FTX and the Thin Confidence Game

"Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless." - Warren Buffett 

The Warren Buffet magazine cover is undefeated. 

FTX, one of the largest crypto exchanges globally, was effectively laid to rest today by the "confidence game." That is, amongst investors, confidence evaporated.

Reputation and credibility ... *poof* ... GONE. 

According to a Dune Analytics dashboard, FTX was a victim of a "bank run." Through mid-day Monday, FTX experienced more than $1 billion in outflows over the past week.

By Tuesday morning, FTX stopped processing withdrawals entirely and it was reported withdrawal request had approached $5-6 billion in total. 

Sam-Bankman Fried (known as SBF) was calling deep pocketed investors seeking a financial backstop. FTX was valued at $32 billion in a January funding round. Investors included household names: BlackRock, Sequoia Capital, Ontario Teachers Pension Plan, among others. 

Something everybody wanted to be part of in January became something nobody wanted anything to do with less than twelve months later.

What the hell happened? 

It all started with a report from CoinDesk last week. A leaked balance sheet for a hedge fund connected to FTX, Alameda Research, showed $15 billion of assets versus $8 billion of liabilities. 

At face value, that asset versus liability situation doesn't seem noteworthy. Looking under the hood, it was very noteworthy.

The "assets" were mostly made up illiquid securities, with the majority of it in a token called FTT. For those unaware (including yours truly) FTT is a token issued by FTX for discounts on trading fees at their exchange. The market cap of FTT a week ago, including portions that were "under lock", was close to $9 billion. 

But the reality was you couldn't sell any large chunk of FTT without pushing the market significantly lower. Things get complicated fast when going "inside baseball" with crypto, but the important distinction is the asset side of Alameda's balance sheet was full of junk.

In effect, "assets" was a pejorative term. 

Before the morning coffee settled, Bankman-Fried was being referred to as BankRun Fraud on social media. Whether "fraud" is accurate or not will take time to sort itself out, but it was certainly a bank run. 

SBF went to Twitter announcing FTX had come to a "strategic transaction" with Binance. "Strategic transaction" is a fancy phrase that means a company became insolvent and needed a bailout. 

After the CoinDesk report last week, Binance CEO Changpeng Zhao (known as CZ), let the world know his company would be liquidating their FTT token, which they received as part of a previous sale of FTX equity. 

In the second tweet, CZ alludes to the fact their is bad blood between Binance and FTX. 

FTX and founder SBF have long been known as one of the biggest donors to politicians in D.C., but specifics on how that negatively impacted Binance are unclear. But to state the obvious, Binance was pissed and they wanted blood.

Blood they got.

In short:

• The balance sheet leaked of a company that is closely connected to FTX

• That balance sheet was full of junk on the asset side

• Binance decided to unload their holding of the junk asset on that balance sheet

• Creating uncertainty from investors on FTX's solvency

• AND THEN proceeded to buy FTX

And it all happened in less than one week. 

A week in crypto markets is like years in financial markets.

Charlie Munger once said, "the liabilities are always 100% good, it's the assets you have to worry about." 

How true that is. 

While terms of the Binance deal were "undisclosed," we can confidently assume the purchase is happening for pennies on the dollar. 

This also assumes the purchase goes through, which is far from guaranteed. After the deal announcement, most crypto assets rallied. But in the hours after, crypto began to sell-off aggressively. The FTT token fell to around $5 and all indications are that it will keep falling. 

Markets are smart and good at sniffing things out. While not conclusive, the market may be sniffing out the FTX/Binance deal is on thin ice. 

Simply put, if there's nothing left for Binance to save, then there's nothing left to save.

Rumors are flying and it's not inconceivable FTX is beyond repair. And there's also the chance something nefarious was happening behind the scenes that will come to light in the weeks ahead.

Frank Chaparro, Editor at The Block, tweeted this to sum up the days events:

A sad day indeed.