It was the third-largest cryptocurrency exchange platform by volume. Investors and several members of the press hailed its founder and former chief executive as the savior of the cryptocurrency market while others called him the J.P. Morgan of cryptocurrencies and the next Warren Buffett. The success of FTX made Bankman-Fried one of the youngest American billionaires with a net worth peaking at USD 26 billion.
However, beginning in November 2022, the Bahamas-based cryptocurrency exchange platform collapsed. It eventually filed for bankruptcy in Delaware on 11 November 2022 together with more than 100 affiliates. The 15 largest cryptocurrencies lost over USD 150 billion in market value within three days. Bankman-Fried lost his billionaire status. What went wrong? What are the causes of the FTX collapse and bankruptcy? Why FTX failed?
Events and Situations Critical to the Understanding of the Causes of the FTX Collapse and Its Eventual Bankruptcy
Volatility and Uncertainties in the Cryptocurrency Market Amidst Unfavorable Macroeconomic Trends
Sean Williams of The Motley Fool predicted the likelihood of cryptocurrencies crashing in 2022 despite experiencing a 171 percent growth in their aggregate value in 2021. He named five major factors. These were reversions following upswings, setbacks in the application of blockchain technology, exposure to the stock market, margin debt incurred by investors to short-sell securities, and the loss of appeal of novelty crypto-coins and crypto-tokens.
The year 2022 proved to be an unfavorable period for cryptocurrencies. Discouraging macroeconomic indicators stemming from the Global Inflation Surge that started in 2021 and the decision of the Federal Reserve to raise interest rates to control inflation have created volatility and uncertainties across the cryptocurrency market. The value of major cryptocurrencies such as Bitcoin, Ethereum, and Cardano has dropped significantly.
It is also important to highlight the fact that cryptocurrencies have a hard time decoupling from the stock market. Stocks from major exchanges have experienced volatility due to the same Global Inflation Surge, the impacts of the Global Supply Chain Disruption, and even disruptions in the prices of oil and gas in the global market due to the Russia-Ukraine Conflict. Factors that affect the stock market also have an impact on cryptocurrencies.
Corrie Driebusch and Paul Vigna of the Wall Street Journal noted that the cryptocurrency market was built on “swagger, enthusiasm, and optimism” but all these three have been in short supply beginning in 2022 due to the internal trends within the market itself and the overall unfavorable macroeconomic trends. David Gura of NPR reiterated the fact that the market is being hit by the same factors affecting stocks and other assets.
Enter Sam Bankman-Fried. The prolific entrepreneur made a billion-dollar investment to save the cryptocurrency market. He expanded FTX further through the acquisition of cryptocurrency exchanges in Canada and Japan. He bailed out a distressed digital currency lender and tried stabilizing another. He poured money into celebrity endorsements and advertisements to promote FTX as part of his goal of bringing cryptocurrencies to the masses.
FTX was expanding at an admirable pace. Note that the firm was established in 2019 and grew to become the third-largest cryptocurrency exchange platform doing USD 9.4. billion worth of trades each day. The investments of Bankman-Fried extended its global reach while expanding further its core business to become an all-around financial services provider. FTX was reinvigorating the cryptocurrency market.
Controversies Concerning Involvement With Alameda Research and Allegations About Commingling of Funds
Bloomberg published an article on 14 September 2022 underscoring the relationship between FTX and Alameda Research. Reporters Annie Massa, Anna Irrera, and Hannah Miller mentioned that Alameda Research functioned as a market maker or liquidity maker during the initial history of FTX. They noted that these two firms would be subjected to scrutiny under the regulatory oversight applied to companies in the traditional equities market.
It is important to note that Alameda Research is a quantitative trading firm specializing in cryptocurrencies co-founded by Sam Bankman-Fried together with Tara Mac Aulay in 2017. It evaluated cryptocurrencies such as crypto-coins and crypto-tokens using quantitative finance and other tools and techniques in applied mathematics in its trading decisions. Its specific strategies include arbitrage, market making, yield farming, and trading volatility.
The Bloomberg article referenced above highlighted that the involvement of Alameda Research with FTX would be prohibited under a traditional regulatory environment that governs all business organizations because the trading firm was in a position to generate occasional financial gains from the losses of others in the cryptocurrency exchange platform. Bankman-Fried defended his two companies on several occasions.
News website CoinDesk published a damning story on 2 November 2022. Reporter Ian Allison reported that a significant portion of the assets of Alameda Research was held in FTT. Note that FTT is the exchange token used by FTX. He added that FTT tokens worth USD 5.1 billion were in circulation and the balance sheet of Alameda Research held “unlocked” FTT tokens worth USD 3.66 billion and “locked” FTT tokens worth USD 292 million.
