The FTX Collapse: What Happened and What It Means

In possibly one of the most significant crypto stories ever, FTX, one of the world’s largest crypto exchanges in the world by volume, (1) completely collapsed last week. The speed and severity of the implosion came as a shock to almost everybody in the cryptocurrency space. Nothing highlighted the severity of FTX’s demise more than watching the net worth of Sam Bankman-Fried (SBF), the owner of FTX, evaporate from $16 billion to $0 almost overnight. (2)

Key Takeaways

• The FTX and Alameda Research collapse was driven by an over-reliance on the FTT token, high-risk business deals, and potentially fraudulent activity.
• FTX’s bankruptcy is pressuring other industry players to have more transparent business models.
• Regulators are acting swiftly to investigate what happened and make adjustments to ensure more oversight of cryptocurrency markets.

Crypto’s 2008 moment

The inner workings of the collapse are complex, and it is not yet fully understood exactly what happened as the story continues to rapidly develop. However, the crisis seemed to stem from the extremely close ties between FTX and Alameda Research, a hedge fund that SBF also owned.

A report by CoinDesk in the beginning of November highlighted that Alameda had $8 billion in liabilities, most of which were bad loans. To make matters worse, over $5 billion of their $14.6 billion in assets were in FTT, the native token of the FTX exchange, which SBF created out of thin air to give perks and benefits to FTX users. (3)

Things began to deteriorate rapidly after that report. On November 6th, Binance, the world’s largest crypto exchange, announced that it would begin liquidating any remaining FTT on its books. Significant downward pressure on the FTT token followed as investor confidence diminished in the asset. (3)

As the sell-off intensified, journalists and industry insiders began fully grasping the implications of the downward price action of FTT: namely, that $10 billion worth of FTX client assets (out of a total of $16 billion) had been loaned to Alameda in order for it to engage in its questionable business practices. As the FTT token dropped towards zero, Alameda’s portfolio—heavily weighted as it was towards the FTT token—was soon made up mostly of liabilities.

Because FTX had loaned client assets to Alameda in order for them to invest in an FTT token that lost most of its value overnight, they were left insolvent and unable to repay customer deposits. (1) As a result, FTX filed for bankruptcy on November 11th. (4)

What this means right now

The effects of this collapse have been felt immediately. Many institutions and retail investors involved in crypto had exposure to FTX. Companies such as BlockFi, a leading crypto financial services company, which had signed a $400 million credit facility with FTX in July, have had to pause operations given the lack of clarity surrounding FTX’s situation. (5)

Meanwhile, high-profile investors in FTX, such as Sequoia Capital, have announced that their investments ($200 million in the case of Sequoia) were now probably worthless. (6) And this, obviously, is on top of the thousands of everyday users who trusted FTX with their assets and are left with no way to access their funds.

In the short term, there doesn’t appear to be many silver linings to these recent events. Customer confidence is shaken, asset prices have fallen, and heavy-handed regulation seems likely. Not to mention, we have to contend with the incredibly painful reality that many people have lost a significant amount of their investments and savings.

However, taking a longer-term perspective, there is a chance that this event will prove to be a seminal moment in cleansing the crypto ecosystem of poor actors and strengthening the controls and practices of existing companies, leading to a new era of transparency and accountability.

Lessons learned

The need for transparency

One of the immediate reactions of the FTX fallout is that there are growing calls in the crypto community for proof of reserves to be the industry standard when it comes to centralized cryptocurrency services.

The opacity by which FTX and Alameda Research operated in did not allow people doing business with them, or those who entrusted their assets with them, to make well-informed decisions based on reliable risk-assessment. This opacity has been a trademark of many centralized crypto projects and has far too often led to people incurring losses.

In the immediate aftermath of FTX’s fall, major crypto exchanges like Binance, OKX, KuCoin, Poloniex and Huobi have all promised to issue proof-of-reserves attestations on an ongoing basis. (7)

Companies like Kraken, BitMEX, Nexo, and Ledn, who had already been taking proactive steps to work with third-party auditors in order to be transparent about their balance sheets, seem to have come out on the other side of the FTX debacle with their businesses intact and services operating as normal. (7) To us, this signifies a very strong correlation between the transparency of companies and the unlikelihood that they would be engaging in highly risky business models.

In an industry that is comparatively unregulated, these are encouraging signs that large players are finally beginning to understand the importance of honest communication with their clients.

The importance of regulation

The prospect of increased regulation irks many cryptocurrency purists who believe in the idea of decentralization and limited government intervention. However, the events over the past year have proven that no matter how smart people think they are, they are still prone to hubris, greed, cabalism, and believing their own hype.

All these things were very much at play in the falls of the Terra Luna ecosystem, 3 Arrows Capital, Celsius, FTX, and Alameda Research. This demonstrates the need for thoughtful regulation to provide investors with some protections and insulation from events like these.

