Six months before the collapse of FTX in November started a cryptocurrency crisis, there was another cataclysmic event: The stablecoin Terra exploded, which wiped out about $1 trillion in value, and triggered a cascade of crypto company failures. The collapse of Terra shocked many—but not everyone.
A hedge fund called Galois Capital was one of the few who smelled something rotten in Terra, and took a short position—betting that the price of Terra’s twin cryptocurrencies would fall. The bet paid off and Galoi made a profitearned accolades for making a smart decision at a time when the rest of the crypto world thought Terra prices would go to the moon.
Galois’ decision to short Terra was the same type of counterintuitive bet mythologized by past financial crises. The most famous example is celebrated in book and movie The Great Briefwhich tells the story of some brave investors who saw the collapse of the US mortgage industry in 2008—and made a lot of money betting against it.
Now, in the wake of FTX’s disastrous $32 billion blowout, it’s worth asking why no one took a “big short” against a company that, in retrospect, was flashing warning signs -from bad accounting to the lack of a board trusting a CEO who spends important meetings playing League of Legends.
‘You thought it was going to end badly’
Chris Drose, the founder of Bleecker Street Research, made his name shorting stocks in a troubled health giant called American Addiction Centers, and has since been published exposed of everything from air taxis to an ill-fated sports hustle called Hall of Fame Village that now trades in penny-stock territory. Drose says he and other short-sellers on Wall Street have been watching the crypto market closely for years.
“[From] the view of someone who is interested in fraud and wants to be associated with fraud, you are outside the best party in the world, and you look inside and think it will end badly,” he said. “But I think they know that if they let you in, it’s going to end faster for them.”
This year, Drose shorted Coinbase stock—but he didn’t short FTX, Terra or any other prominent blockchain project. While FTX does not have a publicly traded stock, the usual currency of short sellers, it has an ample supply of its liquid, in-house token, called FTT. Anyone who held a short position in FTT at the start of November would have been a bandit. Then why didn’t he shorten the FTT?
Drose admitted that he did not see the collapse of FTX coming, but said that, even if he had, there is a lack of financial infrastructure in place for his fund short of a crypto token.
Here’s how to short in more traditional finance: If you’re a fund manager who wants to short Apple stock, for example, you would call a prime brokerage like Goldman Sachs or JP Morgan and ask them to lend you Apple shares for a certain period of time, after which you agree to return them—preferably at a lower cost after the price falls, allowing you, the short seller , keeping the difference as your profit.
This is different from crypto. While there are some crypto prime brokerages, such as Genesis, that are able to arrange short sales of bets, there are no large, registered financial outlets like JP Morgan in the space—and that has a unique that set of risks for anyone in business. to manage other people’s money, said Drose.
“If I short a stock and come back [in] six months when I went to cover it and my prime broker was insolvent, I would be in trouble,” he said. “Especially for a hedge fund manager who manages other people’s money, you really have to trust your prime broker to take care of your client’s funds.”
Drose’s fear seems well-placed. Earlier this month, Genesis—long regarded as a respected name in crypto—exposed that it is in financial trouble, leaving clients unable to withdraw their funds.
Another challenge for retail investors who want to put crypto short is access. Crypto prime brokerages usually cater to large investors, making them inaccessible to the masses—unlike equities platforms like Fidelity or Schwab, which allow retail investors to take short-term positions.
Tom Dunleavy, a senior analyst at Messari, says that there is another way for retail investors in low-cost cryptocurrencies: They can turn to a futures exchange like Binance (or until recently FTX ) to arrange a trade where a short seller has one side of the trade while someone going strong (or “long” in finance parlance) takes the other side. But this is not a very practical option because it is very expensive.
“Most short bets are placed using perpetual futures, a mechanism unique to crypto markets, due to the lack of a stable crypto options market,” Dunleavy explained. “Perpetual futures allow players to go long or short on one side paying the other a small fee for the privilege of holding the position.
The short seller also has to pay an additional exchange fee and there is also a risk, of course, that the future exchange may default and swallow your funds completely.
Can short sellers help prevent a future crypto meltdown?
Short sellers are controversial figures in the financial world, and are unpopular with some who view them as vultures preying on troubled companies. Others, however, believe that they provide an important service to the markets by shining a light on companies that may be cheating or undermining their financial performance—and they are often right, as in the case of protagonists of Big Short.
Ciamac Moallemi, a professor of business analytics at Columbia Business School, sees short sellers as playing an important role. “The general view in academia is that short selling is a net positive,” Moallemi said luck. “Without short-selling there is no market mechanism to call attention to [bad actors].”
Moallemi believes that this applies to crypto markets in the same way as equity markets, suggesting that in the future, a larger and better regulated short-selling infrastructure in crypto may attract attention. of fraudulent companies.
While there are ways to short cryptocurrencies, Moallemi says there is an additional risk for would-be short sellers: losing any profits if an entire exchange collapses, like FTX. “The concern is that if you book a big profit you won’t get it off the platform,” he said.
His concern seems to be well founded. Just ask Galois Capital, the company that profited from the collapse of Terra. It is now stuck with half of its capital stuck on the platform of the bankrupt FTX.