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Editorial note: Admittedly, this edition will take longer than five minutes to read. Given how crypto experienced one of the most damaging events in its history, we felt this was warranted. If you find this newsletter useful, please forward it to a friend.
- FTX Collapse Pt 1: What Happened
- FTX Collapse Pt 2: Who Has Exposure to FTX?
- FTX Collapse Pt 3: What are Regulators Saying?
- The Good News: Bullish CPI Report
- Stocks React to Midterm Elections
- Binance Implies FTX Misused Customer Funds and Walks Away from Deal (link)
- FTX Files for Bankruptcy, SBF to Step Down as CEO (link)
The crypto space is undergoing its Bernie Madoff/Lehman Brothers moment, threatening to shake the foundation of its ecosystem. Due to the extraordinary nature of the event, we covered the FTX fiasco in three parts this week. First, let’s dive into an autopsy of sorts, as best as it can be given during the unfolding crisis.
What exactly happened? On Tuesday, the crypto market as a whole began to correlate with the fate of a lesser known altcoin — FTX Token (FTT).
The total crypto market cap was $1.029 trillion on Tuesday, having shrunk by -23% on Thursday, at $786 billion.
This was its lowest point since December 2020 — nearly two years ago.
The culprit was FTT (and the individual behind it), the native token of the world’s third largest cryptocurrency exchange — FTX.
Before its collapse, FTT held about 0.23% market share of the total cryptocurrency market cap. Image credit: Trading View
Founded in May 2019, FTX made its founder, 30-year-old Sam Bankman-Fried (SBF), into a billionaire and a prolific political donor and crypto investor, often referred to as the “Bailout King” after Terra’s collapse and contagion fallout. As we will see, the Terra (LUNA) meltdown is somewhat connected to the present crisis.
SBF is also the founder of quantitative crypto trading firm, Alameda Research. The relationship here with SBF as the middle-man between FTX and Alameda is crucial.
So, why would FTT token, with its 0.23% market share, have such an impact?
Let’s go through the steps one-by-one:
- The world’s largest exchange, Binance, entered a strategic partnership with FTX in December 2019, by taking a long-term position in its FTX Token (FTT).
- By 2022, FTX grew to over 1 million customers and a $32 billion valuation, just a couple of months ago. Taking third place on the global crypto exchange, FTX international became Binance’s leading competitor.
- On November 2nd, CoinDesk published a report claiming that $5.8 billion out of the $14.6 billion on Alameda’s balance sheet was link to FTT. The problem: As FTX’s native token, FTT was essentially created out of thin air — and now the “real-world” value of that token was being held in reserve by a separate, affiliated entity.
- After some Twitter sparring between Binance CEO Changpeng Zhao (CZ) and FTX CEO Sam Bankman-Fried (SBF), CZ decided to liquidate Binance’s FTT holdings.
- As it typically happens in such selloffs, people panicked and started to sell their own FTT stash, collapsing the token’s price.
- In the middle of the FTT selloff, FTX was no longer able to operate as a company, as it halted customer withdrawals. That’s because the bulk of its assets was tied with Alameda Research, a market-making firm (hedge fund) run by SBF’s ex girlfriend Caroline Ellison, taking over Alameda after Sam Trabucco stepped down in August.
- By November 8th, FTX had seen $6 billion worth of requested withdrawals within the previous 72 hours. For a single time, FTX’s BTC balance dropped to a single bitcoin. For context, compare this to the roughly 500,000 bitcoins held by each Coinbase and Binance.
As a result of FTX unable to process withdrawals, on November 8th, Binance announced a non-binding letter of intent to acquire FTX, pending due diligence.
And just like that, CZ and Binance were seen as the heroes of the day. If FTX were to collapse after all, this would be catastrophic for not just the cryptocurrency community, but CZ and Binance as well. Binance is the largest exchange by trading volume, and CZ is already under pressure from US regulators, as he is under several ongoing investigations.
The crypto community was both shocked — and disappointed — but in a weird way, relieved. Relieved that Binance was there to jump in and not only save FTX, but save the crypto industry.
Until they weren’t.
Just one day later, on November 9th, Binance announced it was walking away from the deal as a result of “corporate due diligence” and the “latest news reports regarding mishandled customer funds and alleged US agency investigations”.
Withdrawals on FTX have been “effectively paused” since the afternoon on November 8th. And after Binance backed out, SBF told investors that FTX would need to file for bankruptcy without a cash injection, according to Bloomberg. The exchange had a shortfall of $8 billion and needed $4 billion to remain solvent.
