Malt Liquidity 60

Exchange Shenanigans

It’s a business, man

If you are an exchange, your core business is essentially getting people to trade more, thereby collecting trading fees. (Of course, once you grow large enough, you can diversify your income stream - exchanges such as NASDAQ and ICE essentially have a monopoly on quality high-level financial data.) As such, your business strategy involves incentivizing people to use your venue. However, you have to take into consideration who is trading on your venue. Liquidity providers (market makers)? Good! You want to show good book depth and have accurate prices. You can reward these traders by offering them rebates for leaving resting orders on the book and letting them fill. Informed traders? It’s a bit more complicated. If you only have informed traders in your book, other traders aren’t likely to give much action or provide liquidity as the risk of adverse trading is higher. (This is why IEX was bound to never take off - why would people use a trading venue where liquidity providers are less incentivized to make a book and larger traders are protected from showing their size?) However, these traders bring size, providing more fees, and it’s not like they are all trading universally in one direction. Retail traders? Very good! Much like how a fair bit of edge in the GTO meta of poker is in game selection, you want to be in a market where people are trading constantly without much (if any) edge. Not only that, as we’ve seen from PFOF, market makers enjoy working with retail flow as well, as it makes their trading much more predictable and less risky.

If you’re a crypto exchange, your core business is the same, but there’s an added twist - what you lack in institutional, block-size trading, you make up for through offering staggering amounts of leverage. While ICE may offer levered products, these are usually capped and you are required to put up a fair bit of margin against the product. They’re not making money directly on the leverage of the product itself - that’s usually your broker allowing you to trade said products, as they’re the ones responsible for making sure you can cover your losses. In this way, a crypto exchange acts not only as an exchange, but also as a lender. On top of your trading fees, there will be a margin fee. Now, you might be thinking, if I’m an exchange, and I’ve offered 15:1 leverage on a $10000 deposit, and the trader goes out and buys $150k worth of coin, how do I protect myself? I’ve taken in $10k and given out $150k of exposure - the additional $140k I fronted has to come from somewhere. Well, what I might do is:

a) be over-capitalized by borrowing against my valuation

b) use offsetting positions from other traders to reduce exposure

c) use various methods to generate a return using client deposits

d) have a liquidation protocol to quickly sell off positions that start to lose money beyond a threshold, to protect my loaned capital.

Normally, in equities markets, these are separate businesses. You’d have an exchange arm to incentivize trading and collect fees, and a lending arm to facilitate trading and collect margin. However, in the case of FTX, they found a way to do both at the same time, using their own native token, FTT. FTT is the vehicle used to incentivize traders and market makers to stay on the platform - holders are given discounted rates on trading fees, and FTX would stabilize the price of FTT by purchasing and burning the supply. In addition, FTT was stake-able for interest income, and, of course, tradable with leverage.

Theoretically, this all sounds fine. Unless, for whatever reason, everyone wanted their money back at once. But that wouldn’t happen, would it?

What did FTX do with their deposits?

About a week ago, an article came out detailing the balance sheet of Alameda Research, a prominent crypto trading firm that presumably supplies liquidity to crypto markets and exchanges. Notably, of the $14.6 billion in assets held, $3.66 billion was in “unlocked FTT”, with a further $2.16 billion of “FTT collateral”. At the time the article was published, the market cap of FTT was roughly $5.1 billion. By whatever mark-to-market Alameda was using, they held a massive amount of FTT relative to the market cap. Given the liquidity on FTT, there is simply no way to liquidate such a massive percentage of the market cap into the open market without absolutely cratering the price. The only way to offload such a large position would be to slowly liquidate into someone purchasing systematically - someone like FTX maintaining a relative price floor. Furthermore, against their book, they held “$7.4 billion of loans”.

On a surface level, at the very least, it would show that Alameda’s book is heavily dependent on the price maintenance of FTT - risky, but not particularly unusual for the wild leverage used across the crypto ecosystem. However, Sam Bankman-Fried (SBF) - the owner and founder of FTX - was the one who founded Alameda a couple years prior to the founding of FTX. This kind of self dealing is pretty suspect. The more FTT held, the more perks one would get for trading on FTX, including “lower fees” and “VIP access” based on tier. For the exchange, token issuer, and floor-maintainer to be so financially tied to a primary market maker/trader and its collateral is nefarious self-dealing - it practically incentivizes front-running from the trading arm (or, as some would put it, “using traders as exit liquidity.”) One can put together a simple model for raising trading capital for Alameda: FTX takes in funds through trading fees and by issuing FTT and incentivizing its purchase. Alameda takes in FTT through issuance for market making on the platform and by purchasing it privately or publicly and marks it on their book at some % of whatever FTX is maintaining the price at, discounting for volatility, and then proceeds to borrow against it. Whatever profits Alameda makes trading is further plunged into the FTT/loan fundraising scheme, creating a sort of feedback loop for increasing leverage and trading capital, fully supported by FTX’s usage of trading fees to maintain FTT price.

