TA Tuesday: Early lessons from the recent FTX debacle

The FTX drama will take some time to digest.

I won’t deep dive into the FTX/Alameda story today, as a detailed post-portem research report will follow from our team in the coming days. I will, however, say a few words about what happened.

Despite the fraudulent moves FTX might have done, in the very end what happened could be related to (i) liquidity duration mismatch and (ii) securities-backed lending. These are also old finance issues.

Can a bank survive a bank run – on its own? FTX saw around $6 billion in withdrawals in the 72 hours before Tuesday morning (according to SBF, they processed on average of “tens of millions” of dollars of net in/outflows), and this was a 27 standard deviation event. Even the Fed’s balance sheet, which is currently $8.679T, has the following status:

  • $4T in US treasury notes and bonds (at different maturities)
  • $2T in mortgage-backed securities
  • $2T in TIPS, US treasury bills, loans and special facilities

This means that – in an extreme scenario – even here things are not 1:1.

Ever since the existence of companies, entrepreneurs have been pledging shares/company stakes/etc. to secure bank/fiat/etc. borrowings. If these shares are sold pursuant to the pledges, such sales could cause stock prices to decline. Similarly, company stakes, real estate, etc. are “fairly” priced (market-to-market) at a certain point in time. Once the borrower is unable to pay back their loan, the lender will keep the collateral, and very likely sell it to get the money back.

But what if the lender (let’s say a bank) is then unable to sell that house or company stake, and needs to sell it at a discount? The result will be a loss. (just think of Elon Musk and Tesla/Twitter).

It has always been known that Alameda (and many others…) was pledging FTT (and many other coins) as collateral in exchange for fiat. But still, everyone believed that they were doing so well and that their balance sheet was healthy.

This was not the case. It is now believed that the hole is roughly $10 billion.

Looking ahead briefly to the short to medium term:

  1. Projects with a small market cap relative to the fully diluted market cap will be dumped hard
  2. Liquidity will shrink as many market makers are (i) out of business and (ii) re-assessing risk (especially counterparty risk) as they prefer to lose money for a couple of weeks, waiting for the chaos subside
  3. Macro figures will have less of an influence (and this is not the kind of decoupling we were all waiting for)
  4. High volatility – and very likely this is downside volatility
  5. Many companies will shut their doors as many hedge funds have funds locked in FTX (e.g., IKIGAI: https://twitter.com/travis_kling/status/1592198107734876160?s=48&t=i2hIMVL_BXl7qfliYmnwhg)
  6. More selling pressure will come as liquidation processes are underway, and companies will be required to sell their treasuries (you can begin by taking a look at all of the projects Alameda invested in)

FTX was able to provide users with one of the best trading experiences due to its GUI, fast API connections, and its once beloved margining and liquidation system. I always believed that Alameda (among others) was good enough to manage all that liquidity. And that its book was deep enough to always have two-way flow. This was always the case, until it wasn’t. At some point in time, they were probably the only buyer of FTT in the entire market.

Crypto is known to be a leveraged marketplace, but still the perfect (or at least working) clearing system needs to be found both for CeFi and DeFi. (This a great opportunity for many other players).

Nevertheless, what FTX designed and did was really good. Now, reluctantly, I am forced to say that it was too good to be true.

In a nutshell, this is how it worked – and it is fascinating:

  1. FTX liquidation engine: Our Liquidation Engine — how we significantly reduced the likelihood of clawbacks from ever occurring :: FTX Research
  2. FTX liquidation flowchart: FTX Liquidation Process Flowchart :: FTX Research

In terms of price: at the moment, I am biased towards further downside. It is too hard for me to believe that we are now seeing the bottom.

In the same vein, I believe BTC dominance (currently 40%) will increase again, and might be back to May values (48% on May 12th), as a consequence of capital rotation into “safer” assets and decentralisation.

I expect Exchange Tokens, which are/were holding up very well, will suffer. This is because many funds are re-assessing risk, and because – ultimately – they are not that different from FTT and FTX.

Lastly, now more than ever is the time for DeFi to shine again – despite the fact that it is currently broken.

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