The FTX fraud
It wasn't a Ponzi. It was far dumber.
I saw a disturbance on my social media feed today. Michael Lewis, bestselling author of Moneyball, The Blind Side, The Big Short, Liar’s Poker, and many other awesome books was on the news commenting about Sam Bankman-Fried (SBF) and his famously failed crypto exchange, FTX. “They had a great real business,” Lewis said. “If no one had cast aspersions on the business, if there hadn’t been a run on customers deposits, they’d still be making tons of money.” People jumped all over Lewis for being a credulous moron. I think they were right to do so; but also, Lewis isn’t wrong. Not exactly. Ftx was a real business, they did make tons of money (and they also lost tons of money; more on that in a second), and if there hadn’t been a run on customer deposits then they might well still be in business making tons of money. But SBF has been accused of fraud, and all indications are that he’s super guilty. He’s been accused of stealing customer money to fund his lavish life style, and all indications are that he’s super guilty of that, too. So how do we square all of these claims?
When I hear people talk about SBF and FTX, I get the impression that people think he was running a Ponzi scheme. In a Ponzi, a scammer offers an amazing investment opportunity with huge returns and gets people to invest, but there’s no underlying investment. Old investors who want to cash out are paid out with the money from new investors, the scheme keeps going as long as it can keep growing, but eventually the whole thing is exposed and it blows up. The scammer usually skims a fair bit of cash off the top, for himself, along the way. This is what Bernie Madoff did. It’s not what SBF did.
Some people will likely protest that SBF went on a podcast with Bloomberg’s Matt Levine, where he described what he was doing in crypto in a sort of abstract way and Levine said “It sounds like you’re saying you’re in the Ponzi business, and business is good.” And SBF didn’t disagree because Levine really had grasped the essence of it. But what SBF was describing in that conversation wasn’t FTX’s business model, he was describing how all crypto works. All crypto is a Ponzi,1 and so FTX, as a crypto exchange, was in “the Ponzi business.” That wasn’t the fraud at FTX.
So what did FTX do, and what was the fraud? FTX was a crypto exchange. That’s a place where people go to buy and sell crypto, and pay FTX a fee for the privilege of doing so. FTX also did a fair bit of crypto investing and speculation in its own right on the side, but that wasn’t the main gig.
Investing and speculation was SBF’s original business venture. He got his start working for a traditional hedge fund, then got interested in crypto and started his own fund, Alameda Research, to make trades that took advantage of inefficiencies in the patchwork crypto market. He was successful, and so a legend was born. FTX was born from Alameda, but was spun off to be its own thing, an exchange rather than a hedge fund (although, again, it did some investing and stuff on the side). Alameda continued under the leadership of SBF’s sometime-paramour, Caroline Ellison.
FTX was brought low by two main sins:
Their bookkeeping was basically non-existent. One way to think of SBF’s career trajectory was that he started off in traditional finance, with hordes of accountants and risk managers. Those guys are a drag; their job is to tell swashbuckling traders “no.” SBF was a swashbuckling trader, and so he set up his own firm without accountants or risk managers. This, it turns out, was a bad idea.
Although FTX and Alameda were different corporate entities, they really functioned as a unit and the walls between the two were paper-thin and full of holes. This could have been basically ok, so long as the nature of this relationship was fully publicly disclosed (it was not) and substantial effort was put in to ensuring that everyone knows what assets belong to Alameda and what assets belong to FTX (it was not; see (1)).
And so the short of it is that money got lost doing normal risky finance things at both Alameda and FTX, but no one realized it until it was too late because the bookkeeping was so bad. The way it went down was a bit entertaining though.
Last summer, Terra collapsed. Terra was a crypto product designed to hold stable value because it was associated with another crypto product, Luna, that it automatically traded against in order to keep its value up. When its price started to go up, Terra would be sold (for Luna), pushing its price down. When its price started to go down, it would be bought (with Luna), pushing its price up. Luna was created out of thin air, as needed, to meet these needs. (All crypto is created out of thin air.) This will work to keep the price of Terra stable so long as it’s only dealing with minor gyrations in its price. But last summer, someone went short on Terra and dumped a whole lot of Terra to push the price down. Luna was printed in huge amounts to stabilize Terra, the price of Luna went to 0, and then the price of Terra went to 0.
