Thursday, March 30, 2023

FTX's Mythical Origin Story

 One of the biggest mysteries about the Sam Bankman-Fried (SBF) debacle has been how he initially vaulted into the wealth stratosphere. The standard story is that he made a fortune on the price discrepancies between bitcoin in Asia vs. the US exchanges in 2017. Even SBF critic CoffeeZilla accepts this narrative, making it seem like SBF was a great trader caught in an anomalous crash. Most people accept the story uncritically, and my favorite version is this.

It was a daring feat of arbitrage—SBF is the only trader known to have pulled this off in any meaningful way—one which quickly made him a billionaire and achieved the status of legend.

Alameda’s capture of the kimchi premium (and other trades like it) gave SBF the grubstake he needed for his next move: founding the crypto exchange FTX

Unsurprisingly, the narrative he promoted was a lie. The money Alameda made on the Kimchi premium was gone within a couple of months, and they generated zero profits before starting FTX in the spring of 2019. The most likely explanation for his ascent was the faking volume on his new exchange, which enabled him to bring in VC money. With prominent VC backers and an exchange, he could issue a token and sell those for more money, access customer deposits on FTX, and make stupid investments that would only work in the first half of a bubble. 

This highlights a persistent crypto problem. On the one hand, you have regulated exchanges that do not offer leverage, trade a limited number of coins, can expropriate, and restrict access via KYC, but are audited by independent third parties. On the other hand, you have unregulated exchanges that will give you 100-1 leverage in meme-coins and permissionless access but are trusted black boxes. It is what game theorists call a ‘separating equilibrium,’ and regulators should know they bear responsibility. Like prohibition laws, draconian crypto regulation encourages a large dangerous black market.

The Kimchi Premium Trade and Loss

Alameda was started in September 2017 by SBF, Tara Macaulay, and Gary Wang. All were members of the Effective Altruism movement living in the San Francisco bay area. SBF and MacAulay both had sinecures at the Centre for Effective Altruism, a charity headed by William MacAskill that focused on rationality and optimization (see his TED talk here). The focus is on utilitarianism ($1000 matters more for a poor person), marginalism (smaller projects have greater returns), and existential risks that threaten generations a thousand years in the future (e.g., the AI apocalypse). These abstract concerns tend to attract analytical atheists, your typical Ph.D.

MacAulay had a background in pharmacy and health economics. Gary Wang was a childhood friend of SBF and worked for Google as a software engineer on the site’s front end for booking airline flights. SBF was given an introduction by MacAskill to Jane Street in college, and afterward, there for a couple of years, where he traded a variety of ETFs, futures, currencies, and equities. While this often is used to portray SBF as a precocious trader, there is no evidence. Someone with two years of experience, even if working for Goldman or Citadel, is still very ignorant and has little discretion in their job. Not only the Alameda founders but all of the initial Alameda employees were enmeshed in the EA community, and none had significant finance or crypto experience.

While I can only speculate why SBF et al. thought they could make money as crypto investors, there is a plausible explanation. MacAskill, like many analytical futurists, was familiar with crypto. In 2017 bitcoin was booming, and as an asset with unprecedented global reach, the new exchanges worldwide were not well connected. Thus in May 2017, the price in Korea would occasionally reach a 50% premium over the US, a huge opportunity.


To arb this, one would need to make the following trades:

1. Buy bitcoin on Coinbase or Gemini with USD.

2. Send bitcoin to Japan

3. Sell bitcoin in Japan for yen

4. Sell yen for USD

5. Wire USD to Coinbase

6. Repeat

Wiring large amounts of money to a new account raises many red flags for regulators and compliance officers suspicious of money laundering, which is a cause for many severe regulatory fines. There are know-your-customer (KYC) rules, caps on withdrawals, citizen requirements, etc. This is where a trusted network pays off: a confidant with connections in Japan could handle one side of the transaction, and another in the US handling the connections to the US financial institutions.

MacAskill must have realized his tight-knit EA community was well-suited for this task. It had access to capital, as a funding report suggests around $10B in funding committed as of 2017. This capital is not spent immediately, and simple utilitarian logic implies that it would be a good thing if they could make arbitrage profits to fund more charities. The EA community in San Francisco was not only close but from all over the world, and young. This would allow them to place trusted people in various countries, which is necessary to set up banking accounts to arbitrage these country premiums.  

