Hedge funds with billions stranded on FTX

Hedge funds have billions of dollars stuck in the failing cryptocurrency exchange FTX and could face years of waiting to recover anything at all from a market they once thought was one of the most reliable bets in the industry.

In a situation reminiscent of Lehman Brothers in 2008, which left billions of dollars in hedge fund assets trapped for years, the investors who traded on the stock exchange in the Bahamas found themselves among thousands of creditors in an extremely complex bankruptcy.

The sudden failure of FTX this month, which is valued at nearly $32 billion this year, has shocked the investors who backed it and the traders who used it. Legal filings revealed Sunday that FTX owes its 50 largest creditors, likely to include a wide range of hedge funds, traditional asset managers and other traders, more than $3 billion.

“I lost investors money after they put their trust in me to manage risk and I’m really sorry for that,” said Travis Kling, founder of Ikigai Asset Management, which has a “significant majority” of its hedge fund assets stuck in FTX. . “I have publicly supported FTX many times,” he added. “I was wrong.”

Crypto-focused hedge funds have direct exposure to FTX Group, or FTT, a digital token FTX has promoted to spur more trading on the major exchange, of about $2 billion, according to data group Crypto Fund Research.

Earlier this month, the Financial Times revealed that Galois Capital, whose founder Kevin Zhou is credited with discovering the collapse of cryptocurrency Luna, had half of its capital stuck in FTX.

Zhou admitted that he was “deeply sorry” and that he did not appreciate the “solvency risk with keeping our money in FTX”. He said it could take a few years to recover “a percentage of our assets”.

Crypto Fund Research estimates that between 100 and 150 crypto hedge funds, or about 25 to 40 percent of the total number of these niche funds, have some direct exposure to the FTX or FTT pool.

The average exposure is around 7 to 12 percent of the total assets of funds under management, with some funds owning the majority of their assets in an exchange, according to the dataset.

Including companies like Genesis Trading, which has halted withdrawals in its lending unit, and BlockFi, which has taken similar steps, exposure could reach $4 billion to $5 billion, Crypto Fund Research said.

FTX said in legal filings Sunday that it owes at least $100 million to each of its 10 largest creditors. The 50 largest creditors, whose names were redacted in the filing, all owe more than $20 million.

Institutions that trade in cryptocurrencies are left wondering who they can trust, if the supposedly powerful FTX could collapse so quickly. Managers were withdrawing money from the exchanges out of caution.

“I think we will see more business failures over the coming weeks, so we have reduced our exposure in all other counterparties,” said one fund manager.

Unlike traditional exchanges, which simply match buyers with sellers, cryptocurrency exchanges usually hold customers’ assets for long periods of time, to make it easier for customers to trade. However, this leaves users vulnerable if the exchange itself gets into trouble.

And unlike Lehman’s situation, where creditors eventually paid off more than 100 percent of the assets, it’s not at all clear how much is left to recover.

In an ominous sign, FTX’s new CEO, John Ray III, said Thursday that he had never seen such a complete failure of the company’s controls. Ray added that he did not trust the budgets he saw.

FTX has so far found just $740 million in cryptocurrency, a “fraction of the digital assets” it hopes to recover, compared to $9 billion in liabilities the day before it collapsed into bankruptcy. Moreover, FTX investigates the “abnormal” transactions that occurred on its exchanges after its bankruptcy.

Many cryptocurrency hedge funds were discovered holding assets on FTX because it was seen as one of the most excellent exchanges in a largely unregulated sector.

“FTX was the top, the prettiest girl in the class,” said Anders Kvamme Jensen, mutual fund manager of AKJ Digital Assets Fund. “They were seen as a clean, sophisticated counterpart, an image that was the main driver behind its success.”

He said crypto hedge funds “generally put a little emphasis on risk analysis” on major exchanges. He said that conducting due diligence is difficult, due to the lack of regulation and the remoteness of the locations where many exchanges have set themselves up.

Su Zhu, co-founder of collapsing hedge fund Three Arrows Capital, tweeted that he moved to trading on FTX last year, encouraged by generous terms and backing from a host of big venture capital names. I assumed someone there did DD [due diligence] They must have grown up.”

FTX has also called out more mainstream hedge funds that were considering trading cryptocurrencies to take advantage of higher asset returns. His offer to potential clients, according to one hedge fund executive, was that it started with cryptocurrencies but would expand into currency and futures trading, allowing the fund’s money to be used efficiently across all of its margin accounts.

“Like many of you, we are confident that FTX is a quality player committed to driving the industry forward,” investment firm Sino Global Capital wrote last week, adding that its direct exposure to the exchange was an “average seven figure.” “We deeply regret that misplaced trust.”

laurence.fletcher@ft.com

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