I would be a “jerk” to suggest that the relationship of FTX (the crypto exchange) and Alameda, the hedge fund started and owned by FTX’s boss Sam Bankman-Fried had parallels with pension funds and the shadow banking system that provided them with leveraged LDI.

But hold that comparison in your head as you read the following analysis from the FT’s Robert Armstrong .

Sam Bankman-Fried

FTX: more questions than answers

From a Reuters story, published yesterday, about FTX and its chief executive

This May and June, Bankman-Fried’s trading firm, Alameda Research, suffered a series of losses from deals, according to three people familiar with its operations . . . Seeking to prop up Alameda, which held almost $15 billion in assets, Bankman-Fried transferred at least $4 billion in FTX funds, secured by assets including FTT and shares in trading platform Robinhood Markets Inc, the people said . . . A portion of these FTX funds were customer deposits, two of the people said

Here is the Wall Street Journal, also yesterday, on the same topic:

Crypto exchange FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm, Alameda Research . . . Chief Executive Sam Bankman-Fried said in investor meetings this week that Alameda owes FTX about $10 billion, people familiar with the matter said. FTX extended loans to Alameda using money that customers had deposited on the exchange for trading purposes . . . All in all, FTX had $16 billion in customer assets, the people said, so FTX lent more than half of its customer funds to its sister company Alameda.

I don’t know if it is legal for a person to transfer customer funds from their crypto exchange to their hedge fund, because I don’t know what a crypto exchange is, according to the laws of the Bahamas, the Cayman Islands, the Forest Moon of Endor or wherever the entities involved are domiciled.

Undoubtedly, though, such a transfer is wildly risky. It takes assets out of an institution that has on-demand liabilities and replaces them with an IOU. This raises the risk of a bank run. What is more, as the Reuters story has it, that IOU was largely collateralised by FTT, a token that the lender invented. That is insane in so many ways I don’t have space to lay them out here. Finally and obviously, such a transfer implies icy disregard for the exchange’s customers.

Bad stuff. But it does help to explain what is going on. FTX can’t meet customer withdrawals because it gave customer assets to Alameda and can’t get them back, at least not in a liquid enough form to be useful.

But this simple story is muddled by another account released yesterday. It came by Bankman-Fried himself, using Twitter. It contained two material claims. The first:

FTX International currently has a total market value of assets/collateral higher than client deposits (moves with prices!). But that’s different from liquidity for delivery — as you can tell from the state of withdrawals.

In other words FTX is solvent (in the limited sense of having enough assets to make its customers good eventually) but not liquid (in the sense of having enough easy-to-sell assets to make customers good soon). It just needs enough time to sell some assets that are hard to sell. And what mistake led to this liquidity problem? Not a huge transfer of assets to a hedge fund. Instead, FTX’s customers were much more levered than Bankman-Fried knew. That’s the second material claim:

. . . a poor internal labelling of bank-related accounts meant that I was substantially off on my sense of users’ margin. I thought it was way lower.

Users’ leverage was 1.7, not 0 as he had thought, Bankman-Fried said (this must be on some sort of net basis, because obviously lots of FTX clients had leverage, leverage is something FTX sells). So for every $1 in customer deposits, customers borrowed aggregate $1.70 from FTX. And the result was that there wasn’t enough liquidity left to meet the rush of withdrawals late last week.

But why would customers having leverage — owing FTX money, in short — cause a liquidity problem in the face of mass withdrawals? The only way I can think of is if the loans the exchange provided to customers were funded by loans from someone else, and that someone else wanted their money back at the same time customers did.

This could happen, but if it is what happened, Bankman-Fried’s mistake looks much dumber. He is suggesting he owed multibillion-dollar callable loans to a third party, and he didn’t know, even approximately, how big they were.

We still have more questions than answers. To wit:

• Can the news reports and the Bankman-Fried Twitter thread both be true? Yes, in a narrow sense. It could be that FTX is solvent and illiquid, and that customer leverage made meeting withdrawals trickier than it otherwise would have been, and that FTX lent billions in customer assets to Alameda. It’s just that FTX is a lot less solvent and liquid than it would have been if it hadn’t made that loan. Of course, if Bankman-Fried wrote that long thread about being more transparent and how sorry he is, and just decided not to mention that he also lent billions of dollars of client assets to his hedge fund in return for the worst imaginable collateral, then he is a jerk of world-historical proportions. But that is a different issue.
• Isn’t it odd that FTX says it is solvent (in the limited sense described above) but needs a whopping $8bn dollars of liquidity? You bet your ass it’s odd (and FTX may be bankrupt or bankrupt-ish already, according to Bloomberg).
• If FTX is solvent, why can’t it get someone to lend it the liquidity it needs? Maybe it can, and it will just take time. Perhaps the problem is that even though loaning FTX the money would be a smart financial move, no one with $8bn wants the reputational risk of dealing with Bankman-Fried, who, as noted, might be a major jerk. Also, lenders might not believe FTX’s books are accurate, given the history of, erm, poor internal labelling of bank-related accounts.
• Can Bankman-Fried’s suggestion that higher-than-thought customer leverage led to the liquidity crunch withstand scrutiny? Yes, but a much simpler explanation is available: that FTX didn’t have enough liquidity because it made a dumb and grossly immoral loan to Alameda.

There is a lot we still don’t know.

Yes, the comparison is unjust and awkward. But the same issues arise here as arose during the liquidity crisis over leveraged LDI and all that is missing at FTX is the white knight coming in to inject liquidity by buying up a lot of debt.

There will be a lot of retail customers who lose a lot of money, but a lot of institutional investors too

#FTX has a major Canadian pension fund as an investor. The Ontario Teachers’ Pension Plan declined to comment today on the turmoil at FTX. https://t.co/Y0MZdeM96w

— Josephine Cumbo (@JosephineCumbo) November 9, 2022

How much more of this stuff is backing up people’s retirement and just why is it a good idea to involve pensions in this shady world of secondary and tertiary banking?