This whole FTX thing is super fascinating. It’s been fun to read Matt Levine’s take evolve over the last few days:
Nov 7
If you are the CEO of a big crypto firm [and] there are negative rumors about a big competitor, do you take to Twitter to say “we’re not a scam like those guys”? One advantage of doing that is that you might win some business and harm a competitor; crypto is a smaller business than it was a year ago, so winning market share is very valuable. Another advantage is that you don’t want people thinking that you’re a scam; saying “we’re not a scam like those guys” is one way to persuade people that you aren’t.
The disadvantage is that it is probably in your long-term interest for people to be confident that none of the big crypto businesses are scams. “Crypto is full of scams and you can’t trust even the biggest exchanges” is a bad message for a crypto exchange to send; adding “except us, you can trust us” does not help.
Nov 8
Well. Another advantage of doing it is that a day later you might be able to buy your valuable competitor for peanuts. One possible reading of this situation is that CZ did some tweets and got himself a $30 billion crypto exchange for pennies on the dollar. But it seems like a dangerous game to play. Bankman-Fried was rescuing crypto firms a few months ago; now he needs a rescue. What lessons should Zhao learn from that?
Nov 9
One other point here is that if this is the story, then it is not a liquidity crisis but a solvency one. That is, the 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, and now the beans are worthless and there’s a huge hole in the balance sheet. On that note:
Changpeng Zhao moved fast when Sam Bankman-Fried’s FTX.com was on the brink, offering to take it over and stem any further crypto contagion.
Within hours, he was forced to reconsider.
For starters, Binance executives quickly found themselves staring into a financial black hole – a gap between liabilities and assets at FTX that’s probably in the billions, and possibly more than $6 billion, according to a person familiar with the matter.
Nov 10
[I]f your affiliated hedge fund comes in and says “hey we need a bunch of dollars and Bitcoins to keep trading, we’ll put up FTT tokens as collateral,” sure, whatever, FTT tokens are tokens, they have a market price, you can lend against them. The problem is … well, one problem is that this is financially a very risky move. FTT tokens are very correlated to your business, so if people are worried about the business they will sell FTT, which will leave your loans undercollateralized, which will cause your business to get worse, which will lead to more selling of FTT, etc., in a death spiral. I said yesterday that this is analogous to a bank lending a lot of money against its own stock, and that that is — in banking — “very dark magic” and possibly illegal.
The other problem is that if those financial risks materialize and you become insolvent, then it just sounds so, so, so bad.
Nov 14
If a troubled company has a few days to beg potential investors for a bailout before it files for bankruptcy, and it sends those investors its balance sheet so they can consider investing, and they all pass, and then the company files for bankruptcy, of course the balance sheet was bad. That is not a state of affairs that is consistent with a pristine fortress balance sheet.
But there is a range of possible badness, even in bankruptcy, and the balance sheet that Sam Bankman-Fried’s failed crypto exchange FTX.com sent to potential investors last week before filing for bankruptcy on Friday is very bad. It’s an Excel file full of the howling of ghosts and the shrieking of tortured souls. If you look too long at that spreadsheet, you will go insane.
. . .
If you blithely add up the “liquid,” “less liquid” and “illiquid” assets, at their “deliverable” value as of Thursday, and subtract the liabilities, you do get a positive net equity of about $700 million. (Roughly $9.6 billion of assets versus $8.9 billion of liabilities.) But then there is the “Hidden, poorly internally labeled ‘fiat@’ account,” with a balance of negative $8 billion.[1] I don’t actually think that you’re supposed to subtract that number from net equity — though I do not know how this balance sheet is supposed to work! — but it doesn’t matter. If you try to calculate the equity of a balance sheet with an entry for HIDDEN POORLY INTERNALLY LABELED ACCOUNT, Microsoft Clippy will appear before you in the flesh, bloodshot and staggering, with a knife in his little paper-clip hand, saying “just what do you think you’re doing Dave?” You cannot apply ordinary arithmetic to numbers in a cell labeled “HIDDEN POORLY INTERNALLY LABELED ACCOUNT.” The result of adding or subtracting those numbers with ordinary numbers is not a number; it is prison.
. . .
[B]roadly speaking your balance sheet is still going to look roughly like:
Liabilities: Money customers gave you, which you owe to them;
Assets: Stuff you bought with that money.
And then the basic question is, how bad is the mismatch. Like, $16 billion of dollar liabilities and $16 billion of liquid dollar-denominated assets? Sure, great. $16 billion of dollar liabilities and $16 billion worth of Bitcoin assets? Not ideal, incredibly risky, but in some broad sense understandable. $16 billion of dollar liabilities and assets consisting entirely of some magic beans that you bought in the market for $16 billion? Very bad. $16 billion of dollar liabilities and assets consisting mostly of some magic beans that you invented yourself and acquired for zero dollars? WHAT? Never mind the valuation of the beans; where did the money go? What happened to the $16 billion? Spending $5 billion of customer money on Serum would have been horrible, but FTX didn’t do that, and couldn’t have, because there wasn’t $5 billion of Serum available to buy. FTX shot its customer money into some still-unexplained reaches of the astral plane and was like “well we do have $5 billion of this Serum token we made up, that’s something?” No it isn’t!
Nov 17
Here is the first day declaration from the chief executive officer of FTX Trading Ltd., John J. Ray III, in FTX’s Chapter 11 bankruptcy case in Delaware. Ray has not been the CEO of FTX for long, “having accepted this position in the early morning hours of November 11, 2022,” and imagine getting that 4:30 a.m. phone call. Before that, Ray had nothing to do with FTX; its CEO was its 30-year-old founder, Sam Bankman-Fried. But Ray is an old hand at big bankruptcies — he has “been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history,” including Enron Corp. — so he got the call here. “I am over the age of 18,” says Ray in his declaration, and it seems relevant.[1]
Because the gist of this declaration is that, while Ray definitely doesn’t minimize the likelihood of intentional fraud and theft, mostly he is aghast at the children who ran FTX and had no idea what they were doing:
Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.
He’s never seen anything this bad in his career, and he saw Enron! Where to begin? With the emojis?
The Debtors did not have the type of disbursement controls that I believe are appropriate for a business enterprise. For example, employees of the FTX Group submitted payment requests through an on-line ‘chat’ platform where a disparate group of supervisors approved disbursements by responding with personalized emojis.
That is not best practices, but I guess it is, like, you-and-a-few-of-your-buddies practices. If you and your friends set up a financial exchange and overnight it became gigantic, and you were like “I would like to pay $6 million for a Super Bowl ad for our suddenly gigantic business,” and your boss said “okay submit a request in our payments system and the marketing committee will approve it and then we will have the payments department disburse the money,” that would feel boring and formal. If you just type in the chat “I would like to pay $6 million for a Super Bowl ad,” and some more senior person — not your boss, just “a disparate group of supervisors” — gives you a thumbs-up, you might be like “oh, cool, what a cool company this is, we do Big Business based on emojis in the chat.” But it is not cool, it turns out.
. . .
On the one hand, it does seem like FTX was what you’d get if a half-dozen college buddies ran a global financial exchange with no supervision. On the other hand, there were in fact hundreds of employees, including a chief regulatory officer. They resigned in shock when they learned about FTX’s insolvency and its misuse of customer money. But presumably they knew about the … emojis in the chats? It is one thing for a small group of top executives, who all live with each other, to do intentional fraud and keep it secret from the rest of the company. But the “complete failure of corporate controls and … complete absence of trustworthy financial information” seems like something someone might have noticed.