What exactly happened? In short, we don’t know. The dust is still settling. If FTX had been doing everything ‘right’, and if they had been doing everything they said they were doing, then they should’ve had possession of enough assets to process all withdrawals. The fact that they didn’t strongly suggests they were doing something they shouldn’t have been doing.
Reuters reported that Alameda suffered a number of peculiar losses. One of these included a $500-million loan agreement with Voyager Digital. Voyager went on to file for bankruptcy, and FTX US paid $1.4 billion for its assets in September. Reuters said they were not able to identify the full extent of Alameda’s losses — but here’s what they were told: SBF transferred $4 billion in FTX funds to Alameda, in order to ‘prop it up’. These funds were secured by FTT and shares of $HOOD (recall that Alameda announced a 7.6% stake in Robinhood back in May). Allegedly, a portion of these funds were from customer deposits. SBF reportedly didn’t even tell FTX executives about this, over fear of a leak.
Yet the fact alone that CZ peaked behind FTX’s curtain and — after just one day — said “nope”, says quite a bit.
It has to be noted that the Alameda-FTX conflict of interest, by running an exchange and trading against the market, has been an ongoing issue since SBF founded both firms in 2019.
Most recently, SBF shut down Alameda Research completely in a last-ditch effort to raise liquidity (up to $8 billion needed) and save FTX. FTX.com withdrawals appear to be preferentially approved for a small number of cases, while FTX US, as a separate entity, appears to be liquid.
Yet, although SBF said that FTX US was “100% liquid”, that may not be the case. FTX US’ latest announcement warns of halting trading hours in a few days.
Some FTX US users have reported the inability to withdraw funds. Image credit: Twitter.
It gets even messier.
SBF admitted to using leverage on user funds:
In other words, SBF was abusing customer funds for purposes outside the user agreement, playing with their funds to maintain a liquidity buffer for withdrawals.
Here’s what that user agreement looks like:
8.2.6 All Digital Assets are held in your Account on the following basis:
(A) Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX Trading.
(B) None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading.
© You control the Digital Assets held in your Account. At any time … you may withdraw your Digital Assets by sending them to a different blockchain address controlled by you or a third party.
Since FTX Intl is a Bahamian organization, it us currently unknown if SBF did anything illegal according to Bahamian law.
But as of November 11, FTX has filed for Chapter 11 bankruptcy and SBF has resigned.
- Who Still Has Exposure to FTX? (link)
The FTX fiasco keeps pointing to a larger issue. Blockchain technology, spearheaded by Bitcoin, was meant to decentralize the world of finance by giving users full custody control. Instead, a layer of wild personas appeared as central-points-of-failure vulnerabilities. They’ve built their wealth on that decentralization vision.
Consequently, the crypto market unfolded precisely as Michael Burry of “Big Short” fame predicted. In a centralized ecosystem, end-users can’t tell where their funds will end up. For which inter-lending, over-leveraging scheme are customer funds being used?
By “Anonymous”, Michael Burry was referring to himself.
Here’s who we know that has been impacted by the FTX fallout thus far:
- BlockFi, a user-friendly digital asset lender valued at $5 billion a year ago, has fallen under a $500 million valuation this year. In June, SBF gave BlockFi a $250 million revolving credit to keep it afloat. Now, BlockFi has recently halted all account withdrawals, repeating the Celsius storyline.
- NFL quarterback star Tom Brady, with his ex wife Gisele Bündchen, had become brand ambassadors for both FTX.com and FTX US, with a large but undisclosed equity stake in FTX in June 2021. In an effort to mainstream digital assets, SBF has been splurging on marketing, including the first-ever stadium renamed from American Airlines Arena to the FTX Arena.
- The Ontario Teachers Pension Plan (OTPP) had invested $95 million in both FTX.com and FTX US, as Canada’s third largest pension fund. However, this represents less than 0.05% of the fund’s total assets.
- Galaxy Digital, a prolific Web3/crypto investor headed by Michael Novogratz, had $77 million in exposure to FTX, of which $47.5 million is yet to be withdrawn. Nonetheless, the VC firm has ample liquidity left, with at least $1 billion per the latest earnings report.
- Genesis Trading, a custodial and trading firm for institutional investors, was the first one to report a -$7 million loss in hedged collateral, including Alameda Research. Presently, Genesis holds $175 million in a locked FTX account, but it doesn’t appear to have affected its trading liquidity.
