Race Capital released an investment memo: Why did we invest in FTX in July 2019?

In mid-July, FTX announced the completion of a $900 million financing round, which brought the company's valuation to $18 billion, making it one of the highest-valued companies in the cryptocurrency industry.

As a result, FTX's early investors received over 100 times their investment returns. Race Capital (formerly known as Proof of Capital) is one of FTX's earliest investors, participating in FTX's $8 million seed round financing at the end of July 2019. Recently, the firm released the investment memorandum that led to their decision to invest in FTX, which includes an explanation of FTX's advantages and risk factors. The translation is as follows for readers' reference:

Summary

Date: July 24, 2019

To: Race Capital Investment Committee

Capital Transaction Team: Chris McCann and Edith Yeung

Company Contacts: Sam Bankman-Fried (CEO) and Darren Wong (CMO)

Subject: Investment Proposal for FTX

Total Size: $8 million

Other Notes: FTX is a subsidiary of Alameda Research, one of the top quantitative hedge funds in the cryptocurrency space.

Company Description:

FTX is a cryptocurrency futures and derivatives exchange. Creating a new top-tier exchange is no small feat; since its trial run on June 1, 2019, the exchange's daily trading volume has exceeded $150 million.

FTX's products include typical top cryptocurrency futures products like Bitcoin, as well as innovative products such as altcoin indices, index futures, and up to 101x leverage products.

Additionally, they have developed an advanced clearing engine in-house, significantly reducing the risk of recovering or socializing losses (to profitable users), which is a major concern for traders using existing products.

Key Metrics:

Employees: 10 in total

Trading Volume: $50 million on June 11, $150 million on June 22, $250 million on July 4, $300 million on July 5

Revenue: (hidden)

User Distribution Regions: Mainly Asia (Mainland China, Hong Kong, Singapore, Vietnam, Japan, South Korea), Russia, and Europe.

Execution Capability

The FTX team is one of the most execution-oriented teams we have encountered in the cryptocurrency space, as evidenced by their update logs:

Milestones from the team

Investment Highlights
In a short period, FTX launched and achieved significant early traction in derivatives trading. Their goal is to become the world's leading derivatives trading platform, replacing BitMEX, Huobi, and OKEx.
Deep Trading Expertise
The FTX team's high appeal is largely due to their extensive experience operating Alameda Research (one of the top crypto quantitative funds).
Founded in October 2017, Alameda Research manages over $1 billion in digital assets and trades between $600 million and $1.5 billion daily across thousands of products. This includes all major cryptocurrencies and their derivatives. The FTX team created and built the exchange they wished to exist, which has resonated with the crypto ecosystem.

Founders

FTX founder and CEO Sam Bankman-Fried is passionate about trading. Sam has a large following that watches his live trades; trading is Sam's entire topic, and he often interacts with new traders across all community forms of FTX.

Similar to Ethereum founder Vitalik Buterin, we also appreciate seeing founders have a deep and passionate love for what they are building. It is clear that Sam and his team are essentially traders, which is reflected in all the products and information they create.

Huge Market

While Coinbase & Binance focus primarily on the spot market, the futures market is just as large. On July 25, 2019, the total trading volume of the spot market was $10 billion daily, while the total trading volume of the futures market was $11 billion daily. However, in the futures market, the three giants (BitMEX, Huobi, OKEx) typically have trading volumes that are three times that of the spot market.

Moreover, there are currently no futures exchanges with their own native exchange tokens. Binance is the cryptocurrency exchange in the spot market with one of the most valuable tokens (market cap of $4.5 billion), and we expect a comparable token (FTT) to exist in the futures market.

Race Capital Investment Thesis

One of our core investment areas is financial infrastructure. Currently, exchanges are the primary drivers of financial activity in the cryptocurrency ecosystem, with trading volumes driven by futures exchanges comparable to those of spot market exchanges.

Given FTX's trading expertise, founder market adaptability, and early traction, FTX has the opportunity to become the number one derivatives exchange in the crypto market.

Market Size/Industry Landscape

In today's market, the subset of futures exchanges is much smaller compared to spot exchanges. The complete list of cryptocurrency futures exchanges (ranked by volume) is as follows:

Data as of July 25, 2019

Trading volumes fluctuate monthly, but the undeniable leader in the crypto derivatives market is BitMEX.

BitMEX only received one angel investment in 2015 (estimated at $200,000), so there is very little public information about the company. However, from several data points, BitMEX's valuation is estimated at $3.6 billion, generating $83 million in revenue in 2017, with its office located in the most expensive office space in Hong Kong. Conservatively, BitMEX's current annual revenue is approximately $500 million (based on volume and fees).

In the derivatives market, liquidity begets liquidity, so one of the biggest questions is how FTX will establish itself in this market. Aside from the FTX team's experience and background, from a market outlook perspective, BitMEX is currently under investigation, which has led to a surge in net capital outflows from that exchange.

We believe this has opened up the market just as FTX is preparing to officially launch on June 29, 2019. If FTX can replace BitMEX as the primary futures exchange, the FTX platform will gain tremendous value.

Team

After engaging with the FTX team in San Francisco and Hong Kong for some time, we believe FTX has assembled the best crypto technology and trading team, comprising individuals from Jane Street, Google, Huobi, PayPal, Blackstone, Facebook, and SIG, all of whom have experience building large-scale trading and exchange systems.

Sam Bankman-Fried, CEO. Before founding Alameda, Sam was a trader in the international ETF division of Jane Street Capital. He traded various ETFs, futures, currencies, and stocks, and designed their automated OTC trading systems.

Gary Wang, CTO. Gary was a software developer at Google, where he developed pricing aggregation and service systems for Google Flights. He graduated from MIT with a degree in Mathematics and Computer Science.

