FTX/Alameda, What Happened?

I think everyone was caught by surprise by the collapse of FTX/Alameda. Why did we end-up where we are now and why did it happen so quickly? Here is my take on it.

A bit of background

Back in 2011, Bitcoin was launched. By using cryptography, a network and a monetary incentive, a very secure and transparent form of digital money was created. Cryptography and network made sure that there was no need for a middle man to transfer value from one person or entity to another. Basically Bitcoin found a way to gain the benefits of trust without drawbacks of trusting. If you have not already, I highly advise you to read the white paper of Bitcoin.

Bitcoin found a way to gain the benefits of trust without the drawbacks of trusting

All the benefits aside, the disadvantages of any cryptocurrency are the technical complexity and that the costs involved because of the economic incentives. This never has changed and this will never ever change. A private key or a seed-phrase comes with a lot a freedom but also with a lot of responsibility. Next to that, there will always be a fee involved in transferring wealth.

These disadvantages are the reason that middlemen and intermediaries got a foothold. They provide a way around the technical difficulties and transaction fees. Al of a sudden the cryptocurrencies had a real, albeit immature market. This is one of the reasons why cryptocurrencies exploded in value as trade became very easy. The big downside of this is that these middleman and intermediaries own your tokens and coins. They are basically banks.

Please always remember that getting rid of middle men and intermediaries is the reason why cryptocurrencies and blockchain technology exists in the first place. On the other hand, middle men and intermediaries do have its place in our crypto-world. Because, no matter how you put it, the crypto world is connected to the old financial system and that will always require a middle man.

How it all started

Back in 2017, crypto experienced an enormous financial boom. More and more people and institutions started to trade cryptocurrencies. Most trade, like now, happened on Centralized Exchanges (CEXs). You know, those entities that actually own your crypto currencies. Because the market was still very immature there were a lot of arbitrage opportunities. Arbitrage is a difficult word for buying something at a low price and selling it at a higher price.

In comes Sam Bankman-Fried. A young guy who used to get his salary from arbitrage deals while working at Jane Street Capital. He saw a very profitable opportunity. Because of the friction in markets back then, the price of Bitcoin was higher on Asian based exchanges than on other exchanges. This was mainly the case in South Korea and Japan and was called the Kimchi Premium.

Making bank on the Kimchi Premium

By buying BTC on western exchanges and selling it on Asian, he started to make bank (pun intended). He then founded Alameda Research. He picked the name because it does not sound like anything crypto related. This helped to easier get loans from institutions and private individuals. Because the trade was so profitable Sam Bankman-Fried went in big. Mind you, it was 2018 and Alameda research was moving $25M per day. The Kimchi Premium eventually grew to more than 50%. If you want an example of arbitrage that makes bank, here you go…

But, arbitrage opportunities never last. They eventually dry-up and so did the Kimchi Premium. With it, Alameda’s money printing press stopped working. Alameda needed to change their game.

The start of FTX

Now greed enters the game. Alameda needed another game to make money and it pivoted into becoming a crypto market maker. Market makers make money from the difference between the sell and buy price of an asset. This is called the spread. And Alameda quickly got the reputation for aggressive trading strategies.

Making money from the spread is profitable. But it becomes extremely profitable when you have your own an exchange and have the clientele to trade against. This is combination is a zero risk money making machine. So, in 2019 Sam Bankman-Fried and Gary Wang founded FTX as a separate company. FTX stands for "Futures Exchange” FTX and it already existed within Alameda Research At that time, Sam Bankman-Fried owned 90% of Alameda research.

Futures trading was still a new area in this space and because of the whizzkid status of SBF, a lot of vc’s lined up to invest in FTX. Sam Bankman-Fried was the crypto version of Michael Burry and that is why nobody raised a flag when, in hindsight there was a clear conflict of interest between FTX and Alameda research.

Changpeng Zhao, the founder of Binance purchased a 20% stake in FTX half a year after Bankman-Fried and Wang started the firm. In August 2020, FTX acquired Blockfolio, a cryptocurrency portfolio tracking app, for $150 million. In July 2021, FTX raised $900 million at an $18 billion valuation from over 60 investors, including Softbank, Sequoia Capital, and other firms. In the meantime, FTX turned into a full-blown exchange and Alameda was given first right for market making activities and making trades against the clientele of FTX. A money making monster was made. And that money making monster also had its own token FTT. A “utility token” that offered trading discounts for owners on FTX. And at its peak, FTT had a market cap of 9.61B.

