Yesterday Tiffany Fong released the first interview that Sam Bankman Fried has done
since the FTX implosion.
It came out on Coffeezillas YouTube channel, with the full conversation being released
on Tiffany’s own channel, I’ll put links to both videos in the comments section – and
they are worth checking out.
Tiffany was kind enough to allow me to use some of her audio for today’s video where
I can hopefully add some value by explaining how I believe FTX first began touching customer
funds.
We will look at how Sam explained this issue to Tiffany combined with some important detail
from the first day declaration from FTX’s Chapter 11 bankruptcy case in Delaware.
What appears to have happened at FTX is something that would never have happened at any properly
organized financial firm.
FTX it would appear was an improperly organized firm.
It’s my opinion that customer funds were likely at risk from day one at FTX and based
on the information from the bankruptcy court declaration the precarious position customer
funds were placed in was likely hard coded into the way the exchange was designed.
Now obviously, more information will come out over time, but that is what it looks like
to me - right now.
Now, I’ll let you guys decide for yourselves if you think that this was an unintentional
issue and can be explained away by the lack of experience of the team at FTX (they are
quite young), or if you think that the exchange was specifically designed this way by people
who were fully aware of the risk they were exposing their customers to.
So, Tiffany had two one-hour long interviews with Sam Bankman Fried where she asked for
explanations as to what went wrong at FTX and what caused the 8-billion-dollar hole.
Essentially, where did all the money go?
Were the customer funds simply stolen, and are the losses somehow tied to trading losses
at Alameda.
I’ll play Sam’s response in just a moment (so that you can hear him answer in his own
words – I have edited the conversation down quite a bit for clarity), but my take from
the recordings is that he mostly tried to avoid any difficult questions that Tiffany
asked.
He doesn’t deny that there is an 8 billion dollar loss at FTX, but he quickly steers
the conversation towards discussions of liquidity and correlation rather than explanations as
to why customer funds were not kept separate from Alameda Capital – his crypto hedge
fund that was run out of the same office as FTX and traded on the platform.
At one point he describes the missing money as a definitional issue – which makes no
sense whatsoever.
Overall, his claim is that the problem at FTX (at least before the hack) was that the
crypto market fell a lot more than he thought it would, and that uncorrelated positions
became correlated, which is something that happens in every market panic.
When you lose 8 billion dollars of customer funds that you had no right to touch “market
went down” is not an explanation that is likely to satisfy the customers who lost their
savings.
Sam does say that there were failures of risk management (which there clearly were), but
he also describes the overall problem as being a liquidity issue rather than a solvency issue.
If that was actually the case, a chapter 11 bankruptcy filing would buy enough time for
the company to reorganize, pay down its debts, and exit bankruptcy in running order.
I don’t think any of us are expecting that to happen at this point – but who knows…
I’m only using a short excerpt of Tiffany’s recording in this video, but every time she
pushes Sam on the question of what happened to customer funds, he steers the conversation
to the crypto market crash, correlation and other risk management failures, but says nothing
about the segregation of customer funds or about what mechanism specifically caused eight
billion dollars or more of customer funds to evaporate over a short period of time.
If there is one positive thing I can say about him, it’s that he doesn’t appear to be
blaming the rest of his team at FTX, he does say that responsibility for these losses ultimately
rests on his shoulders.
So, here is the clip of Tiffany asking “what happened to
the money”
Now, there is some information in there, which becomes a bit more relevant when we go back
and look at the first day declaration from FTX’s Delaware Chapter 11 bankruptcy case.
In there we find mention of a secret exemption for Alameda from certain aspects of FTX.com’s
auto-liquidation protocol, as well as the absence of independent governance between
Alameda and FTX.COM.
This one line in the document possibly explains a big chunk of what went wrong.
In the early days of Alameda Research Sam Bankman Fried made an awful lot of money in
arbitrage trades.
Buying bitcoin on one exchange and selling it instantly at a higher price on another
exchange.
This type of trading will have required very little capital, and with good technology will
have been quite low risk – especially given the high return.
Arbitrage trades like this were especially compelling in South Korea, where the exchange-listed
price of bitcoin was significantly higher than in other countries.
This price difference was known as the Kimchi Premium.
The spread existed for a variety of reasons, tied to financial regulation in South Korea
(combined with enthusiasm for Bitcoin).
This regulation meant that most traders were not able to take advantage of the price difference.
Sam’s company Alameda Research was one of the first to work through all of the loopholes,
and actually trade the price difference.
In an interview a few months ago Sam told the press that the firm sometimes made as
much as a million dollars a day from the Kimchi Premium.
This would have been very profitable in 2017 and 2018.
As time went by, this arbitrage opportunity disappeared as more and more people figured
out how to open accounts in South Korea and trade it.
