What happened?
The story of the rise and fall of FTX is one shrouded with many twists and turns that can ultimately be traced back to poor financial management and possible illicit activities. FTX was founded by Sam Bankman-Fried in 2019. It caught wind at a very integral point in the timeline of cryptocurrency trading as most currencies were at low points in their trading history. As FTX rose to prominence, many cryptocurrencies began to grow meteorically, most notably Bitcoin which rose from a low point at around $10,000 to as high as $64,000 per coin in late 2021. A year before the founding of FTX, the investment company Alameda Research, also owned by Bankman-Fried, published pitch decks promising no risk and high returns. The high cryptocurrency returns over the ensuing years into 2021 gave the company a sense of grounded legitimacy to these claims paired with high profile endorsements and sponsorships. The momentum of cryptocurrencies gained lots of steam and was flooded with venture capital funds.
However, cryptocurrencies quickly lost steam amidst a bear market and interest rate hikes, falling from their highs in late 2021 with bitcoin now trading around $16,000 per coin. While the cryptocurrencies entered a bear market of their own, FTX was seemingly unaffected by this. The situation changed when a balance sheet from Alameda Research surfaced showing the company held large amounts of FTT, a digital currency created by FTX. On the reported June 30 2022 balance sheet, Alameda had $14.6 billion assets listed with $3.66B in “unlocked FTT” and an additional $2.16B of “FTT collateral” representing ~39.9% of the company’s assets according to the CoinDesk.com report. Much of Alameda’s equity was also in the form of FTT. This presented a problem because the valuation of Alameda depended heavily on the performance of FTT. On top of all of this, Alameda is leveraged in $7.4 billion in debt. If FTT were to significantly decline in value, Alameda could be insolvent.
Upon hearing news of the leak of Alameda’s balance sheet, rival cryptoplatform Binance opted to liquidate its supply of FTT in an announcement made November 6. The sell-off caused a sharp decline in the price of FTT which had been trading at $24-25 per token down to around $1.30. The total position of Binance in FTT was estimated to be around $2.1 billion. The sell-off caused a panic and FTX customers rushed to move their money from the platform in a virtual bank run. FTX halted withdrawals on November 8 and the company filed for Chapter 11 protections by November 11.
Poor Financial Management
There are a number of reasons why this situation happened. Overall, FTX practiced poor financial management that runs down into several areas to dissect. Firstly, the company did not produce regular financial statements detailing the company’s financial positions. In common practice, companies at minimum produce quarterly reports for investors. FTX did not do this. Because there was no regular financial reporting, there is no ascertainable way to reliably verify the financial position of the company. Even the leaked balance sheet from CoinDesk is questionable. Furthermore, because there was no audit on the positions in the company paired with the extensive positions in highly volatile and deflating cryptocurrency, the balance sheet very likely overstated the dollar value of digital assets for the company.
The next major issue under poor financial management is the claims that FTX funds meant for customers were improperly used by Alameda for trading. FTX is an exchange meant to act as an intermediary for traders. Alameda Research is an investment company (aka “a trader”). Alameda, by the nature of investment firms, accepts a significantly greater risk profile. Alameda and FTX were highly connected. It made Alameda’s over exposure to FTT a significantly greater risk to both companies. Alameda maintained a significant position in FTT on its balance sheet. News of this concerned investors prompting many to pull their funds from FTT because of the high potential risk of insolvency. Because much FTT sat as a cash equivalent on Alameda’s balance sheet, this meant the buying and selling of FTT acted like a securities exchange for the company. As such, the mass sell-off destroyed Alameda’s solvency and compromised FTX as funds were improperly comingled between the two companies. Bankman-Fried expressed that he thought Alameda had the funds to cover the move, indicating there was knowledge and therefore some underlying intent. Something that proper financial management would have prevented in the first place.