One would think this would be enough for one person to achieve

Sam reached Billionaire status and FTX/Alameda was still growing like a snowball. Next to that the picture was painted that Sam was in it for doing good. His goal, or so it was portrayed, was to give back to the world. He reached crypto stardom, was funding all kinds of projects and even funded political parties to get a foothold in Washington. This to put crypto and legislation on the agenda. One would think this would be enough for one person to achieve…

The rise of Luna/UST

Greed is a bitch, especially when we talk about money. If you are a risk taker, you just do not stop taking risks. No matter how much money you have.

In 2018, Do Kwon and Daniel Shin co-founded Terraform Labs. Terraform Labs raised more than $200 million from investment firms such as Arrington Capital, Coinbase Ventures, Galaxy Digital and Lightspeed Venture Partners.

Terraform labs created a blockchain that leverages fiat-pegged stable-coins to power a payment system. Several stable-coins were built using Terra with TerraUSD (UST) being the most famous one. UST was a so-called algorithmic stable-coin. This means that instead of having real world assets backing the value of TerraUSD, it used math in combination with the. LUNA cryptocurrency to back its value.

It was designed to maintain its peg through model called a "burn and mint equilibrium". This method uses a two-token system, whereby one token is supposed to remain stable (UST) while the other token (LUNA) is meant to absorb volatility. Although it sounds complicated, the gist of it is that LUNA was created or destroyed to increase or decrease its value and thus maintaining the peg between UST and USD. Users were able to redeem tokens at a lower than market value and arbitrage. However, this would require minting new LUNA every time.

To further create demand for UST, Anchor Protocol was created. Investors who deposited UST in the Anchor Protocol were receiving a 19.45% yield that was paid out from Terra's reserves. Now that back. That is one of the biggest “free money” incentives I have ever seen in my life. 19.45% yearly, apparently risk free profit, on a stable coin… This incentive caused a gigantic influx of capital. Both retail and institutions were pouring money into Anchor. Even non-crypto friends of mine were shilling Anchor like it was the best thing since sliced bread. Anchor LUNA/UST grew to a yield generating behemoth with a market-cap of 50 Billion USD. And it did that in no-time. It was the perfect storm for greed and opportunism.

But, there is a huge problem with algorithmic stable-coins. And that is the backing. The backing is purely based on trust. Trust that the absorbing cryptocurrency, in. this case LUNA will always have a certain value and that the arbitrage opportunity will always outweigh the volatility.

Luna/UST, a world on fire

I know, a lot of talk about LUNA/UST. But the in the collapse of LUNA/UST lies the reason why we are currently in this mess. Also, it explains why FTX was forced to “save” Voyager. Furthermore it shows that shows that shit can hit the fan in DeFi as well. Those 12 words come with responsibility.

In hindsight, the crash of LUNA was inevitable. This because the system was based on an algorithmic stable-coin and a carbon copy of the system implemented by Titan/IRON. What happened there? Well… It also used arbitrage of the token that was used to absorb the volatility as a means to create a stable currency. In this case IRON. On the 16th of June, this system collapsed overnight.

Why? The positive feedback loop turned into a negative feedback loop. This means that the volatility outweighed the arbitrage opportunity to stabilize IRON. As a result capital was fleeing the system which caused Titan to be created at such a phase that the value of it dropped to zero overnight.

Was it possible that the same would happen to LUNA/UST? Yes, and oh boy… When it finally did, it literately set the world on fire. But why did it cause such a mess? The keyword here is leverage. Leverage is a posh word for investing with borrowed assets. So, you take out a loan, invest it, make profit and pay back the loan. Basically, it is the foundation of our old financial system.

But there was more going on behind the curtain

Because of the “risk free” profit that could be made by just locking up UST on Anchor, a lot of investors took out loans to do just that. Pay 10% interest on a loan and pocket the difference. Easy money! The bigger the number the bigger the profit, and as a cherry on top it seemed risk-free. So wen everything crashing down, it started to rain margin calls and liquidations as the loans that were taken out could not be payed back. This caused a cascade of events that took many, even big investors down with it. All of a sudden it was raining bankruptcies and apparently even Alameda became insolvent. But there was more going on behind the curtain.

