- The Cautionary
- Posts
- My experience with crypto arbitrage
***You can listen to this newsletter by clicking “Listen” at the top of the page.
Alameda Research was a crypto trading business that ultimately triggered the downfall of its parent company, FTX.
Alameda specialized in crypto arbitrage, which exploits small differences in the prices of Bitcoin and other crypto. These price differences might be Bitcoin trading at $80,000 on an exchange in Asia when compared with $80,100 on an exchange in Europe. Alameda bought Bitcoin in Asia for $80,000 and immediately sold it in Europe for $80,100 to lock in a profit. To make that $100, $80,000 had to be put at risk for seconds or minutes.
The basics of an arbitrage trade. No different than buying a case of beer at the grocery store and selling it for a lot more at the beach.
Based on my own experience in crypto, I have a theory about how the market shifted under Alameda’s feet, creating the problems that ultimately led to the bankruptcy of FTX.
When crypto was gaining attention, I took a look to see if I should make investments, trade, etc. I did not feel comfortable speculating about which direction crypto prices would move, but I did feel comfortable that there was an arbitrage opportunity since there were so many crypto exchanges across so many different countries.
By visually inspecting prices, I was able to see the price differences for Bitcoin at several different exchanges.
I did a handful of manual arbitrage trades and then decided to automate the process. Using existing algorithms and a little programming, I built my automated arbitrage trading system in about 60 days.
A lot happened in those 60 days.
The number of buyers and sellers in the crypto market was rapidly increasing at that time. 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).
That $100 price difference in the price of Bitcoin was gone. With a more efficient crypto market, arbitrage opportunities all but vanished. Crypto markets starting looking like the stock market.
But consider that fact that the crypto market was rapidly gaining participants while trading volumes were exploding. Total crypto transactions went from about $34 billion per month in December 2018 to more than $2.2 trillion per month in May 2021, an increase of 65 times. This is why those price spreads disappeared.
The early days of crypto as it went mainstream
So, if Alameda had such a good thing going, why did its founders start FTX, which was not a trading operation but an exchange. FTX was more 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. By using those customers’ funds to prop up Alameda, FTX broke every rule of being a fiduciary.
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 fund them by creating a new pocket of money (FTX).
Although it needed much more capital, Alameda continued to profit on the smaller and smaller price gaps, with one catch.
Remember the Bitcoin example above? Well, now Alameda was only making $10 by risking $80,000, so to make that same $100, it needed to risk $800,000.
FTX was most likely born to provide capital to shore up Alameda. So, rather than change the business model at Alameda, management simply threw more money at an arbitrage-trading operation that was based on a market theory that was quickly heading into obsolescence. Crypto arbitrage just did not work anymore — for Alameda or for me.
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 overnight, FTX was in bankruptcy.
Key Takeaways
Every business needs to pivot at some point. Don’t bury your head in the sand and act like you don’t need to change when things just are not working. Look up a company called MicroStrategy (now called “Strategy”). That’s a company that made a pivot.
Avoid “bridge financing” unless you know when and how the bridge gets repaid. I am sure Alameda was on friendly terms with FTX (they did have common ownership) and what’s a few million dollars shuffled among sister companies? But Alameda was a bottomless pit and consumed all the cash with no end to the initial bridge extended to it by FTX. The bridge must lead you someplace or don’t take the money.
The hardest thing to do in business is to give up. Sometimes its the prudent thing to do. Alameda should have been shut down as soon as arbitrage margins starting drying up. Admitting something doesn’t work is not a way to get a promotion, but will keep you out of jail.
Things I think about
Rosalie Bradford is in the Guinness Book of World Records because she lost the most weight ever by a woman: 900 pounds.
Recommended reading
Going Infinite
The story of FTX
When Genius Failed
The collapse of hedge fund Long-Term Capital Management, and how it almost brought down the global financial system.
The Secret Race
Lance Armstrong’s teammate, Tyler Hamilton, blows open the cycling doping scandal from the inside.
Fortune’s Formula
The story of the Kelly Formula, still in use today at casinos and Wall Street.
The Billionaire’s Apprentice
Insider trading and the downfall of Raj Gupta, former chair of McKinsey & Co.
Reply