- Wintermute, a market maker providing liquidity to exchanges, has some funds on FTX (not in FTT) but even if they go down, the funds are said to be within Wintermute’s “risk tolerances”.
- CoinShares, a European digital product investment firm, disclosed minor exposure: 190 BTC ($3.1 million), 1,000 ETH ($1.2 million) with $25.9 million as USDC stablecoin. Overall, CoinShares $31.08 million FTX exposure is small compared to its total asset value of $281.12 million.
- Multicoin Capital is one of the most prolific VC investors found in almost every crypto project. According to The Block, the company has ~10% of total assets on FTX, as BTC, ETH and USD, of which 24% was withdrawn just prior to the freeze.
- Sequoia Capital, another crypto VC firm, has $214 million in FTX exposure. This accounts for less than 3% of the committed capital, offset by ~$7.5 billion in “realized and unrealized gains”.
- Liquid Meta (LIQQF), a DeFi platform that has used FTX for yield farming and overcollateralized loans. Liquid’s latest press release revealed $7.5 million in FTX exposure via stablecoins and altcoins, but no FTT tokens. Liquid currently has access to $3.2 million worth of borrowed assets, leaving the platform at a net balance of $4.3 million.
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- SEC Chair Gary Gensler on FTX fallout: Investors need better protections in crypto (link)
Technically, what FTX did with user funds is a bit similar to (but not the same as) what traditional banks do. Though, banks are FDIC insured up to $250k per account, and when they lend customer deposits, there are strict laws they need to follow. But, nobody thought of FTX as a bank.
Consequently, if SBF fails to “raise liquidity” and FTX.com goes down, it is unlikely that FTX depositors will receive Chapter 11 bankruptcy coverage. The crypto space is all too familiar with this, as it recently happened with Celsius.
As previously mentioned, the father of Sam Bankman-Fried’s ex-girlfriend, the one running Alameda Research, is Glenn Ellison. In his former position at MIT, Gary Gensler worked under Glenn who is the head of MIT Economics.
Image credit: MIT
Gary Gensler is the former Goldman Sachs investment banker and current Securities and Exchange Commission (SEC) Chair. Without going into the details of SBF’s wider entanglement with the political donor class, this appears to be an interconnected world.
A day after FTX froze withdrawals, Gensler went onto CNBC’s Squawk Box to address the incident. He tied Terra (LUNA) with lending platforms (Anchor Protocol), saying that all of this is “interconnected”.
“This is a very interconnected world in crypto with a few concentrated players in the middle, and one of those concentrated players had the toxic combination of lack of disclosure, customer money, a lot of leverage (borrowing), and then trying to invest with that.”
Gensler further said that the “runway is running out”, referring to the need to curtail market excesses with regulation. Interestingly, Gensler met with SBF this March, to which Gensler simply responded that he didn’t say to SBF anything he did not already say to the public — “non-compliance is not going to work”.
More interestingly, the general counsel of FTX US, Ryne Miller, used to work as the legal counsel to Chair Gary Gensler at the Commodity Futures Trading Commission (CFTC). On Wednesday, Miller issued a memo, informing FTX employees of the following:
“Folks should prepare to make their own choices as appropriate for their personal situation on next steps,”
A day before FTX meltdown, Rep. Tom Emmer, in the House Committee on Financial Services, noted the following:
“Gary Gensler’s leadership has been marked by unproductive regulation by enforcement action that has jeopardized public trust & harmed our financial markets.”
After the FTX meltdown, Rep. Tom Emmer, informed the public he is looking into Gary Gensler “helping SBF and FTX work on legal loopholes to obtain a regulatory monopoly.”
This is a reference to SBF putting forward a “suitability test” for DeFi platforms, restricting access to digital assets based on net worth and other TradFi frameworks.
We all know that digital asset regulation in the US is a bit messy right now. There’s a lot of talk, and not really a lot of action.
We also know that a lot of US regulators are talking about FTX. They’ve launched “probes” targeting FTX. But as a Bahamian entity, with a separate US exchange (FTX US) which appears to legally operate in the US, it remains unknown if US regulators will have any jurisdiction when it comes to FTX Intl.
- October Inflation Comes in at 7.7% for US: What’s Next? (link)
Alright, some good news for the week:
The Consumer Price Index (CPI) report served as a welcome market relief. CPI exceeded expectations in a positive way.
US CPI is 7.7% YoY, 0.4% MoM vs. a forecasted 7.9% YoY, 0.6% MoM.
