Insight
November 10, 2022
Today, as a preamble to NYDIG Head of Research Greg Cipolaro’s outstanding analysis (below) of the predictable events that transpired over the past few days, we are re-sending my co-authored piece on the ethical, moral, intellectual, economic, and financial bankruptcy of non-Bitcoin crypto and DeFi: On Impossible Things Before Breakfast, written six months ago.1 I will start with the conclusion: my piece failed. Nothing has changed. DeFi-driven blowups have continued. Therefore, in the strongest possible terms, I repeat, with humility: do not invest in non-Bitcoin crypto. Do not invest in non-Bitcoin DeFi. This is why NYDIG is a bitcoin company. Always has been, always will be.
Over the last few years, we have had the “opportunity” to “partner” with Three Arrows, BlockFi, Celsius, FTX, and more. However, at Stone Ridge/NYDIG – far from a mistake-free firm comprised of mistake-free people, including and especially me – we seek to think from first principles. When you cannot satisfy yourself with straightforward answers to straightforward questions such as, “how do you make money?”, or “why are you positive the GBTC-arb will always be positive and what happens to your business if you’re wrong?”, or “why do you think it’s appropriate for us to lend you money with less collateral than what’s required for US Treasury repo or with no collateral or all?”, or “why do some of your external investments come from one entity and other investments come from another?”, run, do not walk, away.
In addition, we have had countless “opportunities” to “invest” in “crypto yield” projects that were momentarily enormously profitable, yet so obviously destined to blowup and so obviously violations of US securities laws. Hard pass.
Life is too short to do anything other than partner with people you like, trust, and would be ferociously proud to be together with in a foxhole when the bullets are flying.
At Stone Ridge/NYDIG, our most important job is risk management – the safety of our clients’ wealth and our own. Every single one of us works in risk management. Whether or not we choose a career in risk management, it chooses us.
Earlier in my career, I learned risk management lessons the (very) hard way. I had far too much confidence in my quantitative and my mental models, and the results were disastrous. Those times of my life were the most painful, but also the luckiest. I never would have learned any real risk management lessons from a book.
As an aside, I also learned I was married to the right woman. After one particularly bad risk (mis)management result about 25 years ago, we could no longer afford our apartment and had to move out ASAP. As a man and as a provider, and the sole source of income in the family, I felt devastated, emasculated, and worried what my wife would think of me. I’ll never forget what happened next: she came home the following day, having viewed 15 tiny studios, found the perfect one, and moved us in with a smile. The ensuing two years of life in that tiny room were among our happiest together.
Right now, the markets are melting down. The causes are myriad and not for this note. Rather, I want to make you aware of what to expect and give you an assignment if you work at Stone Ridge/NYDIG and make a request if you do not.
In times like these, character emerges. Unfortunately, for so many it won’t be pretty. They will desperately cling to ephemeral notions of their (past) status, and lash out in various ways. As a form of psychological self-protection, you will see people be arrogant, aggressive, short tempered, and pinball from topic to topic. Their actions will create and exacerbate their own fragility.
Professionally, it will be very easy to take financial advantage of these people. If you work at Stone Ridge/NYDIG, you are forbidden from doing so. If you do not work at Stone Ridge/NYDIG, please, please, please do not.
Instead, your job right now is to be three very specific things: focused, humble, and kind. Do these with vigor and create and fortify our/your firm’s antifragility. Today, reach out to someone hurting from the markets and just check in. Your goal is not “give to get”, rather just give. Expect nothing in return. Just give.
Because of my painful risk management past, at Stone Ridge Holdings Group (parent company of our five subsidiaries, including NYDIG) I always raised money for our firm when we didn’t have to. 2016, 2018, 2020, 2022. And we still have all of it. That’s survival lesson #1 and so important it’s worth repeating: RAISE MONEY WHEN YOU DO NOT HAVE TO.
As a result, the snow in our snow globe is unstirred. Not only are we extraordinarily liquid and extraordinarily well capitalized, Stone Ridge Holdings Group is having a record year and 2023 is setting up to blow away 2022. Our team is proud of the incredible forward opportunity we have created together for our clients.
How did this happen? Since 2012, we’ve been building our portfolio of business arks ahead of the central bank-driven no-yield flood. Having recklessly submerged the world in fiat fragility, the levees are breaking as yields now rise. The embodiment of our risk management philosophy, and flood preparation, is the 10/10 (“ten ten”) portfolio in Stone Ridge Asset Management. Ten long-term allocations, each 10% weight, each with a persistent, pervasive, and intuitive risk premium, each uncorrelated with traditional markets, each uncorrelated with each other, each anti-fad. We’ve built each of these franchises starting small, brick by brick, and none have been easy or obvious along the way: catastrophe reinsurance, non-catastrophe reinsurance, alternative lending, market insurance, single family rentals, drug royalties, bitcoin, art, natural gas. Nine so far. We’re getting there.
