The Prof G Pod with Scott Galloway - The FTX Meltdown Explained — with David Yermack

Episode Date: November 15, 2022

Professor Yermack, Chair of the Finance Department at NYU Stern, explains how and why FTX fell apart. Learn more about your ad choices. Visit podcastchoices.com/adchoices

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NMLS 1617539. Welcome to a special episode of the Prof G Pod. We're here with David Yermack, the chair of the finance department at NYU CERN and my Yoda for anything crypto or basically anything in finance or the world of finance or alternative investments that I don't understand, which is mostly everything. Professor Urimac, where does this podcast find you? I'm in my office at NYU. Nice, NYU Stern. So let's bust right into it.

Last night, I was emailing with you, and you said, first and foremost, in many cases, the leverage is simply hidden from view. That was a problem at FTX Alameda. Can you explain what you meant by that? In this particular case, you had an exchange that lent customer funds to an affiliate that was doing private investing, this thing called Alameda Trading. And basically, nobody knew about this until some journalists began to expose it, which was over the past weekend. And as soon as the facts became clear, it was more or less like a bank run that people began to get worried that there weren't enough funds to back up all their customer deposits. And within a matter of hours, the exchange melted down.

And then the CEO, Sam Bankman-Fried, said that there was an $8 billion pull. And he has not yet defined what is meant by pull. But I think this was money that was lent out and invested in things that basically are worth $8 billion less. And so there's no way to get it back. But nobody knew that this inter-divisional lending was taking place. And it's only the latest of a number of crypto examples where people have lent money to each of equipment manufacturers lending to miners. You see it between investment funds. You see loans on DeFi platforms that people don't really understand who's controlling the repayment of those loans. Lots of leverage in the system,

which has led to bankruptcies that may or may not be beginning to spiral and cascade one upon another. Okay, so you have, essentially, you have FTX, which is like a kind of a Charles Schwab, but for crypto. Is that accurate? It's a little bit more, though, because Schwab just executes customers' orders. And FTX not only took orders, but was the exchange platform itself and also the clearinghouse. In the regular financial markets, you'd have a separate broker, which would then go to an exchange, which would then have the clearinghouse ultimately settle and ratify the trade. But all of those functions were bundled into one platform here.

So you didn't have the benefit of a number of different parties watching each other and multiple regulators that in principle could have been looking at it. And I may have this wrong, so I apologize, but you have essentially deposits that went into FTX that were then transferred to Alameda, which was, as far as I can tell, sort of acting like a trading quasi hedge fund. That's right. And people didn't realize, or the investors, people who were depositing money into this brokerage, whatever you want to call it, FTX, didn't realize their money was going out to something that had much greater risk associated with it, specifically an investment or a trading

platform. Do I have that right so far? That is correct. associated with it, specifically an investment or a trading platform. Do I have that right so far? That is correct. Okay. And then you have FTX has a coin and the coin is meant to give you better commissions. The coin takes on speculative value. It shoots up in value. And then Alameda, who owns 40% of those coins, uses the inflated value of those coins to even lever up more so, such that they have more money to invest in things like Robinhood and Uzbeki mining firm and all sorts of illiquid investments. Do I have that right? That seems to be correct. We're learning more facts every day, but my understanding so far is in line with what you've said. And then what starts the run on the bank? Is it people wanting their

money out of FTX or out of Alameda? I think it's the former and the exposure of the connections between them. I think people probably understood that like most speculative investors, Alameda was underwater on many of its investors. But what they didn't see until last weekend was the connections between the two entities. So technically, Alameda should have been raising money. I guess if they issue coins and they get money and the coins go down in value, then that's buyer beware, but they still have the cash that they've invested. This was taking money from people that didn't realize their money was being invested in these illiquid assets.

Is that kind of where the, I don't even know if in this instance it's fraud because they're not regulated. Is this a crime? You're asking a critical question because what the news flow is about today is criminal investigations. But these are people in the Bahamas. They're not a regulated broker-dealer. Banks lend out customer deposits every day.

You know, it's part of the model of the banking industry. And if you deposit your money in a bank, you know it's going to be lent out subject to some fractional reserve. But there's deposit insurance, and there's a lot of regulatory oversight that provides safeguards. If you're running a crypto platform in the Bahamas, I don't know what regulatory regime you fall under and whether any of this is legal or not legal. I think a lot of prosecutors are trying to figure that out right now. I think to the extent that they are onboarding customers

from other countries, such as the United States, certainly the American securities laws and the American laws for wire fraud could apply here, would be looked at. And you then get into issues about, you know, can you serve process and get extradition of these people if you do charge them with a crime in another country. And who knows? The legal consequences, I think, are going to have to be sorted out. I think, though, you have to blame regulators in the U.S. and other countries for how slow they've been to give regulatory clarity to this area. The reaction in the U.S. has always been for the SEC to say, we have laws in place that cover this. And everyone knows that they don't, including the SEC, that these are different assets that are traded differently than stocks and bonds. But there's been great hesitation by Congress and by the agency itself to update the rules to deal with the crypto economy. And you're now, you're seeing that