All of this has been suspected in some form or another for a while, but the scheme works as long as FTT maintained its value. As long as that happened, SBF could eat on both sides, collecting trading fees from FTX and market making profits from Alameda. However, a few days later, Changpeng Zhao (CZ), the head of Binance, announced a tape bomb.

The head of the largest crypto exchange in the world comparing a token to LUNA is not to be taken lightly. And, well, the golden rule of trading is to avoid trading against size. If you know a massive sell (upwards of $500 million) is going to hit a book whose total market cap is $5.1 billion, you want to get out before the sell. Already people were looking at Alameda’s balance sheet with an aura of suspicion - $8 billion of loans against $14.6 billion of assets is a lot of leverage when the assets are fairly illiquid - but CZ set everything ablaze. Immediately, FTT began liquidating.

Not only did FTT liquidate, but people began pulling money out of FTX en masse:

Crypto exchange FTX saw around $6 billion of withdrawals in the 72 hours before Tuesday morning, according to a message to staff sent by its CEO Sam Bankman-Fried that was seen by Reuters.

Let’s go back for a minute - we’re all aware that FTX offers high amounts of leverage on customer deposits. To be able to offer this collateral, FTX presumably does something with the deposits - otherwise they’d just be acting as highly leveraged counter-parties to every transaction made with leverage. CZ’s actions caused a run on FTX’s assets. But if this happened to say, Coinbase, or a broker like Schwab, this wouldn’t be a big deal - these firms aren’t allowed to mess around with customer deposits. Coinbase simply brokers your transaction and takes a fee. If you want to withdraw your money (save for platform stability), your money is instantly back in your account after you liquidate your positions. As for Schwab, a large chunk of it’s revenue is simply interest income. For cash, it’s as simple as them paying you a rate for holding money with them while they earn a higher rate of interest on the account and pocket the difference. There are strict regulations on what U.S. firms can do with customer deposits. While bank runs have happened to traditional banks and are theoretically a risk of fractional-reserve banking, the risk is extremely low due to the features of central banking and heavy limitations on what can be done with deposits.

FTX, however, isn’t a U.S. firm. (FTX.US is a separate entity and not really relevant to this discussion.) It’s based out of the Bahamas. Why did suspect liquidity at Alameda cause a “liquidity crunch” at FTX when assets were being withdrawn unless there was cross-dealing between the firms using customer deposits? A simple scenario could have gone as follows after CZ’s tape bomb:

1. FTT liquidates below whatever mark-to-market Alameda used to borrow against it’s FTT holdings, triggering some sort of repayment/margin call

2. Alameda cannot liquidate its other holdings to pay off whatever they have borrowed.

3. FTX loses the ability to maintain FTT’s price because it’s too illiquid of a market and too much volume is being traded

4. As a result, FTX’s “funnel mechanism” to fund Alameda is useless. Alameda is rendered insolvent.

What if FTX had been part of the collateral offered to Alameda against their FTT holdings? In effect, SBF would be eating on all sides by using FTX and FTT issuances to generate trading fees, receiving market making profits through FTX’s consumer-deposit-backed loans to Alameda that they made payments on, receiving market making profits from his stake in Alameda itself, and mark-to-market returns from pumping/staking FTT through Alameda’s holdings. In essence, you have one massive feedback loop of leverage to maximize how much trading profit you could squeeze out of a fee-generating operation. So when all the clientele got spooked, FTX found itself with a bunch of illiquid assets that they needed to liquidate to pay off deposits, and ended up having to sell to CZ for presumably pennies on the dollar to even stay afloat:

Crypto giant Binance signed a nonbinding agreement on Tuesday to buy FTX's non-U.S. unit to help cover a "liquidity crunch" at the rival exchange, in a stunning bailout that raised fresh concerns among investors about cryptocurrencies.

Honestly, this reminds me a lot of the infinite leverage saga on Robinhood, but with far bigger numbers, far more technological achievement, and an even bigger lack of awareness to know that enough is enough. Leverage is a bitch.