Imagine that you thought in early 2008 that subprime mortgages would be trouble, so you bought a large credit default swap on mortgage bonds. In September 2008, Lehman Brothers files for bankruptcy, subprime mortgage bonds are in trouble, and you decide to settle up your bet for a big profit. You pull up the CDS contract to get the contact information for your counterparty, so you can call them up and ask for your money, and, whoops! Your counterparty is Lehman Brothers. You could call them, but they won’t send you the money. You made the right bet, but with the wrong person.
At the Information, Margaux MacColl has a story about “The Pissed-Off Crypto Traders Who Predicted—and Profited From—the FTX Implosion,” mostly by shorting FTT, the token that FTX issued and that seems to have contributed to its bankruptcy. FTT was trading above $25 at the start of this month; it’s at about $1.29 today. If you shorted FTT a month ago to bet on FTX’s collapse, you made a lot of money. Unless:
For some FTT shorters, there was a catch—one that traditional traders rarely have to face: At any moment, the trading platforms themselves could turn against them, trapping their money forever.
Dylan Zhang, an employee at a San Francisco Bay Area crypto startup, learned this lesson the hard way. Before the past few weeks, he had trusted FTX. He liked how centralized exchanges like FTX and Coinbase hold your crypto for you, making it harder to be victimized by phishing scams. He also figured that a trading behemoth like FTX, with its about $2 billion in funds raised, would “have liquidity to cover or compensate users,” even if the exchange ran into financial issues.
Zhang was hanging out in a cafe in Palo Alto, Calif., when he saw the Binance CEO’s promise to sell off massive amounts of FTT. He quickly rushed to his go-to exchange, FTX, to short FTT, putting about $300 into the bet. In his mind, it wasn’t a wager that FTX was going to collapse completely—that was unfathomable to him at the time—but rather a bet that the company would briefly stumble. Why not make a few bucks at its expense?
At 7 p.m. that day, Zhang was sitting in a hotel room when he got a text from his girlfriend: Things were worse than they had thought. Bankman-Fried was an alleged fraud, FTX was potentially insolvent and they had to get their money out of the platform immediately. Zhang raced to the website, managed to withdraw their money and some of his short position before FTX completely stopped withdrawals. But he decided to leave $300 of his short position. Within a few days, his $300 short had magically turned into $3,000—and yet, by that point, it was locked inside the very exchange he had bet against. Zhang is still unable to access his profit.
One thing about the crypto financial system is that, when it’s centralized, it’s really centralized. Crypto exchanges are full-service financial institutions; in traditional finance banks and brokers and exchanges are generally separate entities, but in crypto one company — generally called an “exchange” — holds your money and crypto for you and operates the exchange. If you want to bet against the exchange, you might find yourself making that bet on the exchange, and taking the credit risk of the exchange. Probably a bad idea!