Bank Run at FTX

November 11th, 2022

We’re writing to address the rapidly developing situation at crypto exchange FTX, as it is an impactful event for our industry, and our fund. Messaging has been that customer deposits are a priority but it appears FTX will need to raise funds or face bankruptcy. At the moment of the event, the Flagship Fund held cash reserves of approximately 20% on-exchange at FTX that were in the process of being deployed. We did not own any FTT (FTX platform’s native token) nor did we have any exposure to Alameda (a related entity discussed below) or Solana (SOL), which has been closely associated with Sam Bankman-Fried (SBF).

Background

FTX is a well-known exchange, operating both within the US and internationally, led by Sam Bankman-Fried (SBF), a former quantitative trader from Jane Street. SBF has achieved enormous business success, with a previous net worth close to $20bn, and has become the oft-referenced posterboy for the crypto industry. He has been a central figure for many lobbying efforts in Washington D.C., participated in numerous Senate Committee hearings, made significant donations to both Republican and Democratic candidates in the primaries, and has worked closely with legislators to help create healthy regulation for the digital asset industry in the US. Prior to this event FTX was considered the gold-standard for institutional trading, and was a top 3 global exchange by volume. 

What Happened?

While the dust is still settling, problems began when a Coindesk article examined the financial details of Alameda Research, the crypto hedge fund founded and controlled by SBF. It appeared that while Alameda reported $14.6bn in assets, it consisted mostly of the FTX platform’s native token (FTT), and other illiquid assets. Reports show that according to this balance sheet, Alameda had only $134mm cash in June 2022. Following the leaked balance sheet, Changpeng “CZ” Zhao, the leader of FTX’s primary competitor, Binance, tweeted his intentions to liquidate all FTT held on Binance’s books, recalling fears of a Luna-style collapse. The price of FTT subsequently fell, which called into question Alameda’s solvency, and ability to service any potential margin calls. The focus then shifted to whether or not FTX could have lent Alameda funds, to what extent, and whether FTX would have accepted Alameda’s FTT tokens as collateral. SBF immediately challenged the “unfounded rumors”, tweeting that "FTX keeps audited financials etc. And, though it slows us down sometimes on product, we're highly regulated." FTX clients were left to decipher conflicting opinions and reports. See the below, now deleted, tweet from SBF claiming that all client assets are safe and that all withdrawals will be processed. Nevertheless, a classic bankrun ensued as many depositors rushed to withdraw assets held at the exchange.

A few short hours later, FTX decided to officially “pause” withdrawals as they attempted to fundraise the necessary liquidity to honor customer requests. SBF then tweeted that a deal had been reached with CZ and Binance to purchase FTX, emphasizing that all user assets would be covered 1:1. CZ confirmed Binance’s intentions, tweeting that a non-binding letter of intent (LOI) had been signed and the deal was pending due diligence. But, about 24 hours later, sources reported that Binance had walked away from the deal citing that the liquidity gap exceeded their expectations. Reports later surfaced that the shortfall for FTX was approximately $8bn, and the company needed $4bn to remain solvent.

Fallout

FTX’s sterling reputation has been shattered, and the private dealings with Alameda, if substantiated, are likely to be criminal. Given FTX was a central venue for both professional trading institutions and retail clients, the fallout will likely have wide reaching effects and potential contagion. And while this setback is a massive economic blow, there will also be lasting damage to the trust and regulatory sentiment of our industry. FTX had made a strong marketing push to retail consumers, naming the FTX stadium in Miami and high-profile celebrity endorsements from the likes of Tom Brady, Steph Curry, and others. SBF’s presence in D.C. and his reputation there is likely unsalvageable. We’re seeing time and again that while centralized platforms help introduce digital assets to new users, they lack transparency and decentralized governance, like many of their traditional banking counterparts. Transparency is at the heart of the crypto ethos, but centralized entities continue to obfuscate their operations.

Ironically this event again highlights the need for a trustless, permissionless Decentralized Finance (DeFi) system built on secure self custody. The crypto adage “Not your keys, not your coins” rings even louder than before, since if it can happen to FTX, one of the most “regulatory focused” institutions out there, it can happen anywhere.

How Has This Affected The Fund?

Perceptive Capital’s defensive positioning has helped the Flagship Fund outperform the broader market through much of the year. We avoided the Terra/ Luna debacle, the Celsius/ Voyager insolvencies, and have recently held a higher allocation to market neutral holdings than ever before. The fund has been positioned to take advantage of price dislocations on our favorite assets. And while that positioning has shown itself to be prudent, one of the venue’s we selected to effectuate the trades was not. As the situation unfolded we attempted one of the earliest withdrawal requests, prior to any official halt. Unfortunately the queue was reportedly “backlogged” and while we were able to withdraw some assets, the majority is effectively “locked” on exchange. Should FTX enter bankruptcy proceedings, equity investors are the lowest priority of claimants, and we’re already seeing some equity investors, like Softbank, record significant markdowns (Softbank -$100mm). Messaging from FTX has been that customer deposits are the top priority, but we believe it’s unlikely we’ll see any recovery in the near future. If bankruptcy proceeds, we assume legal battles between customers and shareholders will be a drawn-out affair.

Going Forward

What does this event have to do with the development of DeFi technologies on Ethereum (ETH) and the Web3 builders out there changing our future? Very little. It highlights the need for the radical transparency offered by such technologies. What does this mean for the growth of crypto as an asset class? Unfortunately, we believe quite a lot. Crypto has always been seen as fringe, with many participants hailing decentralization as a form of government protest and a new landscape of financial and technical freedom. But to think that this asset class can reach escape velocity without proper regulation is a fool’s errand. We all abhor useless and ill-advised regulation, but in order for the global investment community to point trillions of dollars toward crypto, we need a regulatory path. This event has once again brought our fledgling industry into the crosshairs of regulators. 

The pendulum is swinging back toward the original ideals of crypto born from the 2008 financial crisis; decentralization and transparency. Code is law. While these events significantly impact the short term growth and adoption of crypto, our long-term view is that a clearing of the forest will allow new growth and opportunities. As part of the aftermath, we hope to see a competent regulatory framework that maintains U.S. competitiveness, and permits safe product experimentation and creativity, while protecting individual financial freedoms and punishing bad actors. We believe that DeFi should be embraced over centralized financial (CeFi) platforms like FTX, Voyager, Celsius, etc. as our industry continues to learn the hard way that centralized, opaque governance structures often end up failing the individuals they are intended to service.  

While the situation is still unfolding, we will continue to keep all of you apprised of any developments. This event has been one of our industry’s most catastrophic failures, but the thesis of a decentralized financial future remains strong. As always, we remain available for any additional conversations. 

Your Team at Perceptive