Doug Noland: SBF, FTX and QE

An outlandish aberration, or a distressing sign of the times – and of what’s to come? Curious readers for centuries have been fascinated by the great 17th century Dutch Bubble. “At the peak of tulip mania, in February 1637, some single tulip bulbs sold for more than 10 times the annual income of a skilled artisan.” Seems rather quaint compared to today’s world of boundless digital tokens. The FTX collapse has been called crypto’s “Lehman Moment.” Odds favor the downfall having more in common with the March 2008 Bear Stearns implosion.

A $32 billion empire. The 30-year-old wunderkind Sam Bankman-Fried’s net worth estimated at $16 billion a couple short weeks ago (down from a $26bn peak). Sharing the stage with Bill Clinton and Tony Blair, in his signature attire – shorts, t-shirt and sneakers (hoodies so last cycle). The son of Stanford Law School professors, “SBF” graduated from MIT (physics). He founded his hedge fund trading firm, Alameda Research, at 25, after four years trading at Jane Street. Launched his crypto exchange, FTX, in May 2019.

As fate would have it, the Federal Reserve would restart QE a few months after FTX began operations. The cryptocurrency Bubble was then bestowed with the greatest windfall in the long history of manias and speculative excess: Covid-19. The Fed unleashed $5 TN of pandemic QE, with many additional Trillions from the global central bank community.

It’s worth noting that Bitcoin was trading at about $5,200 when SBF announced plans for FTX, down significantly from the December 2017 spike to $19,000. There’s no way the crypto Bubble inflates into such a global phenomenon, if not for the Trillions of central bank “money printing.”

November 17 – Financial Times (Kadhim Shubber, Joshua Oliver and Sujeet Indap): “The new chief executive of FTX, an insolvency professional who oversaw the liquidation of Enron, has said that the bankruptcy of the crypto group is the worst case of corporate failure he has seen in more than 40 years. John Ray III, who was appointed to run the FTX bankruptcy, said in a US court filing that he had never seen ‘such a complete failure of corporate controls and such a complete absence of trustworthy financial information’. Ray said he had found at FTX international, FTX US and Bankman-Fried’s Alameda Research trading company ‘compromised systems integrity’, ‘faulty regulatory oversight abroad’ and a ‘concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals’. The scathing filing in the federal bankruptcy court in Delaware painted a picture of severe mismanagement by Bankman-Fried at FTX, which raised billions of dollars from top-tier venture capital investors such as Sequoia, SoftBank and Temasek.”

“This situation is unprecedented.” From someone who would know, FTX at least in some respects makes even Enron accounting and corporate controls look wholesome. SBF doesn’t strike me as the Ken Lay, Jeffrey Skilling or Andrew Fastow type, which makes this financial fiasco all the more intriguing. It’s difficult to believe laws weren’t broken. Yet the more critical issue is the outrageousness of behavior that is these days accepted as within the realm of acceptable conduct.

FTX’s new CEO (John Ray III), with decades of experience, had never heard of the auditor who provided an opinion on the company’s international trading platform financials. When he went to the Prager Metis website, he learned the auditor was the “first-ever CPA firm to officially open its Metaverse headquarters in the metaverse platform Decentraland.” Sophisticated Wall Street firms invested and lent billions to FTX. One would think that if you choose to shower a young guy in shorts and a t-shirt with money, you’d at least demand audited financials from reputable CPAs in suits and ties.

Bankruptcy filings revealed Alameda had extended $4.1 billion of related-party personal loans, including $1 billion directly to SBF and another $2.3 billion to an entity majority owned by SBF (the remainder to three company executives). There are early reports of an eight to $10 billion hole in FTX finances, with talk of customer balances being funneled to prop up the troubled hedge fund affiliate (Alameda). Other reporting has customer balances flowing directly to Alameda, completely bypassing FTX. SBF kept tweeting away, when he would have been better served holed up in his attorney’s office.

Corporate funds “were used to purchase homes and other personal items for employees and advisors.” There was talk early in the week of SBF’s $40 million Bahama’s penthouse hitting the market.

And from MarketWatch: “As of Thursday, [CEO] Ray made clear that while he now controls the various FTX trading and exchange platforms and Bankman-Fried’s crypto hedge fund Alameda Research, he’d ‘located and secured only a fraction of the digital assets’ he hoped to recover. In fact, Ray said only some $740 million of cryptocurrency had been secured in new cold wallets. Ray cited at least $372 million of unauthorized transfers that had taken place on the day FTX and Alameda filed for bankruptcy last week, and the ‘dilutive ‘minting’ of approximately $300 million in FTT tokens by an unauthorized source’ in the days after the filing. FTT tokens were created by FTX to facilitate trading on its exchange and made up a big chunk of Alameda’s assets.”

New tokens have been big business – monstrously big. Create a new token, distribute a small percentage to trade up in price on the crypto exchanges, and then impute the value of the entire big chunk of illiquid tokens based on the price of the trading ones. Use these prized tokens as collateral for loans, liquidity for new speculative assets, or to underpin crypto market prices.

And with your trading affiliate making an absolute killing levering in inflating tokens, why not offer favorable market-making terms to your exchange affiliate customers, boosting the appeal of this rapidly expanding business? While you’re at it, you might as well use some of this bonanza to fund crypto startups and ventures that will work to shore up your ecosystem/dynasty. Give generously to political campaigns and promote regulation, while showcasing enough altruism and charm to ensure you’re perceived as “one of the good guys.”

