Thread by @TensaiCapital

The more I think about it, the more it seems like Alameda's relationship with the FTX risk/liquidation engine is at the heart of this debacle.

A brief, highly speculative thread on what might have gone wrong 🧵👇

One of the distinctive features of FTX was their liquidation engine. During rapid market movements, they "internalized" liquidated positions rather than simply dumping them on the market.

You can read more about this approach in their own words here:
web.archive.org/web/2022111122…

In that post, they describe how backstop liquidity providers (BLPs) take over the liquidated positions and associated collateral. While any market marker could opt in to being a BLP, in practice the vast majority of these internalized positions liked flowed to Alameda.

This system is appealing from FTX's perspective for two reasons.

First, it stabilizes the market and helps prevent flash crashes, leading to a better user experience.

Second, liquidation thresholds could be calibrated so that Alameda would profit from the internalization.

FTX was confident enough in this system that SBF actually went before a US House Committee and testified about its merits! This was part of a larger play to appeal to US financial regulators and expand their operation into traditional asset classes: web.archive.org/web/2022111007…

Okay, so we know liquidations on FTX were routed to Alameda rather than dumped on the market. So how does this lead to a $10bn hole?

The rest of this thread is speculative. But many of the accounts I've heard suggest that Alameda's problems began at the time of the Luna crash.

The key thing to understand about liquidations is that many retail users treat them like stop losses. Users will open a position on high leverage (up to 20x) with some fraction of their funds, and rather than set a stop, they simply hold the position until they get liquidated.

On May 10-12, the price of Luna fell from $30 to $0.00003 in just over 48 hours. This is equivalent to it dropping by 50% 20 times in a row. And on each of those drops, I suspect users were punting leveraged longs in the hope of catching the bottom and getting liquidated instead.

As a BLP, Alameda would have been forced to take on all of these leveraged knife-catches. And unlike previous market selloffs, in this case there was no point where liquidity re-emerged for Alameda to unwind these toxic positions. The price just marched steadily towards zero.

If Alameda wasn't unloading these positions elsewhere - which they likely weren't, since this would have been suboptimal in past selloffs - they would have accumulated an enormous losing position in LUNA. They would have essentially provided exit liquidity to the entire market.

Furthermore, it's likely that Alameda's privileged status on FTX allowed this process to continue past the point where another market maker would have been margin called. As the last-resort BLP, their internalizations may have been treated almost like a component of FTX itself.

Again, I have no concrete info about what happened, this is just a guess. But I find it plausible because it explains both 1) how a supposedly sophisticated firm could lose so much money, and 2) why their losses wiped out FTX users' funds in addition to their own balance sheet.

There are other possibilities too. FTX could have just yolo'd all of its users funds into Anchor. Or FTX/Alameda could have been a shell game from the very beginning. But based on everything we know about the players involved, in my view the liquidation story fits the best.

The easiest way to confirm this theory would be to see how other MMs performed during the Luna crash.

If they saw huge short profits on FTX offset by similarly-sized long losses elsewhere, that would suggest that FTX implicitly provided exit liquidity for the rest of the market.

I'm curious to hear other people's thoughts on this, especially if you are a market maker or quant shop who noticed unusual dynamics on FTX around the time of the Luna crash.