Later you say that this is just one ingredient, but in the beginning you describe a rigid structure of compounding and shoehorn examples into bullet points. I think that structure is too rigid and I object to the examples. I think Theranos and academic Tessier-Levine fit it well. Indeed, for research, pretty much all people have is their reputation.
You describe Enron as a simple Ponzi scheme. I think this is just wrong. My understanding is that the main thing with Enron was a one-time shift from brokering energy today and owning the physical capital to deliver that energy, to brokering long-term deals that were purely virtual. By having unmoored forecasts, they could make arbitrary forecasts about the state of the company. It is not clear how much the senior executives knew they were doing this; perhaps they just accidentally designed poor incentives by allowing the salesmen to price their own deals and get an immediate bonus with no real-world feedback of how the deal turned out years later. You can certainly say that this is an example of extending credit from Enron’s old business to its new business, but I think it was a one-time change and not repeated compounding of credit. It is true that the new business having no physical capital was able to scale very far on financial credit. (Enron is my hobby horse. “Everybody knows” that you’re supposed to hold it up as an example, but it did 3 bad things and no one notices that other people are talking about different things. The main problem was that there whole business was mispriced. When the senior executives discovered this they something more like a Ponzi scheme, but that was just a couple billion, a rounding error. And the third was manipulating California energy prices.)
Similarly, FTX made a one time pivot from trader to bank. As I understand, it stole mainly to cover the trading losses and not to pay for advertising. If it had accepted the trading losses and wound down the trading, it wouldn’t have looked very different from the outside. Trying to convert its credit for trading to being trusted as a steward might be an example of the credit conversion you’re talking about, but not a compounded phenomenon. If that was central to its strategy, then maybe would make it hard to accept the loss and wind down that business.
What scale is “quickly ramping up their PR spending”? Theranos lasted 10 years. Enron lasted 15 years from the merger of much older companies. I don’t think a heuristic about speed would identify either of them. It sounds like you’re only talking about FTX.
As I understand, it stole mainly to cover the trading losses and not to pay for advertising. If it had accepted the trading losses and wound down the trading, it wouldn’t have looked very different from the outside.
Advertising spending ramped up as losses increased as well, as did political spending (FTX spent much more on political lobbying in the months before it collapsed than previous months, IIRC).
I actually think any analysis of FTX on this dimension without looking at FTT has a hole in it, and I might update this post, or write a follow-up one. Patio11 and Matt Levine have written about FTX and FTT and how this resulted in crazy leverage in almost the exact way I document here.
FTX at various points, via indirect channels like Alameda, used FTT, basically it’s own stock as a collateral to get more loans. The value of its own stock was largely determined by the investment it was taking on, which functionality constituted more debt. This was as Matt Levine called it “deep dark magic” of the kind I am talking about in this post.
This full coverage:
But sometimes market moves are catastrophic, and in particular, sometimes securities broker-dealers and crypto exchanges will have “run on the bank” risks. If everyone knows that you are in this situation — that you have a lot of Bitcoin collateral and Bitcoin prices are falling — people will expect you to have to liquidate your Bitcoin collateral, so they will expect Bitcoin prices to fall, so they will sell Bitcoin, which will cause Bitcoin prices to fall, which will cause your long-Bitcoin customers to default, which will cause you to liquidate Bitcoin at lower and lower prices, etc., until you are bankrupt.
Now let’s add one more crypto element. If you are a crypto exchange, you might issue your own crypto token. FTX issues a token called FTT. The attributes of this token are, like, it entitles you to some discounts and stuff, but the main attribute is that FTX periodically uses a portion of its profits to buy back FTT tokens. This makes FTT kind of like stock in FTX: The higher FTX’s profits are, the higher the price of FTT will be. 8 It is not actually stock in FTX — in fact FTX is a company and has stock and venture capitalists bought it, etc. — but it is a lot like stock in FTX. FTT is a bet on FTX’s future profits.
But it 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. 9 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.
The worst case is something like:
1.You have 100 Customer As who are long Bitcoin on margin: They each have 1 Bitcoin in their accounts and owe you $10,000.