FTX contagion

One can take out a loan when your assets cover the value of the loan. Simple huh? Well, hold your horses, we are talking finance here. In the world of finance the value of an asset is sometimes not what it seems.

FTX/Alameda grew at lightning speed. It outperformed competitors that were bigger than them in pure revenue. Although it was amazing, it was also strange. How did it do that? Yes, Alameda was trading aggressively against  FTX customers, Basically f*&^% them over. But that did not cut it. There was something more. What was it?

There is something called tokens, there was something called client assets and there was Alameda doing high risk investments. That combined with a database made things turn into a shit-show.

Basically FTX/Alameda took out loans to make more profit. The assets for these loans were tokens and, as it now turns out, also consisted of client funds. These loans were then used for risky stuf. But not all can be risky so a large part was used to lock-up UST on Anchor. A risk free bet.  When LUNA/UST tanked, Alameda was also going under. The only escape was to use FTX client funds to save it. But why? And why “save” Voyager? The narrative of pride and hubris just does not hold.

But why? And why “save” Voyager?

The reason is the collateral used to create leverage. In simple words: The assets that where used to take out loans. A large part of the collateral consisted of FTT and other tokens that FTX basically owned. These assets were valued at face value. This means that instead of looking at supply and velocity, these tokens were valued using the diluted supply. If you see”diluted market cap” on CMC or CoinGecko, you probably know that is the market value of the project including the tokens that are not in circulation. And using this value as the value for an assets borders on outright lunacy (again, pun intended).

Why? Because if you have an emergency and need to sell these assets, the value of these assets will drop through the floor. And this is exactly what happened in the case of FTX/Alameda. Because of the loans that were taken out by FTX/Alameda, Voyager and Celcius had a ton of overvalued FTT in their books. Because they were going under, they would need to liquidate the FTT in their books. This would cause the price of FTT to go off a cliff and that would expose a hole in the balance sheet of FTX left by saving Alameda. This in turn would cause FTX to go under, taking Alameda with it. Furthermore it would expose SBF and the game he and his henchmen were playing. Jail-time was getting starting to look like a viable option.

FTX/Alameda, now what?

As you can see, Sam Bankman-Fried was only left with one option. The only option to save FTX was to save Voyager and hope for the best. And so it happened. Using client funds, not only Alameda was saved but also Voyager. And putting the word out there that SBF was also interested to buy the remains of Celcius might just do the trick to keep the show from stopping.

At stake was the collateral in the form of FTT and some other tokens. And because of all the turmoil, nobody noticed that this was the game being played by FTX/Alameda.

Enough runway to close the gap in their books

Eventually the dust settled a bit and SBF with FTX/Alameda where hailed as saviors. Just as intended. The practices of FTX/Alameda would stay hidden for time to come and that migh give enough runway to close the gap in their books. All what was needed was the continuation of aggressive trading and risky bets.

So it seems, this worked out brilliantly. No one was really suspicious and although the bear market was in full swing, FTX/Alameda was very confident that it would survive. The problem with getting away with something once, is that it makes people think that they can get away with it all the time. And SBF thought along those lines. It actually fueled his ego.

As a result, he thought that he could out maneuver and out smart his biggest competitors. And also his initial investors. This was fueled by ego and greed and he did not act like the savior he portrayed himself to be. But when you involve yourself in bad practices, they almost always will start to haunt you.

A leaked balance sheet

Competitors and others knew something was fishy. They either could not lay their finger on what it exactly was or they were scared of what the consequences would be. FTX/Alameda is not unique in its practices.

But then a balance sheet was leaked in media… The balance sheet of Alameda. It is still unknown who blew the whistle, but it is clear that some people where doing their thing to make sure it became public.This because of its contents. It showed that a huge part of its assets consisted of FTT and that these assets were overvalued by a mile or … 1000.  This meant that the value just was not there and that FTT became a hot potato.

