The past week is arguably the darkest period of time in crypto history so far and it felt quite personal to me as well. It hurts me to see friends who were very exposed to FTX having a hard time coping.
What’s more frustrating is the inevitable weaponization of the FTX incident as a powerful narrative against crypto systems/values and possible forever closure of the Overton window for any institutional adoption of crypto related endeavors in the foreseeable future.
What happened here is a single point of failure of a highly centralized system, the failure of a deified individual who has accumulated so much clout from politics, tradfi and crypto and the failure of governments/agencies not having proper/clear regulation frameworks on crypto exchanges.
Not really in a mood to talk markets and numbers but want to lay out some thoughts regarding what has transpired and contemplate on the paths forward. It is also not my intention to sugarcoat any events in defense of any particular industry.
Failure of the crypto system?
Since last week we have been watching the whole FTX drama unfolding live time non stop - with new pieces of information coming to light every minute. While the nitty-gritty is still being uncovered, one can get a pretty good idea of what happened using the piecemeal information from the internet.
Here is a summary of what went wrong at FTX based on founder’s own words:
IMO all you need to know is that he(SBF) moved customer deposits for other stuff and as a result exchange deposit was not 1 to 1. This is obviously a big no when you operate a custodial exchange.
Exchange is a really intuitive and easy-to-follow business model. You take user’s money, offer trading and custodial services at the same time and then get paid commissions. The more volume you move, the more you make. The bottom line is that you don’t touch customers’ money and give it back upon request.
This is the failure of a centralized exchange/individual and needs to be distinguished from what crypto represents. Decentralization is the unique value proposition of crypto systems and should/will be defended at all costs. Some compromises on decentralization were made due to scalability issue of existing blockchain technology - an off-chain order book model operated by a centralized server is magnitudes faster and more efficient than putting the whole thing on chain as an example.
I don’t think a lot of folks actually understand the differences between a centralized exchange and a decentralized one. CEX was created to abstract away the process of a user accessing crypto. CEX like Binance, FTX, Huobi are like blackboxes where you put in your money and your faith and pray that they do what was promised. In the case of FTX, they failed to do so…
OTOH, decentralized exchanges worked exactly in the way they promised to. We are actually seeing a surge of trading volume for DEX post FTX incident as users move their assets into self custody wallets.
FTX does not represent crypto. Binance does not represent crypto either.
Crypto venture investing and risk management
Su obviously didn’t manage risk very well but the quote always stands true. Risk management is, at the same time, the most basic requirement and the most important skill if you are managing money.
Venture investing, as the name suggests, is a high risk high return business. Crypto venture investing is another beast - venture investing on steroids. It is a game of huge asymmetric bets given its nascent stage.
But taking high risk reward bets and managing risks properly are not mutually exclusive. Coming from a public market background and now working for a VC, I feel that there is a significant dislocation in terms of risk management capabilities between private and public market funds. In the stock markets, the largest hedge funds in the world have the most sophisticated risk management systems there are to help them navigate through market cycles and volatility. Funds compete with each other to deliver higher risk-adjusted returns to their LPs; Those who are careless in risks get weeded out.
It is not an apples to apples comparison but this is a rather stark contrast when you compare these two structures. Also tough to place blames when everyone was rejoicing in the daily green candles during a “supercycle”.
FTX is a good example. From an investor’s perspective, with all the crazy things going on in the crypto world, exchange seems like a low-hanging fruit to capture the exponential return of the asset class without taking too much unfamiliar risks.
Obviously maybe SBF was just such a good con artist that no one could have known he was misappropriating the funds even if they turned the whole place upside down…
I hope there’s a more thorough and holistic review of the entire DD/risk management approach after marking down the investment and firing the associates whose only job was to copy paste financials from FTX data room onto slides for presentations.
Not pointing fingers but constructive only.
On regulation
The FTX collapse is particularly horrible because , as many have feared, it gave the US govt a perfect excuse to slap even harder regulations on US-based firms even though they are not the problem.
FTX is a Bahamas based exchange and was not regulated by the SEC. The US regulatory bodies have failed to provide a clear regulatory framework for crypto assets and that is precisely the reason most crypto exchanges chose to do business offshore where they can offer a more diverse suite of products and US based customers were driven offshore because of that as well. The US based exchanges like Coinbase, Kraken, Gemini are high integrity players and have been open to regulation from the start.
The US crypto regulators are just grossly incapable and they have failed to protect customers or to effectively regulate the industry in every way. The SEC headed by Gary Gensler has been calling every shitcoin a security while having its petty little fight with CFTC on who can be the bigger boss in crypto. Meanwhile Gary G has these mysterious ties to SBF personally due to his family and SBF’s donation to the Dems. The hole is just too deep at this point…
And what do compliant, US based crypto firms get instead? Someone like Lizzy Warren who prolly doesn’t know the difference between BTC and ETH while being so blatantly anti-crypto, calling to punish them based on what happened to an unregulated offshore exchange. LOL. The battle is just too tough against establishments…
At the same time, SEC was busy going after some project that no one even heard of called $LBRY instead of working on that crypto framework. How about going after ponzi coin $FTT?
