Malt Liquidity 78

If You Come at the King...

…You best not miss.

I was thinking for a while on how I wanted to start off the new year of posts, but much like the index itself, I couldn’t seem to pick a direction all week. Something that has been gnawing at me for a while, though, is the kid gloves with which the king of financial newsletters, Matt Levine, has been treating Bankman-Fried (who I refuse to call ‘SBF’ anymore) and FTX, perhaps best highlighted in this passage:

What happened at FTX? “They stole the money” seems to be a true but insufficient answer. I think that part of the answer is that they found, and helped to build, a toy financial system, and they played with it. They didn’t take the game too seriously; they didn’t spend a lot of energy hiring accountants and compliance people, because that is not the fun part of finance. They built clever systems for margin lending and risk management, because it is fun to build an idealized trading system from scratch. But they also exempted themselves—Alameda—from that system, because it was just a game. In the real world, if you run a hedge fund and your balance becomes negative, the game is over. At FTX, when Alameda’s balance became negative, it got to keep playing.

Look, this is just blatantly false. Bankman-Fried himself has stated that

“I wasn’t even trying, like, I wasn’t spending any time or effort trying to manage risk on FTX,” Mr. Bankman-Fried said in an interview with George Stephanopoulos of ABC News that was broadcast Thursday on “Good Morning America.”

A normal margin system revolves around the “margin call” — when a levered trade draws down such that the capital in the account isn’t sufficient to collateralize the position, the holder is given the opportunity to deposit more funds to “meet” it. This system avoids immediate liquidation because, well, the instrument that has been levered on might not have sufficient liquidity to smoothly sell off the holder’s position. FTX did not follow the traditional system — they had an automated system that would automatically liquidate your positions if they dropped below a certain maintenance threshold. Also note that FTX offered significantly more leverage than your bog-standard TD Ameritrade would — when they reduced their margin offerings, they still offered 20x. Outside of BTC and ETH and a couple other coins, book depth on altcoins is atrocious. An automatically liquidating protocol would have a good chance of eating through the entire book, smashing the price around, further increasing the risk that the client can’t or won’t pay for the botched execution. What seems likely to have happened is that FTX themselves would “backstop” the liquidity of the instrument being liquidated, thereby taking a sort of “short-vol mean reversion” trade. Presumably, this would work during standard chop — however, it has been theorized that this is how FTX blew up a ton of money on LUNA.

(Note that I say FTX, but I could just as easily say Alameda, as there was basically no distinction between the trading funds of the two.)

The second statement I want to critique is a follow up tweet:

Matt Levine @matt_levine

@SMTuffy but did they in fact build out an exchange that a lot of people in crypto used because they thought it was good? yes. did they then steal the money? also yes. but i think it is more interesting to consider that full reality.

Having spent some time discussing crypto arbitrage with a few proprietors of the trade, I am fairly certain that, outside of BTC and ETH, the amount of capital you could deploy across most altcoins on pure arbitrage trades was low six figures, if that. It was long suspected that Alameda’s “quant trading” was bullshit. How the hell was Alameda deploying at least $14.6 billion, which was presumably levered off of? Illiquid venture investments aside, it is simply not possible to trade that much capital with any sort of rigorous, delta-hedged strategy in crypto markets — Rentech itself has trouble deploying more than $10 billion in the most profitable traditional markets trading strategy, the markets of which are significantly deeper than spot BTC and ETH, let alone altcoins. In my mind, all of the trading on FTX was sort of a mirage — Alameda would offer both sides across predatory products (such as leveraged directional coins offering exposure to stocks or other coins which themselves could be traded with leverage) and eat liquidations, all while getting picked off by faster traders in what seemed like easy money:

I particularly like the theory in the thread that Alameda had to operate at a loss to provide the image of liquidity on FTX. It goes a long way in explaining the catch-22 where they can’t stop unprofitable trading because it helps them raise funds, but the funds have to be used to bail out unprofitable trading.

What Matt seems to miss is the whole theory of venue selection that I highlighted in an earlier post:

…the market participants with the most size are going to shy away from the less liquid order books, or at least disguise and mete out their flow into them. They’re going to seek the deepest areas of the market to transact in — as opposed to poker, you want to stay out of the way of whales in the markets. The most sophisticated players will aggregate around ES futures, AAPL stock, and other robust, highly liquid instruments as they try and take each-other out. While there are still ways to trade these products profitably in our smaller size, it’s like being plankton drifting along with the current, where you can find yourself blown out and sucked up into a whale’s mouth in the blink of an eye. However, size does transact out of the depths of liquid books, and when it does, it tends to be a little clunky. The liquidity profile of, say, stock #393 in the S&P 500 is nowhere near what #2 is. If, with our small size, we can bite off a sliver of the liquidity they will demand and flip it back to them, well, that’s a pretty good trade, isn’t it? It’s a very simple start to building up a trading strategy — find the places where the size impacts the book, piggyback in front of it, and ride off their market impact in the direction you want to go.

Crypto exchanges are notorious for highly variable quotes and book depth across eachother. If one exchange is running an inefficient quoter, fast traders can pick off liquidity offered on one exchange and smoothly execute for profit using another. Indeed, a lot of hedge funds got their capital stuck on FTX presumably because of how easy the trading against Alameda-offered liquidity was. Would anyone be trading on FTX with any size if it was just a bunch of retail punters getting liquidated at insane leverages, and not a vast (illegally) funded bad trading strategy consistently losing money on inefficient quoting and forced absorption of liquidations?

I’d like to edit Levine’s paragraph to reflect this reality more accurately.

What happened at FTX? “They stole the money” seems to be a true but insufficient answer. (They also committed blatant fraud and covered it up.) I think that part of the answer is that they found, and helped to build, a toy financial system, and they played with it. They didn’t take the game too seriously; they didn’t spend a lot of energy hiring accountants and compliance people, because that is not the fun part of finance. They built clever systems sold the illusion that they built systems for margin lending and risk management, because it is fun to build an idealized trading system from scratch it was necessary to raise capital to cover leaky trading strategies. But they also exempted themselves—Alameda—from that system, because it was just a game they couldn’t process the fact that they were losing money:

“I generally think there are two major motivations for committing financial fraud. One is greed/hubris — “I know better than other people what to do with money, therefore I deserve it more.” The second is borne out of befuddlement - “I’m a smart person, and can’t believe I’m losing money! If I just had more to work with, I can make it back and then some.” Publicly, given the weird effective altruism cult mentality espoused by SBF, it’s easy to say it’s type one, and people who personally know him could probably attest to that if true. But as a trader, I’ve seen type two happen time and time again when objectively smart people become unable to turn a profit.”

In the real world, if you run a hedge fund and your balance becomes negative, the game is over. At FTX, when Alameda’s balance became negative, it got to keep playing.

It has been particularly grating to read Levine’s coverage of FTX, not because it is technically incorrect, but because he simply doesn’t seem to want to go out on a limb to call Bankman-Fried the scumbag that he actually is. Frankly, it’s a little disappointing.