And this game works miraculously, so long as crypto prices continue to inflate. But like much of contemporary finance, it doesn’t work in reverse. Deflating token prices rather quickly put the dynasty – the whole charade – in grave danger. Desperation and denial. We’ll fudge, but get everything ironed out as soon as token prices recover. Contagion.

Let there be no doubt, if you can create tokens valued in the billions out of thin air, you can go collarless, disregard sound accounting and control, retain your auditor from the metaverse, buy political influence and milk a million unsuspecting crypto speculators out of their savings. But please explain to me the genesis for such a carefree environment conducive to creating token prosperity out of nada?

The great crypto inflation is close enough to a direct offshoot of central bank QE. Both are black box money machines, where the reality of nil wealth creation is no match for the fantasy of prosperity for the taking. Central banks create their own new “tokens”, and these liabilities bolster the value of other financial tokens (assets) generally, while underpinning the market value of central bank assets and balance sheets (especially those levered in “tokens”).

We have often discussed how central bank liquidity/buying power inflates various price levels, certainly including crypto. But I also believe decades of central bank inflationism nurtured late-cycle “money for nothing” zeitgeist that enveloped societies at home and abroad. You’re a chump if you are not making money (thousands to billions) creating or trading inflating “tokens” (crypto, stocks, bonds, options, ETFs, etc.)

FTX is but a microcosm. Zero rates and Trillions of QE – literally free “money” – created the most powerfully destructive financial incentives ever. And this was not the “old” days of egregiously playing fast and loose with the rules to accumulate millions. We’re talking incentives hyper-inflation. Things got so crazy that billions upon billions were just scattered about for the taking. Create tokens, leverage those tokens to speculate in tokens – and you’ve quickly joined the inflating ranks of the multi-billionaires.

Of course, the enterprising will leap at such opportunities. Indeed, there’ll be frenzied leaping far and wide. And the leapers will become intoxicated by unfathomable wealth, lose all perspective, and succumb to some crazy immoral, unethical and legally-challenged activities. It’s like the past, just so, so much bigger. Systemic. In the grand scheme of things, crypto is just the fringe – little different than past fiascos. And things will be much worse than even the direst naysayers foretell. I worry about the entire financial structure.

Not much talk lately of the “macro-prudential” measures that were to safeguard financial stability as the Fed pursued zero rates and QE to bolster the economy. The infuriating aspect of this is that “macro-prudential” was clearly BS from the get-go. Zero rates and Trillions of QE unleashed history’s greatest bout of monetary disorder. Some of the cost of this fiasco have begun to be revealed.

While the crypto Bubble implodes, the “risk on” market rally is, understandably, making the Fed nervous.

November 17 – CNBC (Jeff Cox): “St. Louis Federal Reserve President James Bullard said… the central bank still has a lot of work to do before it brings inflation under control. A voting member on the rate-setting Federal Open Market Committee, Bullard delivered remarks centered on a rules-based approach to policymaking. Using standards set by Stanford economics professor John Taylor, Bullard insisted that the moves the Fed has made so far are insufficient. ‘Thus far, the change in the monetary policy stance appears to have had only limited effects on observed inflation, but market pricing suggests disinflation is expected in 2023,’ he said. Even using assumptions he characterized as ‘generous’ regarding the progress the Fed has made so far in its inflation fight, he noted in a series of slides that ‘the policy rate is not yet in a zone that may be considered sufficiently restrictive.’ ‘To attain a sufficiently restrictive level, the policy rate will need to be increased further,’ he added…”

It’s noteworthy that Bullard was one of the first Fed officials that had the markets thinking “pivot” following the UK’s brush with bond market collapse. The Fed is wishful thinking if it actually believes it can fine tune these markets. We’re in a high-charged “risk on” v. “risk off” standoff. Instability and an Accident in the Making.

November 14 – Bloomberg (Lu Wang and Denitsa Tsekova): “Fast-money quants were effectively forced to buy an estimated $225 billion of stocks and bonds over just two trading sessions, as one of Wall Street’s hottest strategies in the great 2022 bear market shows signs of cracking. As cooling consumer price data sparked a cross-asset rally, trend-following traders were compelled to unwind short positions totaling about $150 billion in equities and $75 billion in fixed income on Thursday and Friday, JPMorgan… strategist Nikolaos Panigirtzoglou estimated.”

November 18 – MarketWatch (Joseph Adinolfi): “Equity options worth $2.1 trillion in notional value are set to expire on Friday in the latest monthly event where weekly and monthly options tied to single stocks, equity indexes and exchange-traded funds expire… Every month, a team of analysts from Goldman Sachs publishes a breakdown of the options that are expiring. And one of the most notable details from this month’s report is a chart showing how much trading has shifted to options contracts with 24 hours or less left before they expire. Trading in these types of options now represents 44% of all trading in options linked to the S&P 500 index. They now trade an average of $470 billion in notional value per day…”

It’s also worth noting that all the enthusiasm for China’s loosening of zero Covid now confronts the reality of surging Covid. China reported 24,473 new COVID infections Friday, the high since Shanghai’s massive April outbreak. Cases are spread out in cities across China.

November 15 – Associated Press: “China’s ruling party called for strict adherence to the hard-line ‘zero-COVID’ policy Tuesday in an apparent attempt to guide public perceptions after regulations were eased slightly in places. The People’s Daily, the Communist Party’s flagship newspaper, said in an editorial that China must ‘unswervingly implement’ the policy that requires mass obligatory testing and places millions under lockdown to try to eliminate the coronavirus from the nation of 1.4 billion people and the world’s second-largest economy.”

Holes are apparent in today’s bullish narrative.

Original Post 19 November 2022

TSP Smart & Vanguard Smart Investor

Categories: Doug Noland