#2: The Smartest Guys in the Room
Edit 2022-12-12: this article was written immediately after the first news of FTX’s insolvency. Today, the facts about FTX look much worse than what was known at the time of writing. My view on FTX today is much closer to “multi-year orchestrated fraud” than what I wrote below with only a fraction of the information.
Until this year, I had never personally seen the collapse of a major financial institution. I became an adult in the early 2010s, living in the US and Western Europe, so I had been too young to really understand or feel the ‘08 Recession, and while financial institutions collapsed from time to time in other nations, those were faraway and necessarily abstract to me.
What I saw for the first decade of my adult life was a bull market. Famously, a rising tide lifts all boats, but it especially lifts the vehicles that are most heavily levered to market beta. Traditionally, that’s frontier technology with expected hockey-stick growth rates and big TAMs to go after — in this case, especially during the inflationary Covid years, the bull market lifted crypto.
Crypto is interesting because it’s such a nascent and volatile market — which creates opportunities, but also a general lack of trust. Who do you rely on in a market that’s barely a few years old, and where the financial incentives are so wild-west hostile? Especially during Covid, while there was significant retail capital entering the market, many of the most vocal participants in the market were hucksters very obviously talking their own books and shilling their pump-and-dumps. There was great demand for a different type of public market participant — traditionally pedigreed and trying to build an institution rather than fleece their followers.
Enter Su Zhu and Kyle Davies. Two guys in their early thirties, checking all the prestige boxes — Andover, Columbia, Credit Suisse — running their own quantitative hedge fund (3AC) for years, slowly moving into crypto, and doing it entirely with their own capital. That was refreshing, a very different look from the regular crypto fund manager. The aesthetics were key for them: because their firm masqueraded as a prop shop, it took down the guard of the audience (their content wasn’t perceived as marketing to potential LPs) and made the purported returns all the more impressive.
They looked like the smartest guys in the room: brilliant traders who worked their way up to managing billions of dollars of their own capital, taking aggressive, high-conviction bets, being right, and flaunting their wins over and over again. It was a very seductive aesthetic that drove FOMO and emboldened many contemporary traders to take bigger, riskier, higher-conviction moves just like their idols at 3AC.
It turned out, of course, that the entire thing was a house of cards built on half survivorship bias, half fraud — 3AC was secretly not at all a prop shop, had borrowed billions of dollars, held out-of-control leveraged exposure to mindnumbingly toxic assets, lied about their reserves, and so forth. The painful unwinding laid it out clearly that Su Zhu and Kyle Davies exploited a marketing opportunity for a particular type of prophet in the crypto industry, but were otherwise far from the smartest guys in the room.
This was personally impactful for me, because I knew the space very well, and Su Zhu had been one of its most respected public actors. While I had my doubts about some of the things he said, his market commentary was the only commentary that has ever had me seriously reconsidering my passive investing style: maybe I am too diversified, maybe I should be bolder where I have high conviction, maybe I should use leverage… I had seen 3AC grow and grow over the years, repeatedly heard how strong their returns were, gotten used to the view — everyone’s view — that these guys are the best, and then saw it burn down in real time, one news headline at a time. Learning that it was all a charade, that I had been fooled, was humbling.
But the story didn’t end with 3AC. Contagion from their collapse pushed other exposed firms into insolvency.Sam Bankman-Fried (SBF), the founder of the exchange FTX, stepped up and rescued the distressed firms. It looked like an opportunistic masterstroke from a generational talent. The press likened it to JP Morgan’s bailout of Wall Street in 1907. SBF’s aesthetics were off the charts: an ultra-sharp, unapologetically nerdy former MIT/Jane Street quant, he previously founded Alameda Research, a prop shop that profited a billion dollars in 2021.
Now barely 30 years old, he had built FTX into a wildly profitable, best-in-class exchange overnight, with a team of just twelve engineers. A jaw-dropping feat. Valued at $32B in January ‘22 by top-tier investors, SBF was cleaning up: running an amazing business, lobbying like no-one else, cash-rich and able to M&A steamroll the industry for pennies on the dollar. Sam Bankman-Fried looked like the smartest guy in the room.
We are now about 40 hours into the public collapse of FTX. Apparently the firm has an $8B liquidity shortfall. While the full story is to be told, rumors suggest that Alameda Research became insolvent back in Q2 due to 3AC contagion, and that (I am skipping several paragraphs of speculation about truly head-spinning, too-clever-by-half financial acrobatics) FTX bailed Alameda out by lending them X billion dollars of FTX's customer deposits, and Alameda paid FTX back X billion, but in a token that did not have the liquidity to be sold for X billion on the open market, which, after a bank run on FTX, meant that FTX was ultimately short X billion dollars that it was unable to return to customers.
This is shocking to me in two ways. The first is that SBF was so profoundly hoisted by his own petard — whenever SBF gave talks, it was so clear that he knew what not to do. He gleefully discussed the craziness of ponzi schemes with Matt Levine in an interview that now has to be interpreted in a totally different light. FTX by itself was an amazing, market-neutral business! Having his entire empire blown up by his commingled vestigial hedge fund is baffling. Truly, he looked like the smartest guy in the room — and once more, he was not. And the prodigious twenty-something MIT/Jane Street alums at Alameda no longer look like wunderkinds, but like fall guys.
Secondly, I’m shocked that I fell for it again! A few months ago, it seemed so obviously clear that SBF would dominate crypto markets for years to come. You would think that after seeing 3AC unwind with a catastrophic fall from grace for its founders, that I (and others) would approach the next smartest guy in the room with a bit more skepticism, but nope. Once more, I am humbled and forced to admit that I fell for the marketing.
The victor from this saga is Changpeng Zhao (CZ) of Binance, who seemingly toppled his biggest rival with a few tweets. The commentariat is already elevating him to the status of the new smartest guy in the room. I will reserve judgment this time.
There are two more takeaways for me. A few years ago, I read a book about the rise and fall of Long-Term Capital Management in the late 1990s, an all-star hedge fund that ended up managing capital only for the short-term, and ended up needing to be bailed out of about $3.6B in debt. I recall finding it academically interesting, but the sensation of reading about the abstract past is totally different from living through the cultural impact live — believing the popular view for years and then seeing it all get blown up one tweet at a time.
The difference between perceiving a rare experience in theory and in practice is so vast that I think virtually all historical lessons are massively underappreciated by their readers. Certainly the financial markets repeat the same story over and over again, no matter how seemingly infallible the main character is.
Perhaps the issue is that when pressed, the smartest guys in the room are always smart enough to think of a high-wire-act solution that just might work, and confident enough to overestimate the odds of it actually working. 3AC tried to make up their losses with riskier bets, a story as old as time. SBF’s credit engineering between FTX and Alameda could have worked (though regardless, it would’ve been certainly unethical and probably unlawful). But of course it didn’t. Market actors who did not perceive themselves as the smartest guys in the room might not even have bothered trying, and would be infinitely better off.
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While I did think about them, I did none of those things and stuck to my guns.
These firms were Voyager Digital, BlockFi, and Celsius, among others. Importantly, while the liquidation of 3AC had a “ripple effect” on the industry, it followed the near-total wipeout of the $45B-market-cap LUNA token, which 3AC had been heavily exposed to. These other firms were also exposed to LUNA directly, which contributed to their liquidations.