently liquid began to swirl, investors pulled $650m of assets from the exchange on November 7th, before it stopped meeting requests. The value of an FTX Token, a mechanism for sharing the firm's profits, has fallen by 84% since November 4th. On November 8th Mr Bankman-Fried and Changpeng Zhao, the boss of Binance, the biggest crypto exchange, announced that Mr Zhao's firm had signed a letter of intent to buy FTX. Then on November 9th it pulled out of the deal, having taken a look at FTX's books. Binance stated that FTX's issues were 'beyond our control or ability to help'. According to Bloomberg Wealth, Mr Bankman-Fried is now worth less than $1bn, a drop of 94%, the biggest one-day fall on record."

That's from The Economist, which provides a short summary of what happened, some of which remains unknown.

But none of this should come as a surprise; the whole Bankman-Fried/FTX regime has had a bad smell around it for some time. Take this podcast Bankman-Fried did with Bloomberg back in April, in which he practically admitted that a lot of high yielding, decentralised finance (DeFi) products were Ponzi schemes:

"Bankman-Fried: Describe it this way, you might think, for instance, that in like five minutes with an internet connection, you could create such a box and such a token, and that it should reflect like, you know, it should be worth like $180 or something market cap for like that, you know, that effort that you put into it. In the world that we're in, if you do this, everyone's gonna be like, 'Ooh, box token. Maybe it's cool. If you buy in box token,' you know, that's gonna appear on Twitter and it’ll have a $20 million market cap. And of course, one thing that you could do is you could like make the float very low and whatever, you know, maybe there haven't been $20 million dollars that have flowed into it yet. Maybe that's sort of like, is it, you know, mark to market fully diluted valuation or something, but I acknowledge that it's not totally clear that this thing should have market cap, but empirically I claim it would have market cap.

Joe: It shouldn't have any market cap in theory, but it practice, they always do. Okay.

Bankman-Fried: That's right. So, and obviously already we're sort of hiding some of the magic impact, right? Like some of the magic is in like, how do you get that market cap to start with, but, you know, whatever we're gonna move on from that for a second. So, you know, X tokens [are] being given out each day, all these like sophisticated firms are like, huh, that's interesting. Like if the total amount of money in the box is a hundred million dollars, then it's going to yield $16 million this year in X tokens being given out for it. That's a 16% return. That's pretty good. We'll put a little bit more in, right? And maybe that happens until there are $200 million dollars in the box. So, you know, sophisticated traders and/or people on Crypto Twitter, or other sort of similar parties, go and put $200 million in the box collectively and they start getting these X tokens for it.

And now all of a sudden everyone's like, wow, people just decide to put $200 million in the box. This is a pretty cool box, right? Like this is a valuable box as demonstrated by all the money that people have apparently decided should be in the box. And who are we to say that they're wrong about that?
...
Matt: I think of myself as like a fairly cynical person. And that was so much more cynical than how I would've described farming. You're just like, well, I'm in the Ponzi business and it's pretty good."

Joe: At no point did any of this require any sort of like economic case, it's just like other people put money in the box. And so I'm going to too, and then it's more valuable. So they're gonna put more money in, and at no point in the cycle, did it seem to like, describe any sort of like economic purpose?"

An effective altruist (read our issue on that subject here), Bankman-Fried has previously expressed a willingness to gamble humanity for a 51% shot at duplicating Earth somewhere else, which might give you some insight into his risk tolerance.

So how did FTX Sam Bankman-Fried's empire collapse? According to Matt Levine, it all starts with FTX's own token called FTT. When FTX would make a profit, it would buy back FTT, propping up the token's value. Essentially the token was designed to behave somewhat similarly to a stock, except:

"[I]t is also a crypto token, which means that a customer can come to you and post $100 worth of FTT as collateral and borrow $50 worth of Bitcoin, or dollars, or whatever, against that collateral, just as they would with any other token. Or something; you might set the margin requirements higher or lower, letting customers borrow 25% or 50% or 95% of the value of their FTT token collateral.