2.You have 100 Customer Bs who are short Bitcoin on margin: They each have $20,000 in their account and owe you 0.5 Bitcoin.
3.You have loaned 50 of the Customer As’ Bitcoins to the Customer Bs, and $1 million of the Customer Bs’ dollars to the Customer As. You keep the other 50 Bitcoins and $1 million as collateral.
4.Your accounts show that you owe clients 100 Bitcoins and $2 million, and that they owe you back 50 Bitcoins and $1 million, and you have 50 Bitcoins and $1 million on hand, so everything balances.
5.You have one Customer C who says “hi I would like to borrow 50 Bitcoins and $1 million, I will secure that loan with 150,000 FTT, each of which is worth $20.”
6.You say “sure, sounds good,” and hand over all your collateral.
7.Now you have 150,000 of FTT, worth $3 million, as collateral (and no Bitcoins or dollars).
8.Your accounts show that you owe clients 100 Bitcoins and $2 million and 150,000 FTT, and they owe you back 100 Bitcoins and $2 million, and you have 150,000 FTT of collateral, so everything balances.
But then if the value of FTT drops to zero, you have nothing. You have no Bitcoins to give to the customers to whom you owe Bitcoins, no dollars to give to the customers to whom you owe dollars. You just have to call up Customer C and say “hey we need all those dollars and Bitcoins back.” But Customer C will not want to give you back all those valuable dollars and Bitcoins in exchange for now-worthless FTT. Also the fact that Customer C had all that FTT in the first place is not a great sign. It is an FTT whale, and FTT is now worthless. Has it been borrowing elsewhere against FTT? Are all those debts coming due?
Now let’s add a few more FTX-specific elements. One is that FTX is an exchange for levered traders, offering products like perpetual futures and leveraged tokens that build in margin lending. So whereas the basic model of Coinbase is “they buy Bitcoin for you and put it in an envelope,” the basic model of FTX has to be “they lend you money to buy crypto and then make use of your crypto to get the money.” In financial terms, they have to rehypothecate your collateral; you can’t expect them to just keep it in an envelope if they’re lending you the money to buy it.
The other is that FTX is closely associated with a hedge fund called 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”:
The financials make concrete what industry-watchers already suspect: Alameda is big. As of June 30, the company’s assets amounted to $14.6 billion. Its single biggest asset: $3.66 billion of “unlocked FTT.” The third-largest entry on the assets side of the accounting ledger? A $2.16 billion pile of “FTT collateral.”
There are more FTX tokens among its $8 billion of liabilities: $292 million of “locked FTT.” (The liabilities are dominated by $7.4 billion of loans.)
That is not in itself a reason for a run on FTX! It might be a reason for the price of FTT to go down, if you think that Alameda has too much of it and might need to sell it.
The reason for a run on FTX is that you think that Alameda is, in my terminology, Customer C. The reason for a run on FTX is if you think that FTX loaned Alameda a bunch of customer assets and got back FTT in exchange. If that’s the case, then a crash in the price of FTT will destabilize FTX. If you’re worried about that, you should take your money out of FTX before the crash. If everyone is worried about that, they will all take their money out of FTX. But FTX doesn’t have their money; it has FTT, and a loan to Alameda. If they all take their money out, that’s a bank run.
And all of this is self-fulfilling: 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.
Anyway it is still early and confusing but that seems to be the story of FTX.
What channels other than Alameda? If this was entirely about Alameda, how is FTT adding anything to the story above saying that they stole to give to Alameda? Who are they fooling other than their own internal accounts? The Coindesk article is very late in the story because no one saw the accounts before they tried to get a bailout from Binance, who wasn’t fooled.
If a customer puts up FTT as collateral to short bitcoin, then FTX is confused about how much collateral it has. But this is the customer exploiting FTX, not vice versa! This is FTX exploiting all the other customers by falsely claiming that it has hedged risk. But this isn’t what took it down. It did manage to largely liquidate shorts before they ran out of collateral.