As such, the most impactful part of this situation is that cryptocurrency is a highly unregulated digital asset. There are no guarantees or protections for crypto traders. While there was significant mismanagement of finances at FTX and Alameda, one could also posit that the rug pull by Binance to remove its $2.1B stake in FTT could have been done to intentionally tank its competitor. Albeit that would be difficult to effectively prove, that is the nature of the cryptocurrency world. No holds are barred with digital assets.
Lack of Regulations
That brings me to my next theme. Cryptocurrency is almost completely unregulated. There are very few laws to govern the situation. Because so much capital on Alameda’s balance sheet was in FTT, that opened the pathway for predatory behavior against the company. There has always been lots of speculation of high net-worth individuals using pump and dump schemes in the crypto world. Elon Musk is famously speculated to have been involved in such schemes with Dogecoin. Alternative cryptocurrencies with smaller market capitalizations are high susceptible to this. Because these cryptocurrencies have little to no intrinsic value, the entire value of a coin is rooted in a P * Q = S equation. An individual or company with enough pooled cash under their control could in theory manipulate a cryptocurrency how they see fit. In the case of Binance with FTX, the $2.1 billion of owned FTT at around $25 price per coin at the time would be approximately 25% of the total value of FTT.
This risk should have been acknowledged by Alameda and a greater portion of funds diversified into other cryptocurrencies or simply converted to a stable currency like USD.
Over-Leveraged Debt
Finally on the one hand, you can absolutely fault FTX for poor and improper financial management. The company acted recklessly using customer funds to trade risky assets in its sister company Alameda Research. On the other, there has to be questions asked about the lending process. How was $7.4 billion collateralized for Alameda? What information was presented to the lenders to merit allowing this amount to be leant? Most banks are incredibly scrutinous for much lower lending values. With the facts we have presented now, it’s hard not to directly point a finger at illicit behavior. In January 2022, the company held a $32 billion valuation according to CNBC. As a part of this valuation, Crunchbase cites 12 investors in the FTX US subsidiary of the company that receive a $400M equity investment (which yes this is an equity deal, not debt). At this time, FTT was still trading in the $35-40 range. There is another key point made in the article. Alameda claimed that “locked digital assets” were quoted conservatively at 50% of marked face value. FTT traded at the $24-25 range at the time of the June 30 balance sheet. It is very possible in the unregulated volatile cryptocurrency environment that the drop in prices before the Binance sell off contributed to Alameda and FTX’s compromised position.
No Risk, High Returns?
Is it possible to have high returns with no risk? In simplest terms, no. Cryptocurrencies are an amazing phenomenon that have come into the mainstream view over the last decade. They are backed by blockchain technology that has an amazingly wide range of applications and uses. Unfortunately, most cryptocurrencies are not used for their original intent. Cryptocurrencies are treated as speculative assets that carry little to no intrinsic value. The sentiment draws lots of comparisons to the story of Tulipmania in Holland in the 1600s in my mind. Until cryptocurrencies reach a point of practical application in our day-to-day life, they will unfortunately continue to be treated speculatively.
There are movements for institutionalization of blockchain technologies. JPM Chase has experimented with its own JPM Coin in a project called Onyx. While the project creates an institutional platform for blockchain technology, banks are still limited by AML/BSA laws. Though it is a step in a positive direction as rumblings continue for the implementation of a national digital US-backed currency.
With all of this in mind, any perception of no risk with high reward should be treated scrutinously, as demonstrated by the case with FTX and its precipitous fall from grace.
Overall, poor and improper financial management executed in a risky environment caused the collapse of FTX. Ironically, Sam Bankman-Fried is believed to have amassed his fortune before FTX through arbitrage, a fairly low risk trading method that takes advantage of fluxuations in the equilibrium of currencies.
Coindesk Report discovering Alameda’s balance sheet
Binance Liquidates FTT
FTX Valuation
FTT Ticker
https://finance.yahoo.com/quote/FTT-USD?p=FTT-USD&.tsrc=fin-srch
FTX US
https://www.crunchbase.com/organization/ftx-us/investor_financials
JPM Chase Onyx
https://www.jpmorgan.com/onyx/index