The FTX Meltdown Explained — with David Yermack

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

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:01Scott Galloway?

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• 1:27Scott Galloway?

  Welcome to a special episode of the Prof G Pod. We're here with David Yurmac, the Chair of the Finance Department at NYU Stern 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 Yurmac, where does this podcast find you?

• 1:45Speaker 02

  I'm in my office at NYU.

• 1:47Scott Galloway?

  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?

• 2:03Speaker 02

  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 the 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 hole.

• 2:45Speaker 02

  And he has not yet defined what is meant by hole. 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 other, but not had any reason to make that fact public. You've seen it throughout the supply chain of mining companies lending money to utilities, 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

• 3:30Speaker 02

  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.

• 3:42Scott Galloway?

  Okay, so you have essentially, you have FTX, which is like a kind of a Charles Schwab, but for crypto. Is that, is that accurate?

• 3:51Speaker 02

  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. That 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.

• 4:27Scott Galloway?

  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.

• 4:41Speaker 02

  That's right.

• 4:42Scott Galloway?

  And people didn't realize, or the investors, people 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?

• 5:01Speaker 02

  That is correct.

• 5:02Scott Galloway?

  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?

• 5:30Speaker 02

  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.

• 5:38Scott Galloway?

  And then what starts the run on the bank? Is it people wanting their money out of FTX or out of Alameda?

• 5:45Speaker 02

  I think it's the former, and the exposure of the connections between them, I think, you know, 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.

• 6:07Scott Galloway?

  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?

• 6:33Speaker 02

  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

• 7:15Speaker 02

  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, you know, the legal consequences, I think, are going to have to be sorted out. I think, though, you have to blame regulators in the US and other countries for how slow they've been to give regulatory clarity to

• 7:55Speaker 02

  this area. The reaction in the US 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 going to pay a big price for that now.

• 8:36Scott Galloway?

  And so the depositors are now the creditors and they will have an administrator go and say, "All right, we want to sell these Robin Hood shares. We want to sell this equity stake we took." My understanding is they invested in other, in an artificial intelligence fund. I thought I read they invested in Sequoia Capital.

• 8:56Speaker 02

  Yeah, there's just all kinds of stuff that if you really want to liquidate it will take a long 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 has been dropping without much interruption. So I think you're talking about getting 50 cents, 60 cents on the dollar, maybe much less for, 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.

• 9:30Scott Galloway?

  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?

• 9:42Speaker 02

  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, it may happen, you know, sometime in the 2030s.

• 10:05Scott Galloway?

  We'll be right back.

• 10:10Scott Galloway?

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• 12:22Scott Galloway?

  So the thing that ultimately started the run on the bank, my understanding is, was that Binance owned a lot of the FT coin? Was that what it was called?

• 12:29Speaker 02

  Yeah, but even before that, it was a report in CoinDesk, the online news service, that triggered Binance. And then Binance said, "We're selling." And then, once the stampede began, they then offered to buy the platform, the same platform that they had helped drive down the value of the assets of 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.

• 13:05Scott Galloway?

  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?

• 13:24Speaker 02

  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'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.

• 13:56Scott Galloway?

  So a big, 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?

• 14:23Speaker 02

  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 at a 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 six months ago, it quickly dragged in Three Arrows Capital, which dragged in Celsius, you know, there were, it turned out a lot of people owed money in sequence to one another. And once you pulled the plug on the first one, a lot of people went down and you're still feeling the effects of that

• 15:08Speaker 02

  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, it can reverberate or ripple all the way up the chain of creditors.

• 15:28Scott Galloway?

  So the one I think that everyone's asking about is what's different about about Binance? Why won't this ultimately? It feels like we're working up the food chain here.

• 15:39Speaker 02

  Yeah.

• 15:39Scott Galloway?

  What is, what dynamics might or should be different at Binance? What, why won't this happen to Binance?

• 15:47Speaker 02

  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.

• 16:07Scott Galloway?

  What do you think this means for Coinbase?

• 16:09Speaker 02

  Yeah, Coinbase is very different because they're a public company in the United States and they file Form 10K, Form 10Q, 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, of the type that got FTX into trouble. I think if you take their finances, it's at face value and you probably should.

• 16:53Speaker 02

  The greater, 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 businesses back. 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.

• 17:16Scott Galloway?

  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?

• 17:25Speaker 02

  The one that comes to mind is a brokerage called MF Global. And this goes back to John Corzine when he, he lost reelection 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 a hundred cents on the dollar. And he was right, but it happened too late that the 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.

• 18:08Speaker 02

  So the fact situation at FTX looks to me a lot like MF Global, except it's literally about a hundred times bigger in terms of the amount of money involved. I think you were talking about a hundred 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 are, 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.

• 18:53Speaker 02

  And, you know, given how new the whole type of investing is, I'm not so sure there is, but 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, like, 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 in on the public record already by some of their leadership.

• 19:29Scott Galloway?

  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 are 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

• 20:10Scott Galloway?

  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.

• 20:22Speaker 02

  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.

• 21:06Scott Galloway?

  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 Yahoos 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?

• 21:32Speaker 02

  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, you know, 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, you know,

• 22:17Speaker 02

  the the OpenSea 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 know, 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.

• 22:50Scott Galloway?

  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 not that is more news than noise, if you will?

• 23:04Speaker 02

  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 US dollar. That already happened in China. And the Chinese economy, I don't know if you noticed, but is, you know, 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,

• 23:48Speaker 02

  the Federal Reserve, the European Central Bank and so forth, could lose the hegemony they have over printing money, what we call the senior. 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.

• 24:27Scott Galloway?

  David Uremack is a professor of finance and business transformation at NYU Stern. He serves as chairman of the finance department and director of the NYU Pollock Center for Law and Business. Professor Uremack 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.

• 24:57Speaker 02

  Thank you for having me on, Scott.

• 25:08Speaker 02

  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, 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.

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