Is FTX The Catalyst Crypto Needs?
The Epic Collapse of FTX & Where We Go From Here
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The Epic Collapse of FTX
Crypto is reeling from the collapse of FTX and fall from grace of its founder and crypto’s “white knight,” Sam Bankman-Fried (SBF). Just over a week ago, FTX was the world’s third largest centralized crypto exchange. Known for a great interface and user experience, it catered globally to investors with a particularly strong offering in derivatives and leveraged trading products. It previously raised equity at a jaw-dropping $32bn valuation from the likes of Tiger Global, Sequoia, Temasek, BlackRock, Ontario Teachers’ Pension Plan, and Softbank. As recently as November 5th, its native token, FTT, had a market cap of over $3.4bn. 30-year-old SBF was regularly featured on mainstream media and adorned covers of magazines like Fortune and Forbes. He renamed the arena of the NBA’s Miami Heat, FTX Arena, and was the democratic party’s second biggest individual donor in the 2021-22 election cycle. He became a well-known representative of crypto and a strong voice on Capitol Hill with regulators and lawmakers. Amidst the recent crisis brought on by Luna-Terra, 3AC, and Celsius, he came to the rescue to bail out embattled crypto companies BlockFi and Voyager. He also became known for his commitment to “effective altruism” and large charitable donations, expressing a desire to make as much money as possible for the express purpose of giving it all away to charity.
Prior to its implosion, SBF’s crypto empire was made up of FTX, his fast-growing exchange, and Alameda Research, his prominent trading firm that controlled more than $14bn in assets. Poor risk management, excessive leverage, and alleged illegal misuse of customer deposits to prop up the flailing Alameda is at the core of this violent demise.
Timeline of Events
CoinDesk Story on November 2nd Exposes Frail Alameda Balance Sheet
In a November 2nd story, CoinDesk exposed muddled lines between FTX and Alameda and a weak balance sheet. Specifically, Alameda’s balance sheet was full of FTT token, the exchange token of FTX, including $3.66bn of unlocked FTT, and $2.16bn of FTT used as collateral. This revealed that the trading giant with a total of $14.6bn in assets actually rested on a foundation largely made up of a coin that a sister company invented, not an independent asset like dollars or another crypto. The balance sheet also reflected significant holdings of SOL, the native token of blockchain Solana that was heavily backed by FTX as well as other FTX-created and/or backed Solana-ecosystem tokens, and $7.4bn of loans.
In short, Almeda’s exposure to relatively illiquid tokens so operationally close to SBF and FTX, drew criticisms and concerns that Alameda was on the verge of insolvency and/or vulnerable to a liquidity crisis.
Where There’s Smoke, There’s Fire. CZ Adds Fuel
Shortly after the Coindesk story, the CEO of Binance, Changpeng Zhao (CZ), tweeted that they would be liquidating the firm’s substantial FTT holdings (worth approx. $580m), essentially fanning the flames.
Although CZ tweeted that this sale was just a matter of prudence and post-exit risk management learned post-Luna, this was the straw that broke the camel’s back. Binance’s potential selling, combined with rising concern about Alameda’s balance sheet and fear that Alameda’s high exposure to FTT tokens potentially used as collateral to FTX in exchange for borrowing customer’s assets on the platform, led to panic and fear of a potential Terra-style death spiral. Massive selling pushed the price of FTT down dramatically, putting pressure on Alameda and its loan collateral. Investors and traders rushed to exit all their funds from FTX leading to approximately $6bn of withdrawals in 72 hours in a textbook bank run. The exchange then halted customer withdrawals amidst fears of market-wide contagion and a broad sell-off across the sector.