At our opponent’s slight move, the 10/10 moves first, a portfolio of business arks already in place. It’s extraordinary diversification harmonizing with its quiet humility, structurally anticipating the un-anticipatable, keeping our snow unstirred. To be clear, the snow will return for us someday. And when that happens our arms will remain locked together in mutual support, as they are right now.
Amidst attention-grabbing headlines this week that will be talked about for decades, I want to bring your attention to one far more profound and awe-inspiring non-headline: every 10 minutes a new bitcoin block was produced. Every 10 minutes. Every 10 minutes. Bitcoin cares about SBF or CZ or me or you as much as gravity does. Or the honey badger.
While Stone Ridge is just one small firm and we can only do so much, it has always been our mission to help the vulnerable and the unprepared. This includes our own decision to opt-out of the intrinsic corruption of the fiat monetary system. It also includes our relentless drive, every day, to accelerate access for all 8 billion of us to decentralized, non-state money – bitcoin – powering personal sovereignty, fostering political freedom, enhancing human flourishing. At Stone Ridge, we innovate to prepare for an uncertain future, focused on our mission: Financial Security for All.
Ross L. Stevens
Founder & CEO, Stone Ridge Holdings Group
Founder & Executive Chairman, NYDIG
Greg Cipolaro, Global Head of Research at NYDIG
This week, in a stunning turn of events, FTX, the upstart exchange that was the product of crypto wunderkind Sam Bankman-Fried (SBF), suffered financial setbacks that caused systematic risk to ripple through the industry. The news, which shocked even the most astute crypto observers, came only days after a CoinDesk article outlined Alameda Research’s balance sheet, a prop trading firm founded by SBF with close ties to FTX. It is important to note that this news story is still in motion and our understanding of the situation relies on the combination of public disclosures, media reports, blockchain data, and exchange analysis. While we can only infer what happened behind the scenes, the reality of the situation is likely known to a small number of people, and it is unknown when we will get a full and truthful accounting of the situation, if ever.
Late last Friday morning, Ian Allison at CoinDesk published an article detailing Alameda Research’s balance sheet. The trading firm, also founded by SBF, has been noted for its trading prowess as well as its VC investments and support for Solana (SOL) and its ecosystem. The CoinDesk article highlighted the perhaps-too-close relationship between Alameda and FTX, something that was frequently suspected in the crypto industry. The heavy concentration in FTT also cast doubt on Alameda’s financial position. While all the details of the balance sheet weren’t disclosed, we have done our best to recreate the balance sheet from the details disclosed in the article, also noting that it is now over 4 months old. Our calculations show that at the time Alameda was not heavily indebted on a debt-to-equity basis, but $5.8B of its assets, nearly 90% of its equity value, were tied to its ownership of FTT. Alameda CEO Caroline Ellison tweeted that the details outlined by CoinDesk were just for one of their corporate entities and did not account for >$10B of assets held elsewhere. It is unclear to us what or where those assets are, but given the swiftness of Alameda’s and FTX’s collapses, perhaps those assets were inaccessible for liquidity reasons.
Like many tokens issued by exchanges (the largest of which is Binance’s BNB), FTT can be posted as collateral for trading services, unlock discount trading fees for holders of a certain size, and capture revenue from FTX’s trading fees through a burn mechanism. But it is important to understand, the value of FTT is entirely based on its issuer, FTX. The fact that Alameda owned 73% of the supply of FTT (based on our best guess at total supply) at the time shows how closely tied Alameda and FTX were.
SBF and his cadre of companies were well known as being supporters of Solana (SOL) and its ecosystem. It is no surprise then that Alameda owned a large position in SOL, though the position was smaller in size both in terms of dollars and in terms of the outstanding supply of SOL compared to its FTT position. Given the connection to SBF and sell pressure on SOL, SOL’s precipitous drop of over 60% since Friday has not been surprising.
Following the balance sheet leak, on Sunday morning, Changpeng Zhao (CZ), Binance’s founder and CEO, posted a tweet that would eventually result in the downfall of FTT, and with it, FTX and Alameda. The tweet said that Binance owned $2.1B worth of FTT and Binance USD (BUSD) in connection with an early investment in FTX and that it would be liquidating that position. Before the tweet, FTT had been trading at about $24 but dropped sharply to $21.50 on the news before recovering to $23.
In one of the more distressing communications of the entire episode (in addition to SBF’s now-deleted tweets that everything at FTX was fine), Alameda CEO Caroline Ellison responded 15 minutes later to CZ’s tweet, offering to buy his entire FTT position out at $22. But it seems as if CZ had already made up his mind, having already transferred 23M FTT tokens to Binance for sale even before he tweeted his intention to sell. CZ would take to social media a few hours later and clarify the move with FTT as part of their risk management process and a reflection of their experience with the LUNA fiasco. Binance was an early investor in LUNA and owned the token from its highs to its demise without selling. Binance didn’t intend to make the same mistake with FTT.
