Skip to content

Home Hub News How did FTX collapse, and who was responsible?

How did FTX collapse, and who was responsible?

In the second week of November 2022, investors from all financial markets were waiting eagerly for the latest print of the US Consumer Price Index..

Posted November 16, 2022

ftx.ftx
ftx.ftx

In the second week of November 2022, investors from all financial markets were waiting eagerly for the latest print of the US Consumer Price Index. It was later revealed that the print returned values that were better than expected; investors could lessen their worries of a possibly long recession.

Unfortunately, in the same week, the crypto market was not doing so great. The collapse of FTX seemed to have reawakened crypto investors’ worst nightmares after the Terra ecosystem collapse a few months earlier.

What exactly happened with FTX and who could be responsible? The crisis has not yet ended, but this article is for those who would like some clarity into how FTX collapsed.

The main characters

FTX is a centralised exchange founded by Sam Bankman-Fried, commonly referred to as “SBF”. Bankman-Fried got into crypto in 2017 when he discovered crypto arbitrage trading. He saw that crypto could be bought cheaper in the United States and sold for a premium in the Korean market, simultaneously.

This was at a time when few crypto markets were connected. The gaps in liquidity in various crypto markets created lucrative but risky trading opportunities. Bankman-Fried scaled up his risky trading operations through Alameda Research, his very own crypto hedge fund — and succeeded in processing millions of dollars daily.

SBF later founded FTX, with Alameda Research incubating the platform. To fuel his operations, SBF issued the FTT token, a utility exchange token that was sold to the public in similar fashion to an initial public offering. 

Though founded by the same eccentric billionaire, SBF had previously emphasised that FTX, a market, and Alameda Research, a trading firm, have no further link other than the fact that SBF founded both firms.

Crypto market’s recovery from trauma

At the time of the crisis, investor confidence was already battered. Macroeconomic factors like the Russia-Ukraine war and the US central bank’s high interest rate policy caused uncertainty in the financial markets.

In the crypto world, investors and traders are still recovering from the traumatic experience of the Terra ecosystem collapse. Several months earlier, the cryptocurrency LUNA lost more than 90% of its value in a “death spiral” as its algorithmic stablecoin UST fell out of sync with the US dollar, and caused panic selling. 

In the same crisis, crypto lending and exchange Celsius and Voyager Digital saw a “bank run”. Users were not able to withdraw their funds, and painfully discovered that the two well-known names in the crypto space had used their funds to save themselves. Their tokens, CEL and VGX respectively, fell to zero within a few days.

Little did we know that the events that took place several months earlier would reoccur with FTX, one of the world’s biggest crypto exchanges. 

A hole in the balance sheet

Earlier this week, a CoinDesk investigation revealed  that Alameda Research had been borrowing money from FTX, and it is using FTT tokens as collateral. This was shown from a study of the company’s leaked balance sheet.

This is considered a red flag for two reasons — first, this shows that Alameda and FTX are not really independent of each other as SBF claimed before. Then, it’s a matter of where the money came from.

According to Bloomberg, FTX held 16 billion dollars in customer assets, but it managed to fund its sister company $10 billion using FTT tokens as collateral, instead of other tokens that are not associated with FTX. 

To understand the fragility of the situation, let’s imagine a publicly traded bank. The bank does what the bank does, which is to reinvest a portion of the depositors’ money for its own profit, whilst having enough within its reserves to honour customer withdrawals.

For some reason, a business owner uses the bank’s stock as collateral for borrowing money. The bank also didn’t do its due diligence in ensuring the right reserve balance.

The owner believes that in the event that they aren’t able to return the money, the bank can take its own equity and sell it for liquid cash. The bank reassures critics that they have the liquidity.  

But what happens when the bank’s stock price drops? The collateral wouldn’t be equal to the amount of borrowed (customers’) money. Liquidity means nothing if the borrower’s collateral does not cover their debt. That would just mean the bank has become insolvent.

Screenshot of a tweet by SBF
Bankman-Fried apologising on Twitter. Source: Twitter

In the crypto world, news travels fast. 

The CoinDesk article had led to speculation that FTX does not have all the funds to honour withdrawal requests. On Sunday, 6 November 2022, FTX was hit with a 5 billion dollars withdrawal request, which was “the largest by a huge margin”, said SBF in an apologetic tweet.

In our bank analogy, this is equivalent to a bank run where customers no longer trust the bank and want their deposit back. Seeing the banking company in trouble, its stock would plummet, and its collateral would also become increasingly worthless. 

FTX called its biggest rival for help

Seeing a possible liquidity crunch and bankruptcy, the following Tuesday SBF sought Binance to acquire FTX. This move was to save the company from total collapse. Meanwhile, the withdrawal requests had already inflated to a total of 6 billion dollars prior to the deal.

The relationship between the big rivals is rather complicated. Binance CEO Changpeng Zhao was the first investor FTX have ever had , and is therefore one of the large holders of FTT tokens. In fact, Zhao’s tweet on that fateful Sunday was a powerful trigger for a massive sell-off of FTT tokens. Zhao tweeted:

Tweet from Binance CEO

In the tweet, Zhao refers to an unrelated case where SBF had contributed $39.8 million to Democratic Party for the US midterm elections, of which many industry players do not approve.

