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PaperclipPerfector  7mo ago (text post)   29323 thread views

Culture War Roundup for the week of October 2, 2023

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The trial of Sam Bankman-Fried begins tomorrow.

As a person that has worked in crypto quant trading[1], I have the tiniest slice of sympathy for him. He still seems like an unsympathetic freak overall, and has done some stuff that seems pretty unethical, and some of his actions are definitely criminal. He has given EA a bad name as well.

There are certainly a lot of process crimes he's guilty of. The fact that the US has pulled his international operations into US jurisdiction means he's in for a universe of pain and if they can't fight that he's going to jail for infinity years. I consider this legal theory a bit dubious but the US has taken the position that it can prosecute crimes that happen in the rest of the world if they even marginally involve US citizens[2]. Is everyone in the world really supposed to follow US laws? That strikes me as a bad precedent; on the other hand, I also do appreciate it sometimes that the US is an international law enforcer of last resort.

That's not really where my sympathy lies though. He knows he was playing a dangerous game. Pretty much everyone who works in quant finance occupies enough legal gray area to worry that they could all be shut down at any time and end up in court. This is even worse in the crypto era, as the position taken by the SEC and friends is shameful, giving very little guidance on new forms of financial technology and telling firms years later by indictment that they were frowning on their behavior all this time.

Many tradfi firms prostrate themselves before the SEC in the hopes of maintaining a good relationship. Even still, reputable firms who were attempting to operate outside of US jurisdiction have been caught with their pants down in the crypto era e.g. Trading Firm A, B and C in the recent Binance indictment: https://www.bloomberg.com/opinion/articles/2023-03-27/the-cftc-comes-for-binance (paywall bypass: https://archive.ph/aMi5Q )

It's still not clear to me that SBF and FTX spent user funds as a matter of course, or if it effectively became spending user funds because so much of their other assets imploded. Though, again, that's not necessarily a crime if you operate outside of US jurisdiction, which is what their international arm believed it was doing. But, that's also sort of secondary.

The primary question I keep coming back to, and I come to this every time there's a large corporate fraud scandal, is: what is fraud, actually? Because it seems indistinguishable from "I thought our business was legit and every indication I had was that it was legit and then it failed and it failed really hard and lots of people lost money".

FTX was a successful business. It was a high quality crypto exchange among many exchanges where the standard at the time was "complete clown show". They were probably the last people I would have bet on imploding and disappearing user funds. The failure is shocking. It's so shocking it's hard to believe.

One thing that's common to these frauds is that people always seem to have a moment of reckoning where they know they're fucked and they can either pack up and go home and face the consequences, or they double down and hope it'll all work out. Indeed, there are some legendary stories from doubling down: FedEx for example where the CEO literally doubled down with their last remaining $5000 in Las Vegas to turn it into a much needed $27,000 to keep the business alive. In this timeline FedEx is legitimate, but if it hadn't worked out he could've possibly gone to jail.

As far as I can tell Uber was based on complete fraud. Its business plan from day one appeared to be: completely ignore taxi laws the world over and just push out a product that was so much better than calling taxis that before jurisdictions knew what was happening they would have tons of passionate users that would be furious if Uber was taken away. This seems to be a resounding success. But it was very much organized crime? If Uber had failed their founder would have definitely gone to jail. In fact he was involved in so much other generally shady stuff that he was forced out. Yet he definitely moved the needle.

Anyway, this isn't meant to be an impassioned defense of SBF, more like my continuing fascination and horror at this alien thing we call modern business. Poor fool tried to play the game of changing the world and got burned. And in this case the burning is fantastic public spectacle.

  1. To be clear I think crypto is not that world changing and its only redeeming quality for the foreseeable future is of the flavor "casinos are fun to build and play in".
  2. Arthur Hayes of Bitmex was busted for something similar, though he was "wink wink" keeping US citizens off of his exchange whereas FTX International was pretty serious https://www.justice.gov/usao-sdny/press-release/file/1323316/download

EDIT: Matt Levine's newsletter today is about SBF's trial, which hit my inbox right after I submitted this comment. Amazing, as usual. https://www.bloomberg.com/opinion/articles/2023-10-02/sbf-s-defense-will-be-tough

EDIT2: As replies have pointed out, I am probably technically wrong for calling what Uber did fraud. Sorry to distract. I should've made my case that Uber was more like a plan to openly disregard and defy taxi regulations across many jurisdictions with the excuse that this isn't a taxi it's a "carpooling app" tee hee. I think this is an insane business plan and it depended on them delivering an amazingly useful app. And if they hadn't succeeded (by delivering an amazingly useful app) they would've all been busted for something rising to the level of organized crime.