However, US CPI Core (without food and energy) is 6.3% YoY, 0.3% MoM vs. a forecasted 6.5% YoY, 0.5% MoM.
The first thing to keep in mind when looking at these numbers is that we are dealing with the annual rate increase. If we start from October 2021, when CPI was 6.2%, it means that the total inflation rate counting from 2020 is 6.2 + 7.7 = 13.9%.
The second consideration for the new CPI numbers is the distribution of inflationary pressures. Fuel oil is the most problematic at a +68.5% increase, within the energy category weighted at 19.8% of CPI. This caused inflation to increase in both transportation and food away from home.
Image credit: @LizAnnSonders
Alongside energy, shelter weighs at 32.77% of CPU, distributed at 7.8% to rent and 23.68% to private housing. Shelter is now showing 6.91% inflation, the highest it has been since the early 1980s. The 15-year mortgage rate is closing in on that level as well. It’s now at 6.38%, its highest level since 2007.
Image credit: MacroMicro
Lastly, wage growth does not follow the cost of living. In fact, wages have gone down by -1% since February 2020, adjusted for inflation.
Image credit: @charliebilello
What does all of this tell us? Incoming data aligns with Jerome Powell’s wishes. Since May, he has clamored “to get wages down”. Increased rent (~36% of Americans rent) and draining mortgage rates further drain consumer power, cooling down inflation. Remember what Powell said at the last FOMC meeting:
“If we overtighten, we can use monetary policy tools to support the economy but if we don’t tighten enough inflation becomes entrenched.”
In other words, the Fed will err on the side of recession, but a soft landing could be in the cards. By “soft landing”, the Fed means avoiding a recession, or at least a deep recession.
Presently, the crash of used car prices shows that deflationary forces are taking over, in addition to lowered demand making supply chain issues moot.
Although we are still a long way from the Fed’s 2% inflation target, the market has now priced in a decrease in rate hikes.
- December 2022: 50 bps hike to 4.25% — 4.50%
- February 2023: 25 bps hike to 4.50% — 4.75%
- March 2023: 25 bps hike to 4.75% — 5.00%
If deflationary pressure continues, market volatility might just finally simmer down.
- S&P 500 Usually Rallies after US Midterms, but Could Things Be Different This Time? (link)
Just as September is historically one of the worst S&P 500 (SPX) performers, November is historically one of the best. Specifically, when it comes to midterm elections. In the last 10 years, November delivered the greatest average monthly returns.
Since 1950, the average S&P 500 return is ~15%, without negative years. Image credit: @RyanDetrick
Midterm elections typically signify restructuring of the political scene, causing market speculation on more spending and government investments.
Sometimes, they signify government gridlock, which is also good for the markets as businesses can continue as they’ve been operating — no new tax policies will impact end-of-day profits.
This time, however, it is unlikely that election outcome matters. After all, the Fed Chair Jerome Powell is a Republican lawyer, renominated by a Democrat President.
Instead, one should look into stocks that are recession-resistant, whether they be discount retail chains like Dollar Tree (DLTR) or Walmart (WMT), or green companies like Invesco Solar ETF (TAN.P). Given that President Biden repeatedly called for oil drilling stoppage, investment calculus should be adjusted accordingly.
The stock market had a lift after the CPI report. Image credit: Trading View
Moreover, the US is likely to have more military entanglements across the world. Last month, a former Pentagon official said that $17.6 billion worth of US military assistance to Ukraine is draining US stockpiles. The latest Congressional Research Service (CRS) report revealed $14.05 billion worth of appropriations to replenish these stockpiles.
And that historically means more supply contracts for Raytheon Technologies (RTX.N) and Lockheed Martin (LMT.N). Year-to-date, both have outperformed the S&P 500 significantly. While SPX is down -17.52%, RTX is up +12.50% and LMT is up +38.49%.
Inflation is a critical factor for the stock market going forward. To illustrate, let’s look back.
US workers who switched jobs received pay increases of 7.3% over the last year vs. 5.3% for those who stayed at their jobs. With data going back to 1997, this is the widest gap we’ve ever seen.
Meta is laying off 13% of its workforce this week.
More than 11,000 workers.
Here is a look at tech layoffs in the past year.
What was SBF lobbying against? DeFi. 🤔
What would have prevented this? DeFi. 🤔
What exchanges already publish real-time proof-of-reserves? DeFi. 🤔
What will US regulators try to shut down? DeFi. 🤷♀️
The larger the stock market crash, the higher the returns for the 5 following years.
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