Tokens as Junk Equity

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                             When Icarus flew too close to the sun, at least he didn’t have to face the fallout and
                             consequences of his actions. Sam Bankman Fried (SBF) may have his ~$1bn fortune to
                             cushion his fall but he must now answer to the public and government having fallen
                             into the very trap he minimized the adverse consequences of: leverage.

                             Investors need to be wary of the hidden leverage created by token-based junk-equity
                             financing models. We addressed this topic in a piece we wrote a couple months ago: on
                             predicting the FTX fiasco, we wrote:

                             “However, companies pursuing this method of junk equity (token) financing should be very
                             wary of Double Leverage. Your token is capitalized on your balance sheet as equity and an
                             asset, it’s super sensitive to mark to markets. Borrowing against this “asset” which is actually a
                             financing liability provides scope for other market participants to manipulate your asset side of
                             the balance sheet, and force your equity negative.”

                             As shocked as we are, FTX died in a bank run: the most common source of death for
                             financial institutions. But how did nobody see it coming, and why did Alameda’s
                             balance sheet being leaked change that? Alameda is SBF's proprietary trading shop,
                             and historically very connected with FTX: investors can use one to infer the health of
                             the other.

                             We previously argued that many tokens in the crypto ecosystem function only as junk
                             equity: a claim over the option value of a future token-based network. Acolytes will
                             insist tokens represent limited value today, but in that future world where the issuing
                             company decentralizes, could be worth a ton. Traditionally, tokens begin accruing
                             value as they create utility or underly governance of a decentralized network. But what
                             of networks with valuable tokens day-1, that don’t necessarily fit this junk-equity
                             criteria?

                             Many networks can structure as DAOs day-1 (ie. Uniswap), providing a clear path to
                             token value accrual or as utility tokens (ie. Helium), backing a claim to a resource like
                             bandwidth – in these cases, the value of the token is clear. Others like FTX’s token
                             FTT doesn’t really offer much utility or governance value other than a slight fee
                             discount on FTX trades – the value to the token is the option value that the company
                             may eventually become a DAO or underpin utility for a network. Projects using a
                             token only as junk equity are the most susceptible to runs against their token, as there

                             often isn’t organic customer demand, and a company must use its real revenue to
                             defend the token’s price.

                             In bear markets, when liquidity dries up and optimism vanishes, investors wake up to
                             the lack of fundamental value in these junk equity tokens besides their belief in the
                             founder and project. The company is increasingly put in a position of having to use
                             their cash flows to defend their token. Token defense drains any substantial free cash
                             flow: pushed to an extreme companies must borrow debt to create the necessary
                             liquidity to defend their token. When this goes wrong, it’s often a death knell, and this
                             is likely what happened here. We break out this classic death spiral in more detail
                             below.

                             Assets = Liabilities + Equity is one of the first foundational principals drilled into most
                             professional investors, and surely half the industry didn’t just forget the basis for their
                             entire industry overnight… However, investors have never had to deal with the
                             question of junk equity before. Below is Alameda’s leaked balance sheet from June 30,
                             2022. Note the price of FTX at that time was ~$25 vs. $3 where it currently is.

                             So where did the debt even come from? Alameda/Sam was able to convince some
                             lender to accept the FTT token as collateral for a loan. The sheer size of the loan has
                             led many to speculate it came from FTX itself: after all, who else would let a lender
                             with no financial track record borrow billions of dollars with no real collateral?

                             The implications here are monstrous: Alameda’s net worth is majority comprised of
                             FTT, a junk equity token controlled by FTX. In other words, those $7.4bn of loans
                             were back by Sam’s good faith – probably worth something in bull markets, but
                             worthless in a liquidity-drained bear market.

                             The sovereign individual remain but a dream. Other market participants (read: CZ)
                             jumped at the opportunity to bankrupt Alameda, and did so quite effectively by driving
                             the FTT token’s value down significantly, and shrinking the asset side of the balance
                             sheet. In doing so, he set off a classic crypto death spiral. This is an estimation of what
                             Alameda’s balance sheet would look like today.

