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naraburns  nihil supernum  1yr ago (text post)   34959 thread views

Culture War Roundup for the week of November 28, 2022

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I have a lot of sympathy (or maybe pity) for SBF. "Stole client funds" appears to have solidified as a meme much the same way "crossed state lines" had in the Rittenhouse case.

I think it's hard for people, including technologists who haven't worked as quants, to appreciate the level of technology risk that's present in quant trading. In most of tech your biggest risk is having all of your data destroyed, and you can address that with well worn improvements in backups. You also risk being hacked but those breaches tend to be embarrassing rather than company ending. Even Sony, which was pwned as hard as you could possibly be pwned, ultimately recovered. But an additional risk in quant trading is accidentally and irrecoverably giving all of your assets away in a few seconds.

Even companies that are following all of the rules and have the right number of members of the professional management class in their ranks can destroy themselves in a matter of minutes. Knight Capital Group destroyed itself in 30 minutes by (with some creative license) failing to follow heroic practices around retiring old flags in protobufs.

Alameda/FTX had a culture that resembled "move fast and break things". They grew extremely quickly. I'm highly skeptical they were able to stand up robust accounting and practices to mitigate technology risks in so short a time.

When SBF says he didn't realize they were leveraged due to accounting error, I believe him. It's not like you can just install the QuickBooks Enterprise Crypto Derivatives Exchange plugin. All of this stuff was bespoke, and in a hurry.

When you thought you had $30b in assets and minimal liabilities, you can spend a billion or two on indulgences, charitable giving and campaign contributions. Your can say confidently you're not investing client funds. If those assets are suddenly marked down 90% you look like a fraud and you're in deep shit.

That's the nature of the business and he knew the risks. But probably in hindsight I'm sure he wishes he had been even more careful.

This isn't to say that I believe he definitely didn't commit fraud. Rather this is me saying that as someone who has pushed code that I thought accidentally gave away $10 million of my employer's money (the gigantic exhale of relief came when we learned I failed to scale by 1000x in the reporting and not the ordering), I am defaulting to blaming it on stupidity before malice.

So, I also have worked in HFT Finance and am currently director of Operations for a (fully CFTC regulated) BTC futures/options exchange. I completely sympathize with losing scads of money in seconds ( my biggest hit was $70k because I misread a settlement value) and I was working the day Knight Capital imploded (I had met the VP a week earlier at a CME training session!).

Anyway, I guess my point is that there's some serious differences between running a trading firm and running an exchange and as stated below, the security of your customers' accounts is paramount, possibly more important that the actual functioning of the exchange. This is why US exchanges are required to use 3rd party clearing houses and a variety of other services to ensure the proper handling of margin, reserves, fees, open interest and settlements. We have industry wide annual disaster recovery tests, risk control evaluations and hundreds of other hoops to jump through.

I think this was a huge hit to the credibility of all things Crypto but if there's a silver lining, it's that companies like mine, who take the extra few years to not only align with CFTC regulations, but help to inform how they can be improved, will ultimately be preferred over foreign companies that lack these controls--if BTC can maintain it's value. I don't want to seem like a CFTC fanboy, but regardless of the extent to which you think they make good decisions ,their mere existence creates some sense of normalcy and safety and provides a history of precedent that is mostly transparent. (I'm not sure I'd say the same about the SEC, fwiw).

Of course the big question is what is all this stuff and what's it worth and is the value of Bitcoin actually reduced because of US government controls. I'm not sure and always wonder about what the future of this stuff will be but I feel confident in saying some sort of digital blockchain currency will perpetuate into the future.

As for SBF, it seems like there's a lot reasons to be upset with the dude and his team. They really screwed up (or maybe they pulled a fast one, I dunno). To me, this whole episode seems to be more reflective of the un-serious direction our civilization has taken where we consistently fall for the hype and never seem to do the boring research. We hand billions of dollars to kids because we feel they've been vetted by some university or other pedigree. I've spent a life surrounded by grad students and high IQ scientists, doctors and lawyers and can say emphatically: smart people are some of the dumbest people I know.

They really screwed up (or maybe they pulled a fast one, I dunno).

I think, with regard to what you say about regulation, that this was the space they were trying to exploit. Looking for unregulated markets to get that edge, with of course the attendant risk, and they couldn't keep up the promise of "we will make gazillions" because the exploit holes were getting plugged one after another, so Bankman-Fried had to take bigger and bigger risks to keep the appearance going of "this guy is a whiz who knows how to make a fortune overnight". His One Weird Trick with Alameda, exploiting the difference in the price of bitcoin between Asia and the rest of the world, only worked - and could only work - once. After that, to make the same kind of returns as fast, he tried setting up FTX

In 2017, when he was merely 25, SBF collapsed the so-called kimchi premium, an anomalous delta between the price of Bitcoin in much of Asia and its price in the rest of the world. It was a daring feat of arbitrage—SBF is the only trader known to have pulled this off in any meaningful way—one which quickly made him a billionaire and achieved the status of legend.

Because of the existence of regulations, he could only pull it off once:

SBF decided to create some accounts on different exchanges and see if he could execute the trade. He couldn’t. But, interestingly, it wasn’t because the arbitrage opportunity wasn’t there—it was. But there was so much red tape with the banking system and currency controls that it was a difficult trade to execute.

