What did Bankman-Fried, FTX and Alameda do wrong?
By Tim Worstall
08:19, 14 November 2022
Now we've got the actual bankruptcy filing we can say that something really did go wrong. So, what was it that Sam Bankman-Fried, his companies FTX and Alameda, did wrong? Well, you know, apart from going bust?
The short answer is that they used all the client money to go gambling and lost it. The longer answer is the rest of this piece. Whether anything illegal happened is something we'll find out in time. It's not actually necessary that anything did for the result we've now got to have happened. That probably needs a little explaining so here goes.
What is your sentiment on BTC/USD?
FTX token (FTT) price chart
When a hedge fund and an exchange go ‘boom!’
Alameda was a hedge fund. A pot of money which then bet on markets. That it's all about crypto makes no difference. That it might be playing with the price movements of Bitcoin against Ethereum or Solana isn't important for the underlying economic point. Hedge funds bet on price movements.
FTX was an exchange. People put their money in to buy or sell whatever. That the whatevers are crypto makes no difference to us here. Euro to Bitcoin is something that can be bought and sold just as potatoes can be.
Now, yes, obviously, that this is all about crypto does matter because we'd of course like to know what's going to happen to crypto prices as a result. The FTT token looks pretty fried right now (sorry). The Bitcoin price is wilting a bit. But it’s important to understand that this is just one hedge fund and one exchange gone down not the entire crypto universe.
The London Stock Exchange (not a fair comparison, but a useful one) and Crispin Odey's (again not fair but...) fund going “pop!” would change prices but not destroy capitalism nor financial markets. The interesting thing would be how prices would change and could we get ahead of them?
So, a hedge fund and an exchange are different things. The slight problem here seems to be that they were both (majority) owned by the same person. Sam Bankman-Fried, who might not have been quite as careful as he possibly should have been about ensuring that the finances of the two stayed separate.
Bitcoin (BTC/USD) price chart
Problem of joint ownership
One little bit of background. Brokers and exchanges are allowed to invest client money. We all put cash in as margins, it's just sitting there. Standard law is that the exchange, the broker, can then invest that money and keep any profit. Sure, they've got to be careful about it. Try and earn 2% a year or something by buying government bonds, that sort of thing – even just a bank account that pays interest.
But they are allowed to invest it and they keep the profits, not we the punters. This has caused problems, as it did at MF Global back a decade and more. A futures broker, it was trying to make more from those client margin deposits and it invested in Greek government bonds – yes, at that time. Lost it – it was itself investing on margin – and so went bust.
So, what's different with SBF, FTX and Alameda? Mainly, it’s the joint ownership.
That FTX lends to Alameda is OK. Yes, this is true of both the margins and of the actual underlying assets. A broker is indeed allowed to lend out client assets for a fee. That's how everyone short sells stocks after all – the pensions funds, insurers, who hold those on behalf of investors lend them to those who cover a short sale. But FTX’s and Alameda’s joint ownership throws up two problems.
The first, is that a broker – and FTX was a broker as well as an exchange – can lend out pooled funds but not specifically segregated client funds. That second would be like the London Stock Exchange borrowing against all the BP shares on the market to go speculate in the oil price. Not wise and certainly not legal.
The second is that lending to connected companies is very frowned upon – to the extent of not being legal under some circumstances, allowed in a minor way in others. FTX and Alameda were very definitely connected companies. So, lending of assets across the corporate divide should have been minimal or at least well managed.
What actually happened is that some $10bn moved across that divide – the legality of which, we’ll find out about during the inevitable court cases that follow over the next few years.
The real problem is that Alameda then lost that $10bn. Or, as some suspect – and there is no proof of this – that Alameda had already lost it before the move.
Three chief takeaways for investors
- The first is that this is not the end of crypto. Any more than the death of MF Global killed futures markets. Or that of Northern Rock killed off mortgages. Crypto will survive or not based on the use value of crypto, not on the shenanigans of whoever might be trading in it.
- The second is that the prices of varied crypto are obviously impacted by this and, as should be, obvious prices changes are trading opportunities. That's what the trade is, after all, exploiting changes in prices.
- The third is that we might not want to be trading actual crypto in this immediate future. We've no idea who else is also going to be affected by the fallout of FTX not being able to repay anyone, let alone everyone.
Contracts for Difference – which are at one remove from the physical custody of the assets which might be lent to whomever – sound like a good way of trading those price movements. Assuming we want to trade those price changes, of course.
That a crypto exchange, broker or hedge fund goes bust doesn't change the case for crypto itself – it just changes the relative prices of varied cryptos. Which is, of course, a trading opportunity.
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