Alameda Research had held assets and funds from the customer base of FTX. The CoinDesk report explained further that FTX channeled a huge chunk of FTT tokens to Alameda Research. Lenders allowed Alameda Research to use these tokens as collateral. There was a commingling of assets between the two companies. Bankman-Fried was further accused of using FTT as collateral to borrow billions of dollars that he spent to expand his cryptocurrency empire.
The entire FTX mess started when Bankman-Fried resolved to support the cryptocurrency market by extending a lifeline to struggling cryptocurrency companies. Remember that 2022 was a disparaging year for cryptocurrencies. He relied on high-risk bets from Alameda Research which committed USD 500 million. Bankman-Fried purchased Canadian cryptocurrency broker and lender Voyager Digital for USD 1.4 billion in September 2022
Note that the funds coming from Alameda Research came from its lender who allowed the trading firm to use FTT tokens as collateral. The company rested on a crypto-token invented by its system company instead of an asset like a fiat currency or a more popular cryptocurrency. The problem unraveled further when both Alameda Research and FTX experienced liquidity crunches they needed to resolve to honor their liabilities.
In addition, aside from the issue with the FTT tokens, FTX channeled USD 10 billion to Alameda Research. The trading firm used this fund to either pay its debts or use it as capital to generate income from trading and investing. Recent expositions from the media which included an anonymous source cited by The Wall Street Journal showed that key executives knew that client deposits were transferred from FTX to Alameda Research.
Impact of Binance, Massive Withdrawals, and the Eventual Collapse of FTX and Filing For Bankruptcy Protection
Some of the deals made by Bankman-Fried resulted in several losses. This exposed Alameda Research to possible implosion. It is also important to note that the FTT tokens the trading firm held had low liquidity. It had a hard time converting them into cash assets to supplement its finances and pay its troubled lenders. Remember that FTX channeled billions of funds to Alameda Research to prop up its finances. Concerns grew.
Binance announced on 7 November 2022 that it would offload all of its entire FTT holdings. Note that Binance is the main competitor of FTX and the largest cryptocurrency exchange platform by volume. It was a supporter of FTX. However, its founder and chief executive, Changpeng Zhao, later figured into a series of tirades with Bankman-Fried. Both have accused each other of exerting extreme efforts to win market share.
News about Binance selling its FTT tokens, as well as the heated Twitter exchanges between Zhao and Bankman-Fried, resulted in the prices of FTT and other cryptocurrencies plummeting. Zhao later announced on 8 November 2022 that it entered into a non-binding agreement to purchase FTX to address its liquidity crisis. However, Binance took to Twitter on 9 November 2022 to announce that it would not move forward with the deal.
Binance cited two key reasons for refusing to acquire FTX. These include the reported mishandling of customer funds in line with its commingling issue with Alameda Research, and the pending investigations involving the possible legal liabilities of the cryptocurrency exchange platform. The website of Alameda Research was taken down on the same day and Bankman-Fried announced that his trading firm would wind down trading and close.
Several employees from the legal and compliance team of FTX resigned. Other employees from entities related to FTX also resigned. FTX, Alameda Research, and more than 100 affiliate companies filed for chapter 11 bankruptcy on 11 November 2022. Bankman-Fried resigned as chief executive and was replaced by corporate restructuring specialist John J. Ray III. Anonymous sources said the FTX owed as much as USD 8 billion.
The events during the first and second weeks of November resulted in FTX customers rushing to withdraw from the platform. However, because of the liquidity crisis and due to the fact that the exchange used FTT as collateral, they were not able to withdraw funds. Investment advisors have been warning people about the risks of leaving their assets unclaimed on cryptocurrency exchange platforms that use crypto-tokens as collateral.
Reports about missing funds worsened the situation and aggravated further the distressed customers. Some USD 473 million worth of funds were removed from the platform. An FTX general counsel explained that their system logged an unauthorized transaction. In addition, between USD 1 billion to 2 billion customer funds could not be accounted for as of 12 November 2022. Several institutional investors stand to lose their money due to their stakes in FTX.
FURTHER READINGS AND REFERENCES
- Allison, I. 2022. “Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet.” CoinDesk. Available online
- Driebusch, C. and Vigna, P. 2022. “The Crypto Party Is Over.” The Wall Street Journal. Available online
- Gura, D. 2022. “Why Cryptocurrencies Have Gone From The Next Hot Thing To A Full-On Meltdown.” NPR. Available online
- Massa, A, Irrera, A., and Miller, H. 2022. “Crypto Quant Shop With Ties to FTX Powers Bankman-Fried’s Empire.” Bloomberg. Available online
- Michaels, D., Yu, E., and Ostroff, C. 2022. “Alameda, FTX Executives Are Said to Have Known FTX Was Using Customer Funds.” The Wall Street Journal. Available online
- Williams, S. 2021. “5 Reasons Cryptocurrencies Can Crash in 2022.” The Motley Fool. Available online