What happened to FTX?

The digital asset space has recently been witness to one the quickest falls from grace in its history. Earlier this month, FTX and Alameda Research, previously a leading crypto exchange and trading firm, filed for chapter 11 bankruptcy. For those who haven’t seen, here’s a quick rundown of how the events played out:

• On Nov. 2, CoinDesk reported that Alameda Research, SBF’s quantitative crypto trading firm, had issues with its balance sheet
• On Nov. 6, CZ, the founder and CEO of the largest crypto exchange, Binance, announced that it would sell all of tis FTT holdings (FTX’s exchange token).
• FTX claimed that there were no ongoing issues at FTX
• Then FTX’s exchange token, FTT, saw its price tank
• Shortly after, this headline appears: FTX Agrees to Sell Itself to Rival Binance Amid Liquidity Scare at Crypto Exchange

Although the purchase of Binance was unexpected by many, the number of people who thought it was actually going to go through was even smaller – and although the full extent of the aftermath is yet to be seen, It is likely things are going to get worse for crypto before they get better.

For comparison, many market participants are comparing this collapse to 2008 – dubbing it cryptos Lehman Brothers moment. During this time, similar activity was unfolding – with banks using customer funds to support highly risky speculative activity.

Unfortunately, in its current state, the cryptocurrency market enables this kind of activity. Lack of regulatory clarity means that exchanges are able to use money they receive from customers to fund other business transactions – ultimately allowing exchanges to act as banks – if they are so inclined.

What does this mean?

Simply put, FTX, in its current state, is unable to honor user withdrawal requests for any funds stored on its platform as it was lending this money out to try and generate yield. This is actually considered normal practice in the banking world – however, traditional banks are regulated, insured, and must adhere to frameworks and disclose their financial liabilities. These factors create an environment in which market participant funds are safeguarded – to an extent.

For example, if you give £1 to your bank, it would proceed to lend your £1 out to other banking customers to generate a return on your money. However, FTX wasn’t just lending you money out to generate yield,  instead, it was engaging in degenerate activity, allowing customers to borrow absurd amounts of cash to partake in risky trades.

The above activity is actually ok, when you employ proper risk management. Where FTX failed, however, was when SBF started using FTT (a token created by FTX) as collateral for loans between the exchange and its sister company, Alameda. A CoinDesk report showed that Alameda listed $3.66 billion of “unlocked FTT” and $2.16 billion of “FTT collateral” as assets on its balance sheet as of June 30.

“If the exchange issues a huge number of tokens and holds them on their balance sheet, only offers a small number of those tokens for trading—restricting the ‘free float,’ which can create an artificially high valuation—and uses the locked tokens on its balance sheet as collateral for loans, this creates a systemic risk because the collateral’s paper value isn’t real,” Matt Hougan, CIO at Bitwise Asset Management, told Fortune. “If the loans get called, the exchange may be insolvent.”

The issue? Well, the lion’s share of a multibillion-dollar fund lies in the native token of its partner company, which not only has little utility, but also little demand. As such, the unwinding of FTT meant that Alameda saw its balance sheet reduced to ashes in front of its eyes – meaning it could not honor liabilities. Thus, all it took was a significant decline in the price of FTT to bring down the once mighty firm and SBF’s crypto empire.

Wait a minute… should this be allowed?

Should exchanges be able in place of banks? No, they shouldn’t – or not yet, anyway. Crypto and consumer protection doesn’t exactly go hand in hand at the minute, but the industry should be doing everything it can to safeguard market participants. What this means is that until the industry is properly regulated and exchanges disclose their liabilities, provide insurance and operate in a more transparent way, then it is unlikely playing with this kind of fire will ever end well.

So given the insistence of crypto-natives to avoid the failings of traditional finance (TradFi), what has the reaction been from people in the industry?

Proof of reserves

The issue around FTX was the lack of transparency, liability and disclosure of its use of customer funds. One of the most reasonable replies to this misfortune has been for “Proof of Reserves”, in an attempt to rebuild consumer confidence and restore credibility to digital asset exchanges.

While it might be seen as too little, too late, there has been a swift and thorough response to the events of the last few days which has seen numerous exchanges, including Binance and Crypto.com, provide transparency about exchanges holdings and liquidity.

Although this is a step in the right direction, proof of reserves in itself is not enough to help heal the wounded industry. Exchanges need to want to make these changes for the better of the industry, looking to empower consumers and market participants, not prey on them.

Conclusion

It may be a dire time for the digital asset industry, however, we want to remind you that crypto isn’t going anywhere – it is going to play a big role in the future and top firms around the world are gearing up for the next phase of adoption. If you want to get involved, then reach out to us at info@defirec.com.