Alameda Research CEO Caroline Ellison also took an effort to prevent Binance from flooding the free market with FTT tokens. This is her tweet:

Tweet from CEO of Alameda Research

However Binance CEO refused Ellison’s over the counter offer in a tweet. The leaked balance sheet documents of Alameda Research did not help with the deal. 

Binance now firmly believes that FTX had mishandled customer funds, based on “corporate due diligence”. As such, Binance no longer pursues acquisition of FTX, according to their official tweet.

FTX collapse

Losing support from both retail and institutional investors, Sam Bankman-Fried saw his crypto empire collapse in the following seven days. The now ex-CEO of FTX had reportedly asked for an $8 billion bailout to help “make customers and investors whole”.

Deposits were discouraged by the FTX website, and the message that withdrawals are unable to be processed continued to haunt many of FTX’s customers. FTX US, a subsidiary of FTX that has more regulatory oversight for US customers, also halted trading activities at the time of writing. Unlike FTX International, withdrawals are to remain open on that platform.

FTX filed for a “Chapter 11 bankruptcy” according to US laws on 14 November, 2022.

The contagion

We must now talk about the contagion, which is a term to describe the negative effects to the market as a result of this event. 

First of all, Alameda Research was a significant market maker for many crypto exchanges, both centralised and decentralised. It also trades pretty much all types of cryptocurrency. What this means is that they provide liquidity (or excess cash) so that traders can trade with leveraged positions. 

The shutting down of Alameda Research due to this collapse sparked fears of large sell-offs of many crypto tokens — which is already happening now, at the time of writing.

FTX is a major investor in several DeFi protocols. Each DeFi protocol raises their startup funds in similar ways. They would issue their own utility tokens, and then put them up for sale.

FTX is not unique in shoring up large amounts of tokens by becoming an early investor in DeFi projects. However, due to FTX’s ultimate circumstance, there is a chance that tokens within its portfolio will be sold in order to pay back its creditors.

Some of these projects, highlighted by The Block, have already experienced heavy losses in the past week. Solana’s native cryptocurrency, SOL, fell by about 60%, even though it’s not a protocol token backed by FTX.

Solana has somewhat of a strong tie with the centralised exchange. As FTX does not operate its own blockchain, it heavily relies on Solana’s network to settle crypto transactions. Solana also allows FTX users to buy new project tokens in similar ways to an initial public offering on Solana’s blockchain. 

In a disclosure by Solana Labs, the organisation reveals that FTX and Alameda Research have collectively purchased around 58 million SOL from 2020 through 2021. However, only 4 million of which is completely “unlocked”, which means that these are liquid enough to be sold by FTX.

table of transactions between ftx and solana.
Another table of transactions between ftx and solana.
Solana Labs’ official statement of their link to FTX. Source: Solana.com

A possible view on how centralised exchanges can be regulated

FTX is the latest multi-billion dollar institution whose valuation has gone from sky high to zero in a matter of days. This was preceded by the Terra ecosystem, Celsius, Voyager, and the hedge fund Three Arrows Capital — all within this year.

Decentralised finance and crypto used to be almost like a hobby worth exploring by bright computer scientists. Many projects have good intentions to improve the way we transfer and store value. More importantly, crypto was set to help us take full responsibility for our own wealth without third party involvement.

However, the moment traditional finance and business models get on board with this new technology, we become vulnerable to a terrible scenario. In this scenario, centralised entities take control of customer funds in a largely unregulated environment.

These shadow banks have been masquerading as “new innovations” that will disrupt banking and financial markets. 

In reality, this is not a truly DeFi experience. Centralised exchanges only simulate the DeFi world, helping newbies try DeFi services at the comfort and familiarity of traditional banks.

It should, in my opinion, be regulated like a bank, with standardised protocols and reserve requirements, at least unique to its own class of banking services. Centralised exchanges have done their job well at bringing new people into the space. It is now time to put an end to irresponsible and opaque ways of operating a crypto business. 

A true on-ramp into the crypto world will not hold user funds. Furthermore, a crypto retailer, like Easy Crypto, will find it impossible to misuse user funds. Fiat currency is readily converted into cryptocurrency, to be sent directly to user wallets, and vice versa.

After the dust settles, we should pay attention to the regulatory side of things. 

Views, thoughts, and opinions expressed in the closing section belong solely to the author, and not necessarily to the author’s employer, organisation, committee or other group or individual. 

Make sure to follow our Twitter, Instagram, and YouTube channel to stay up-to-date with Easy Crypto!

Also, don’t forget to subscribe to our monthly newsletter to have the latest crypto insights, news, and updates delivered to our inbox.

Disclaimer: Information is current as at the date of publication. This is general information only and is not intended to be advice. Crypto is volatile, carries risk and the value can go up and down. Past performance is not an indicator of future returns. Please do your own research.

Last updated November 25, 2022

Scroll To Top