If you think of the token as 'more or less stock,' and you think of a crypto exchange as a securities broker-dealer, this is completely insane. If you go to an investment bank and say 'lend me $1 billion, and I will post $2 billion of your stock as collateral,' you are messing with very dark magic and they will say no. The problem with this is that it is wrong-way risk. (It is also, at least sometimes, illegal.) If people start to worry about the investment bank's financial health, its stock will go down, which means that its collateral will be less valuable, which means that its financial health will get worse, which means that its stock will go down, etc. It is a death spiral. In general it should not be possible to bankrupt an investment bank by shorting its stock. If one of the bank's main assets is its own stock — is a leveraged bet on its own stock — then it is easy to bankrupt it by shorting its stock."

But the model Bankman-Fried was running was even riskier than that. FTX "is an exchange for levered traders, offering products like perpetual futures and leveraged tokens that build in margin lending", and as anyone familiar with Nassim Taleb's Antifragile will tell you, leverage makes you fragile – small mistakes can compound into catastrophes.

It's almost as if he applied the logic we discussed earlier to his personal life, continuously flipping a coin that had a 99% chance of doubling his wealth and a 1% chance of it all disappearing, until he eventually St. Petersburg paradoxed himself "into his own grave".

But we digress. Matt Levine also draws our attention to the important relationship between FTX and Bankman-Fried's personal hedge fund, Alameda Research:

"Sam Bankman-Fried founded Alameda to do crypto arbitrage and market-making trades, and then he founded FTX to basically have a better exchange for Alameda to trade on. Alameda has lots of FTT, and last week Coindesk reported on its balance sheet; the gist of that report was 'wow its balance sheet is mostly FTT'."

That report is what prompted rival Binance owner Zhao Changpeng to tweet his concerns and sell a roughly $530 million holding of FTT coins, setting in motion a self-fulfilling collapse:

"If you are worried about FTX's business, then the price of FTT should go down. If the price of FTT goes down, then FTX's business is riskier, because it has less collateral. If, say, the operator of the biggest crypto exchange gently raises one eyebrow and says 'FTT, eh?' that can be enough to topple FTX. FTT goes down, leaving FTX undercapitalized, leading to customer withdrawals, leading to ruin.
...
"[T]he problem is not a timing mismatch, in which FTX's customers asked for their cash back but FTX did not have enough ready cash because it had long-term but money-good loans out. The problem is that FTX took its customers' money and traded it for a pile of magic beans [FTT], and now the beans are worthless and there's a huge hole in the balance sheet."

Bankman-Fried is now seeking up to $8 billion from investors to avoid bankruptcy and the carnage has spread to the rest of the crypto world, with the total market capitalisation at one stage down more than 20% from a week ago.

The fundamental lesson is that if something seems too good to be true, it probably is: there ain't no such thing as a free lunch. Bankman-Fried was able to earn above-normal profits only by exposing himself (and his investors/clients) to fat tail risks.

You can read The Economist's coverage here (~4 minute read), or Matt Levine's take in Bloomberg here (~15 minute read).

2—Learning how to bank

3—Further reading...

🌍 A global problem with global solutions: "Switzerland is paying to install efficient lighting and cleaner stoves in up to five million households in Ghana; these installations would help households move away from burning wood for cooking and rein in greenhouse gas emissions. Then Switzerland, not Ghana, will get to count those emissions reductions as progress toward its climate goals."

🕵️‍♀️ The Japanese government hopes to gain "the ability to remotely turn down privately owned air conditioner/heater units... to decrease energy usage during expected power shortages, which the committee feels are a growing concern as Japan attempts to shift towards renewable energy sources such as solar power".

🔥 Facebook owner Meta has finally acknowledged the tech crunch, laying off over 11,000 staff, or nearly three times as many as Twitter recently sacked (from a much higher base). The reduction takes Meta's staff count back to December 2021 levels, which gives you some idea of the amount of hiring that took place this past year.

⚔️ "No matter how Russia spins it, the retreat from Kherson — the biggest city and only regional capital captured and occupied after the Feb. 24 invasion of Ukraine — is a huge military failure for Putin."