Dubai: The recent ruin of a prominent crypto exchange FTX and it’s 30-year-old billionaire founder has been sending shockwaves across the crypto industry these past ten days, causing the market to tumble and the investor community to worry about how the entire sector will be hit.
Formerly worth $32 billion (Dh117 billion), US-born Sam Bankman-Fried’s FTX filed for bankruptcy last week in one of the highest-profile crypto blowups after frantic traders withdrew $6 billion (Dh22 billion) from the platform in just 72 hours.
The billionaire’s riches too wiped out as a result. Bankman-Fried’s 53 per cent stake in FTX was last worth about $6.2 billion (Dh22.77 billion), according to the Bloomberg Billionaires Index, and his crypto trading house Alameda Research, which his collapse was centered around, contributed $7.4 billion (Dh27.18 billion) to his personal fortune.
Here’s an in-depth look at his businesses and practices that led to the downfall of FTX.
Potential bailout exposes discrepancies
FTX’s troubles were first made apparent when top crypto exchange Binance called off an agreement to acquire the smaller rival on “issues beyond control or ability to help”. So when panicking FTX customers began demanding billions of dollars in withdrawals a day, it was money that FTX didn’t have, because it was using client deposits for other purposes.
A week before the announcement of liquidation of FTX, Binance – currently the world’s biggest cryptocurrency exchange in terms of market valuation at $48 billion – revealed intent to buy FTX’s non-US operations but abandoned the deal a day later, triggering the bankruptcy.
FTX was engulfed in more chaos soon after it said that it had detected unauthorised access, with analysts evaluating hundreds of millions of dollars of assets moved from the platform under "suspicious circumstances."
Alameda, a hedge fund run by Bankman-Fried, used billions from FTX users without their knowledge
How did trouble start brewing at FTX?
While crypto brokers are primarily known to help you buy and sell alomost all cryptocurrency coins or digital tokens, and also allow you to send money in whatever currency to anywhere in the world, they also create and trade their own self-named tokens. Similarly, FTX has a native cryptocurrency token ‘FTT’.
There are about 197 million FTT tokens worth $5.1 billion (Dh19 billion) in circulation, according to FTX’s website. Owners of the FTT tokens get discounts on FTX trading fees, increased commissions on referrals and earn rewards. The value of FTT is maintained by FTX’s rolling program of buying back tokens.
“It seemingly running smooth until the prominent crypto publication CoinDesk reported on a leaked document that appeared to show that Alameda, a hedge fund run by Bankman-Fried, held an unusually large amount of FTT tokens,” said Brian Deshell, a UAE-based cryptocurrency trader and analyst.
But what’s wrong with that?
“While there is nothing technically wrong about that, it shows Bankman-Fried’s trading giant Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another cryptocurrency.”
In other words, FTX and Alameda are legally required to operate as separate businesses, but the report claimed that they had close financial ties. Moreover, it was also uncovered that Alameda was trading billions of dollars from FTX accounts and leveraging the exchange’s native token as collateral.
“The trading firm was reportedly able to quietly use customer funds from exchange FTX in a way that flew under the radar of investors, employees and auditors in the process. The way they did it was by using billions from FTX users without their knowledge,” added Deshell. But that’s not all.
Alameda was borrowing from FTX, and using the exchange’s in-house cryptocurrency, FTT token, to back loans
Rolling, mixing customer funds
The crypto exchange also underestimated the amount FTX needed to keep on hand if investors were to cash out. Trading platforms are required by regulators to hold enough money to match what customers’ deposit. They need the same liquidable cash cushion, in the event a user borrows money to make a trade.
None of this was disclosed to customers. In general, mixing customer funds with counterparties and trading them without explicit consent, according to US securities law, is illegal. It also violates FTX’s terms of service. The bankruptcy filing was reportedly due to issues with a ‘leveraged trading position’.
“In making leveraged trades, the fund was using a cryptocurrency created by the exchange called FTT as collateral. In a lending agreement, collateral is typically the borrower’s pledge to secure repayment. It’s often money, or something else of value — like real estate or gold,” explained Deshell.
“In this case, Alameda was borrowing from FTX, and using the exchange’s in-house cryptocurrency, FTT token, to back those loans. The price of the FTT token nosedived 75 per cent in a day, making the collateral insufficient to cover the trade.”
Illegal trades bankrupts top firm
In the past week, FTX has crashed from a cryptocurrency powerhouse, into bankruptcy. The blurred lines between FTX and Alameda resulted in a massive liquidity crisis for both companies. Bankman-Fried stepped down as CEO of FTX and said Alameda Research is shutting down.
FTX has since stopped trading and withdrawals from its platform, and moving digital assets offline after a suspected $477 million (Dh1.75 billion) hack. “Part of the issue was FTX’s web of complicated leverage and margin trading,” agreed Brody Dunn, an investment manager at a UAE-based asset advisory firm.