Before joining Huobi Global as Business Development Manager, COO Constance Wang worked at Credit Suisse in private banking AML/KYC and risk control. There, she focused on expanding institutional business and managing strategic partnerships with crypto exchanges in the Asia-Pacific region.

Darren Wong, CMO. Darren was an early software engineer at Simility, a machine learning fraud detection startup later acquired by PayPal. He audited smart contracts for projects like Wabi and was an early investor in dozens of ICO projects. He graduated from Johns Hopkins University with a degree in Applied Mathematics and Economics.

Jennifer Chan, CFO. With 10 years of private equity and fund operations experience, she served as the investment accounting manager at Blackstone Group and as AVP at Deutsche Bank. She graduated from the Hong Kong University of Science and Technology with a degree in Accounting.

Nishad Singh, VP. Nishad is a software engineer on Facebook's application machine learning team. He graduated with honors from UC Berkeley with a degree in Electrical Engineering and Computer Science.

Andrew Croghan, Head of Business Development. Andy led the crypto business at Susquehanna International Group, helping it become one of the first large institutions to enter the space. He worked in options trading at SIG for 5 years.

Investment Considerations

Unique Positioning

FTX is built by traders for traders, aiming to become the world's largest cryptocurrency futures exchange. They have significant early traction, achieving over $300 million in trading volume in less than 30 days, and their products resonate within the cryptocurrency trading community.

Meaningful Growth Opportunities

We believe FTX has three main growth drivers:

Full Suite of Futures Products

Traditional futures exchanges primarily focus on Bitcoin derivatives. For example, 90% of BitMEX's trading volume consists solely of Bitcoin (perpetual, 60-day, and 30-day contracts).

FTX is applying the same concepts and extending to long-tail crypto assets, including:

• Medium Token Index Futures - Futures products built on all mid-cap crypto assets
• Stablecoin Futures - People love to speculate on stablecoins (especially Tether), and FTX has created a tool to support their trading.
• Shitcoin Index Futures - This humorously named product is a collection of all the long-tail cryptocurrencies that people love to hate (also known as "shitcoins").
• Exchange Token Futures - An index of all exchange tokens in the market, a category that traders love to trade. All these products are uniquely created by FTX, and all traders enjoy them.

Due to the strong fit between the founders and the market, they are able to create products that traders love to trade.

Unique Market Infrastructure

While there are some "exchange-as-a-service" providers, the FTX team decided to build their own exchange from scratch. Reasons for this decision include:

• Real-time - The exchange must be able to process trades in real-time across a wide range.
• API - FTX is building an API gateway into the exchange for professional and consumer traders to use.
• Multiple Collateral Types - Unlike BitMEX, FTX wants to allow traders to use any asset type as collateral (such as Bitcoin, Ethereum, stablecoins, etc.)
• Simplified Tech Stack - FTX has built an internal OTC desk to handle large orders, eliminating the need to rely on external service providers to execute trades.

FTX's motto is "by traders, for traders," and their foundational technology infrastructure reflects this.

Expanding the TAM (Total Addressable Market) for Future Traders

Futures are often considered a complex financial instrument that retail traders find difficult to understand. Historically, futures have always been limited to a small subset of more advanced traders and trading firms.

FTX has been able to abstract away much of the complexity of creating futures products and deliver them in a way that is intuitive for most traders in the crypto ecosystem.

Thus, we assume that FTX will not only eat into the existing futures exchange market (like BitMEX) but also expand the TAM of traders that these exchanges cater to.

Below are examples of the interfaces of BitMEX and FTX:

BitMEX trading interface

3x leverage token (BNB) product

Expansion into Asia

FTX has most of its internal team based in Hong Kong and focuses on attracting large traders and trading firms from Asia to the exchange.

Asia is a major trading hub for global cryptocurrency trading volume, with the vast majority of top exchanges located in Asia. FTX has seen meaningful traction in these regions and is doubling down on efforts to attract traders from the area to join the platform.

Risk Factors

• Alameda vs FTX

It is unclear how much time Sam will spend on Alameda vs FTX. Given the speed of execution, we believe there will be dedicated FTX time, but this remains to be seen.

• Trading on Their Own Exchange

Exchanges need a market maker to get started, and Alameda will be the initial market for FTX itself. Over time, the team intends to bring in more market makers, but this is a major risk. We have spoken with other quantitative hedge funds that have hesitated to trade on FTX for this reason.

• Other Derivatives Platforms Issuing Their Own Exchange Tokens

If one of the current top derivatives exchanges (like BitMEX) launches its own platform token, FTX's momentum will weaken.

• Regulatory Risks

Like BitMEX, FTX must be cautious with KYC, AML, and compliance practices when onboarding new customers. Fortunately, KYC has become more standardized for exchanges, and there are external service providers that will support this capability, but if mishandled, this will be a significant risk.

• Other Large Spot Market Exchanges Offering Derivatives Products

If Binance or Coinbase launches their own futures products, the derivatives market will face greater competitive pressure. Currently, the futures and derivatives market and the spot market are essentially separate, but we believe this situation will not last forever.

If BitMEX, Huobi, and OKEx continue to dominate the futures market, FTX will face pressure to rely solely on net new customer growth.

• DEX Becoming the Primary Form of Trading

If decentralized exchanges (DEX) become the primary form of trading, decentralized derivatives like dYdX may capture the largest market share in the future. So far, there are no signs that this will happen, but it is worth monitoring the DEX space.

• Major Hacking or Security Incidents

If FTX suffers a major hacking incident or loss of funds, traders will lose confidence in the platform and be reluctant to try a new exchange.

Investment Terms: (hidden)

Exit Strategy: (hidden)