We have to remember that cryptocurrency is still in its infancy. And much of what has been happening over the last year, echoes the history of our commercial banking system. In 1933, the year before the Federal Deposit Insurance Corporation (FDIC) was created, there were over 4000 bank bankruptcies in the United States. In 1934, the year that the FDIC was created, there were only four. (8) This illustrates the power that properly constructed legislation, oversight and support can have in stabilizing markets and protecting customers. In this sense, it’s encouraging to see law makers taking action in the wake of FTX’s fall. Some of the most notable action that has been undertaken recently is listed below:

• United States’ Senator Cynthia Lummis, famous for her openly pro-crypto position, promised to investigate with her colleagues if there was market manipulation at play in FTXs downfall.
• Maxine Waters, chair of the United States House of Representatives Financial Services Committee, pushed for additional federal oversight of crypto trading platforms and consumer protection.
• United States Senators’ Debbie Stabenow and John Boozman further committed to publishing a final version of the Digital Commodities Consumer Protection Act 2022.
• European lawmakers appear even more eager to push through the Markets in Crypto-Assets bill, which was preliminarily accepted by the European parliament on October 10. (9)
• This is on top of the potential investigations likely to be opened up against SBF by the Securities and Exchange Commission, The Department of Justice, and the Bahamas’ Financial Crimes Investigation Branch. (10)

The severity of this recent event could result in heavy-handed or knee-jerk legislation. And in the short term, this could do more harm than good to the industry. Though, in our view, it will be important for well-structured and thoughtful regulation to be implemented in a way that promotes innovation and protects consumers.

Looking forward

There is no doubt that FTX’s downfall is unacceptable and extremely unfortunate for the industry in the short term. However, we are hopeful that the scale and severity of this event will force companies into more transparent business models and increase the urgency among regulators to implement legislation that provide clarity and protection to investors.

For investors, this event underscores the importance of conducting thorough due diligence on potential counterparties, and questioning firms that have chosen to operate in mostly unregulated environments when taking on exposure to digital assets.

That is, how you invest in an asset is as important a decision as if you should invest in an asset. As an example, regulated and structured investment products, such as crypto ETFs, provide a shortcut for those that do not have the bandwidth to conduct thorough due diligence themselves. Although the collapse of FTX is sending shockwaves throughout the industry, it is likely a speed bump on the journey towards a safer future for digital asset investing.

—Haan Palcu-Chang, Crypto Specialist

Sources

(1) “The Collapse of the FTX Empire,” CoinDesk: https://www.coindesk.com/policy/2022/11/09/the-collapse-of-the-ftx-empire/

(2) “Bankruptcy filings attributed to FTX US and Alameda Research estimate each company has $10 billion to $50 billion in liabilities,” CoinDesk: https://www.coindesk.com/policy/2022/11/11/ftx-files-for-bankruptcy-protections-in-us/

(3) “Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet,” CoinDesk: https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/

(4) “Binance to Sell Rest of FTX Token Holdings as Alameda CEO Defends Firm's Financial Condition,” CoinDesk: https://www.coindesk.com/business/2022/11/06/binance-sells-holdings-of-ftx-token-as-alameda-ceo-defends-firms-financial-condition/

(5) “Embattled Crypto Exchange FTX Files for Bankruptcy,” The New York Times: https://www.nytimes.com/2022/11/11/business/ftx-bankruptcy.html

(6) “BlockFi says it can no longer operate its business as usual, pausing client withdrawals in the wake of FTX collapse,” Fortune: https://fortune.com/2022/11/11/ftx-collapse-blockfi-pausing-client-withdrawals/

(7) “Proof-of-Reserves Concept Gains Traction as Major Crypto Exchanges Provide Wallet Lists and Promise Full Audits,” Bitcoin.com: https://news.bitcoin.com/proof-of-reserves-concept-gains-traction-as-major-crypto-exchanges-provide-wallet-lists-and-promise-full-audits/

(8) “Crypto Needs an FDIC-Like Protocol to Prevent Liquidity Crises,” CoinDesk: https://www.coindesk.com/layer2/2022/11/15/crypto-needs-an-fdic-like-protocol-to-prevent-liquidity-crises/.

(9) “MiCA proponent cites FTX in advocating for regulation: ‘Crypto assets are not play money,’” Coin Telegraph: https://cointelegraph.com/news/mica-proponent-cites-ftx-in-advocating-for-regulation-crypto-assets-are-not-play-money

(10) “FTX’s Failure Is Sparking a Massive Regulatory Response,” CoinDesk: https://www.coindesk.com/policy/2022/11/14/ftxs-failure-is-sparking-a-massive-regulatory-response/

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