You might enjoy Matt Levine's take in Everything Everywhere is Securities Fraud

You know the basic idea. A company does something bad, or something bad happens to it. Its stock price goes down, because of the bad thing. Shareholders sue: Doing the bad thing and not immediately telling shareholders about it, the shareholders say, is securities fraud. Even if the company does immediately tell shareholders about the bad thing, which is not particularly common, the shareholders might sue, claiming that the company failed to disclose the conditions and vulnerabilities that allowed the bad thing to happen.

And so contributing to global warming is securities fraud, and sexual harassment by executives is securities fraud, and customer data breaches are securities fraud, and mistreating killer whales is securities fraud, and whatever else you’ve got. Securities fraud is a universal regulatory regime; anything bad that is done by or happens to a public company is also securities fraud, and it is often easier to punish the bad thing as securities fraud than it is to regulate it directly.

...

But the principle of the thing is that U.S. securities law is a global universal regulatory regime: If a foreign company never issues shares in the U.S. and files its financial statements and other reports only abroad, it can still be sued in the U.S. for securities fraud. And in the U.S., everything is securities fraud.

He also has a take on the Bankman-Fried trial in today's issue.

In the FTX case I think the case for fraud is pretty simple.

  1. As an exchange FTX was a custodian of customer assets. If a customer bought 10 BTC then FTX was obliged to hold that 10 BTC in case that customer wanted to sell it or transfer it or whatever.

  2. FTX did in fact represent to customers that it was a custodian of their assets and did have their assets.

  3. FTX did not actually have custody of the relevant assets. They sold them or lent them or sent them to Alameda or otherwise did not retain the assets they were obliged to.

Well, it's fraud if you do that on purpose. It's a mistake if you have an accounting accident. And, as per Matt Levine, I agree your accounting accident is not sympathetic if you were also spending lavishly on yourselves. Where did FTX fall here? I'm slightly inclined to believe in the accounting accident story, but only because I've made multi-million dollar accounting mistakes before, which we thankfully discovered immediately. More than once. And I wasn't in a "move fast and break things" grow to the moon kind of place that FTX was.

I realize SBF arguing "accounting accident!" doesn't sit well with people amongst all of his other horrendous behavior. Poor slob.

I think part of it was an accounting error but it's an error that's ubiquitous in crypto: valuing your shitcoins at their spot price * volume. My understanding is a bunch of the loans from FTX to Alameda were "collateralized" by billions of dollars of other coins Alameda held. The problem comes when you need to turn those coins into dollars and find out the market is not as deep or liquid as you supposed.

Levine again:

And then the basic question is, how bad is the mismatch. Like, $16 billion of dollar liabilities and $16 billion of liquid dollar-denominated assets? Sure, great. $16 billion of dollar liabilities and $16 billion worth of Bitcoin assets? Not ideal, incredibly risky, but in some broad sense understandable. $16 billion of dollar liabilities and assets consisting entirely of some magic beans that you bought in the market for $16 billion? Very bad. $16 billion of dollar liabilities and assets consisting mostly of some magic beans that you invented yourself and acquired for zero dollars? WHAT? Never mind the valuation of the beans; where did the money go? What happened to the $16 billion? Spending $5 billion of customer money on Serum would have been horrible, but FTX didn’t do that, and couldn’t have, because there wasn’t $5 billion of Serum available to buy. FTX shot its customer money into some still-unexplained reaches of the astral plane and was like “well we do have $5 billion of this Serum token we made up, that’s something?” No it isn’t!

