Six months before the collapse of FTX in November set off a crisis in cryptocurrency, there was another cataclysmic event: The stablecoin Terra blew up, wiping out around $1 trillion in value, and triggering a cascade of crypto company failures. The collapse of Terra came as a shock to mostbut not to everyone.
A hedge fund called Galois Capital was among the few that smelled something rotten at Terra, and took a short positionbetting that the price of Terras twin cryptocurrencies would fall. The bet paid off and Galois made a profit, earning plaudits for making a smart decision at a time when the rest of the crypto world thought Terra prices would go to the moon.
Galoiss decision to short Terra was the same type of counterintuitive wager that has been mythologized in past financial debacles. The most famous example was celebrated in the book and movie The Big Short, which told the story of a handful of bold investors who foresaw the collapse of the U.S. mortgage industry in 2008and made big money betting against it.
Now, in the wake of FTXs catastrophic $32 billion blow-up, its worth asking why no one took out a big short against a company that, in retrospect, was flashing warning signsfrom shoddy accounting to the lack of a board to relying on a CEO who spent important meetings playing League of Legends.
Youre thinking this is going to end poorly
Chris Drose, the founder of Bleecker Street Research, made his name shorting the stock of a troubled health giant called American Addiction Centers, and has since published exposés on everything from air taxis to an ill-fated sports hustle called Hall of Fame Village that is currently trading in penny-stock territory. Drose says he and other Wall Street short-sellers have been watching the crypto market closely for years.
[From] the perspective of someone interested in fraud and wanting to be around fraud, youre outside the worlds best party, and youre looking inside and thinking this is going to end poorly, he observes. But I think they know that if they let you in, its going to end quicker for them.
This year, Drose shorted Coinbases stockbut he didnt short FTX, Terra or any other prominent blockchain project. While FTX did not have publicly-traded stock, the usual currency of short-sellers, it did have an ample supply of its liquid, in-house token, called FTT. Anyone who held a short position of FTT at the start of November would have made out like a bandit. So why didnt he short FTT?
Drose admits he didnt see FTXs collapse coming, but says that, even if he had, there was a lack of financial infrastructure in place for his fund to short a crypto token.
Heres how shorting works in more traditional finance: If youre a fund manager who wants to short Apple stock, for example, youll call up a prime brokerage such as Goldman Sachs or JP Morgan and ask them to lend you Apple shares for a specific period of time, after which you agree to return themideally at a lower cost after the price falls, letting you, the short seller, keep the difference as your profit.
Its different in crypto. While there are a handful of crypto prime brokerages, such as Genesis, that can arrange short-selling bets, there are no large, registered financial outlets like JP Morgan in the spaceand that poses a unique set of risks for anyone in the business of managing someone elses money, Drose says.
If I were to short a stock and came back [in] six months when I went to cover it and my prime broker was insolvent, I would be in trouble, he said. Particularly for a hedge fund manager that is managing other peoples money, you really have to trust your prime broker to take care of your clients funds.
Droses apprehension appears to be well-placed. Earlier this month, Genesislong viewed as a respected name in cryptodisclosed that it is in financial trouble, leaving clients unable to withdraw their funds.
Another challenge for retail investors who wish to place a crypto short is access. Crypto prime brokerages typically cater to large investors, making them inaccessible to manyunlike equities platforms such as Fidelity or Schwab, which let retail investors take out short positions.
Tom Dunleavy, a senior analyst at Messari, says there is another way for retail investors to short cryptocurrencies: They can turn to a futures exchange like Binance (or until recently FTX) to arrange a trade in which a short seller takes one side of the trade while someone who is bullish (or long in finance parlance) takes the other side. But this is not a particularly practical option because it is very expensive.
Most short bets are placed using perpetual futures, a mechanism unique to the crypto markets, due to the lack of a robust crypto options market, explains Dunleavy. Perpetual futures allow players to go long or short with one side paying the other a small fee for the privilege of holding the position.The bullish sentiment in the crypto market often makes bearish bets expensive to hold for prolonged periods of time.
The short seller must also pay an additional fee to the exchange and there is also a risk, of course, that the futures exchange might go insolvent and swallow your funds altogether.
Could short sellers help avert future crypto meltdowns?
Short sellers are controversial figures in the finance world, and are unpopular with some who regard them as vultures that prey on companies in trouble. Others, however, believe they provide an important service to the markets by shining light on firms that might be committing fraud or misrepresenting their financial performanceand often they are correct, as was the case with the protagonists in the Big Short.
Ciamac Moallemi, a professor of business analytics at Columbia Business School, sees short sellers as performing an important role. The general academic view is that short-selling is net positive, Moallemi told Fortune. Absent short-selling there is no market mechanism to call attention to [bad actors].
Moallemi believes this applies to crypto markets in the same way as it does to equities markets, which suggests that in the future, a larger and better regulated short-selling infrastructure in crypto could draw attention to fraudulent companies.
While there are ways to short cryptocurrencies, Moallemi notes there is also an additional risk for would-be short sellers: losing any profits if a whole exchange collapses, as with FTX. The worry is if you book a large profit you wont be able to get it off the platform, he says.
His concern appears to be well-founded. Just ask Galois Capital, the firm that profited from the collapse of Terra. Its now stuck with half of its capital trapped on the platform of bankrupt FTX.
