How Has FTX Impacted VCs?

https://revelointel.substack.com/p/empire-arthur0x

In this episode of Empire, hosts Jason and Santi are joined by Arthur, CEO of Defiance Capital, to discuss the fall of FTX and its impact on the industry.

Read our notes below to find out more.

How Defiance is holding up

• Arthur says this is the toughest six months he has ever experienced.
• The Three Arrows Capital (3AC) event in June prepared Defiance well in crisis and risk management.
• Arthur says Defiance is relatively unaffected by the FTX event.
• Defiance mainly used Binance and FTX for CEXs.
• Due to recent market conditions, all money in Defiance was moved from CEXs to cold storage.
• Defiance also trades with OTC desks such as Galaxy.

How FTX is dominant in Singapore

• Local crypto exchanges were restricted to only offering spot trading services.
• FTX had good UI, deep liquidity, and offered perpetual futures trading.
• Binance stopped serving Singapore in 2021.
• MAS (Monetary Authority of Singapore) put Binance on the investor alert list.
• FTX was not on the investor alert list although they offered identical services to Binance and was based offshore.
• Temasek, a Singapore Sovereign Wealth Fund, led one of the most recent funding rounds. 
• Arthur says this is an example of unintended consequences, where it may seem like the government gave implicit endorsement to FTX with regards to FTX not being on the investor alert list and Temasek’s involvement.
• Since Binance was inaccessible, FTX naturally became the second choice.
• Jason: Was it known that Alameda was picking off trades but users continued using FTX due to the tight spreads.
• Arthur: Not really because Alameda was not the biggest market maker of FTX after the first year and there were other market makers such as Wintermute.
• Arthur says one of the greatest innovations of FTX was cross margin collateral.

Did Defiance ever consider investing in FTX?

• Only looked into the FTT deal in 2019.
• Passed on the deal because Arthur was not convinced that a new exchange could compete with an established exchange.
• Never saw the equity deal.

Due diligence in a bull market

• Arthur says they were affected by how fast the market was moving.
• Defiance did 5 to 7 deals per month between Q4 2021 and Q2 2022, which was more than intended.
• With the vast amount of ecosystems and verticals topped with optimism, it became natural to be more active in investing.
• Less time and resources spent in doing diligence.
• Arthur says Defiance still does thorough due diligence but was not given sufficient time in some cases.
• In general, less diligence is done in a bull market.

FTX Contagion

• Arthur thinks this will lead to a significant drop in liquidity.
• This might lead to some projects losing a chunk of their treasury..
• Arthur says less than 5 companies in Defiance’s portfolio were hit by FTX’s collapse according to recent updates.
• 2 of those companies had a sizable amount of their treasury in FTX.
• There could be more that were affected but did not update them yet.
• More than half of the companies in Defiance’s portfolio should be fine.
• Arthur thinks the percentage of funds affected by FTX is not high if venture funds are included.
• Most of the new fundraises over the past 12 to 24 months were by venture funds who should not be badly affected by FTX.
• Liquid funds, especially those that run active arbitrage and delta neutral strategies, are most likely to be affected by FTX as they need to keep their capital on exchanges.

Did Arthur see red flags?

• Alameda having two accounts on BitMEX P&L leaderboard gave them legitimacy.
• People thought that Alameda were good and profitable traders.
• Arthur was wary of FTX/SBF creating new tokens on Solana with high fully diluted value (FDV) with long vesting periods.
• This was considered predatory and bad business practices but not fraud.
• Arthur did not expect them to commingle user funds as FTX was supposedly very profitable.

Did SBF have malicious intent all along?

• Arthur thinks SBF likely used the effective altruism principle as an excuse to justify his actions.
• SBF aggressively pursued low float high FDV tokens in early 2021 thinking there was no issue with it.
• Being idolised and well-received in the political circle led him to believe he can’t do wrong.
• Arthur thinks this is similar to other firms that got too big too quickly, such as 3AC and Celsius.

Jason

• He thinks this has been going on for years.
• SBF wanted people to think that Alameda was a market neutral firm and not a directional fund but their portfolio was poorly managed.

Why did CZ wait?

• Arthur doesn’t think CZ knew about FTX commingling user funds.
• Arthur thinks CZ just sensed that it doesn’t seem right that Alameda’s balance sheet is so fragile.
• Binance Labs rarely sells any investments and wrote off their Luna investment.
• Binance makes so much money that they do not bother to exit most investments.
• Binance Labs is generally a long-term investor.
• Arthur says Binance’s investment gave Binance some leverage against FTX and SBF, if sold, the leverage would be lost.

Damage on Solana ecosystem

• Community is trying to fork Serum as the private key is held by a FTX employee.
• FTX marketed their Solana projects to investors in a way to get money as quickly as possible.
• Arthur thinks the Solana ecosystem will need a long time to recover from this.
• Arthur thinks the Solana ecosystem should be able to survive but not sure that it can get back to ATHs for user activity and market cap.
• Santi agrees with Arthur and thinks there are good builders on Solana.
• FTX owns 6-8% of Solana tokens.
• Arthur thinks there will be huge selling pressure for Solana over the next 12 months due to the uncertainty of what the bankruptcy estate will do with it.

Liquidation Process

• Arthur thinks this will be the most complex liquidation process in history due to the large number of creditors spread across different jurisdictions.
• At least 5-10 major countries’ courts are needed to acknowledge the liquidation before they can enforce anything.
• Since FTX is in chapter 11 and not declared bankrupt yet, there is a slim chance that they can restructure, pay off creditors, and continue operating.
• Arthur thinks the brand is so tarnished that it is not possible anymore.
• He questions why FTX, including FTX International, is filing for Chapter 11 when FTX Trading is an Antigua entity and FTX Digital Market is headquartered in the Bahamas.
• This action skips the jurisdiction of Antigua and Bahamas.

Impact on token deals

• Current standard practice is to bundle token deals with equity due to US regulations.
• Arthur thinks pure token deals will be unpopular unless the project and team are built in a decentralised manner from the start.
• He believes most of the deals will continue to be equity + token warrant deals moving forward.

Public vs Private Markets

• Defiance’s new fund will be a liquid venture fund.
• Arthur thinks there are many opportunities in the public market worth devoting time to.
• He says liquid funds can manage market risk better than venture funds.

Santi

• A crypto venture fund needs to be managed actively.
• There will be huge opportunities to do distressed deals.
• Public markets are compelling but not enough risk to reward ratio currently.

Arthur’s Takeaways

• More opportunities are given to bad actors than good actors.
• It is a lot easier for those that are willing to take shortcuts to rise to the top in the crypto industry. 
• There needs to be checks in place to mitigate these acts and stop bad actors early.