Another day of work dealing with the red-tape problem netted SBF a single round-trip trade—to Asia and back—for a $20 profit. That was it: the proof of concept. There was an opportunity to be had. SBF immediately put $50,000 of his own money to work. The first job was just getting the money into the system. The operational challenges were huge. Not just anyone can walk into a foreign bank and start wiring money out of the country every day. There are know-your-customer rules, caps on withdrawals, citizenship requirements. Even worse, to any normal bank, the constant zeroing out, then maxing out, of a cash account—with the money coming and going overseas, to and from fly-by-night Bitcoin exchanges—raised every red flag in the book. It looked like laundering. It looked like drug money. There were even monetary policy concerns: The liquidity of the South Korean won is sharply limited by the country’s central bank.

So in hindsight, the system was working as it should work, except that there was a loophole. He found the loophole, but eventually it was filled in.

With a goosed-up capital account, the money started piling up so fast that SBF placed what he refers to as “a market order for employees” to tend to the Rube Goldberg operation that kept the capital spinning. There were constant blowups with banks, which are wary of anything crypto. Crypto was so new that regulators in South Korea and elsewhere were constantly changing their mind about regulations—then making those changes retroactive. It was a swirling mess.

And that's when he seems to have decided to go for the dodgy (sorry, "risk-neutral") side:

The Bitcoin arbitrage didn’t—and couldn’t—last forever. The Japanese appetite for overpriced Bitcoin withered (or, more likely, another shadowy arbitrage outfit also found its way to the trade and collapsed it). Either way, the spread narrowed to almost nothing. But there were other trades to be had. The simple fact that crypto was new, and that the tools traders needed to handle it were still under construction, meant that there were market inefficiencies all over the place. And behind every market inefficiency is an arbitrage opportunity.

The biggest headache for Alameda wasn’t finding the opportunities, but executing the trades. At that time, when it came to crypto exchanges, the choice basically boiled down to Coinbase or Binance. Coinbase makes a point of being regulated by authorities in the U.S., but as a consequence, didn’t offer the kinds of options contracts and derivatives professional traders need to hedge their bets. Binance, on the other hand, offered the kinds of derivatives SBF was familiar with when he traded for Jane Street—but as a company, it was continually moving from country to country in an attempt to evade all jurisdictional authority. Neither exchange was particularly good to trade on.

“Everything was rickety—there was no avoiding the ricketiness. Obviously, the line between rickety and shady is a little unclear at times, but the places that seemed like they were going to steal customer funds outright, we didn’t touch,” Singh says. “Even the best players in the space were having big problems.”

At this point, mid-2019, SBF decided to double down again—and scratch his own itch. He would bet Alameda’s multimillion-dollar trading profits on a new venture: a trading exchange called FTX. It would combine Coinbase’s stolid, regulation-loving approach with the kinds of derivatives being offered by Binance and others.

Looking back with hindsight, the warning signs were already showing up, but everyone was so ready to believe in golden geese and magic beans when it came to producing huge fortunes out of thin air that they ignored them:

The problem, as Bailhe saw it, was that FTX didn’t appear to need any money. She was correct, but what she didn’t know was that SBF was starting to think about raising money anyway. Alameda had some unexpected losses due to so-called counterparty risk. Arbitrage is, in theory, riskless. But not when the rickety exchange you’re using to place your trades suddenly locks up and refuses to disburse your money. Or, worse yet, when two crypto exchanges can’t even agree on what a crypto transfer looks like, and so the act of sending crypto from one exchange to another results in tokens just disappearing into the ether. And don’t even ask about futures contracts that see their terms unilaterally changed mid-agreement: the dreaded “clawbacks.” Alameda was not immune to the exchange-level shenanigans that gave crypto as a whole its sleazy reputation. But FTX had an ambition to change that. It was built to be the exchange traders could count on. SBF needed to get the word out. He wanted FTX to be known as the respectable face of crypto. This required ad campaigns, sponsorship deals, a charitable wing—and a war chest to pay for it all.

...FTX did need money, after all. And it needed that money from credible sources so it could continue to distinguish itself from the bottom-feeders who came to crypto to fleece the suckers. So, in the summer of 2021, when FTX started to raise its Series B from a who’s who of Silicon Valley VCs, Bailhe and Lin hit the “Don’t Panic” button. “Embarrassingly, we had never tried to reach out to Sam, because we figured he didn’t need us,” Bailhe admits. “I thought they were just minting money and had absolutely no need for investors.”

Uh, yeah, about those charities...

Alameda Research, the company that generated the FTX grubstake, still exists, and its purpose seems to be to generate profits—on the order of $100 million a year today, but potentially up to a billion—that can be stuffed into the brand-new FTX Foundation. Similarly, even now, 1 percent of net FTX fees are donated to that same foundation, and FTX handles nearly $5 billion dollars’ worth of trades per day. The foundation, in turn, gives to a diversified group of EA-approved charities.

So was it all really a sham? They plugged EA as their reason for existing, but nobody from FTX ever actually showed up to meet EA people?

A cocktail party is in full swing, with about a dozen people I don’t recognize standing around. It turns out to be a mixer for the local EA community that’s been drawn to Nassau in the hopes that the FTX Foundation will fund its various altruistic ideas. The point of the party is to provide a friendly forum for the EAs who actually run EA-aligned nonprofits to meet the earn-to-give EAs at FTX who will fund them, and vice versa. The irony is that, while FTX hosts the weekly mixer—providing the venue and the beverages—it’s rare for an actual FTX employee to ever show up and mix. Presumably, they’re working too hard.

Bankman-Fried kept shifting FTX headquarters to countries deemed crypto-friendly and lax on regulations, precisely because although he needed the appearance of being solid and reliable, the real money-making was done through being 'shady' and 'rickety'. And of course, the entire house of cards eventually came tumbling down.

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