FTX Crash: How The Meltdown Of One Of The World’s Largest Crypto Platforms Led To Unprecedented Selloffs
Sam Bankman-Fried's FTX imploded primarily due to extremely poor risk management.
We witnessed a massive round of selloff in the cryptocurrency market after Binance announced that it won’t buy FTX. This implies no liquidity for the investors of the FTX, which is one of the largest crypto exchanges in the world. Binance, the world’s biggest crypto platform, was set to acquire troubled rival FTX.com, but soon did a U-turn and walked away from the deal citing problems with FTX's finances as well as potential regulatory investigations. Its decision to walk away led Bitcoin to tumble to the lowest level in two years.
Let us start by understanding what exactly happened with FTX.
FTX was founded by Sam Bankman-Fried in 2019. Speculation about the financial health of FTX which started over a November weekend amplified into $6 billion of withdrawals in just 72 hours.
What led to the falling financial health of FTX
Amid rising interest rates, investors pulled out from riskier assets. This led to a fall in the cryptocurrency market by about two-thirds from its peak of $1.07 trillion. The root of FTX's downfall which started months earlier originated from mistakes Bankman-Fried made after he stepped in to save other crypto companies as the crypto market collapsed amid rising interest rates.
The story begins with Alameda Research, founded by Bankman-Fried in 2017. Alameda began as a proprietary trading firm involved in cryptocurrencies. It made money by buying and selling crypto. Soon, Bankman-Fried decided to help others do the same. So, he built an exchange in 2019, named FTX.
FTX also gave customers loans if they were willing to bet big in return of interest.
Problems started arising when customers wanted their funds returned, which they had set aside on the exchange for buying and selling crypto in the future. FTX, inevitably, couldn’t return their money.
Why couldn’t FTX return investors’ money?
After setting up the FTX exchange, Bankman-Fried also launched a cryptocurrency token — FTT. FTX itself started buying this token using the revenue generated from exchange transaction fees. So, basically, FTX was trying to inflate demand by buying its own FTT coins.
Now, Alameda had bought FTT tokens at very low prices and then waited for their value to blow up. And then it began borrowing real money, keeping these highly inflated FTT tokens as collateral.
Another popular speculation is that FTX loaned out money to fund customer trades by using its own money, or by borrowing it from outside. And when suddenly customers began demanding their deposits all at once, they simply didn't have enough to cover all investors' holdings. This was clearly a case of poor risk management.
Why did customers begin demanding their deposits back all at once?
Alameda's balance sheet, which got leaked, implied that the company must pay their lender $8 billion. However, the majority of the assets were in FTT. Once investors saw this leaked balance sheet, they realised how uncertain the situation was. They could see how both companies could surrender very quickly. So, they began withdrawing their deposits.
This is where Binance came into the picture.
Changpeng Zhao, the 45-year-old CEO of Binance, said that he was willing to buy out FTX after due diligence. When FTX was set up by Bankman-Fried, just six months after the company began its operations, Zhao took up a sizeable stake in it. And his bet actually paid off. FTX grew in popularity. It raised a lot of money from investors and its valuation increased.
But then in 2021, Bankman-Fried bought out Binance’s stake in the company. It wasn’t an all-cash deal. A bit of it was paid in FTT tokens and Zhao held onto those tokens.
The recent Binance deal to cover a liquidity crunch was non-binding and it was subject to further due diligence which led few investors and analysts to question it.
As a result of news reports regarding mishandled customer funds, corporate due diligence, and alleged US agency investigations, Binance decided to not pursue the potential acquisition of FTX.
Bankman-Fried approached cryptocurrency exchange OKX about a similar deal prior to the Binance-proposed deal, however, the exchange declined to move forward.
All this led to massive turmoil in the industry and led to massive distrust among the public towards centralised establishments. Thus, it is highly advised to always invest in something which you understand and is regulated.
(The author is a certified financial planner and the Head of Training, Research & Development, Fintoo.)
Disclaimer: The opinions, beliefs, and views expressed by the various authors and forum participants on this website are personal. Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. Cryptocurrency is not a legal tender and is subject to market risks. Readers are advised to seek expert advice and read offer document(s) along with related important literature on the subject carefully before making any kind of investment whatsoever. Cryptocurrency market predictions are speculative and any investment made shall be at the sole cost and risk of the readers.
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