This was a huge deal. Terra was a huge player in crypto, and when it went to 0, people began reflecting on the basic Ponzi-like nature of crypto and started pulling their money out. The price of crypto started dropping across the board. Lots of major players were getting wiped out. This was not good for SBF’s businesses, either FTX or Alameda. But FTX was making tons of money as a crypto exchange. So SBF started engaging in white knight investments to prop up the crypto ecosystem, to buy cheap when everyone was selling scared. For a little while, it looked like it would work.
But then FTX’s main rival, Changpeng Zhao (aka CZ), CEO of Binance, called bullshit. Binance had been getting battered by the crypto downturn, and CZ knew that FTX was not in nearly as good a position as they claimed to be. Now, CZ didn’t have access to FTX’s books. (That’s at least partly because no one had access to FTX’s books, because FTX didn’t keep books.) But he had a sense of the state of FTX’s finances, and it didn’t make sense for FTX to be buying worthless crypto assets at inflated prices at this point. So CZ publicly dumped his assets that were affiliated with FTX. This was the beginning of the run on FTX. People got spooked and started pulling their money out.
At first, SBF apparently thought everything was going to be fine. They were solvent, they could redeem customer outflows. But lots of questions were being asked about FTX’s finances and answers had to be given. And people were asking for their money back, which he had to provide. So SBF and Ellison put their heads together and started to collate their scattered financial records. Then they realized they were in trouble.
Suppose you have two businesses. One has $100, the other has $0. Then you loan the $100 from one business to the other. How much money do you have now? Of course, the answer is still just $100. Business 1 has $100 in IOUs from Business 2, and Business 2 has $100 in cash. But Business 2 also has $100 in liabilities because it owes the $100 back to Business 1. But if you do a bad job of bookkeeping, it might look like $200. And this is basically what happened with FTX and Alameda. Alameda had huge losses on crypto (like everyone else), and SBF and Ellison had papered over those losses by taking money from FTX. But they then double-counted the money that they had transferred over to Alameda, counting it both as an asset at Alameda (they had the cash!) and at FTX (they had the IOUs!). When the customers asked for their money back at FTX, they realized that all of the money had gone to Alameda, and Alameda had lost most of it. FTX had lost tons of money, too, on the crypto downturn. But SBF went around white knighting because he thought he could. FTX was fine if Alameda just paid back the money it owed. Alameda was fine if it just didn’t have to pay back the money. But both of those things couldn’t happen simultaneously, and no one realized how fucked they were because no one was keeping records. $8 billion had been double-counted and so, in the end, didn’t exist.
The rest is history. SBF realized there were deep solvency problems. He went looking for an external loan to bail out FTX and Alameda together. His report on FTX’s finances featured a big red “negative 8 billion” labeled “Hidden, poorly internally labeled 'fiat@' account.” When potential investors saw that, they laughed and said “No thanks.” And so FTX went into Chapter 11, and SBF went to prison.
So there was a real business there. FTX did make tons of money from trading fees. And if there hadn’t been a run on FTX, maybe they could have papered over that $8 billion hole and refilled it eventually and everything would have been fine. So to that extent, Michael Lewis’s statements were all correct. But SBF did spend lavishly on himself, his friends, his family, and his companies. He thought he was just making use of the massive profits that FTX was making. But FTX wasn’t making massive profits, it had lost tons of money. (Or maybe it was Alameda that had lost money, and FTX loaned all its profits to Alameda and it was all lost that way. It’s hard to tell; no one was keeping track.) So the money that SBF had been lavishly spending wasn’t profits, it was company assets that should have been put somewhere safe for the customers. And FTX’s sins were not properly disclosed, which is a fraud perpetrated almost on its customers; the customers wouldn’t have invested if they knew about the shambolic state of FTX’s bookkeeping and finances! So SBF did defraud customers to the tune of billions of dollars and use those illicit gains to fund a lavish lifestyle. Both narratives are true.
That’s the weird, stupid tragedy of FTX. SBF wasn’t a moustache-twirling fraudster ripping off his clients. He was just a hubristic fool who was making so much money that he didn’t bother keeping track of where it all went. Of course, he said he was keeping track of it, and he did have an obligation to do so. And that’s why he’s almost certainly going to jail for a long time. The moral of the story? When you have a fiat@ account, don’t keep it hidden and poorly internally-labeled. It’s not a great moral, but it turns out to be a really important one in certain situations.
This is a surprisingly uncontroversial claim! The more honest and knowledgeable crypto enthusiasts will say it explicitly. They usually follow it up with the claim that all currency is a Ponzi scheme which is… kind of true? If people are interested, I can do a follow up explaining the reasoning behind that, but that’s a topic for another day.