Many financial dynasties were founded on a kinship network that reduced transaction costs. For example, when Mayer Rothschild sent his five sons to the major capitals of Europe around 1800, this allowed them to move capital much more quickly than those doing business merely backed by their reputation and civil law. Trust removes the delay in drafting contracts because you can be confident that the recipient of your money will not just disappear. Similarly, the EA community was small enough, and a shared vision of the ultimate good is a great foundation for trust. They could then get people into Korea or Japan to execute an arbitrage unavailable to anyone without a presence in both nations. As the opportunity was temporary, the speed generated by the trust was crucial.

As this Kimchi premium was the only trade mentioned by SBF before January 2018, it seems the obvious motivator, and MacAskill created the team to profit off this specific mispricing, internalizing his experience placing people at Jane Street and then waiting for their donations.

While the bitcoin premium disappeared when Alameda started in October 2017, it returned in December. Alameda tried to get around Korean capital controls, but this proved impossible,  which is why it was so anomalously large. Japan, however, was different. An EA colleague in Japan set up a bank account at a Japanese regional bank. Once SBF executed the arbitrage successfully with a small amount of money ($50k), he had a proof-of-concept that anyone could understand. At that point, wealthy EA members Luke Ding and Jaan Tallinn invested $50 to $100 million to capture this trade (see here and here for lower and upper bounds).

Given round-trip transaction costs were probably at least 2%, and it would take at least two business days to complete the transaction, estimates that Alameda made $10 to $30 million seem reasonable. Note that while the premium reached 15%, its average that month was only 5%. As Ding and Tallinn had given Alameda virtually all of its capital for these initial trades, they could demand an outsized percentage of the profits on these initial trades because Alameda was acting merely as a broker as opposed to a discretionary trader at that point. Everyone knew what needed to be done.

Alameda may have made several million dollars in January, but it was soon gone. Bitcoin fell by 40% by April, Etherum by 60%, and other coins more than that. SBF was blamed for several losses in that period, such as:

A long ETH position

OTC shitcoin trades

A botched XRP trade

Transferring a USDT to a bitcoin address

SBF was not merely a bad programmer, an incoherent advocate of crypto principles, but an incompetent trader.

With these failures and the Japanese premium over, big funders Ding and Tallinn had seen enough and demanded their money back in March, leaving Alameda with little capital. Most Alameda insiders blamed SBF, so in April, MacAulay and others offered to buy SBF out for $1M, but he refused, so they left to start their own firm, Pharos Capital (aka Lantern). As most trading firms pay bonuses annually, it is doubtful Alameda has a large bonus pool because leaving forfeits one’s bonus. Further, as a co-founder, SBF would have had legal ownership of a sizeable amount of the bonus pool, so any buy-out would have to include a premium over that.

In October 2018, another Alameda trader, Victor Xu, left to join Pharos. If Alameda made a boatload from April through October 2018, it is unlikely that Xu would have left then instead of waiting until the following year to get his bonus. This all suggests Alameda had virtually zero accumulated profits at the end of 2018, after the Kimchi trade that most think funded FTX.

Throughout 2018, SBF’s focus was on raising money to start FTX. In January 2019, Alameda  sponsored an event at Binance Blockchain Week in Singapore, promising 20% returns “risk-free.’ Somehow he got the money to start FTX, which began trading on May 1. FTX reported $50 million daily trading by June 11, which grew steadily. Volume reportedly rose steadily until it hit $300 million daily on July 5, two months after inception (see here). They had only ten employees.

This was sufficient to get $8MM in funding from well-known crypto VCs Race Capital, FBG, Consensus Labs, and Galois Capital in late July. FTX launched its token on July 31 with an initial market cap of $30 million. By the end of 2019, SBF convinced Binance head CZ to invest $100 million for a 20% stake.

At that point, FTX had enough money to capture the crypto bull market starting in June 2020. Through the end of 2021, bitcoin would rise by 400%, Etherum by 1500%, and new coins like Solana and Shiba Inu would rise 10-fold. Thus, the subsequent growth of FTX is straightforward, as Alameda/FTX was investing in small coins and funding new projects.  

The volume stats FTX presented to VCs in July 2019 were almost surely fake. If you search on Google or Reddit for “FTX Exchange” before July 5, you find almost nothing. How could an exchange generate such volume without notice on the entire internet?

Just before FTX pitched the VCs in July, it released a white paper on fake trading, summarized like a press release by several media sites (see Forbes). This would make total sense if FTX was faking their trades, as they realized fake volume was a common tactic because it was feasible and effective. In creating their own fake trading statistics, they would necessarily learn to avoid fake trading signatures, as several reports had examined this phenomenon back then. Common tactics included regurgitating the trading tape from larger exchanges with minor modifications, implausibly small bid-ask spreads, having most trades post within a bid-ask spread, etc. A white paper on fake trading would have been the ultimate complementary good for someone engaging in fake trading stats.

