An 'Eshay' Discovered a Loophole in FTX Derivatives and Exploited It for 5000% Profit
Adlay.eth went toe to toe with Sam Bankman-Fried and won.
In the early days of November last year, one of the world's largest crypto exchanges, FTX, went down in flames.
The crypto industry reeled from the unexpected and rapid demise of the exchange, and the revelation that FTX's founder Sam Bankman-Fried — who goes by the three-letter acronym ‘SBF’ — had been misusing billions in customer funds caught many crypto enthusiasts completely off guard.
The vast majority of investors, journalists and analysts struggled to wrap their heads around the fact that SBF’s once-revered trading prowess was nothing more than an extremely well-fabricated facade.
Despite SBF’s reputation in the wider industry as some sort of curly-haired trading wizard, there were a small number of extremely proficient traders who had been profiting off Sam’s greed, arrogance and ineptitude for years.
Adlay.eth —who describes himself as an “eshay turned trader” — was one of these traders.
This is the story of how Adlay.eth managed to "systematically extract value” to the tune of a 5000% profit by gaining a strategic edge over the derivative balancing strategies utilised by Sam Bankman-Fried at FTX.
Here's how it all went down.
"When you offer financial instruments that are derivatives they obviously need to have some sort of value backing them, since the fact that something called BTC-FUTURE isn’t enough to give it value," says Adlay.
How this is usually established, is through simple trade orders, like offering a Bitcoin futures contract, and traders will trade the price until the market thinks that it's of “fair value”.
Adlay points out that FTX made a fatal mistake when it offered these types of financial products to the broader market, oftentimes choosing to back them with something called "tokenised assets" instead of a real asset. This then opened up a hole in FTX's books that allowed Adlay to jump in and scrape some extremely respectable gains.
"Sam was greedy," Adlay says.
"He didn't want to wait for liquidity to come to give the market value. So what he did was use something called 'tokenised assets'."
"My personal favourites were these things called bull/bear tokens. Basically, if you own this thing called BTCBULL you would get 3x long exposure to Bitcoin. If Bitcoin goes up 10%, you earn 30%. On the other side was BTCBEAR which offered 3x short exposure. If Bitcoin goes down 10%, you make 30%."
It's worth noting here that these tokenised assets are not given value through means of traditional trading and are instead “backed” by a certain amount of liquidity in a market with respect to the tokenised asset.
"So BTCBULL is backed by '3x' worth of long leverage in the form of Bitcoin perpetual contracts, which is yet another derivative," he notes.
Since the perpetual markets are a publicly traded market, this meant that all the holders of bull tokens would lose their leverage if the market was to go up since other investors are going long and using up that liquidity. Similarly, if investors have a bear token when the market went down, they would also lose leverage.
"Essentially, all of this meant that a 3x bull token might only have 1.5x worth of leverage. And while the correct choice lost leverage, the incorrect choice would gain leverage, making this a lose lose instrument.”
For those of you reading along and wondering what all of this means, it ultimately spells out a significant problem that FTX had to constantly fix up by "rebalancing" the leverage of these tokens, which they did at certain intervals throughout the day.
Adlay generously describes the process as the most "idiotic rebalancing procedure" he'd ever seen.
"To 'rebalance' the leverage of these bull/bear tokens, FTX would routinely inject a certain amount of liquidity to back the bull/bear tokens."
Red Alert on Baskets LTD
Adlay also draws attention to the fact that FTX didn't actually manage the rebalancing of these tokens itself, instead it chose to outsource the process to a shell company called 'Baskets LTD' which operated out of Antigua.
A closer look at their bankruptcy filing documents show that Baskets have a gaping whole in their balance sheet, which could spell potential losses of up to US$50 billion.
It was at this critical moment of 'rebalancing' that Adlay chose to strike. By calculating how much capital FTX needed to inject and when they would choose do it, he could make a leveraged countertrade of that move for significant profit.
Adlay picks a direction
"Eventually, I was able to calculate exactly how much they needed to inject and in what direction they'd do it."
"This entailed me doing the same directional trade as FTX a few seconds before they did it. I would use all my capital at 20x leverage due to the trade being that constant. This resulted in about 20-50% of profit per day for me," Adlay explains.
"This worked for around three to four months, and it was when I was up about 2000% that Sam Bankman-Fried decided to 'brick' (close down) my account and change the rebalancing process so they could frontrun my frontrun."
"Luckily for me, FTX's onboarding process was easier than Gmail in 2004 and I made burner accounts that I could loop my capital into and continue to extract value from SBF."
Now that Adlay was primed with multiple accounts and FTX choosing to frontrun their own rebalancing — with funds that were probably never actually theirs — Adlay ended up being able to scrape even more profit from the exchange, bringing his total exploit of FTX to a total of 5000% over time.
He says that this process went on for nearly eighteen months, saying that he's only just comes to terms with the reality that he will most likely never "get gains that good ever again" due to FTX's rebalancing process being a rare glimmer of tradable inefficiency in otherwise efficient markets.
While Adlay was pleased to have made some serious money from Sam Bankman-Fried and his associate's ineptitude as traders, he also points out that this situation makes it very clear that Bankman-Fried shouldn't be allowed to go down in history as anything that comes close to being a savant.
"I just hope that this all of this able to provide some insight into how bad Sam Bankman-Fried was as a whole. It should really make you have a think if you ever thought he was a genius."