FTX: The Backstory

• SURRENDERING TO FOMO. The FTX crypto story is also the FTX FOMO story. Avoid situations where there is a rush to “get in” and little fear of failure. For this, you need to trigger not a reaction of excitement, but that primal reaction of “fear and threat.” Instead of thinking, “I better hurry to get in before I miss it,” try thinking, “Why is there all this pressure to rush into this?” Use the fear-threat emotion to develop and refine your FOMO Radar.

• Surrendering to FOMO is one of the Seven Deadly Stupidities.

Alameda Research was a crypto trading operation. It risked its own money on crypto trades, many of which were sophisticated. It was Alameda’s inability to realize its business model was flawed that led to the multi-billion-dollar collapse of crytpo exchange FTX and the arrest of its 30-year-old founder, Sam Bankman-Fried or, as he is known, SBF.

Arbitrage is more fruitful when dealing with less-popular assets as the markets for these are generally less efficient, meaning price differences can exist between crypto exchanges, if only briefly. Think about it as if you have the only lemon tree on the block and want to charge $2 per lemon. People can pay you the $2 or walk a mile to the next lemon tree and pay $1.  Or they just don’t know what pricing is outside of your offer of $2 per lemon. Alameda used powerful computers to search for, find, and buy those other lemons for $1 and sell them at $2. 

Arbitrage traders take advantage of these small price inefficiencies, which may last only seconds, to make big bets and lock in a profit. So, if Alameda had such a good thing going, why did its founders start FTX, which was not a trading operation but an exchange, where it took in money from consumers and institutions, helped them place a trade and then FTX collected a small commission? 

FTX did what was – yawn -- pretty close to what goes on in the world of stocks, bonds, and retirement accounts at places like Merrill Lynch, TD Ameritrade, and Charles Schwab. Not all that exciting, but these institutions act as fiduciaries for its customers’ funds, meaning that they are trusted with the safekeeping of customers’ funds. 

Based on my own experience in crypto arbitrage, I have a theory about how the market moved around on Alameda, creating the problems that ultimately led to the bankruptcy of FTX. 

As discussed above, arbitrage trading is based on market inefficiencies and the ability to capture a profit quickly. When Alameda was formed in 2017, crypto was not quite as “mainstream” as it is today. Young and “brilliant” MIT graduate SBF was not in the business news every week and Crypto Super Bowl ads did not show up until a few years later. Think about our lemon example above:  in the early days of the Alameda arbitrage operation, buyers and sellers did not have “perfect” information. There were information gaps that could be exploited.

From our basic training in economics, if a market has more participants and there is more knowledge about that market, the market will become more efficient, which means that buyers and sellers can more easily establish a clearing price where the bid (what the buyer is willing to pay) is close to the ask (what the seller is willing to take). If there were suddenly hundreds of people buying and selling your lemons and the lemons from a mile away, the $2 price and the $1 price would likely converge to around $1.50.

This is what I think happened at Alameda: As trading volumes and the number of market participants surged, the small price spreads that previously worked for Alameda slowly evaporated. In this theory, the basis for the Alameda business model changed and the adjustment was not to move on but rather to increase the size of the trades and funding them by creating a new pocket of money (FTX). Although it needed much more capital, Alameda continued make a profit on the smaller and smaller price gaps. Remember the Bitcoin example above? Well, now Alameda was only making $50 by risking $20,000, so to make that same $100, it needed to risk $40,000 (two times the $20,000).

FTX was most likely born, ultimately, to provide capital to shore up Alameda. So, rather than change the business model at Alameda, management simply threw more money at a trading operation that was based on a market theory that was quickly heading into obsolescence. Crypto arbitrage just did not work anymore, but SBF -- as the anointed young genius of crypto -- could still raise FOMO-driven money.

Once Alameda drained the FTX piggy bank -- trading more capital in a market with dwindling arbitrage margins -- FTX was unable to meet its own customers’ demands for withdrawals and almost overnight, FTX was in bankruptcy. 

But wait, there’s more! Bankruptcy is a process to essentially sell off a company’s assets (buildings, cars, stock holdings, etc.) to pay off the company’s liabilities (think “paying off the mortgage”). Once in bankruptcy, a new management team is appointed to sell off assets and pay off liabilities in an orderly manner.

The problem with FTX was the internal record keeping was so poor or non-existent that the new managers could not even figure out what assets and liabilities FTX even had. Imagine the scenario when the new managers took over:

I think you get the picture.  An entire professional bankruptcy management team spent months just trying to determine how much cash FTX had. And this was a multi-billion-dollar organization.

Were there plenty of red flags that FTX was headed for trouble? Certainly. But what the media focused on was its boy-wonder founder and the great things he was doing in charitable circles (with his illicit gains), as well as his scooping up of other companies in his industry. Everybody was too busy anointing SBF as the Warren Buffet of crypto without looking under the covers. The media appealed to our impulses and emotions, which by now, you know is bad news for decision making and an accelerant to the FOMO fire.

Surrendering to FOMO is not the way to make a Tectonic Decision.