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“It draws in a lot of charlatans … who are trying to create various sorts of exchanges … where people who are of less-than-stellar character see an opportunity to clip people who want to get rich because they see their neighbors getting rich buying stuff that neither one of them understand. It will come to a bad ending.”

— Warren Buffett on crypto, 2018 [emphasis added]

Cryptopocalypse Now?

The presumed John Piermont Morgan of crypto turns out to have been Elizabeth Holmes, Dick Fuld, Bernie Madoff and Jordan Belfort all rolled into one — a finance Frankenstein of previously unimaginable proportions.

But, if we’re speedrunning the history of finance, could making every possible mistake all at once turn out to be for the best?

As many have been quick to note, the collapse of FTX starkly illustrates the core value-propositions of decentralized finance: trustless, permissionless, self custody.

But it illustrates a couple of DeFi’s core weaknesses, as well:

1) It was the LUNA token, DeFi’s original sin, that broke the FTX liquidation engine and blew a hole in Alameda’s balance sheet.

2) It was an attempt at using crypto tokens as collateral that broke the FTX bank.

You might say, fine, no more Ponzi coins, like LUNA, and no more CeFi banks, like FTX.

But swearing to never, ever make those two mistakes again may be tantamount to conceding that crypto cannot scale.

And we’re all here because we think crypto can scale.

Is it even possible to build a trustless financial system of any significant size?

FTX’s spectacular implosion should make us think hard about that one.

But it’s too early to prognosticate as to what it all means: The implosion is ongoing — and may just be picking up steam.

So, the best we can do right now is just try to keep up with events and review what we’ve learned thus far.

I spent most of the weekend doom-scrolling Twitter with that in mind.

Here’s my TLDR.

What we learned this weekend:

Sam was lying on Twitter last week: FTX did not have an old-fashioned liquidity mismatch (“a total market value of assets/collateral higher than client deposits”). Clients’ deposits were simply gone.

Sam has been lying to us for months: All evidence suggests FTX has been insolvent since LUNA. So, everything that happened since was old-fashioned fraud.

Sam may have been lying for years: He’s reported to have built a “backdoor” into FTX’s accounting system, allowing him to move assets and fake the financials. Was any of this real?

Sam is still lying: The withdrawals being made last week were neither at the request of nor in compliance with “our Bahamian HQ's regulation and regulators.” Those same regulators said Saturday the withdrawals were illegal: “The commission does not condone the preferential treatment of any investor or client of FTX Digital Assets Ltd. or otherwise.” It’s lies piled upon lies.

FTX prevented the LUNA/3AC contagion from fully playing out early this year: The consequences of the May/June crash were delayed — and may now be magnified.

Open questions:

Was it a Ponzi right from the start? Circulating on Twitter this weekend was Alameda’s 2019 pitch deck in which they offered 15% on loans with “no downside,” based on a trading P&L of Madoff-like consistency. (Note: If a hedge fund is making 7% returns per month, they won’t need to ask you for a loan.)

Was Alameda selling bitcoin as soon as it got deposited on FTX? The FTX balance sheet leaked to the press this weekend showed $1.4 billion of BTC liabilities and $0 of BTC assets. To meet BTC withdrawals prior to shutting down last week, FTX was probably buying them in the market.

Could FTX have kept the juggling act going if not for the LUNA crash? It increasingly looks like FTX’s liquidation engine is what caused the bulk of the losses at Alameda. But, it also looks like FTX’s numbers did not add up before that, either.

Where, for example, did SBF get the $500 million to buy shares in Robinhood and another $500 million to invest with Sequoia and other VC funds? Could he have taken that much out of Alameda based on legitimate trading gains? Or was he spending FTX’s customer deposits?

Was Alameda any good at trading at all? People are questioning whether SBF’s origin story of windfall profits in the kimchi arb trade was BS, too.

Who's the hacker? $477 million in various tokens were stolen from FTX’s wallets on Saturday morning. Can that be anything other than an inside job?

Is this more tragedy or farce? SBF’s single-letter tweeting could tip the balance in either direction.

And what does FTX stand for, anyway?

How could it have come to this?

Self-custody is not fit for purpose: Hardly anyone wants to custody their own financial assets, so they look for someone trustworthy to entrust them to (ironically). SBF convinced everyone he was trustworthy.

Self-custody may not even be fit for crypto natives: Crypto.com admitted this weekend to having accidentally sent 80% of its ETH to another exchange (which generously chose to send it back).

A lack of infrastructure forced exchanges to do everything themselves, including two things that should never mix: lending and market making. You don’t want a financial system in which the liquidity providers are also the leverage providers.

VC funded and enabled it all with minimal due diligence, because they needed a regulatory-compliant way to get crypto exposure. VCs (and their investors) suffer from FOMO just like the rest of us. When SBF came along and offered a “safe” way to invest in crypto, they couldn’t resist.

What do we now know?

Fractional reserve banking doesn’t work when the reserves in question are shitcoins.

Think twice before investing in a financial firm whose auditor is domiciled in the metaverse.

Don’t deposit assets with an exchange that is simultaneously making you a market and offering you leverage.

Crypto bank runs are different from non-crypto bank runs: Even after the crypto bank has shut the front door to depositors, hackers may be taking the assets out the back door.

Short every advertiser you see at halftime of Super Bowl LVII.

Advertisers for Super Bowl LVII included FTX, Meta, Rocket Mortgage, Crypto.com, Draft Kings, Uber Eats, Netflix, Amazon and DraftKings. Nice short portfolio, that.

We probably live in a simulation.

Or in the dumbest timeline of the multiverse.

— Byron Gilliam

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Written by @bgilliam1982.

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