the industry has been taking advantage of the lack of clarity to push into spaces that, you know, really didn't give the customers the benefit of much oversight one way or the other. And we're going to pay a big price for that now. And so the depositors are now the creditors, and they will have an administrator go and say, all right, we want to sell these Robinhood shares. We want to sell this equity stake we took. My time. And right now, the prices of these assets are way below anything that anyone probably imagined. You know, that for about a year now, crypto cents on the dollar, maybe much less for a lot of these investments. And that if I'm an investor, I really want to play for time and hope that these things come back. But that's not the way a bankruptcy liquidation works. So the administrator will try and recover as many assets as possible and then start sending checks 10, 20, 30, 40, 60 cents on the dollar back to the creditors, the former investors. Is that accurate? Eventually, and it's not like this will happen quickly. The bankruptcy of Mt. Gox in Tokyo

began in 2014 and is still very much an active case eight and a half years later. So I would use that as the benchmark that eventually there would be a liquidation and payouts to people, but it may happen sometime in the 2030s. We'll be right back. The Capital Ideas Podcast now features a series hosted by Capital Group CEO, Mike Gitlin. Through the words and experiences of investment professionals,

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my understanding is, was that Binance owned a lot of the FT coin just hours early. So round trip, this raised a lot of eyebrows. But this was critical for Binance perhaps to initiate this or to be giving the exchange a big push by saying that they were going to dump all of their tokens. So, I mean, there's just so many layers to this. And I just, this has dawned on me that does, do the creditors of FTX have a case against Binance who under normal circumstances would have no reason to disclose sales unless they were trying to tank the value of a firm? Isn't this market manipulation? I would bring them in and depose them. You know, at the very least, they're trying to tank the value of a firm? Isn't this market manipulation? I would bring them in and depose them. You know, at the very least,

they're going to be witnesses in a case like this, but whether they ultimately end up being parties to it, you could theoretically see them being on either side. They may be creditors or they may be held, you know, somehow liable for manipulating the value of the tokens and the ownership shares of the exchange. I, you know, anything'sable for manipulating the value of the tokens and the ownership shares of the exchange. You know, anything's possible at this point. And I think if I'm a

prosecutor, I'm going to wait for more facts to come out before I move too quickly. So a big component of this was Binance flooding the market with FT coins that drove down the value of these coins, created insecurity, and then this run on the bank, if you will. But when the administrator comes in and starts selling the illiquid private stakes that FTX and Alameda held, won't that in effect create multiple smaller and maybe larger runs on different banks, if you will? That's the risk, yeah. Because if you're an investment fund that is underwater, you know, and then the trustee puts this back to you and asks for cash to settle it at fair market value, that could make it hard for them to pay their own

debts. You know, when I mentioned a cascade a few minutes ago, there could be like one domino knocking over the next one. And when we had the problems at Terra Luna one, a lot of people went down and you're still feeling the effects of that event. I think this could be something comparable, that there could be a lot of people who use borrowed money to invest borrowed money and borrowed money. And once somebody tries to reverse the flow of the money, it can reverberate or ripple all the way up the chain of creditors. So, the one I think that everyone's asking about is, what's different about Binance? Why won't this ultimately, it feels like we're working up the food chain here. What dynamics might or should be different at Binance? Why won't this happen to Binance? I don't know enough about Binance to speculate about that one way or another.

What's characteristic of all these platforms is that their balance sheets are really not available for public view. So you and I could speculate about this, but until we actually see the assets and liabilities, it's very hard to know. What do you think this means for Coinbase? Yeah, Coinbase is very different because they're a public company in the United States, and they file Form 10-K, Form 10-Q, the registration statement with their public offering. They've tried from the start to be very transparent. And I think given that they've opted into being regulated and overseen, however uncomfortable that would be, it buys them the kind of investor confidence that you don't necessarily see in private offshore platforms.

Now, I'm not aware that they're doing any kind of private lending, you know, the type that got FTX into trouble. I think if you take their finances, it's at face value and you probably should. The greatest risk to them is simply a sustained crypto bear market where people stop trading, they lose interest and so forth. And they've already been through layoffs, as you're seeing in many of the technology firms right now, just because business is bad. But I think to say that there's any kind of default risk or bankruptcy risk there, it wouldn't make a lot of sense. And what's the metaphor here? People are saying it's Lehman. No, it's not. It's Enron. Have you thought about what is a similar situation historically? The one that comes about what is a similar situation historically?

The one that comes to mind is a brokerage called MF Global. And this goes back to John Corzine when he lost re-election to Chris Christie. Corzine had a long time before that been the CEO of Goldman Sachs. So he tried to make a Wall Street comeback by taking over a small bank called MF Global. He made a big bet by buying Greek bonds, being of the mind that they would be restructured and would pay off 100 cents on the dollar. And he was right, but it happened too late that the bets he made expired. He lost a lot of money. And it turned out that customer accounts had been raided at the brokerage to pay for these bets that went bad. So the fact situation at FTX looks to me a lot like MF Global, except it's literally about 100 times bigger in terms of the amount of money involved.