                             The equity in Alameda has been wiped out completely due to the collapse of FTT’s and
                             Solana’s price. This collapse would then lead Alameda to fire sale assets to repay the
                             $7.4bn of loans, which given the illiquid markets they’re selling into, would further
                             accelerate the asset side decline. I suspect the ~20% fall in Robinhood’s price yesterday
                             was panic sellers, getting ahead of FTX/Alameda having to fire sale equity securities.

                             So what of double leverage, and the concept of junk-equity? Well, it proved to be just
                             that: junk when misused: junk-equity relies on the full faith of the issuer to be paid
                             back, with no real recourse for value destructive action. Traditionally when a company
                             issues equity, both sides of the balance sheet increase. Tokens are a form of company
                             equity, held as an asset for the company to utilize as needed, and don’t fit squarely into
                             any accounting box. In effect, the company controls its entire junk equity financing
                             source up front. However, that financing source is held as an asset without a
                             corresponding liability, so changes in the mark to market of the asset have drastic
                             effects on the company’s true shareholder’s equity. In good times, this can be a lot of
                             fun. In essence, the token amplifies the equity risk of the company, like debt normally
                             does by adding leverage.

                             Once the token has increased in value, the founder now has a lot more freedom to
                             create liquidity: she can sell her token for cash which is rare, as it depresses price and
                             reduces the value of her assets. More likely, she will borrow to give herself some
                             optionality for future building and buffer to defend her token. She gets the cash, and
                             knowing she isn’t spending all of it today, will invest some of it.

                             This company already has amplified equity risk through the issuance of junk equity (a
                             token). Adding debt, increases that equity risk even more, but more importantly gives
                             competitors and ill-wishers a kill shot. As the diagram above shows, wipeout of the
                             token can put this company near bankruptcy. These tokens tend to trade in illiquid
                             markets and are susceptible to price manipulation due to poor price discovery. In
                             FTX’s case, a $600m sale of tokens on the open market by CZ provided just that
                             impetus: the token price collapsed ~90%, driving the company into default on it’s
                             loans.

                             The death spiral has come full circle. Because junk equity fills no utility, it relies on
                             company generated demand to support price in bear markets when liquidity

                             disappears. With significant downward market pressure, the company doesn’t have
                             enough revenue to defend its token – it turns to capital markets to finance the deficit.
                             The borrowing then sets into motion a self-fulfilling prophecy as leverage increases
                             the volatility of the company’s equity. Finally, with enough sell impetus at this point, a
                             bad actor can cause the token price to collapse, putting the company into bankruptcy
                             given their debt leverage. When investors believe in the long-term decentralized
                             model, you have enough market buy pressure to maintain price organically, but as soon
                             as that disappears, malicious actors can thrive if the token doesn’t underlie a
                             productive system with utility.

                             FTX failed where most great financial institutions before it has: a leverage spiral
                             amplified by changes in the asset side of its balance sheet. The kicker here was that it
                             did all this with an asset that it created in the first place – a junk equity asset with
                             limited fundamental value beyond speculation. We’re not going to say FTX was a
                             ponzi, because it wasn’t – there was an extremely strong operating business and
                             consumer brand here. FTX was mismanaged badly partially driven by one of the
                             biggest changes in market context in history, and partially by the need to stay big and
                             strong to fight off the perception of a bank run.

                             But it does raise a big question around how companies should account for their own
                             tokens. In equity markets, company shares would never be listed on the asset side of
                             the balance sheet – repurchased or issued shares are either sold or in the treasury
                             reserve account. This raises an important question that we will save for another piece:
                             should a company be able to hold it’s own token as an asset on it’s balance sheet?

                             Businesses that own their own token need the same accountability, and should realize
                             they are already implicitly leveraged. Adding debt leverage to token leverage is
                             hopefully a mistake CZ won’t make.

                             The King is dead, long live the king!