My point being that US regulators have failed to serve their roles to protect customers amidst their attempts to advance their own political agendas. The problem is not we need harsher regulations but we need more competent leadership and clearer regulatory structures.
Alameda Research
The most common theory of explaining the demise of FTX starts with Alameda losing money and SBF plugging that hole with FTX customer money. I haven’t seen any convincing stories on how they lost this much but the why and how is not what I’m trying to focus here today.
The relationship between Alameda Research and FTX is particularly interesting in this backdrop: Despite SBF’s claim of operational independence between the two entities, the honest truth is that SBF owns both of them. Imagine being the sole owner of both an exchange and a trading firm… picture ICE/CME owning Jane Street/Citadel and forming a giant cluster of trading/market making/exchange complex - you have information on all the flows and you can just arb the heck out of each trade; You make a few bps on each trade and repeat thousands of times per minute and there you have it - a machine that prints money harder than the 2020-21 Fed. The best part about all this is that there’s literally no downside IF YOU DO IT RIGHT! It’s like playing a video game in god mode.
So clearly these guys were not very satisfied with making pennies on the dollar trading spreads… Former Alameda CEO Sam Tabasco hinted in the below thread with a “super powers” metaphor which he has since deleted:
When you are a market participant and you think you are playing god after you make money, it is not far before the market finds a way to humble you. Also just reading in between the lines of a 2018 Alameda pitch deck, I saw multiple red flags:
“We haven’t had a losing week in 6 months”
“15% annualized fixed rate loans no lockup” with “no downside”
“We are extremely confident we will be pay this amount”
Looking through this past cycle, I see a lack of maturity in handling the relationship with markets from the “villains” of this cycle (Do Kwon, Su and Kyle, SBF). Every single one of them is incredibly smart and capable. However, they failed because of their foolhardiness and hubris towards the unknown, their egotistical obsession with always being the “smartest guy in the room” and their self righteousness demonstrated with other people.
On the other hand, I also feel incredibly bullish towards the future funds (liquid/illiquid) that can capitalize on these valuable lessons - more efficient structures/frameworks, more prudent risk management and better leadership.
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Some personal note on crypto as an asset class
Not gonna lie recent events have caused me to do some self reflection and soul searching on the path I’ve chosen. It takes certain courage to hold on to your beliefs in an industry fraught with rampant speculations, egomaniacs and deceits.
However, no one entering the industry last year or earlier this year should expect smooth sailing in these uncharted territories. Coming from tradfi, I venture to say that crypto is hands down the best personal education on global finance, risk management and frontier technologies + it is insanely entertaining. I want to share my personal view on crypto as an asset class and why I’m still bullish.
Crypto has high convexity
Convexity is a math/physics term referring generally to the concept of non-linearity. Mathematically speaking, the EV(expected value) of a convex function is greater than or equal to the function of the EV.
Perhaps more intuitively, convexity equals optionality. When we long an option, we are long gamma. Gamma is the second derivative of price of the option w.r.t the price of the underlying. High gamma = high volatility of position’s directional exposure. If an option has high gamma, its delta will shift significantly when the underlying moves.
From an investing perspective, we like non-linearity and long gamma situations. Crypto is such an asset with high gamma/convexity exposure. The concept of convexity is important in this case because it gives you an asymmetric risk-reward bet. As an investor/trader, one should always think in EV terms and hunt for situations which generate competitive edges in a systematic way. Risk should not be shunned like a plague.
Would you have an asset in your portfolio that maybe has a 50% downside but a 10/20x upside?
Shitty graph but you get the idea.
Crypto is antifragile
Antifragility is a concept brought forward by Nassim Taleb. (Man has not been the most keen on crypto and sometimes mean AF but his teachings are extremely well-regarded.) Antifragility is the ability to thrive and improve with the presence of external stressors/volatility.
Crypto network is extremely resilient as evidenced by past events since inception. The DAO hack did not kill Ethereum; Mt.Gox did not kill Bitcoin; Thousands of exchange/defi hacks did not kill crypto; FTX will not either. The network has only grown more robust and more antifragile as time went by.
Just like the crypto network, both incumbents and new participants learn and grow at a demanding pace to keep up with the growth of the network. Having a growth mindset in crypto is crucial; By constantly looking to take on new challenges/learning new things, one can empower themselves to be antifragile as well. This creates a positive feedback loop.
Build antifragility by going long volatility!
Crypto is a global online casino on steroids
A less serious point is that crypto is the ultimate playground for human greed and imagination. This point is pretty self-explanatory as we have seen million dollar monkey pictures and all the other crazy stuff. Putting aside the argument whether this is justified or not, one should look at it in a more dialectic way.
Statements like “It is just pure scam.” “ no way this is sustainable.” are perhaps true and fair judgments. But isn’t it better to think in terms of why and how instead of pure rejection when we see something out of the ordinary? I think the former is an underrated practice and extremely valuable in life.
And now imagine being short human greed. Gotta be a painful one!
Sources from the Internet, NFA.
Views do not represent the firm’s in any way.
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