I think you were talking about 100 million, give or take, in MF Global, and this is on the order of 10 billion. But the fact situations are pretty similar. MF Global, they essentially laid it off on sloppy record-keeping in a fast-moving market. And it appears to have been much more intentional, though, at FTX. You know, you have tweets and public admissions by some of their top people that they were aware

that the customer funds had been raided. And really, the question boils down to whether there's a relevant law in the Bahamas that covers this. And given how new the whole type of investing is, I'm not so sure there is, but we'll wait and see about that. With MF Global, there were clear FINRA regulations that were being violated, and they were able to extricate themselves from any personal life. No one went to jail, basically, because they were able to just blame, I thought I told somebody, and it was moving so quickly, we didn't keep good records. Seems to have been much more intentionality, though, at FTX, based on even the admissions on the public record already

by some of their leadership. So, I wonder if this is more spectacle than significant. And I think there's been so much noise around the layoffs of Twitter. And then Meta, under the cover of darkness, lays off 11,000 people. And when I think about the entire market capitalization now of crypto, I think it's around $700 or $800 billion. And Meta has shed more value than that in the last year. Or Amazon has lost over a trillion dollars in market cap. Is this a situation where I recognize there's some people who are going to get hurt very badly here, but in terms of the broader economy, if you will, isn't this kind of a, it's going to make for a great Netflix series, but really sort of insignificant as it relates to the larger economy? Because again, it's the total value of this market is about one third the value of Apple. I couldn't agree with you more. This is highly entertaining stuff, but it is not what we call systemically important in that it can drag down the whole economy,

cause changes in interest rates, lead to mass unemployment. This was a small organization run by a bunch of people under 30 living in a house in the Bahamas. And it's definitely bad for them and for anyone who trusted them with their money. But a lot of these are people who either could afford to lose it or are so unconnected to the real economy that the

caveat emptor lesson of buyer beware will probably be learned by them, but have not a lot of significance for the rest of us. And do you think this is, where do you think we are in the life cycle? The bulls will claim this is 2000 and we're going through a pruning and that the Amazons and Yahoo's will emerge from this or the Ebays. Do you think this is the beginning of the end for the asset class? It's going to be severely impaired, a shadow of itself, or that we're going to see some big players? We're going to see the crypto equivalent of Amazon come again, emerge from the fire. What I've always thought, and my opinion's no different today, is that the technology will migrate into the big banks, the big stock

exchanges, and especially government. So things like central bank digital currency, things like private coins issued by JP Morgan to do interbank overnight settlements. You're seeing a lot of blockchain applications that don't involve speculative assets, but are really using them for the underlying utility, the mission that the technology was built for. I think digital assets have an enormous role to play in the financial system by providing security and transparency and ease of settlement. And they're here to stay. But these standalone speculative tokens, the open sea NFT platforms and so forth, all of that the sun is going to set on. We've had speculative frenzies for as long as there have been financial markets. You still hear about the tulip bulbs 400 years ago

in the Netherlands. And I think a lot of this will be just another chapter in a book somebody writes about this. But I do think the technology is fundamentally changing the architecture of financial markets, but in a way that's much more boring than people like to hear about. In terms of systemic risk, whether it's a collapse in real estate prices or raising interest rates too fast, do you see systemic risk anywhere that is more news than noise, if you will? Not at this point. The thing that I think people have worried about, and rightly so, is that the big social media companies

might start issuing their own coins as essentially competitors, stable coins that might usurp the U.S. dollar. That already happened in China. And the Chinese economy, I don't know if you noticed, but everything is down a lot. And I think the loss of control of their financial system to WeChat and Alibaba has played a role in that.

They have rolled out their own central bank digital currency probably later than they should have to compete with this. But I worry that if something like that happened in the Western economies, the Federal Reserve, the European Central Bank, and so forth could lose the hegemony they have over printing money, what we call the seniorage. But the only attempt to do that so far was by Facebook. And I think they made a lot of strategic mistakes out of the blocks with the Libra, and everyone else is pretty chastened by that. So I think the potential for social media companies to enter this on a large scale with hundreds of millions of customers and so forth, it can't be taken lightly. But it would be best for the government to reach a regulatory accommodation rather than to sit in the background and do nothing about this.

David Urimack is a professor of finance and business transformation at NYU Stern. He serves as chairman of the finance department and director of the NYU Pollack Center for Law and Business. Professor Urimack teaches joint MBA law school courses in restructuring firms and industries in Bitcoin and cryptocurrencies, as well as PhD research courses in corporate governance, executive compensation, and distress and restructuring. He joins us from the great Soho campus of NYU Stern. David, thanks for doing this on such short notice. Really appreciate your time. Thank you for having me on, Scott. People shouldn't be speculating in crypto and should be trying to understand what it was designed for. Bitcoin is a payment system. Ethereum is to launch smart contracts to automate risk management tools.

Many of the initial coin offerings are to allow you to store files on Filecoin's blockchain. You know, things like that. When people just speculate into assets that have no cash flows, no ownership rights, no intrinsic value, someone's going to get hurt and lose all their money. Hey, it's Scott Galloway. And on our podcast, Pivot,

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