FTX Bankruptcy Speculation: Liquidation Engine Like a 24/7 Money-Losing Machine, Reinvesting to Inflate Valuation
As a highly profitable exchange, even with excessive expansion, marketing, and market rescue efforts, FTX is not likely to have a nearly $10 billion fund shortfall. Where did the money go?
Researchers Westie from Blockworks and Doug Colkitt, founder of CrocSwap, analyzed and speculated on this matter. The former believes that FTX's liquidation engine is the main culprit for long-term losses, while the latter leans more towards FTX continuously investing money through Alameda in exchanges and DeFi liquidity to boost FTX's valuation and Solana project's market value.
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Where Did the Money Go?
Doug pointed out that in the 3AC case, they set up a large amount of leverage and went long, but lost money against market trends; Lehman Brothers died from bad loans; and in the Anlong Storm, they invested heavily in projects with no tangible returns.
It is apparent that some of FTX's assets were invested in low-quality and illiquid seed round investments, but Doug believes that this alone is far from enough to explain the huge funding gap.
Is Alameda Not So Strong After All?
In 2017 and 2018, Alameda was a giant in the market, but Doug speculated that Alameda was actually just an ordinary trader. At that time, the crypto market was small, and many people were not involved.
As the market will not always stay inefficient, with more professional institutions entering, Alameda's profits gradually reduced to zero.
Therefore, Alameda came up with a bold idea - since they couldn't make money through quantitative trading, they could use liquidity to build a cryptocurrency exchange, with Alameda continuing to act as a market maker and the liquidity moving to their own exchange.
Doug also pointed out, why should Alameda provide liquidity for other exchange owners to get richer? FTX was thus born.
FTX Growth Indicator = Liquidity = Valuation
At that time, the token "market price" was dominated by Binance, so Alameda's liquidity was being phased out. However, SBF ultimately transformed Alameda's trading strategies with negative expectations into the FTX exchange.
Doug believes this is not a big deal, as many companies also adopt loss-leading strategies for growth. Apart from being out of Alameda's control, their expected negative value is increasing, losing money in trades every day, but they are not a trading institution, so they can simply stop trading:
They can't get off the ride anymore, and FTX's valuation depends on Alameda's liquidity. And Alameda's liquidity is burning money.
FTX Liquidation Engine is the Biggest Problem
Westie pointed out that FTX has reported bad debt of nearly billions of dollars, while most of Alameda's strategies are neutral one-sided liquidity mining and low-risk long and short trades. Such trading strategies do not match the losses, leading to the conclusion that the FTX liquidation engine has been operating improperly for a long time.
FTX has been known for its powerful liquidation engine, which operates extremely complexly. However, in an explanation on the FTX Blog, it is easier to understand:
In cases where a large amount of liquidation is needed, for example, in a significant market downturn where long positions need to be liquidated, it may not be possible to rely on buy orders from the FTX order book for liquidation. In such situations, the liquidity provider system will be activated, internalizing the position, taking over the collateral, and hedging on other exchanges.
As shown in the figure below, in extreme market conditions with huge spreads, the liquidity provider system Backstop LP will take over Account A's position, and the resulting hedging costs and debts will be handled by the liquidity insurance fund.
Westie infers that "liquidity provider system" is Alameda, operating "liquidity insurance fund" is FTX.
Liquidation System Becomes a White Knight
Westie mentioned that the market has collapsed several times this year, including GBTC discounts, DeFi hacks, etc. If the liquidation of LUNA and UST has already hurt Alameda, then the massive liquidation of $600 million on 10/25 will definitely deal a heavy blow to them.
Previously reported, Binance's derivatives trading volume market share exceeded 50%, while FTX only had 8.8%. However, Coinglass data shows that FTX liquidated $618 million in 24 hours, which is 14 times more than Binance's $43.55 million liquidation.
Westie believes this reasonably explains why Alameda team members are completely unaware of the bankruptcy issue. If poor trading or DeFi strategies result in serious losses, the team should be aware of the details,
As of now, there are two speculations regarding FTX misappropriating a large amount of user funds leading to bankruptcy:
FTX Liquidation Engine: As speculated in this article, Alameda's long-term role as a liquidator has led to huge losses for FTX.
Excessive Use of Funds and Leverage: Insiders have pointed out that Alameda has received a large amount of loans in the past few months, but since the market crashed in Q2, lenders have begun to tighten liquidity, leading Alameda to start misappropriating FTX user funds.