Image: FTT 14-day price chart. Source: Coingecko
On Tuesday November 8th, SBF announced that FTX International (distinguish from FTX U.S., a separate US-regulated entity) had agreed to sell itself to Binance via a non-binding letter of intent (subject to due diligence), which was confirmed by CZ. After briefly undertaking due diligence, however, Binance walked away from the deal on Wednesday. Binance cited concerns over circling regulators investigating mistreatment of customer funds and a hole in FTX’s books worth as much as $8-10bn. With the deal failing and no one else coming to the rescue, bankruptcy became imminent. Reuters then published a story on November 10th reporting that SBF had transferred at least $4bn in FTX funds that included customer deposits to Alameda after it suffered a series of losses in May and June following the collapse of Terra and the broader crypto crash.
Malfeasance & Bankruptcy
Facts continue to be uncovered, but fraud seems certain. FTX reportedly actually lent around $10bn of customer funds to Alameda to help prop up the sister company after it suffered big losses. These actions at a minimum are in explicit violation of FTX’s own Terms of Service, which state that customer’s retain title to their assets, and could constitute theft. It also appears that Alameda and FTX executives knew FTX was using customer funds to help Alameda meet its liabilities. Moreover, it has been reported that SBF created a “backdoor” in FTX’s bookkeeping system that allowed him to execute commands that could alter the company’s financial records without alerting other people, including external auditors.
On Friday November 11th, FTX filed for Chapter 11 bankruptcy protection in Delaware along with more than 100 corporate entities affiliated with FTX, including Alameda Research and FTX US. SBF resigned and John J. Ray III, the Chicago-based attorney known for overseeing the liquidation of Enron, has been appointed to take the position. Since filing, several US agencies including the SEC, CFTC and DOJ have opened investigations into FTX. The complicated legal and bankruptcy process is just getting underway, and a timeline to a resolution is unclear and potential recovery, if any, is at best uncertain.
Market / Investor Impacts
FTX’s collapse has sent shockwaves through the industry. The speed and suddenness of the events left many professional and prominent crypto investors, including crypto trading funds, with assets stuck on the exchange pending withdrawal. Based on available information including coverage from Blockworks, 25% to 40% of crypto hedge funds have some exposure to FTX or the FTT token with that exposure averaging from 7% to 12% of AUM. For some, including several funds we are familiar with, it is a majority of their assets that are probably lost. Those funds are likely to close and return remaining investor capital. FTX-related investments will be marked down to zero, as Sequoia already announced. The extent of the follow-on contagion effects to other counterparties and ecosystem participants may be profound. Companies FTX and Alameda invested in or bailed out will no longer be able to rely on that funding. Solana ecosystem companies, many of which were heavily supported by FTX and Alameda, may struggle. In sum, there will be pain in the near term as businesses and funds will be shuttered and losses add up.
FTX May Be the Catalyst Crypto Needs
Unequivocally, this event is another black eye for crypto and a powerful example of poor risk management, excess leverage, and fraud by bad actors. It further undermines the credibility of the space and sets back the industry. However, perspective remains important and there are talented developers and entrepreneurs using blockchain technology to build the next generation of innovations in DeFi, NFTs, asset tokenization, and data infrastructure. There is growing and broad-based adoption of blockchain technology and almost daily news illustrating real-life integrations—whether it be J.P.Morgan executing a DeFi trade using blockchain or blockchain empowering creators with NFT-based royalties not previously dreamed of. FTX and SBF’s malfeasance was financial fraud committed by a centralized financial intermediary. This was not a crypto-specific crime. It should not be used as a condemnation of the underlying technology, which was not in any way complicit. To the contrary, decentralized blockchains are trustless, transparent, and enable non-custodial monetary sovereignty. And DeFi works.
What is necessary for the long-term growth and success of the crypto sector? J.P.Morgan calls FTX the catalyst crypto needed to accelerate the timeline to usher in crypto-related regulation and massively ramp the institutional adoption of crypto. The industry has been demanding responsible regulation and it may finally be forthcoming. This would be a positive for the industry, which desperately needs clearer regulatory guardrails and frameworks, especially around centralized exchanges and stablecoins. We have already seen numerous centralized actors, including exchanges and custodians, commit to providing cryptographic proof of reserves. Binance has come forward with “Six Commitments for Healthy Centralized Exchanges” putting forth the six most important requirements centralized exchanges should follow to ensure trust with users. Auditing and transparency are important along with stricter oversight and risk controls. These measures are necessary to protect consumers, usher in mass institutional adoption, and allow blockchain technology the opportunity to unlock its full potential.
