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Monthly Market Review - November 2022

Dear Investor,

The implosion of FTX was the most significant event of the month and arguably of the digital asset space since its inception. Yet, it is still shrouded in confusion. It's the job of John J. Ray III to work out exactly what happened, and it will take him time. We will briefly describe our theory of what happened and what we are doing moving forward.



Price (1 Nov. 2022)



Price (30 Nov. 2022)



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Firstly, there has been a disturbing divergence between digital asset focused media and more mainstream publications in their framing of this event. Mainstream media outlets have typically opted to call this a 'bank run', 'liquidity crisis' or 'meltdown', whereas the digital asset media has been much quicker to call this for what we believe it was – fraud on a massive scale. FTX's founder, Sam Bankman-Fried, has already started his charm campaign and attempted to come across as an apologetic and inexperienced executive who took his eye off risk management. And in the mainstream media, it appears to have worked. Bloomberg even asked for a round of applause after his video interview at its latest summit. Instead, Coindesk (a sizeable digital asset specific media house) has a much more factual article, which I encourage you to read.

Critically, these exchanges are not banks and aren't entitled to lend user assets like a bank. The margin system only allows users to trade against each other in a peer-to-peer fashion. The first point of the agreement between FTX and its users is that FTX does not own your assets.

To understand what happened on FTX and why it wasn't a 'meltdown', let’s look at a brief background on how the risk management systems work on these exchanges (and how FTX indicated it worked). At a high level, a trader posts a margin against a position. If the margin drops below a 'Maintenance Margin Fraction', the position is forcibly liquidated until the position size is reduced. This process happens instantly.

For small positions in liquid order books, the MMF was set to 3%. The fraction scales quickly for larger positions, even exceeding 100%. In practice, an automated system manages risk across the system. The next level is a 'Backstop Liquidity Provider' who takes over positions if the automated system can't get rid of it quickly enough. This liquidity provider absorbs the position (and the risk) and, in turn, can make a quick profit. Typically, large market makers fulfil this role. In this case, Alamanda Research (wholly owned by SBF) was one of the market makers fulfilling this role. Additionally, Alameda and FTX had an undisclosed no-liquidation agreement, which meant that as their margin on the exchange approached zero, FTX's automatic system did not liquidate them. They effectively traded other users' funds when their margin account went negative.

Alamanda Research was known to make markets on FTX aggressively. Initially, SBF openly said they did this at a loss, so that FTX could have the tightest book across many instruments. In 2019, they were 40% of the volume of FTX. The tight books attracted institutional investors as FTX was the most profitable place to trade and had a good reputation. This hoodwinked us, too, as our internal models indicated that adding FTX would allow us to trade more profitably. Given the potentially profitable trading, its market share (third biggest and climbing) and its good reputation especially with regulators, we decided to integrate it.

If we give SBF the slightest benefit of the doubt that he didn't start defrauding users from the beginning, then our suspicion of what happened is as follows:

  1. During 2021, Alameda Research switched from delta-neutral to being aggressively long digital assets (their CEO documented this on Twitter), and they used this profit to make markets on FTX. In November 2021, the market turned, and they were losing money. Documents reveal that FTX and Alameda combined lost $3.7 billion by the end of 2021.

  2. In May 2022, the Luna / Terra fiasco happened, and Alameda lost money on Luna and Terra.

  3. Lenders became concerned about Alameda in May. According to its CEO Caroline Ellison, she and SBF agreed to send user funds off the platform to cover payments to lenders. In turn, we believe Alameda pledged FTT tokens (FTX's illiquid token) to cover the funds. If this happened, FTX took users' funds without their consent and covered it up, which is fraud.

  4. In November, when this came to light, a Coindesk article revealed the fraud by exposing Alameda’s balance sheet, and FTX could not process withdrawals.

We expect that SBF will continue to obscure what truly happened and do his best to appear remorseful. We are not sure how this will work with the broader public, but luckily the courts deal in facts, and we believe that the courts will reveal the fraud in time, and he will be punished. Unfortunately, we will have to put up with his PR campaign in the meantime.

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