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Yes, It Was a Scam

by | Nov 15, 2022 | Market Outlook

This weekend, I had a preview of what awaits me in exactly a month…

While traveling to Orlando, we stayed at a hotel close to Walt Disney World.

Hundreds of other peoples’ children were running around. I saw no shortage of tired-looking parents… They looked like a gang of armed, six-foot chipmunks had mugged all their disposable income.

And who doesn’t enjoy a good $4 bottle of water at the hotel market?

Inflation is one thing, but the Disney World area might be the closest thing to the federal government itself picking your pocket.

We’re taking our daughter to Disney for her fifth birthday in December. She already deduced on Sunday that the characters are people in costumes, despite our efforts to get her to believe otherwise… so much for the “magic.”

At least Disney doesn’t have a cryptocurrency, right?

Oh… no… MATIC? That doesn’t look like a sound investment.

Speaking of ways people are losing money, I wanted to take a minute to continue our conversation about crypto.

Yes, Friends, It Was a Scam

Over the weekend, I wrote 40 pages on the FTX crypto scandal. If you haven’t read it, it’s here. Pour yourself a bottle of wine — maybe even two — because it’s quite a story.

Now, FTX founder Sam Bankman-Fried had become the savior of crypto over the past two years. His company sponsored a major conference near its Bahamas headquarters in April. I attended. And I offered a recap of my thoughts.

What most people didn’t understand about the operation is that Bankman-Fried also owned a hedge fund called Alameda. People in the industry knew it existed, but they didn’t understand the extent of the relationship.

SBF — as he’s known — told the markets he wasn’t involved in the operations of the hedge fund. That role had been handed off to Caroline Ellison, a 28-year-old math contest winner and Stanford graduate.

Oh… and they dated off and on.

For a solid year, most venture capitalists I follow couldn’t figure out where SBF was getting all of his money. They assumed that the hedge fund had become a money-printing operation. But the question was how this hedge fund — which traded crypto and other assets in the space — was so good at what it did.

Well, as I expected, that news dropped yesterday.

The hedge fund had access to crypto that FTX would later sell. It bought those assets and then sold them at inflated levels on the FTX exchange. In simple terms, they were front-running on data from FTX.

Now, since crypto isn’t regulated well and FTX is abroad, it’s actually not illegal. But it shines a spotlight on payment for order flow.

A lot of the people at FTX had worked at Jane Street, a proprietary trading fund that engages in payment for order flow. These funds buy the order flow of stock brokers like Robinhood and TDAmeritrade, and then front-run trades ahead of large volume purchases. It’s completely legal.

And that’s why you don’t pay to trade on Robinhood and other “free” brokers.

You see… your data is the product.

This Is Where FTX Screwed Up

Now, while the frontrunning might actually be legal…

Here’s where things collapsed.

The company created its own token called FTT. This is a crypto that existed on FTX, offering traders rewards for ownership. Those perks might include lower trading fees, better rewards for referrals and even free crypto.

The problem is these tokens are basically a house of cards… You see, token economics creates value from essentially nothing.

As SBF said in a podcast last April, the DeFi crypto market largely depends on buyers’ and sellers’ behavior as a mechanism of determining price. He famously said that investors should imagine a box that can change the world.

The entire premise of determining value depends on the public perception of this box’s potential… the speculators who climb on board and drive up the value… and the willingness of other parties to accept the value and allow it to be used as collateral for loans.

The entire premise is illogical. And it’s the subject of Charles Mackay’s famous book “Extraordinary Popular Delusions and the Madness of Crowds.”

That book was written in 1847.

Alameda likely lost a lot of money earlier this year when other crypto hedge funds and exchanges failed.

The Celsius Network and Three Arrows Capital imploded in May. SBF used a large amount of capital to buy up stakes in failing businesses, or to offer them loans. BlockFi, a business that failed this year, gave SBF a fantastic deal to buy them in the future, and was forced to move its assets to FTX.

A colleague deep in this business said that BlockFi’s employees were to ask no questions. But as Bitcoin continued to drop this year, people started to worry about Alameda. Its Co-CEO stepped down during the summer, leaving only Ellison at the helm.

Now, Alameda Research owned a ton of the FTT token at a high price. In my view, the token had no monetary value, just perceived social value —the perks.

But Binance — one of its rivals — also owned a large amount of this token. Binance had a big position after it divested from FTX last year.

So — in a very public way — Binance’s CEO announced plans to sell its full position in FTT. Alameda’s CEO said that the hedge fund was willing to buy out all of Binance’s position for $22 per token.

There’s just one problem… That $22 level was likely the margin level that Alameda needed to keep the token at in order to prevent its own insolvency. The second FTT broke under that $22 level, Alameda was toast.

But what did that mean?

FTX had an $8-billion hole on its balance sheet last week…

It was soon revealed that FTX’s executives had used customer cash to loan money over to Alameda to help it plug a hole from earlier this year. But — and this is the most important component here — the hedge fund was using FTT as a backdrop against the loan.

So now that FTT had collapsed in price, there was no way for the fund to recover… and there was no way for FTX to collect its cash to plug the hole.

This IS illegal. The use of customer deposits to fund operations is strictly bad news. Customers are now facing significant losses because their assets were either burned by FTX, or they’re frozen.

This is a lesson from a long time ago… Back during the dot-com bubble, companies in the payment world were explicitly warned that they couldn’t use customer deposits. It’s a serious breach of trust, and a lesson that has been taught in financial law classes for decades. FTX’s compliance department deserves its own reckoning in the future.

I have an impossible time trusting the token economy. And I wouldn’t spend much of my money and time speculating on assets that are specifically allocated to individual projects. Bitcoin does have a future. FTT and other “tokens”?

That reckoning will continue.

Enjoy your day,


WRITTEN BY<br>Garrett Baldwin

Garrett Baldwin

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