Within CZ’s text were some words that stoked concerns about Binance’s true motivations. “But we won't support people who lobby against other industry players behind their backs,” which made the move to sell FTT seem like this was a bomb lobbed at a competitor rather than risk management. Outsiders can only speculate what has been going on behind closed doors, but based on this text, it seems like Binance was unhappy about how it was being portrayed to regulators or legislators by FTX.
Even amidst a potential wave of market sales coming from Binance, the price of FTT had held above the $22 level through Sunday and into Monday evening. Perhaps, until then, Alameda had been standing on the bid side, making good on its offer to buy FTT at $22. But clearly at about 9:30 PM ET Monday evening, something changed and the price of FTT began to fall rapidly. Given the size of FTT ($3B in free float market cap, much of which was already owned by Alameda) in comparison to Alameda’s supposed balance sheet (+$24B), it is a surprise that the prop firm could not buy the entire supply of FTT trading. How such a small asset took down such a supposedly large enterprise remains one of the many mysteries of this event.
Several hours later, at about 3 AM ET on Tuesday morning, FTX’s wallet address began to dramatically slow withdrawals according to blockchain data. Reports began to trickle in from social media shortly after that regarding the halting of withdrawals. According to tweets from SBF after the fact, FTX processed $5B worth of withdrawals beginning on Sunday. It appears as though the balance sheet scare at Alameda resulted in a “run on the bank” at FTX and it was unable to satisfy client demands.
On Tuesday morning, FTX appeared to find the white knight it severely needed, although it would come in a form that no one expected: Binance. The non-binding deal was still subject to Binance’s due diligence, as it appears to have been consummated via a phone call and little else. Still, despite the news, the price of FTT began to free fall, from nearly $20 following the news of the acquisition, to $3 by mid-afternoon. It seems as if investors either didn’t trust the deal to close or didn’t know how FTT would be treated in the event of the acquisition. By Wednesday afternoon, the deal crumbled as Binance announced that it would not pursue a potential acquisition of FTX. Reports in the media suggested that FTX was searching to raise $8B in capital from new investors to replenish customer funds. If it were unable to do so, it might file for bankruptcy, concluding one of the swiftest and darkest moments in crypto’s history.
From the information available, it is unclear what specifically caused the catastrophic collapse of FTX in such a short period. The proximate cause was the $6B in redemptions requested by depositors in 72 hours, but the fact that FTX couldn’t redeem depositors in full indicates they had done something else with customer deposits. According to a recent Reuters article, $4B of customer deposits were lent out to Alameda following losses sustained in the market volatility of 2Q. The collateral posted by Alameda for borrowing in part consisted of FTT tokens, which evaporated in value, meaning FTX could’ve taken significant losses on its loans to Alameda. Making matters worse, if FTX called the FTT tokens posted as collateral by Alameda and sold them in the market to close out its loan, it would further push down the price of FTT, exactly what it did not want. This series of events highlights precisely why you need exogenous capital, an error that echoes from the LUNA/UST fiasco a few months back. A system is vulnerable to a circular reference death spiral like this one when the capital base is entirely reliant on the system itself.
The industry is presently in a state of high alert. Like in the aftermath of the LUNA/UST collapse, investors were keenly attuned to other counterparty risks that may arise because of the collapse of FTX. Galaxy Digital ($77M), CoinShares ($30M), Coinbase ($15M), Genesis Trading ($7M), and Multicoin (10% of its Master Fund) all have disclosed exposure to Alameda or FTX. It appears that Genesis had credit exposure to Alameda, while the other entities had trading balances stuck in the FTX exchange. It is unknown who else might be affected because of this washout, but it might just be narrowly contained to FTX, individuals and institutions with deposits on FTX, Alameda, and whoever else lent money to Alameda. One of the unfortunate knock-on effects may be that the lifelines extended to BlockFi by FTX and Voyager by Alameda may be in trouble, although we have heard no updates. We can confirm that NYDIG has no exposure, and has never had any exposure, to Alameda, FTX, or Binance.
Certainly, the industry is amidst some soul-searching. The fact that two well-known entities have collapsed in a matter of days has left many shocked and searching for answers. Anecdotally, the frustration with business practices across the industry, the rapid fall from grace from the industry’s wunderkind, and the financial losses sustained have been a lot for people to bear. While we may indeed find other institutions or investors that were affected by the fallout from the collapse of Alameda and FTX in the coming days, it is unlikely that the industry immediately snaps back from this event. It will likely take several months of price consolidation, business practice adjustment, and perhaps new regulations before investors are comfortable dipping their toes in the crypto waters again. We do think the long-term benefits of the technology have not changed, but in an unfortunate ironic twist, the technology designed to eliminate the need for financial intermediaries continues to be adversely affected by the operations of poorly operated financial intermediaries. We hope that the industry learns from these mistakes and builds a safer environment for all participants.
Sincerely,
The NYDIG Team
1 For a more complete treatment of this subject, I refer you to the masterpiece by Allen Farrington and Anders Larson, Only the Strong Survive.
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