The “Sam Procedure”
The rise and fall of Sam Bankman-Fried and what it meant for crypto
Boy-oh-boy have we been caught by surprise with the whole FTX saga. My latest letter was labelled “Same Procedure as Last Year, James” (tribute to the old short movie “Dinner for One”) as symbolism for the fact that everything was moving sideways in mini-cycles.
After the entire fallout of the FTX saga, I realise that letter had included one letter to much and should have been titled “The Sam Procedure” instead.
Note: I have written quite the lengthy walk-through of what happened with FTX, which is still a good read if you’re not fully up to speed with what happened.
In this letter we’ll focus on how FTX and Alameda Research rose to the sky, and how everything tumbled to the ground. A procedure, we call “The Sam Procedure”.
The Sam Procedure
Start a Hedge Fund
Our protagonist Sam Bankman-Fried's journey to become a crypto rockstar started back in November 2018 with the establishment of a small hedge fund named Alameda Research. Alameda Research did like any hedge fund everything in their power to attract capital and went as far to approach initial potential investors with an aggressive term sheet promising "HIGH RETURNS WITH NO RISK". The product was a market neutral product with an annualised fixed rate and a yearly return of 15%.
This initial ‘lucrative’ offer went unnoticed by most crypto natives but founder of the now bankrupt hedge fund 3 Arrows Capital, Zu Shu, actually went to comment on it on Twitter.
Launch a Crypto Exchange
Barely a year into the business, Sam Bankman-Fried (SBF) would proceed to launch FTX exchange in July 2019. The seed round was quite a success, attracting $8 million from several funds. However, in one investor’s memo, SBF’s commitment to both entities was for the first time put to question:
How would Sam and the team dedicate time to grow both entities?
Is Alameda and its market making on FTX a risk?
According to inside sources, FTX was actually launched to assist Alameda Research in its attempt to raise significant capital as things were moving slower than the team wanted. This is where the shenanigans seemingly began, and where the lines between the two entities started to get blurry.
Window Dress the AUM of the Hedge Fund
The DeFi summer of 2020 was the spring moment for FTX and Alameda Research, where the team figured out that the illiquid tokens that were being issued on the market could be manipulated to prop up the assets under management numbers (AUM) of the hedge fund.
Because if there is anything that works in ability to attract capital, it is the attraction of capital!
Following what we know now from the entire saga, it seems evident that the user deposits made on FTX were made available for Alameda Research so the funds could be utilised as risk capital to generate returns. At what point in time this happened and to what degree is still unclear but what we do know is that Alameda Research at some point pivoted away from its market neutral strategies to directional strategies. Perhaps because the market edge evaporated or maybe because the larger AUM levels the fund reached meant that it was no longer possible to utilise meaningful capital in its strategies.
Media outlets are currently very concerned about how this all blew to pieces, and while that is of course true, we must not forget how well this machine worked, when it worked!
Sam had created a money making machine. The insane increase in customer inflow on the FTX platform greatly increased the AUM of Alameda Research meanwhile FTX on its own were also generating tons in trading commissions. Alameda Research was at the same time attracting enormous investor commitments.
All of this happening in a market that was expanding with exploding valuations. Almost too good to be true!
Sam Bankman-Fried went from being more or less unknown to the crypto world to being the wealthiest individual in crypto in a mere 2.5 years!
The Downturn and Collapse
If there’s anything history in crypto teaches you, it is how violent market conditions can be and how quickly they can turn. This is of course very great when you are investing directionally and the markets are giving you back wind. The bankruptcy filings show that Alameda and FTX made a wealth of strategic investments in both venture and direct crypto exposure. Most of these investments were hugely profitable.
However, as the general markets started to tumble, the winds of crypto followed suit and turned around in a violent fashion with severe contractions in valuations across the board. The situation for crypto only got worse as massive blow-ups such as Celsius and Luna got completely eradicated. In fact, LUNA, CEL, and UST alone represented a total of more than $57B around its top valuations in April 2022.