One simple point here is that FTX’s Serum holdings — $2.2 billion last week, $5.4 billion before that — could not have been sold for anything like $2.2 billion. FTX’s Serum holdings were vastly larger than the entire circulating supply of Serum. If FTX had attempted to sell them into the market over the course of a week or month or year, it would have swamped the market and crashed the price. Perhaps it could have gotten a few hundred million dollars for them. But I think a realistic valuation of that huge stash of Serum would be closer to zero. That is not a comment on Serum; it’s a comment on the size of the stash.

...

In round numbers, FTX’s Thursday desperation balance sheet shows about $8.9 billion of customer liabilities against assets with a value of roughly $19.6 billion before last week’s crash, and roughly $9.6 billion after the crash (as of Thursday, per FTX’s numbers). Of that $19.6 billion of assets back in the good times, some $14.4 billion was in more-or-less FTX-associated tokens (FTT, SRM, SOL, MAPS). Only about $5.2 billion of assets — against $8.9 billion of customer liabilities — was in more-or-less normal financial stuff. (And even that was mostly in illiquid venture investments; only about $1 billion was in liquid cash, stock and cryptocurrencies — and half of that was Robinhood stock.) After the run on FTX, the FTX-associated stuff, predictably, crashed. The Thursday balance sheet valued the FTT, SRM, SOL and MAPS holdings at a combined $4.3 billion, and that number is still way too high.

If you have one of your companies give another of your companies a loan collateralized by an asset at many times what that asset could actually be sold for, is that fraud?

The core of this is a concept called "Mark to Market." The Enron documentary (The Smartest Guys in the Room. 10/10 would recommend) spends some time on it.

It's also the same core mechanism that fucked the whole mortgaged-backed securities market in 2008-2009.

Mark to Market was never really intended for intermediate goods with weird cashflow and long-term appreciation dynamics (like houses). It definitely was never intended for use with Magic Internet Money.

Mark to Market was originally conjured up as a way for oil extraction companies to better value their inventory (oil) as daily markets could fluctuate pretty wildly. The thing there, however, is that that oil was both (a) a thing you had on hand that had a long established market and (b) a commodity that functioned ... like a commodity! There was a spot price and ... that was kind of it. Yeah, there are futures markets, but it's not like a house that has a monthly cashflow (rent or mortgage) but also an asset appreciation profile determined by all sorts of things (mainly location, but also real improvements and hyper local supply/demand profiles). There's just so much more inherent complexity in things like houses that Mark to Market can't really be a stable valuation scheme. [:1]

For a digital currency with zero non-digital assets backing it you're marking-to-a-made-up-market with a formless thought experiment of an asset. Yes ... that's really, really, really obvious dumb as shit.

[:1] To be fair, there are people who will disagree with this and make a (good) point that as long as markets stay liquid enough, they can perform accurate price discovery. I actually think 2008-2009 strongly supports that argument. The crisis point wasn't mortgages going down in value per se, it was in the lack of overnight and short term cash to help firms shift their positions and recapitalize. Firefighting by Bernanke et al. goes into the (quite technical) details of this. To "yes, but," one last time, there are also those who would say that the sheer size of the MBS market and all of the related assets and liabilities made it impossible to "soft land", regardless of any amount of short term credit and liquidity. I can't really refute that because we decided not to test it out back in '09. If we had, and gotten in wrong, we'd be having this conversation in person beneath the rubble of Midgar.

Firefighting by Bernanke et al. goes into the (quite technical) details of this.

One of the points that got bandied around in the aftermath of that crisis was that the US government could have simply made the mortgage repayments on every delinquent mortgage for less money than they actually ended up handing out - but furthermore, that this wouldn't actually be enough to prevent the crash from happening due to the precarious financial structure involved. Given that you seem to know a fair bit about what happened, is there any truth to this?

Three points worth considering.

  1. "Speed of Money" - It's hard to overstate how fast moving the 2008 financial crisis was. It wasn't hour to hour, it was minute to minute. We actually got lucky that some of the critical events took place late in the week so that there was a weekend (markets not open) to stop, think, and re-orient. The government paying back all of the mortgages directly would've taken too long. Remember during COVID how everyone got checks? How long did it take between announcement and the check arriving. IIRC, a couple weeks (at best). Even when Congress faces a crisis and passes a bill, the machinery of government can only go so fast. The best thing to do is what they did - telling the market to help itself out as much as possible while also passing TARP and constantly repeating "the full faith and credit of the USA is behind this."