The platform’s ‘spot margin trading’ feature let users borrow from other customers on the platform. For example, if a customer deposited one Bitcoin they could lend it to another user and earn yield on it.
“Every time an asset was borrowed, FTX reportedly subtracted the borrowed assets from what it needed to keep in its wallets to match customer deposits. In a typical situation, an exchange’s wallets need to match what customers deposit,” Dunn added. “But because of this practice, assets were not backed one-to-one and the company was underestimating the amount they owed customers.”
Every time an asset was borrowed, FTX reportedly subtracted the borrowed assets from what it needed to keep in its wallets to match customer deposits
Borrowing customer funds for free
The trading firm Alameda was also able to take advantage of this ‘spot margin’ feature. Alameda was reportedly able to borrow and use customer funds at no cost. Also, Alameda could post the FTT tokens it held as collateral and borrow customer funds.
“Even if FTX created more FTT tokens, it would not drive down the coin’s value because these coins never made it onto the open market. As a result, these tokens held their market value, allowing Alameda to borrow against them – essentially receiving free money to trade with,” added Dunn.
“FTX had reportedly been able to sustain this arrangement as long as it maintained the price of FTT and there was no rush of customer withdrawals on the exchange. So in the week leading up to the bankruptcy filing, FTX did not have enough assets to match customer withdrawals.”
Auditors likely missed this discrepancy
Outside auditors likely missed this discrepancy because customer assets are an off-balance sheet item, research reports revealed, and therefore, would not be reported on FTX’s financial statements. So if not for the rescue deal from Binance falling through, none of these discrepancies would have come to light.
While the evidence prompted concerns about the financial stability of Sam Bankman-Fried’s two crypto companies – leading to a liquidity crunch at FTX, the situation exacerbated when Binance would sell its holdings of the FTT cryptocurrency issued by FTX.
In response, FTT’s price plummeted and traders rushed to pull out of FTX, fearful that it would be yet another fallen crypto company.
Many crypto trading firms will be wiped out and shut down [following the collapse of FTX]
FTX scrambles to process withdrawal requests
So as FTX scrambled to process requests for withdrawals, which amounted to an estimated $6 billion (Dh22 billion) over three days, the once major league crypto exchange seemed to enter a liquidity crunch when it lacked the money to fulfill customers’ withdrawal or liquidation requests.
After Binance said it had reached an agreement to bail out FTX by buying the company, with an addendum stating that “it has the discretion to pull out from the deal at any time,” the mandatory due diligence that followed unearthed evidence of undocumented practices.
While Binance technically had 30 days to explore a takeover, the next day the top crypto exchange backed out of the rescue plan, saying in a statement that FTX’s “issues are beyond our control or ability to help.” As one of FTX’s first investors, Binance knew the company well.
Industry-wide implications unfold
Bankman-Fried, who resigned from the company and was replaced as CEO by restructuring expert John Ray III, says he’s still trying to reach a financing deal in a way that can help depositors and that he had found very little documentation of finances and that what did exist couldn’t be trusted.
Ray also told the US Bankruptcy Court that he had never seen a situation as chaotic as what he was running into at FTX. More than 100 affiliated companies are filing for bankruptcy with FTX. Here’s why.
Crypto companies are deeply intertwined — they invest in one another, buy one another’s tokens and lend tokens and capital to one another — which means the collapse of FTX could continue to topple others, as cautioned widely by industry experts.
The collapse of FTX is likely to spur action. Some crypto companies that see regulation as key to legitimacy would welcome it
What’s next?
“Many trading firms will be wiped out and shut down,” US crypto venture firm Multicoin Capital wrote to its investors in a letter last week, explaining that it had put too much money in FTX.
Another renowned crypto lender BlockFi, which signed a deal to be rescued by FTX when crypto prices nose-dived, paused withdrawals last week and is preparing for a possible bankruptcy. BlockFi said it had “significant exposure” to the failed exchange and FTX’s trading arm, Alameda Research.
“Several industry insiders have widely warned that they expect more firms to follow. The collapse of FTX is likely to spur action. Some crypto companies that see regulation as key to legitimacy would welcome it,” added Deshell.
The situation worsens with FTX having previously said it doesn’t know who its top creditors are or where many assets can be found.
According to reports, the company had raised money from prominent investors, and made multiple trips to Washington, D.C., to testify in front of lawmakers. A separate filing on Saturday said FTX owed $3.1 billion to its largest 50 unsecured creditors.
In the aftermath of crypto exchange FTX's fall from grace, US Treasury Secretary Janet Yellen said the industry now needs "very careful regulation". “It shows weaknesses of this entire sector,” Yellen added, referring to the collapse of Sam Bankman-Fried's multibillion dollar enterprise.
As to what will unfold next in the FTX fiasco, only time will tell.
