What happened to the cow?
In the classic fairytale Jack and the Beanstalk, Jack is charged with the important job of taking the family’s cow to market to sell for some much needed money to put food on the table. Jack, however, gets stopped by some scammers and is convinced to sell the cow for a handful of ‘magic beans’. The rest of the tale is well known and works out well for Jack. However, the gaping hole in the story is what happened to the cow?
FTX is a similar fairytale where related parties have exchanged valuable assets for the equivalent of a handful of magic beans. The beans are fiat tokens that FTX can simply create from nothing. But what happened to the valuable assets, the cow, that FTX was taking to market?
Suppose you deposit $1 with a broker. The money is in a hard currency and can be exchanged for securities like Tbills or shares, or just sit there in a bank account. Alternatively, the broker can change the basis of the deposit, presumably with your permission, for a token that it values at $1. The deposit then becomes a token and the $1 then goes to the broker. If you want your money back, the exchange reverses, and the $1 goes back to you in exchange for the token.
The transfer of $1 back and forth using the token, in this example, does not change the core asset’s value which is the original $1. The only difference is who gets to control the $1 until the withdrawal takes place. If the broker doesn’t do anything with the original $1 after the temporary exchange of a token then, by and large to a first approximation, the token is fully backed by the $1 and he can make good on the claim.
The now collapsed FTX crypto exchange did not do this. It seems that the exchange transferred the $1 to itself for its own token, FTT, and then whisked the $1 away to spend on something else. That something else became worth less than $1 and the exchange collapsed because they could not redeem the FTT tokens. This is a classic bet-gone-wrong situation that many financial actors have suffered over the centuries. But what must have happened is a bet on something that didn’t work well for FTX causing a loss. The FTT token is not the problem here and its decline in value reflects the loss rather than itself being the difficulty. I say this because a cheap FTT token that lays claim to something worth more is an opportunity for arbitrageurs to make a buck. Indeed, that seemed to be the role that Almeda was supposed to play in the FTX empire where they would be a fund to buy assets cheap when they presented themselves. However, Almeda seemed to have been the repository for FTT tokens to extract a lot of $1 from. Where did this money go? What happened to the cow?
The classic movie Dumb and Dumber is useful here where Jim Carrey and Jeff Daniels realise that there is $1m in a briefcase and go on a spending spree – ferraris, hotel suites in Aspen, fancy tailors – all accounted for with IOUs that they are ‘good for’. FTX’s IOU’s are just FTT tokens with an artificial value previously administered by FTX itself. Whereas Jim and Jeff’s spending spree is transparent in knowing where the money went, we are not so fortunate to know if FTX stole or lost the money in the markets. If it’s the former, then $9Billion is hard to hide. If it’s the latter then there are some traders on the opposite side of the ledger who are being very quiet. Most probably its a mix of both bad deals (paying a negative spread on yield farming ventures) and outfight theft.