In the latest and most spectacular in a series of collapses and failed projects in the cryptocurrency and blockchain space, crypto exchange FTX declared bankruptcy on Friday as its 30-year-old founder Sam Bankman-Fried stepped down as CEO.
The collapse of the world’s third-largest cryptocurrency exchange has already sent reverberations across the digital assets space, prolonging and deepening a year-long slide by bitcoin, ethereum and thousands of different altcoins. FTX and its founder’s ubiquity in financing, investing in and rescuing digital assets projects mean its influence is felt almost everywhere.
The bankruptcy means that the future of many projects, partnerships and bailouts supported by FTX will remain in limbo as courts attempt to untangle its complex web, said CK Zheng, founder of digital assets hedge fund ZX Squared and former head of derivatives at Credit Suisse and Morgan Stanley.
“It’s all immensely complicated and it’s hard to tell what is going to happen. It will take a while to sort all of this out,” said Zheng. “Remember Lehman Brothers—it took forever for that bankruptcy process to play out.”
Zheng says the comparison with Lehman Brothers should stop there, though, explaining that the Lehman collapse quickly triggered failures and stressed other institutions across the financial system, while FTX’s collapse thus far seems to be limited and unlikely to spread much beyond the digital assets space.
Crypto industry executives, however, said they fully expect the crisis to lead to an aggressive reaction by government regulators.
“The way cryptocurrency exchanges do business will be significantly different in the future,” said Mo Islam, head of Republic Capital.
What Happened
When Sam Bankman-Fried created FTX, he also created Alameda Research, a sister firm operating as a quantitative trading and market-making arm of FTX. At that time, Binance, another global cryptocurrency exchange, was a seed investor in FTX.
FTX also created a token, FTT, to provide incentives for people to trade on its exchange, Islam said. Owners of FTT received discounted FTX trading fees and earned rewards for using the token to trade, with FTX maintaining FTT’s value through a program of buying back and burning tokens.
Binance eventually sold its stake back to FTX, receiving FTT in return.
Alameda was borrowing funds from FTX, posting FTT as collateral, according to Islam, with FTX giving funds directly from customer deposits. The collapse was precipitated by a report from the digital news website CoinDesk that a large portion of Alameda’s balance sheet was in FTT.
Shortly afterward, on Nov. 6, Binance CEO Changpeng “CZ” Zhao tweeted that it would liquidate its FTT allocation, resulting in panic selling in the retail market and a precipitous drop in the price of FTT. As FTT dropped, Alameda’s collateral lost value and market participants sought to withdraw their funds from FTX.
At the time of CZ’s tweet, there were nearly $1 billion in outflows from FTX, said Islam. Between Nov. 6 and when withdrawals were halted on Wednesday, more than $5 billion in additional withdrawals had occurred, with FTX unable to find the funds to process all the withdrawals.
Earlier this week, Binance signed a non-binding letter of intent to purchase FTX before beginning due diligence, but quickly claimed that FTX did not meet its requirements, citing concerns over servicing outstanding credit, said Islam. On Wednesday afternoon, Binance pulled out of the deal and FTX’s freefall began anew.
What Does It Mean
FTX International, the non-U.S. component of the company headquartered in Hong Kong, is still working to process customer withdrawals, said Islam, while yesterday the U.S. Securities and Exchange Commission froze the assets of FTX Digital Markets, the FTX parent firm.
In the near term, investment in the crypto and blockchain space is likely to slow down as people are more careful about taking risk, said Zheng.
“People are going to be even more so faced with the challenge of how to differentiate a good crypto company versus a not-so-good crypto company, and how to assess the vlaue of those companies,” he said.
As for investors with crypto on the FTX platforms, it's unclear who, if any, will be made whole.
Zheng believes that FTX’s collapse will trigger more risk-off posturing in digital assets, leading to the demise of many so-called “altcoins,” defined as anything non-bitcoin, and the increasing prevalence of the two largest cryptos, bitcoin and ethereum.
Islam, on the other hand, argues that several crypto projects like Avalanche and Solana have proven their utility as technology stacks upon which developers can build decentralized applications, and are likely to survive and thrive in the post-FTX environment.
Regulation
In an email yesterday, Nigel Greene, head of international RIA deVere Group, argued that digital assets need to be held to the same standards as the rest of the global financial system.
“They are here to stay—and the market is only set to grow,” he said. “There can be no doubt that regulation of the crypto ecosystem is required and, I believe, it should be a priority.”
Moving forward, crypto exchanges are likely to be required to show their balance sheet and proof of reserves to make sure customers are protected, said Islam.
“Regulatory agencies will clamp down onto exchanges because retail investors lost a significant amount of money," Islam said. "Now, cryptocurrency exchanges will have to fully comply with regulations. This means that they will have to show proof of reserves, audits, financial statements, and proof of transaction monitoring within their exchange. “
Zheng agreed, arguing that crypto exchanges will become more centralized over time and that increased scrutiny by investors and regulators may tilt the digital assets space towards traditional finance firms like BNY Mellon, FIdelity and Bank of America/Merrill Lynch.
In any case, regulators, especially in the U.S., are likely to act relatively quickly, especially in light of a coordinated effort by federal agencies to create a unified regulatory framework for digital assets. Islam believes the sense of urgency around regulating digital assets has been accelerated.
“It’s inevitable that there will be issues in the future, but the hope is that such swift and devastating drops in value actually become tail risk events versus what they are now in the crypto world today, which are regular occurrences,” he added.
Who Is To Blame
According to Islam, at Republic Capital it was generally known that Alameda and FTX co-mingled funds and that FTX was using customer deposits to fund Alameda.
There were other warning signs that FTX was a risky enterprise to begin with, said Gene Grant, founder and CEO of LevelField Financial
“The yellow caution lights were flashing for FTX for some time,” wrote Grant in a note yesterday. “The world loved the story of a brash young man taking on the world, building an empire, and creating a firm from nothing. The problem is that financial services companies are not the same as other companies, and the qualities that make a great leader are those that are less flashy: trustfulness, safety, and risk mitigation.”
Grant cites a pair of examples:
• Sam Bankman-Fried's origin story involves the arbitrage of bitcoin prices between Korea and Japan—a difference created by Korea’s capital controls, which lends to an appearance that the business was founded through violating or testing the limits of Korean law.
• Bankman-Fried also took to YouTube to explain that the “research” in Alameda Research was added because upon founding they could not obtain bank accounts for a crypto-trading company—suggesting that he and his partners were making false statements to banks.
“These two incidents alone are indicative of the lack of critical leadership qualities,” wrote Grant. “Should the leaders of financial services companies, the ones we trust to keep our funds safe, speak about their potentially unlawful activities? We may admire great leaders who push the envelope to make things happen, but these two activities do not seem like someone making great changes to the system, but rather someone violating well established laws for personal benefit. Maybe not the type of person we want safeguarding other people’s money.”
FTX’s collapse underscores the importance of solving the crypto custody question for investors and advisors. Crypto-curious clients are likely to turn to traditional financial institutions, including advisors, for answers about where and how they should acquire and store their cryptocurrency.
“An exchange’s security protocol, liquidity, fees, ownership, history and user experience are essential checks you should make,” wrote deVere’s Greene.