Like it, love it, or hate it – cryptocurrency dominated the news cycle for the past few years as rocketing valuations in Bitcoin, Ethereum, and other big-name coins led to the proliferation of new coins, NFTs, and a bevy of startups looking to capitalize on the new asset class.
In a new era of economic turbulence and rising interest rates, though, the crypto sector fell harder and faster than the struggling equities market, and many proclaimed the death of crypto.
Unfortunately for crypto bulls, FTX and Sam Bankman-Fried may be the final nail in the crypto coffin.
Prior to the collapse of centralized cryptocurrency exchange FTX, the company was a star of the cryptocurrency community, with an estimated worth of $32bn.
However, over the course of one week in early November 2022, the equivalent of a digital bank run uncovered that FTX had siphoned money illegally to fund losses in sister company, Alameda Research.
Sam Bankman-Fried, the founder of FTX/Alameda and one of the most famous crypto celebrities, has been arrested for fraud that caused losses in the tens of billions to institutional investors and depositors.
What Is (Was) FTX?
FTX was a cryptocurrency exchange for users to buy and sell varied crypto coins. Before its collapse, the exchange was the third-largest by user volume and lagged only behind Coinbase and Binance, behemoths in their own right.
Concurrent to its primary exchange business, which profited from steep commissions and user fees, was FTX founder Sam Bankman-Fried’s (SBF) hedge fund that exclusively speculated and traded within the crypto markets rather than traditional equities or fixed-income investments.
A New Era of Bank Run
Bank runs historically happen when customers, fearing some economic or bank-specific risk, flood the bank to withdraw their cash. Since banks use customer cash for loans and to generate interest through Treasuries, they never have the full cash amount equivalent to total deposits. So, when a bank run happens, the bank is at risk of running out of money to return to customers.
In November 2022, a digital bank run proved to be the downfall of FTX.
Alameda Research was a trading firm founded by SBF that proved to be closely intertwined with FTX’s core business. A CoinDesk report published in November 2022 revealed that much of Alameda Research’s holdings were in FTX’s token, FTT. Sensing foul play, Binance announced a fire sale of their FTT holdings, triggering a digital bank run as customers tried to sell their own FTT positions.
Ultimately, a textbook bank run fallout happened – having (illegally) used customer money to fund and finance Alameda Research’s trading, FTX was unable to fulfill redemption, and customers saw their net worth evaporate.
The Dirty Details
That’s a high-level overview of what happened to FTX. But the details are even more intriguing and damning to SBF and his cronies.
From the onset, Alameda Research served as a primary market maker for FTX to ensure customers had a buyer or seller on the other side of the transaction and were all but required for a robust exchange, just like one would see in a stock market.
But, what’s different with Alameda and FTX, is the incestuous relationship between exchange and market maker. In traditional equities markets, a clear and legal distinction and separation must be maintained between a market maker and exchange due to the inherent conflict of interest. In the crypto world, however? No such regulation exists.
As time wore on, the scope of the unscrupulous lending to fuel Alameda Research was uncovered. Ultimately, SBF funneled more than USD$10 billion of customer cash into Alameda Research. Alameda, in turn, used that money to fuel its riskiest bets. Even if Alameda had held onto the money as a cash reserve or invested into Treasuries to milk a little alpha, it would have been unethical – using the money to essentially gamble, though, is beyond reckless.
Even worse? Alameda Research CEO Caroline Ellison seemed to have little understanding of either due diligence or risk management, even admitting in past interviews to eschewing stop losses as part of their trading strategy.
As the fallout continued, employees and executives (including SBF) scrambled to manage the firm’s internal downfall, reassure investors, and present a cheerful public face. Behind the scenes, though, further illegalities were in full swing.
On November 11th, right at the onset of what would prove to be a maelstrom, almost $500M was slyly transferred out of FTX and, presumably, into offsite wallets for SBF and cronies. This early action indicates that all involved knew what was on the horizon and took steps to secure their affairs rather than executing fiduciary duty.
After hunkering down in the Bahamas, founder SBF was arrested on December 12, 2022, and is pending extradition to the US. What’s more, the effect FTX will likely have on the broad crypto market is wider-reaching than his arrest.
As the overall landscape lacks much of the regulatory structures and mandates that traditional (and even alternative) assets are subject to, investors can expect imminent legislation to clamp down on the Wild West feeling of crypto and manage transactions more closely (if not negate much of those transactions in favor of government-approved coins).
The call for regulation is also coming from all sides of the market. Investors, of course, enjoyed the effects of excessive and impractical market exuberance but now clamor for regulation as part of a classic cycle. Private institutional investors, too, see the need for regulation: “You’re going to get a judicial outcry now to regulate the system and bring these guys to justice,” said hedge fund giant Jim Chanos.
And, of course, the formal regulatory bodies are hungry for legislation and mandates to encircle crypto markets.
Ultimately, nobody can predict with specificity what the outcome of the FTX debacle will be, especially as it remains in its relative infancy. Over time, though, there is no doubt that the fallout will be wide-reaching and impact the global crypto market. Interest rate hikes might have been the killing stroke to crypto speculation, but FTX buried the body.
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