After that, Alameda needed new trading strategies, that would hopefully be as profitable and
low risk as the Kimchi Premium.
Coffeezilla has reported that Alameda employees used insider knowledge of which coins would
be listed on FTX to front run their customers, in a manner similar to what Coinbase employees
got in trouble for doing this summer.
I guess that is probably a low risk, if extremely unethical trading strategy.
The Wall Street Journal reports that the two firms (Alameda and FTX) were structured such
that employees of FTX had no idea what was going on at Alameda but Alameda employees
knew exactly what was going on at FTX, possibly allowing Alameda to profit from this information.
The court document says that Sam communicated using messaging apps that were set to auto-delete
after a short period of time and encouraged employees to do the same.
This might indicate that that they were aware of the possible criminality of their actions,
but, who knows – maybe Sam was just trying to minimize the amount of hard drive space
used up by storing text messages.
It is a huge red flag though, and there are lots of red flags in this case…
A lot of Alameda’s trading was – as I said - possibly low risk – with a lot of
it being unethical and possibly illegal too.
(That is (of course) a different type of risk.)
One of the things that often happens with apparently low risk trading strategies, is
that people leverage them such that they become extremely high risk.
But, possibly Sam and his team decided that the trades were so unlikely to lose money
that there was no need for Alameda to be held to the same margin requirements as other FTX
customers.
So, while every other trader on FTX who was using leverage would have been required to
post a certain amount of money as margin and would have then received margin calls as they
lost money.
Alameda it would appear was getting special treatment.
Exchanges usually have a means of selling customer positions as the customer gets close
to losing all of their money, and this is done to protect the exchange from having to
absorb customer losses – which can bankrupt an exchange.
When the court filing says that Alameda had a secret exemption from certain aspects of
the auto-liquidation protocol, what this means is that they could keep losing money, and
never be knocked out of their losing trade.
This is equivalent to a casino where let’s say they allow their biggest customer to gamble
without putting any money in the cage.
This will work out fine if that customer is winning money consistently from the other
players, (let’s imagine they have a way of cheating at the games) but if they have
a big losing streak and the other players have been winning.
When those winning players go to cash out, there is not enough money deposited in the
cage to pay them out.
In fact, the way Alameda was mostly capitalized with FTX’s own native FTT token, makes the
real story even more like this casino analogy.
Alameda were using the casinos’ own chips (or FTT tokens), they hadn’t deposited enough
money for the chips they were playing with and they were allowed to lose much more money
than they actually had, and when the other customers wanted their money at the end of
the night, there were only worthless chips left in the cage – no money.
I think there is a lot of confusion right now, where people think that a big loss occurred
– let’s say a few months ago, and a conscious decision was made at FTX to raid the customer
funds.
Sam seems to have been willing to discuss these huge losses in the interview – both
losses that occurred over the summer and losses that occurred again last month, but he never
acknowledges or explains the mechanism through which the customer funds went missing from
FTX.
It is my belief that there was no specific point at which a decision was made to raid
customer funds, because such a decision never needed to be made.
The fact that Alameda – who is reported to have been the biggest trader on the exchange
was exempt from automatic liquidation means that whenever they took a big enough loss
which would normally require liquidation, but weren’t liquidated, they were then playing
with customer money.
Everyone else had put money in the pot, but the biggest gambler, at the table the one
who was simply expected to always be profitable, because they were able to trade with a number
of advantages which would be illegal in regulated financial markets, had nothing in the pot
and was running up big losses.
If we are charitable (or altruistic - as some might say), we could imagine that Sam possibly
didn’t realize that an exemption from the auto-liquidation protocol - which was hard
coded into the way the exchange worked from day one - put all customer money at risk.
He possibly couldn’t imagine a state of the world in which Alameda not only lost 100%
of his wealth, but then went on to dig an eight billion dollar hole.
A less charitable way of viewing things is that the entire business was designed from
day one to not only put customers at a disadvantage when they trade, but to also use the money
they keep on the exchange as a cushion for the in-house trading operation - a “heads
I win, Tails you lose” situation.
In a number of interviews and Twitter threads, Sam has said that he approaches financial
decisions with little or no risk aversion.
He doesn’t think about Expected Utility, and instead makes his decisions based on maximizing
the Expected Value of his wealth directly.
This type of approach in the real world, pretty much guarantees that you will go bust at some
point – and usually pretty quickly.
While Sam might be OK with his own situation, the customers who were dragged along for the
ride against their will are likely less amused.
If you enjoyed this video, and want to understand how Chapter 11 bankruptcy (the situation FTX
is in right now) works, you should watch this video I made explaining Guitar Center’s
bankruptcy a few years ago.
Thanks for watching, and thanks for subscribing to the channel, see you again next week.
Bye.