The FTX Debacle ELI5

Here’s my high-level explanation of the FTX crash.

Imagine that I own a house and I create a million coins representing the value of the house. I give half of the coins to my wife. I then sell one of my coins to my wife for $10. Now the house has a nominal value of $10 million dollars and my wife and I each have assets worth $5 million. Of course, no one is likely to buy my house for $10 million or lend me money based on my coin wealth but suppose I now get my friend Tyler to buy a coin for $15. Tyler says why would I want to buy your s!@# coin! To encourage Tyler to buy I give him a side-deal that is not very public. Say an extra 5% of our textbook royalties. Tyler buys the coin for $15. Now the coins have gone up in value by 50%. My wife and I each have $7.5 million. Other people may want to get in while they can—Tyler bought in! Are you in? I’m in!

Now if it’s not obvious, I am SBF in the analogy, and my wife is Alameda run by his sometimes girlfriend Caroline Ellison. Who is Tyler?—the seeming outsider who gets a kind of under-the-table deal to pump SBF’s coins? One possibility, is Sequoia a venture capitalist firm who invested in FTX, SBF’s house, while at the same time FTX invested in Sequoia. Weird right? Tyler in this example is also a bunch of firms that Alameda invested in but which were then required to keep their funds at FTX. Many other possibilities exist.

Another relevant point to our analogy is that there are one million coins but only a handful of them are traded, the handful that are traded are called the float. Similarly, many crypto coins were created with emissions schedules where only a few coins were released, the float, with a majority of the coins “locked” and only released over time. Keeping the price high, and thus the imputed value of the stock high, meant you only had to control the float.

Ok, so far this is crazy but despite nominal values in the millions a relatively small amount of real money has actually changed hands. But suppose that I now open a bank or an exchange. People want to bank with me since I have clearly shown that I know how to get wealthy! Now the money coming into the exchange is real money and it’s a bull market so when people check their accounts everything looks great, everyone is making money.

Suppose I take some of these assets and lend them to my wife for her to take speculative bets on. Is this illegal? Well, it’s actually hard to say. A bank is supposed to make loans. It’s more complicated with an exchange. Maybe it’s illegal, maybe not. After all when I lend assets to my wife I can say that there was lots of collateral. What collateral? Well remember my wife has $7.5 million in coins so I am lending say $3 or $4 million which is backed by twice as much collateral—that looks safe, right? Actually, it’s even better since she is going to invest the assets in other assets, unfortunately other coins not the S&P500, but now there is even more collateral. Everything looks safe.

Importantly, if the assets my wife is investing in are going up in price—she is getting very, very rich. She borrowed billions and keeps all the profits on the upside. Give me a house of assets to stand on and with leverage I will rule the earth! Moreover, the more prices go up, the safer this trade looks since the collateral is increasing in value. Also, my wife and I can coordinate on which coins to buy. She buys and then I list the coins on my exchange and offer them to all my customers. More demand, more price appreciation, more demand. My wife decides to borrow even more, since the trade is working so well.

Ok, now we get to the end of 2021 and what happens? After a massive run up in prices, crypto price start dropping.* Other firms in the space including Voyager and BlockFi start to come under pressure because of the TerraUSD-Luna collapse in May of 2022. Now, the bets aren’t starting to look so good. So what do I do. Either I come clean and reorganize or double down. It looks like SBF doubled down. More borrowing and more big bets. Amazingly, SBF offered to buy Voyager and BlockFi and bail them out. At the time, this looked like a visionary move to save crypto. Finance experts compared SBF to JP Morgan, the private banker who took big bets in 1907 to reestablish confidence like a proto-central bank. What we learned later, however, was that SBF owed these firms money and if they started to demand payment that would put pressure on his collateral, the coins on the house that we talked about earlier. So SBFs efforts to buy these firms were an effort to keep his own weakness hidden. Indeed, as people start to sell their coins, Alameda had to step in to buy, to keep the price up.

Eventually, as people began to look more closely at the assets of Alameda and FTX they realized that many of the numbers were huge stock-valuations made on tiny floats–not just the original house coins but also many of the coins, like Serum, bought by Alameda as investments. And once people realized that, they ran to get out before the house burned down. Now everything works in reverse—a $10 trade goes to $1 and your valuation is cut by billions overnight. We also get fire sales—as firms try to sell assets to meet their customer demands the prices of those assets fall which makes people sell other assets and so the contagion spreads (as described in Modern Principles).

Ok, final analogy. Suppose to help me run my house I invite over a bunch of friends and we do a lot of drugs and hook up together and suppose that none of us really knows anything about accounting or financial controls.

Well that about covers it.

N.B. Much of this story is familiar. The assets involved were crypto tokens but they could have been fiat currencies, internet stocks or mortgage backed securities. The new and original aspects of cryptofinance such as decentralized consensus, crypto wallets, and automated marker makers continue to work well. Unfortunately, these fine distinctions are not likely to be widely understood.

*You might wonder why crypto prices started dropping. One important reason is macroeconomic, rising interest rates. When interest rates are very low a dollar in the far future is worth almost as much as a dollar today. Thus, in a regime of low interest-rates, crypto and other projects with (speculative) long-run payoffs could be valued highly. As interest rates rose, however, long-run speculative returns began to look much less attractive than say T-bills and money flocked out of assets in the long-run sector causing prices to plummet.

Addendum: Drawing on many excellent sources including Matt Levine, the FT, and Milky Eggs.


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