Onward
It has been a painful period for crypto, but we are mindful that crypto is resilient and not going anywhere. As an institutional allocator and manager, we have the benefit of deep industry connectivity across the many hedge fund and venture capital managers, retail and professional investors, builders, and industry participants in our network. We are energized by the talent committed to the sector, believe in the technology, and see huge potential for innovation and growth. This episode reminds us that we have a long way to go to capitalize on that potential, but we remain steadfastly committed to doing so.
REFERENCE SOURCES
1.https://www.cnbc.com/2022/01/31/crypto-exchange-ftx-valued-at-32-billion-amid-bitcoin-price-plunge.html
2.https://fortune.com/2022/11/10/sam-bankman-fried-ftx-joe-biden-democratic-party-second-biggest-donor/
3.https://www.bloomberg.com/news/articles/2022-11-11/bankman-fried-s-effective-altruism-implodes-with-his-fortunes?leadSource=uverify%20wall
4.https://ftxfuturefund.org/about/
5.https://www.espn.com/nba/story/_/id/35004915/miami-heat-cut-ties-bankrupt-ftx-rename-home-arena
6.https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/
7.https://www.wsj.com/articles/alameda-ftx-executives-are-said-to-have-known-ftx-was-using-customer-funds-11668264238
8.https://www.bloomberg.com/news/articles/2022-11-07/bankman-fried-cz-zhao-tensions-spill-into-crypto-markets
9.https://thedeepdive.ca/the-cz-sbf-twitter-feud-explained/
10.https://thedefiant.io/ftx-crisis-shifts-into-new-phase-as-contagion-spreads-and-investors-scramble-for-cover
11.https://www.wsj.com/articles/binance-is-said-to-be-likely-to-walk-away-from-deal-to-buy-ftx-11668020963?mod=hp_lead_pos1
12.https://www.bloomberg.com/news/articles/2022-11-09/binance-seen-likely-to-balk-at-ftx-deal-after-spotting-deep-hole?leadSource=uverify%20wall
13.https://www.reuters.com/article/fintech-crypto-ftx-hole-idCAKBN2S2023
14.https://www.reuters.com/technology/exclusive-behind-ftxs-fall-battling-billionaires-failed-bid-save-crypto-2022-11-10/ utm_source=hs_email&utm_medium=email
15.https://markets.jpmorgan.com/research/email/cgthn5g9/h7ZA1m4PbEYOrkfNA_rP0g/GPS-4260670-0
16.https://www.coindesk.com/policy/2022/11/10/ftx-violated-its-own-terms-of-service-and-misused-user-funds-lawyers-say/
17.https://www.theblock.co/post/185083/ftx-files-for-chapter-11-bankruptcy
18.https://decrypt.co/114050/sec-cftc-investigating-ftx-lending-structure-report
19.https://blockworks.co/news/funds-with-ftx-exposure-have-7-to-12-of-aum-trapped-report/
20.https://www.coindesk.com/business/2022/11/09/who-still-has-exposure-to-ftx/
21.https://cointelegraph.com/news/sequoia-capital-marks-down-entire-214m-ftx-stake-to-zero
22.https://www.ar.ca/blog/the-animals-are-being-blamed-for-the-zookeepers-felony?utm_campaign=Arca%20Weekly%20Digest&utm_medium=email&_hsmi=233848648&utm_content=233848648&utm_source=hs_email
23.https://niccarter.info/proof-of-reserves/
24.https://www.binance.com/en/blog/from-cz/six-commitments-for-healthy-centralized-exchanges-2882536671495731236
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