Accusing others of doing something wrong before even being accused is disarming. Non-psychopathic people think no one would be so bold as to do what they campaign against. However, it happens all the time. For example, the government-led disinformation campaign on social media was done under the pretext of fighting disinformation. Their tendentious definitions of truth, or ‘higher truths,’ revealed them as the primary disseminators of disinformation.

It’s an SBF staple to inadvertently reveal his scammy tactics with the overconfidence typical of narcissistic fraudsters. In his April 2022 Bloomberg interview, he explained yield farming in a way that, as Matt Levine noted, was a classic Ponzi scheme. SBF responded, ‘that’s one framing of this,’ as if it was not a Ponzi if it had not collapsed. CoffeeZilla made a YouTube video on that bizarre interview that, in retrospect, is quite humorous. I suspect this same Ponzi mindset was behind the initial VCs and CZ’s interest in 2019. While I am long-run bullish on crypto given government fiat incentives, one has to admit the current crypto community is a hive of scum and villainy on par with Mos Eisley.

The EarnToGive Alignment Problem

EA community was instrumental in creating the SBF train wreck. Not only did it supply all of the initial personnel and capital, but their wealthy and well-connected leaders would also give investors much reassurance. Further, the EA vision, applied to entrepreneurship, creates a classic misalignment of incentives. It centers on a profound flaw in their ‘earn to give’ and ‘80000 hours’ initiatives, promoted most conspicuously by MacAskill and Sam Harris, who were both big SBF supporters all the way through November 2022 (I think they are both innocent, but this naivete should disqualify them from administering a large charity ).  

Earning to give involves deliberately pursuing a high-earning job or investment strategy as an instrumental goal to maximize their ultimate goal, ‘total welfare,’ the present value of the utility of billions of people over the infinite future. The EA conceit is that you can be a superstar, lawyer, entrepreneur, or investor while seeing it purely in instrumental terms. Anything not directly helping others, like giving food to the starving, or preventing existential risks like an AI apocalypse, is irrelevant in itself. It’s fine to be a well-paid rodeo cowboy or disc jockey, but only as a means to a much more ennobling end. The emphasis makes it highly unlikely one will excel at lawyering, investing, etc.

Almost everyone knows that their ultimate objective is not their day job. The difference is that the status or importance of most jobs is virtually indefensible within the EA worldview. In a traditional family, the loving wife of a great attorney loves not only that her husband’s income supports their family, but she feels pride in his excellence at his craft. The husband can then focus on his job, knowing that it not only supports his family but generates appreciation from those he loves most, as well as clients and colleagues. This helps him to focus and apply himself, making him an excellent attorney.

In a modern economy, the division of labor makes it virtually impossible to see how our jobs move the needle. It takes faith in the market, where the division of labor prices services at their marginal value, to believe that if you are well-paid for doing something, it adds to world utility, even if it is not as transparent as handing food to a starving child, or getting a million likes for a TED talk on saving the planet. Though this does not work perfectly, it works naturally, undirected, better than any centralized plan.

Abstract thinkers have always had a problem appreciating the value of various professions in an economy. Socialists thought that one could do without the entire field of finance and advertising. What did they produce? It has been a good thing that most people respond to market forces instead of intellectuals when choosing professions.

The earn-to-give ethos degrades all instrumental fields, those not contributing directly to the magical EA objective function. Given the nature of most people’s jobs, pride in their work would reflect a pathetic unworldliness. If you, and those you love, consider your job as important as a Clown Car driver, it’s inconceivable you will become elite in that field.

It is not rational to expect to make outsized returns on an avocation. In a competitive economy, builders of great companies not only have a vision but pay attention to details, the way that John D. Rockefeller implemented efficiencies in oil refining using meticulous cost-benefit analysis and understanding scale efficiencies. Rockefeller was a devout Christian and preferred fellow teetotaling Baptists like himself as partners, so he did not ignore his ultimate objective at work. However, he had confidence that doing one’s job well, whatever it was, was a great way to serve God. Most people not focused on abstract conceptions of world utility have no pangs of guilt doing something they find profitable and interesting. That allows them to focus and become great at it.

In contrast, the only people who boldly proclaim their EarnToGive attitude is consistent with extra-normal profitability are fools and frauds, like SBF.

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