This resulted in ,the now infamous, response of Alameda’s CEO, Caroline, saying that Alameda had more assets than those that were listed in the balance sheet. As a result, CZ put out a, now also infamous tweet, saying that Binance was off-loading FTT. It had become a risky asset because of the recent revelations. Mind you, Binance had a 500M reserve of FTT. So. By doing so, CZ knew he was shooting itself in the foot. But there was more than meets the eye and CZ knew. Being “transparent” just does not cut it. And thus, FTT got off loaded and dropped in value and the hole in the balance sheet of FTX/Alameda grew even bigger.

There was still a bit of trust left, but the rumor mill was already in full-throttle. If Alameda was technically bankrupt, would FTX be in trouble? Because we live in a crypto world, users can just leave a platform and it is better to be safe than sorry. There is no downside risk involved.

Like in Titan wave

That turned into a tidal wave. Like in Titan wave. This would not have been a problem if it were not for the huge hole in client funds. It would take an exodus to expose the hole, but in the end, that exodus happened. In a matter of days, one of the most successful centralized exchanges in crypto went under like the Titanic (jeez these puns), taking a lot of investors and institutions with it.

And of course, now we are learning that every project that FTX invested in, was forced to hold large bags of FTT. Furthermore, their native tokens were also used as collateral by FTX. Not only that, the value of this collateral was overvalued. Some tokens were listed with a value higher than the circulating supply.

The near future

Because of the size of FTX, it is still unknown how many other dominoes will fall. The thing is, this event will not blow over in a few days. It is an event that will its mark in crypto history. And because leverage has also become the goto way to trade in crypto, nobody knows how far the fire will spread.

What is clear is that a lot of people gut hurt by the collapse of FTX/Alameda. The reason why name them as one company is because that is what they are. One company with two names and with a clear conflict of interest between each other. And this conflict of interest is one of the reasons that we are where we are.

I personally think that the contagion will spread. There are numerous projects and companies that have already stated that they have direct exposure. Others are still in silent. But in the end, their remaining liquidity will just dry-up and they will be forced to downsize or close shop.

Trust is hard to gain but easy to loose

The biggest problem is trust. Although blockchain provides the features of trust without the need for trusting, there are a lot of middle men and intermediaries in our space that require trusting. That trust has left the building and it will take a long time for it to come back, if ever.

Then there is the problem of red-flag legislation. A company and founder that cuddled up with law-makers will probably be used to push regulation that does not benefit our space. This because for lawmakers, crypto is crypto. The distinction between intermediaries and self custodial crypto is not made.

If we talk about intermediaries, I am not opposed to regulation. If you are acting like a bank, meaning that you own the wallets of your clients, you should be regulated like a bank. Still, it will not prevent from things like this from happening. In my opinion, the old financial system is dead. That system proves that regulation does not work. Just a month ago Credit Suisse was going bust. A few weeks earlier, pension funds in the UK were in a lot of trouble.

Troubling is that the big banks are saying that it is positive event. They probably know what legislation will be pushed. Like always, they are not after a piece of the pie, they are after the entire pie.

We have been set-back years

Our space has been set-back by a couple of years. Currently a lot of people are hurting and trust is at an all time low. What happened was a lesson that needed to be taught and we will learn from it. It is teaching us the that we should not forget the importance self custody.
We cannot do without centralized exchanges. Things like trading BTC would not function well without them. And there are some great exchanges out there who take their job very seriously. Coinbase and Kraken are examples and Binance is good as well. But, if you are on an exchanges that sends 400M in client funds by mistake, you know that it is time to move. There is no downside risk in that so please do it.

My final words, for now

Personally, I feel a combination of anger, numbness, rage and sadness. A few days ago I said to some people that I was working as a consultant in the pay rolling industry. Just to evade the conversation.

Talk with others. It really helps

I really feel for the people who got hurt. And if you are one of those, you are not alone. Nobody saw this coming. I hope you have the strength to talk about it with others. That really helps. And although you might not feel it now, you will overcome this. I share the same anger towards the people who caused this and I really hope that justice will be served. But,FTX/Alameda is not unique case. There are others in our space doing the exact same thing. I hope that they will be called out as well. The less rot there is left, the better.

There are some people that really helping our space during this period. People who provide a platform to speak out. People who are hosting twitter spaces days on end. People who provide information and insight. It is really amazing to see and I hope it will give people strength to continue.

Although our space has been set back a couple of years and it will take time to regain trust, I am sure eventually our space will come out of this stronger than ever before.