  2. Because everything was moving so fast and the scale of the collapse was unprecedented, Congress, the Fed, and the Treasury didn't exactly know if what they were planning on doing was legal. This is also in Firefighting. It wasn't just saying, "have general counsel look at this" it was literally unknown constitutional waters with (allegedly) the potential for personal liability. You can have differences of opinion with Bernanke et al., but those guys had to make some Big Time decisions under massive stress that could've (maybe) landed them in jail no matter how noble their intent.

All of this is to say, the government blanket paying mortgages might have some legal traps within it. Even if it did come back "clean" the time taken to review it would've been catastrophic (see point number 1)

  1. Organizations don't have all of the information and sometimes getting it is illegal. Remember AIG? They were an insurance giant who collapsed in 2008. This was (to oversimplify) because they wrote a bunch of insurance policies to other financial entities that went really bad really fast. Well, why didn't AIG just do better diligence? (1) There were layers and layers of counter parties, derivatives, and reinsurance. Impossible to trace through all of it (2) In some cases, getting a complete picture of a counter-party's risk or exposure is illegal as it would involve revealing trade secrets. How do mortgages fit into this? At the time, I'm not sure it was readily apparent that mortgages were the root cause of all of this. The crisis itself was on liquidity and short term financing for big financial instiutions, everyone could see that. What caused that may have been more mysterious, so I don't think the Gov't was in a position to quickly say "let's get these mortgages figured out." And, to beat the dead horse, taking the time to figure it out would've been the wrong move.

2008 is fascinating to me for tons of reasons. People experienced a lot of pain in the years following and it has a non-trivial part in the political situation we have today. But it could've been so, so, much worse, and I think we avoided it just barely.

Thank you for the well thought out reply! Of course I actually think that the guillotines not being rolled out for the people responsible for the crisis was a societal failure, but I appreciate your analysis here.

For a more detailed discussion of how mark-to-market accounting affected the 2008 crisis, see chapter 12 of Peter Wallison's book Hidden in Plain Sight.

At the peak of the panic in 2008, the [mark-to-market] value of available-for-sale non-agency mortgage-backed securities declined by almost 25 percent from the value they would have had under historical cost accounting. Needless to say, if historical cost accounting had been permitted at the time, it might have had a major stabilizing effect on public perceptions of the financial condition of many large financial firms.

 

Companies required to write down the value of their mortgage-backed securities when they had not actually suffered any losses were desperately aware of the absurdity of their situation.

Mark to Market was originally conjured up as a way for oil extraction companies to better value their inventory (oil) as daily markets could fluctuate pretty wildly.

Not really. Mark to Market (in technical accountancy terminology, "fair value accounting") first comes in as a way for financial institutions (banks, trading firms, brokerages etc,) with assets whose price varied based on movements in liquid financial markets to better assess their current solvency than historical cost accounting. It was brought in after the S&L crisis - a big part the reason why the S&L crisis got so bad is that you had institutions that were accounting-solvent (because 30-year fixed rate mortgages with interest rates that were now below-market were on the books at par) but clearly could not meet their obligations over a 30-year time horizon, and so they had an incentive to double down with what was in effect other people's money. (SVB was in the same situation, but had a lot of tightly-networked, financially sophisticated depositors with balances over the FDIC limit, so they got taken out by a run).

The thing that made Enron special was that they applied the mark-to-market accounting that made sense for the energy trading division of the firm to things that would not usually be marked to market like long-term contracts for wholesale gas supply, and that this allowed them to recognise revenue and profit earlier than competitors. It also meant that the business model wasn't sustainable because the contracts didn't produce long-term profits, so Andrew Fastow ended up having to double down repeatedly until he ended up ratting on Jeffery Skilling for a light sentence.

You are correct!

I had an EPIC brain snap and swapped the Mark to Market for Master Limited Partnerships in discussing their original application to Oil and Gas. Wow, yeah, my mistake. Thanks for correction.

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