A brokerage, in simple terms, is an entity where a customer can deposit their money and buy investment assets, in hopes to grow their money over time. Typically, a customer can open two types of accounts in a brokerage:
- Cash account: This account can exclusively buy and sell assets
- Margin account: This account can not only buy and sell assets, it can borrow against those assets. For example, you can deposit $10,000 USD and buy Apple stock. You can then use that Apple stock as collateral and borrow against it. Typically you could borrow up to a certain amount. For a stock like Apple, you could borrow up to 70% of the value of the stock, so in our example, you could borrow up to $7,000 USD, which you could use to buy whatever you want. However, there is a caveat: if Apple stock falls 50%, you would be faced with a margin call: Your account balance is $5,000 USD in Apple stock, but you borrowed $7,000. When this happens the brokerage will call you and ask you to deposit $5,000 USD in collateral so your account is covered. If you don’t have the money, the brokerage has the right to sell your remaining Apple stock to cover your bad debt. However in our example, there is a shortfall of $2,000 USD ($5,000 from the sale of Apple stock - $7,000 loan you took). In that case the brokerage will try to get that $2,000 from you through legal means, but that would cost money and time and they might not be able to recover it. What would happen is that the brokerage would then realize a loss of $2,000 against their capital.
- Charging commissions on trading. You buy $10,000 worth of Apple stock? That trade costs you $10.
- Charging a fee on your account. You have $10,000 in your account. The brokerage charges an 1% annual fee for holding your assets, but your trades are free. So if your account balance stays at $10,000 for a year, you would pay $100 for having your assets in there.
- They charge for making a market in an asset. In simple terms, they sell the asset to you at a price slightly higher than the purchase price in the open market, or buy the asset from you at a lower price than the sale price in the open market. The best example of this model for making money are currency exchange houses.
- Lending. They will lend cash and other assets to margin accounts, and charge an interest fee to the customer that borrows. Like I explained in our Apple example above, this adds considerable risk to the business model, so brokerages that engage in margin lending must have robust risk management processes to ensure that there are no shortfalls in the customers accounts. No brokerage wants to be constantly calling their customers asking for more money. Furthermore, a brokerage must have capital on hand to be able to lend to their customers and to be able to absorb shortfalls. A Brokerage (in most countries) is not allowed to lend customer funds out, unlike a bank. It must hold all customer deposits 1:1. This means that if you deposited $10,000 USD, it must always hold that $10,000 USD. If you deposited 10 Bitcoin it must hold that 10 Bitcoin at all times.
FTX was a crypto exchange and brokerage, with a slick trading platform. FTX’s founder and CEO was Sam Bankman-Fried (SBF). What separated FTX from the rest of the firms that offered similar services was how fast and efficient their platform was, how liquid their market making business was (This means, in simple terms, that FTX was one of the best places to buy and sell cryptocurrencies. It was fast and the prices they offered where some of the best), and their margin lending business. At FTX, you were allowed to deposit cash or cryptocurrencies, then borrow against them. Their systems were so advanced when it came to risk management that the sale of collateral when margin was breached was automatic, no need to call the customer asking for cash to cover.
Enter Alameda Research
Alameda was an investment firm founded by SBF prior to his founding of FTX. Alameda invested in cryptocurrencies and its strategies were considered wildly successful in the crypto space. As a fund it only managed investments of its employees and a few early backers. SBF was the CEO of Alameda before becoming the CEO of FTX. Alameda was a major client of FTX.
Enter FTT Token
FTT is a cryptocurrency created by FTX as a rewards system for its customers. You were rewarded FTT tokens for trading in FTX (Although you could also just buy the tokens in the open market). Having FTT in your FTX account allowed you to have discounts on trading fees, and FTX allowed you to borrow up to 95% of the value of your FTT tokens in your account. How did the FTT token maintain its value? FTX would use some of its trading profits to buy back FTT in the open market and destroy the tokens. This would theoretically mean that FTT would increase in value the more trading profits FTX generated. FTT token holders theoretically had a partial claim to the future profits of FTX, similar to a stock.
So, how does this all lead to the implosion of FTX?
It is assumed that, like many other crypto investment and trading firms, Alameda Research incurred significant losses in their portfolio during the crypto downturn of this year. Alameda traded and invested using loans, and at one point their losses became so big that their lenders asked for their money back, which Alameda did not have. For reasons still unknown to the crypto space, SBF made a decision to bail out Alameda. Now allegedly the hole was so big that SBF’s own money or even FTX’s own capital was not enough to cover these losses (It is assumed that the losses at Alameda could have been over $10 billion USD), so SBF decided to use FTX’s customer funds to bail out Alameda.
Now, how can SBF do this without raising any flags? Transferring billions of dollars in assets from FTX to Alameda would have raised all of the red flags, and it would have leaked to the crypto market fairly quickly. SBF knew that he had to keep this hidden from the majority of the FTX organization.
by Jorge I Velez, Learning Decision Theory and its Applications (Substack) | Read more:
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See also: What happened at Alameda Research (Milky Eggs):If you want to read a poorly researched fluff piece about Sam Bankman-Fried, feel free to go to the New York Times (PDF). If you want to understand what happened at Alameda Research and how Sam Bankman-Fried (SBF), Sam Trabucco, and Caroline Ellison incinerated over $20 billion dollars of fund profits and FTX user deposits, read this article. (...)
To be clear, we still don’t have a perfect understanding of what exactly happened at Alameda Research and FTX. However, at this point, I feel that we have enough information to get a grasp on the broad strokes. Through a combination of Twitter users’ investigations, forum anecdotes, and official news releases, the history of these two intertwined companies becomes progressively less hazy, slowly coalescing into something resembling a consistent narrative.
Of course, without witness testimonies and a full financial investigation, our claims only remain tentative at best. Any given piece of information may be flawed or even fabricated. However, if they are assembled together and put in context, they together lend credence to the following timeline:
- SBF, Trabucco, and Caroline were (probably) initially well-intentioned but not especially competent at running a trading firm
- Alameda Research made large amounts of book profits via leveraged longs and illiquid equity deals in the 2020-2021 bull market
- Although Alameda was likely initially profitable as a market maker, their edge eventually degraded and their systems became unprofitable
- Despite success with some discretionary positions, on net, Alameda & FTX jointly continued to lose large amounts of money and liquid cash throughout 2021-2022 as a result of excessive discretionary spending, illiquid venture investments, uncompetitive market-making strategies, risky lending practices, lackluster internal accounting, and general deficiencies in overall organizational ability
- When loans were recalled in early 2022, an emergency decision was made to use FTX users’ deposits to repay creditors
- This repayment spurred on increasingly erratic behavior and unprofitable gambling, eventually resulting in total insolvency
