Disclaimer: This is an evolving situation. It might take months to get an accurate picture of what exactly happened. This post is my attempt to simplify what is currently the general theory of what happened at FTX as of November 16, 2022. The goal of this post is to explain to those not well versed in investment finance how it all (potentially) went wrong. If you have a sophisticated understanding of investment finance, this post is probably too elementary for you.
I think this simplification, while probably close to the big picture (clearly it is a story of overleverage of crap collateral), misses some technical points:
A) the spot margin lending system cannot of its own bankrupt the exchange because it is opt in, FTX clients needed to (1) switch on spot margin (2) actually allocate positive coins or fiat balances to it. That's the max borrowers could take out, and yield auctions balanced that market. The terms were that FTX would "try" to make up a default, but it did not guarantee it, so if someone withdrew all the ETH or USD participating in the lending system by depositing a lot of shitcoin, and the shitcoin zeroes, lenders just get nothing or the shitcoin but the exchange is not bankrupt. Cash accounts and uncommitted balances in margin accounts should still be backed 1:1 so there was fraud at some point.
B) There is a haircut based on the square root of position size (listed in tables of borrowable coins), so if 1 account puts a lot of 1 shitcoin, the collateral requirements gets bigger. Alameda could not bypass without fraud (either a switch server side, or creating 100000 sock puppet accounts).
C) Why did SBF bail out Alameda? It looks it's the other way round: clients deposited FTX funds in that "mislabeled" Alameda bank account, and it looks like Alameda thought it was their own money from PNL or fundraising or whatever and basically spent it (if they did not keep records of what startups they were investing in, it's thinkable that they could not be bothered to reconcile cash balances). When the exchange is growing the exchange does not actually need the margin at all, as deposit are more than withdrawals on most days and regular withdrawals could be handled from the "correctly labeled" FTX bank accounts. If they discovered that too late, there was no way out: Alameda had already taken client funds inadvertently. Then it looks they tried to take some more of non-lending client assets to bet their way out of the hole, which might have worked out in a crypto rebound.
A remark is that this construct with "deposit shitcoin/withdraw a large part of the current value as fiat or blue chip coin" is common in many exchanges. If someone has a big bag of shitcoins they can dump it on all exchanges that take it to effect a synthetic sale without (initial) market impact, which makes lending markets very fragile even if operated by the book.
Hi Freddie, I will give you one example where the crypto ecosystem is useful: Argentina
In Argentina, a good portion of the population owns crypto, mainly in the form of stablecoins. It has allowed them to protect their wealth in a novel way, rather than doing stuff like buying jewelry, cars, and $100 dollar bills stored in safes at home.
In Argentina, stablecoins are not only a store of value but also a peer to peer transfer system.
There are other examples which have not reached critical scale, but I hope my answer satisfies your question.
Do we have a good idea of how much the Argentine population uses it? I've seen one in-depth article about this [1], it and it sounds like some people with foreign jobs use it, and it's also used extensively by cuevas (black market money changers), because it's more secure for them than hauling large amounts of US currency around on motorcycles.
Are there other good sources for how extensively cryptocurrency is used in Argentina?
The part I don’t get: if we think of FTT as “magic beans” rather than real money, how does transferring FTT to Alameda result in real assets leaving FTX?
Also, who would accept FTT as collateral for a loan?
You could deposit $1000 of FTT and withdraw $950 of ETH. If FTT balance times price of FTT minus negative ETH balances times price of ETH goes below $50 they keep all your FTT and try to sell them to recover the ETH for the mug who put their ETH in their yield programme.
I think this simplification, while probably close to the big picture (clearly it is a story of overleverage of crap collateral), misses some technical points:
A) the spot margin lending system cannot of its own bankrupt the exchange because it is opt in, FTX clients needed to (1) switch on spot margin (2) actually allocate positive coins or fiat balances to it. That's the max borrowers could take out, and yield auctions balanced that market. The terms were that FTX would "try" to make up a default, but it did not guarantee it, so if someone withdrew all the ETH or USD participating in the lending system by depositing a lot of shitcoin, and the shitcoin zeroes, lenders just get nothing or the shitcoin but the exchange is not bankrupt. Cash accounts and uncommitted balances in margin accounts should still be backed 1:1 so there was fraud at some point.
B) There is a haircut based on the square root of position size (listed in tables of borrowable coins), so if 1 account puts a lot of 1 shitcoin, the collateral requirements gets bigger. Alameda could not bypass without fraud (either a switch server side, or creating 100000 sock puppet accounts).
C) Why did SBF bail out Alameda? It looks it's the other way round: clients deposited FTX funds in that "mislabeled" Alameda bank account, and it looks like Alameda thought it was their own money from PNL or fundraising or whatever and basically spent it (if they did not keep records of what startups they were investing in, it's thinkable that they could not be bothered to reconcile cash balances). When the exchange is growing the exchange does not actually need the margin at all, as deposit are more than withdrawals on most days and regular withdrawals could be handled from the "correctly labeled" FTX bank accounts. If they discovered that too late, there was no way out: Alameda had already taken client funds inadvertently. Then it looks they tried to take some more of non-lending client assets to bet their way out of the hole, which might have worked out in a crypto rebound.
A remark is that this construct with "deposit shitcoin/withdraw a large part of the current value as fiat or blue chip coin" is common in many exchanges. If someone has a big bag of shitcoins they can dump it on all exchanges that take it to effect a synthetic sale without (initial) market impact, which makes lending markets very fragile even if operated by the book.
I would still like a plain-language explanation of what crypto and "defi" do that traditional finance doesn't do. What problem is being solved?
Hi Freddie, I will give you one example where the crypto ecosystem is useful: Argentina
In Argentina, a good portion of the population owns crypto, mainly in the form of stablecoins. It has allowed them to protect their wealth in a novel way, rather than doing stuff like buying jewelry, cars, and $100 dollar bills stored in safes at home.
In Argentina, stablecoins are not only a store of value but also a peer to peer transfer system.
There are other examples which have not reached critical scale, but I hope my answer satisfies your question.
Do we have a good idea of how much the Argentine population uses it? I've seen one in-depth article about this [1], it and it sounds like some people with foreign jobs use it, and it's also used extensively by cuevas (black market money changers), because it's more secure for them than hauling large amounts of US currency around on motorcycles.
Are there other good sources for how extensively cryptocurrency is used in Argentina?
[1] https://www.freethink.com/hard-tech/crypto-argentina-black-market-cash
Thank you. Very well written and explained.
The part I don’t get: if we think of FTT as “magic beans” rather than real money, how does transferring FTT to Alameda result in real assets leaving FTX?
Also, who would accept FTT as collateral for a loan?
Well, the transfer of FTT from FTX to Alameda was not accounted as real assets leaving FTX. They left through a back door.
As far as I know, the only entity accepting FTT as collateral for a loan was FTX itself.
You could deposit $1000 of FTT and withdraw $950 of ETH. If FTT balance times price of FTT minus negative ETH balances times price of ETH goes below $50 they keep all your FTT and try to sell them to recover the ETH for the mug who put their ETH in their yield programme.
Thanks for this, I appreciate the simplified explanations of complicated events for simple people like me. !