Other known blow ups from the time include the hedge fund 3 Arrow Capital which at its peak had an AUM of more than $18B. 3AC filed for bankruptcy shortly after the Luna meltdown and many other companies struggled to stay afloat following the massive contagion in crypto.
We still don’t have the full answers in full, but in this market situation, it is very likely that Alameda Research faced heavy losses. How much those losses amounted to and if Alameda Research on paper were actually facing the same difficulties at 3AC is also not clear. Regardless, we can safely assume that Alameda Research company was in massive distress.
With the incestral overlap of shareholders and leadership between FTX and Alameda Research, we don’t have to look long for a good motivation to keep Alameda Research afloat. But to strengthen the strong incentive, Alameda Research was also the biggest holder of FTT, FTX’s native token. A position, which in case Alameda Research would face insolvency would be sold on the market.
So with the intense stress Alameda Research was in, we can assume that FTX resorted to the only thing it could to salvage the hedge fund: by lending it significant capital (+$4B, and most likely much much more!).
Problem was that FTX reserves probably did not cover the whole lot, why customer funds were also being lent in the process to Alameda Research secured by the companies large holding in… FTT.
This relationship would essentially mean that if the value of FTT would fall, so would the collateral of Alameda Research, which would bring the company in risk of defaulting on its loans from FTX.
Note: Some observers of the whole event actually speculated that some of the bailouts FTX later made (Voyager, et. al,) were strategically targeted towards big FTT holders not to risk them being sold on the market in case of liquidation.
The whole crypto industry has taken a beating and contracted by ~$200B representing around 20% value loss for the entire market capitalisation. The sentiment among market participants are decidedly negative, and even though valuations following many indicators are at “fair value” or even “cheap”, the bargain hunters are refraining from stepping in too quickly at the risk of continued contagion in the markets.
Contagion Spreads in the Industry
According to a November 15 story by the Wall Street Journal, cryptocurrency lender BlockFi Inc. is preparing to file for bankruptcy after suspending withdrawals of customer deposits and admitting it has "substantial exposure" to collapsed exchange FTX.
On Monday, Liquid crypto exchange, reported that it has suspended both fiat and cryptocurrency withdrawals in order to comply with regulations related to the ongoing FTX Chapter 11 bankruptcy filings.
Ikigai’s founder and CIO Travis Kling also tweeted on November 14 that a majority of the total assets under management are stuck on FTX. He was particularly keen to note that it is still uncertain what will happen next, other than Ikigai will continue to trade the remaining assets until they can reach a decision whether the fund will keep going or move into winddown mode at some point.
Obviously there is a lot of wrongdoing involved here and even though the full picture is not fully there yet, it is clear the FTX has not been playing fully by the rules. This is an issue for the industry as exchanges and especially the dominant ones bear big responsibility in this industry. Remember what Peter Parker’s uncle always said? “With big powers come big responsibilities”, and while SBF and FTX have certainly not lived up to theirs, we must try and learn from their mistakes and so we can start healing the industry.
Crypto Exchanges are the Achilles Heel
Those of us who have been around long enough know that the “not your keys, not your coins” is more than a mantra hurled about in the crypto industry. The saying is an actual fact. For those not around in this industry back in 2013, I remember watching Mt.Gox go down, and only by sheer luck did I survive that event moving my bitcoins of that exchange one week before it went down.
That experience has never left me and is one I have carried with my as I have been operating in this space since then. Hopefully, many of the people influenced by the FTX saga will now carry that memory with them and be more careful in the future. Because while the exchanges ultimately carry the responsibility, it is the responsibility of us users to demand transparency, security, protection and oversight.
This Industry Needed a Wakeup Call
The famous stock market idiom “no tree grows to the sky” continues to be true, even if we have to experience it over and over again in the markets. In mid 2021, it seemed like the crypto rally would never end, and it is in those moments that we need to hold on to our common sense.
Common sense that will tell us to invest only in quality. Common sense to not take bigger positions in anything than we can afford to lose. Common sense to not overexpose ourselves to any one entity or project.