Why the FTX Blowup is Good for DeFi
The world’s third largest Crypto exchange is now insolvent. Here’s as quick a synopsis as I can make, and why I think it’s a net positive.
Sam Bankman-Fried, aka SBF, child of Stanford professors, MIT grad yadda yadda, finds an arbitrage opportunity to exploit a JPY/BTC premium and makes like a billion dollars. He then proceeds to go on a stated mission of effective altruism, making him the golden boy of Crypto, pledging to (at a future date) give all his money back to charity. Cover of Forbes, Fortune, etc, etc.
All of this arb business is done under his hedge fund, Alameda Research. Which, after the arb opportunity is closed, turns into a market maker with their fat stack of cash. SBF then “meme-raises” a cute $420M more, from 69 investors at a $25B valuation to start FTX, a Crypto trading exchange (similar to Coinbase, Crypto.com, Binance, etc). This is known as a centralized exchange (CEX), which SBF has based in the Caribbean to avoid regulatory issues.
FTX rises to become one of the biggest CEXs in the world, getting their name on an NBA arena in Miami, as well as the Mercedes F1 car, and many celebrity endorsements such as a very long commercial with Tom Brady and Gisele Bundchen.
Everything was going really smoothly until this past week.
CoinDesk gets ahold of Alameda’s balance sheet and finds out that $5.8B out of their $14.6B in holdings are in FTX’s exchange token $FTT. FTX users get benefits like free trades for holding $FTT. FTX also used 33% of their exchange revenue to “buy and burn” $FTT, a common Crypto tactic, basically the same as a stock buyback. Both tactics (incentivizing users to hold $FTT for benefits, and the buy and burn) act to lower the circulating supply of $FTT, which keeps its price high.
It is already suspicious enough that SBF’s hedge fund would be holding such a high percentage of their portfolio in his own exchange token, but it gets worse. By design, the supply of $FTT is low, but it is so low that the $5.8B of it that Alameda is holding is 2-3x greater than the actual circulating supply. What does this mean? It means that even if Alameda wanted to sell all of their $FTT, there would never be enough buyers for it. Which means that 40% of their balance sheet is valued at a price that would be impossible to obtain. And of course they are borrowing against this phony valuation.
So here is the scam in a nutshell: FTX creates $FTT, Alameda buys (or pre-mines) it at a low price, FTX pumps the price with their extensive marketing reach and sells it to their users (who must hold it to reap its benefits), Alameda then posts their $FTT back to FTX in exchange for real customer assets, essentially trading money with fake value for money with real value.
This circulates paying customer’s money out of FTX and into Alameda for them to trade with (which if you are wondering, is illegal). In contrast, Coinbase, which is based in the US, publicly traded, and thus highly regulated, is required to keep customer assets backed 1:1. Since SBF clearly has a “higher purpose” of effective altruism, he is basically saying “nah dog” to such primitive regulations and ethics. Plus, he’s partying in the Caribbean so its all good, right?
The only thing that can break the party up at this point is if there is massive sell pressure. And maybe they would have gotten away with it if it wasn’t for that damned blockchain which keeps a public ledger of all the transactions flowing between the entities (that were supposedly at arms length). A journalist with a block explorer gets suspicious, a balance sheet leaks, and the record player skips.
Enter CZ, the head of rival exchange Binance, who gets wind of the balance sheet and publicly announces that he is going to dump his $500M of $FTT, to which the Alameda CEO publicly offers to purchase at the (then current) price of $22, and CZ publicly declines. This is odd. Wouldn’t Alameda (if they had nothing to hide) prefer to have the price to fall to market value and buy it at a more favorable price? And wouldn’t CZ (if he were not looking to tank a competitor) want the opportunity to sell it at the highest price possible? Both sides seemed to have telegraphed their intentions.
So what happens? The news creates a bank run type of situation as everyone tries to dump their $FTT as quickly as possible, which obviously tanks the price. Sponsors rapidly remove all ties with FTX, and the industry is left with a black eye. The remaining funds left in FTX accounts (roughly $1B) have reportedly been drained, and SBF is on the run, potentially in Argentina. Crypto haters rejoice.
And I think this is a good thing. Why?
I have been saying for a while that 99% of Crypto is grift. I have also been saying that CEXs are inherently antithetical to the ethos of Crypto, DeFi, and web3. I have also been saying that trading is bad.
Blockchains were not created with the intention of giving users 10,000x returns. They were created to be a permissionless, immutable ledger of transactions that grant users the ability to resist censorship of transactions. The concept of DeFi (decentralized Finance) is based around this permissionless environment, which operate using DEXs (decentralized exchanges), which utilize AMM bots (automated market makers) to swap currencies when necessary. Notice how there are no middlemen involved in that formula.
For myriad reasons (no KYC, loss of revenue), banks and governments don’t want people offloading their fiat currency into DeFi Crypto. If you have ever tried putting money on chain you know this first hand. Credit card companies do everything they can to block the transaction, or at least limit it to $500 per day with hefty transaction fees. No one is disrupting the entire global financial system with $500 per day, so if you want to want to be more aggressive you usually have to use a CEX. CEXs allow you to connect your bank account and have less restrictive limits on transaction amount. So CEXs are the gatekeepers of fiat onramps, but their influence doesn’t stop there. Now that they have everyone’s money, they can gamify the ecosystem with all sorts of concoctions. New coins every week, yield farming, incentive tokens, and the almighty transaction fees. CEXs are not only the unnecessary layer of fat between people’s money and the underlying protocol, but they are actively engaging in predatory marketing tactics with the purpose of taking their money. CEXs don’t care if you win or lose, as long as you play the game. I went over this a few weeks ago in Why the Degen Movement is Bad for Web3.
As much as I love Brian Armstrong and what he has done with Coinbase making Crypto more accessible to the masses, I don’t think that CEXs are healthy. Yes, they provide KYC and are required to back your funds 1:1, but they could (if they or the government wanted to) block your transactions or take your money. Everything is “safe” under the purview of the CEX, until it’s not. “Not your keys, not your coins” as the popular DeFi saying goes.
So another leg gets taken out of Crypto during this bear market. First the dumping of the overflow capital from equities that was pumped during the bull run, and now the distrust of CEXs. There is more to come. There are massive pools of capital out there waiting to be dumped on the market, the bottom is not in. But the faster we get there, the better. The distrust of CEXs is good long term as people will do extra diligence before investing. Caribbean-based exchange? Pass. 17% APY yield? Sus. Algorithmic-based stablecoin backed by majority BTC? C’mon man..
The rampant speculation is never going to end, but such a high profile blowup can only garner feelings of suspicion in the future when things appear too good to be true. Education solves many problems, and a big lesson was just learned on quite a large scale. So when interest rates start to drop again in a year or two, and money starts flowing back into Crypto, and bags start pumping, and Tom Brady is calling you personally asking if “you’re in”, and you can’t resist trying to get a little taste of that sweet, sweet 10,000x, remember:
CEXs aren’t DEXs
Not your keys, not your coins
Only invest in things with product market fit