The problem is that Alameda then used that FTT as collateral for other loans from external parties, while of course presenting the FTT as an uncorrelated asset!
We were borrowing billions of dollars from Genesis using FTT as collateral on our loans,
I agree that if Alameda had just borrowed from FTX, then only FTX would have been fooled. But given that Alameda loaned billions of dollars from Genesis using the FTT as collateral means external parties were fooled in the way I am trying to describe in this post!
Later you say that this is just one ingredient, but in the beginning you describe a rigid structure of compounding and shoehorn examples into bullet points. I think that structure is too rigid and I object to the examples. I think Theranos and academic Tessier-Levine fit it well. Indeed, for research, pretty much all people have is their reputation.
You describe Enron as a simple Ponzi scheme. I think this is just wrong. My understanding is that the main thing with Enron was a one-time shift from brokering energy today and owning the physical capital to deliver that energy, to brokering long-term deals that were purely virtual. By having unmoored forecasts, they could make arbitrary forecasts about the state of the company. It is not clear how much the senior executives knew they were doing this; perhaps they just accidentally designed poor incentives by allowing the salesmen to price their own deals and get an immediate bonus with no real-world feedback of how the deal turned out years later. You can certainly say that this is an example of extending credit from Enron’s old business to its new business, but I think it was a one-time change and not repeated compounding of credit. It is true that the new business having no physical capital was able to scale very far on financial credit. (Enron is my hobby horse. “Everybody knows” that you’re supposed to hold it up as an example, but it did 3 bad things and no one notices that other people are talking about different things. The main problem was that there whole business was mispriced. When the senior executives discovered this they something more like a Ponzi scheme, but that was just a couple billion, a rounding error. And the third was manipulating California energy prices.)
Similarly, FTX made a one time pivot from trader to bank. As I understand, it stole mainly to cover the trading losses and not to pay for advertising. If it had accepted the trading losses and wound down the trading, it wouldn’t have looked very different from the outside. Trying to convert its credit for trading to being trusted as a steward might be an example of the credit conversion you’re talking about, but not a compounded phenomenon. If that was central to its strategy, then maybe would make it hard to accept the loss and wind down that business.
What scale is “quickly ramping up their PR spending”? Theranos lasted 10 years. Enron lasted 15 years from the merger of much older companies. I don’t think a heuristic about speed would identify either of them. It sounds like you’re only talking about FTX.
Advertising spending ramped up as losses increased as well, as did political spending (FTX spent much more on political lobbying in the months before it collapsed than previous months, IIRC).
I actually think any analysis of FTX on this dimension without looking at FTT has a hole in it, and I might update this post, or write a follow-up one. Patio11 and Matt Levine have written about FTX and FTT and how this resulted in crazy leverage in almost the exact way I document here.
FTX at various points, via indirect channels like Alameda, used FTT, basically it’s own stock as a collateral to get more loans. The value of its own stock was largely determined by the investment it was taking on, which functionality constituted more debt. This was as Matt Levine called it “deep dark magic” of the kind I am talking about in this post.
This full coverage:
What channels other than Alameda? If this was entirely about Alameda, how is FTT adding anything to the story above saying that they stole to give to Alameda? Who are they fooling other than their own internal accounts? The Coindesk article is very late in the story because no one saw the accounts before they tried to get a bailout from Binance, who wasn’t fooled.
If a customer puts up FTT as collateral to short bitcoin, then FTX is confused about how much collateral it has. But this is the customer exploiting FTX, not vice versa! This is FTX exploiting all the other customers by falsely claiming that it has hedged risk. But this isn’t what took it down. It did manage to largely liquidate shorts before they ran out of collateral.
The problem is that Alameda then used that FTT as collateral for other loans from external parties, while of course presenting the FTT as an uncorrelated asset!
Caroline said directly:
I agree that if Alameda had just borrowed from FTX, then only FTX would have been fooled. But given that Alameda loaned billions of dollars from Genesis using the FTT as collateral means external parties were fooled in the way I am trying to describe in this post!