CRYPTO’S LEHMAN BROTHERS’ MOMENT: WHAT HAPPENED TO FTX?

“If you think something cannot happen, you have not been around long enough. I thought I had seen everything there was to see, but then oil went negative in 2020, and there was another learning experience. It never stops.”

FTX Exchange – the world’s third-largest exchange by volume alongside its sister trading firm – Alameda Research, renowned for its market-making and venture investing prowess has gone “bust”. At its peak, FTX was valued at $32 billion while Alameda reported $1 billion in profits alone, last year. If these Goliaths of businesses could collectively be worth a negative $6 – 8 billion today, then one could scream into the void, “Is there anything too big to fail?” And the walls of FTX and Alameda would echo, “Yes, but definitely not in crypto land.”

The year 2008 started out moderately quiet or so it seemed to most people. Cyprus and Malta had just adopted the Euros and well, housing prices were falling. However, things got tumultuous in the coming months. Lehman Brothers — a US financial hegemony — suffered an unprecedented loss to its subprime mortgage business and ultimately failed in September. This triggered a financial crisis in the US which had severe ripple effects across the globe. Lehman is fondly remembered as the first basal brick in the string of domino collapses within the financial industry that led to the eventual crisis.  It is 2022 and the crypto industry is going through its own “Lehman event”. The year began less eventful too for the industry. Industry players were mostly consolidating as retail enthusiasm decelerated against increasing global inflation. Then things suddenly got eventful. 

The Warning Signs from 3AC and Voyager

In July this year, a crypto hedge fund based in Singapore, Three Arrows Capital (3AC) filed for Chapter 15 bankruptcy in New York after it defaulted on a $660 million loan to Voyager Digital. 3AC insolvency was set off after a significant investment in the Luna “Decentralized Finance” Protocol went south. Then the 3AC contagion spread. Its creditors came calling but there was little or nothing to give. One of these creditors was Voyager Digital, a crypto lender in which Alameda Research both owned and had a significant stake. 

Amidst its liquidity issues, Voyager reached out to Alameda and was able to recall some of the loans it made to the trading shop to the tune of $377 million. Asides from this, Alameda also loaned $200 million in cash and USDC as well as 15,000 BTC to Voyager in order to “mitigate current market conditions.” At the time, FTX was bidding for the assets of Voyager and after Voyager filed for Chapter 11 bankruptcy that same month, it acquired them under its US arm. This was however the first crack that gave a glimpse into what the balance sheet of Alameda looked like and what business activities FTX was indulging in. Sam Bankman-Fried, the CEO of FTX and owner of Alameda Research was even dubbed crypto’s “lender of last resort”.

How FTX and Alameda Became Bankrupt

The CoinDesk Article

It all started with a Coindesk article released on November 2nd where the news publisher reported on the inadequacies it had found on the balance sheet of Alameda Research. It had found significant illiquidity on the asset side of Alameda’s books. About 71% of its assets were tied in crypto tokens with 48% specifically in either FTT or SOL. Ideally, this should have instigated some more due diligence from its creditors. It was getting cloudy but then there was a “rainbow”. Its main creditor was a blue-logo’d company, FTX and FTX already knew about this. The only question now was how did FTX finance the process?

In the meantime, the CEO of Alameda Research, Caroline Ellison tweeted a reply stating that Alameda had >$10 billion of assets that aren’t reflected in the balance sheet to which Coindesk had access. The balance sheet only represented a subset of Alameda’s corporate business, she said. She however did not give any insight into what the unreported $10 billion of assets constituted. Sam Bankman-Fried (SBF), the CEO of FTX and owner of Alameda did not make any personal comments but retweeted Caroline.

CZ and His FTT Dump

Changpeng Zhao, who is fondly called CZ within crypto circles, is the CEO and co-founder of Binance, the world’s largest exchange by volume. It was November 6th and CZ had made this series of tweets

“As part of Binance’s exit from FTX equity last year, Binance received roughly $2.1 billion equivalent in cash (BUSD and FTT). Due to recent revelations that have come to light, we have decided to liquidate any remaining FTT on our books. 

We will try to do so in a way that minimizes market impact. Due to market conditions and limited liquidity, we expect this will take a few months to complete.

Binance always encourages collaboration between industry players. Regarding any speculation as to whether this is a move against a competitor, it is not. Our industry is in its nascency and every time a project publicly fails it hurts every user and every platform.

We typically hold tokens for the long term. And we have held on to this token for this long. We stay transparent with our actions.”

At the time, no one knew for sure what the recent revelations were, so speculations began. Is FTX insolvent? Is Alameda in debt? What is going on? This subsequently triggered a bank run. Users were “panic-withdrawing” their assets from FTX so FTX or Alameda had to make a public statement to quell this massive outflow. It was Caroline again this time making a tweet and tagging CZ to it. Here, she offered to buy all of Binance’s FTT holdings in an over-the-counter deal at a unit price of $22. CZ laughed this off and the bank run intensified. FTT price had declined 7% within the day.

Proposed Acquisition of FTX by Binance

Six minutes apart on November 8th, both CZ and SBF dropped devastating news on the situation. FTX had reached out to Binance for a potential acquisition. Both parties had signed a non-binding letter of intent (LOI) with effective due diligence to be done in the coming days.

The crypto industry was taken by surprise. No one had seen this coming. The main challenger to Binance’s dominance was failing and panic within the market went fever-high. FTX reported that it was hit with over $5 billion in withdrawal requests and had to pause withdrawals when it could no longer fulfill them. The price of FTT declined by 85% and prices of almost all digital assets declined wildly. Bitcoin dropped by 15% and Ethereum by 20%. 

Binance Backs Out of the Deal

On November 9th, Binance, in a tweet, announced that it was no longer following through with the FTX acquisition due to corporate due diligence and the news reports of how FTX had mishandled customers’ funds. The company also stated that the alleged US agency investigations had influenced its decision. Following this announcement, FTT declined by a further 80%, BTC by another 15%, and ETH by 19%. 

Workplace Tensions

A day later on the 10th, SBF was calming employees over a message in the company’s Slack group. He had appreciated the work everyone was doing and in a remorseful tone, promised to communicate better and make sure that “the right things happen”. The company was planning to raise money with the goal of prioritizing customers, current and possible new investors, and the staff in that order. He threw out the idea that a merger might happen between FTX International and its US subsidiary as he was still in talks with the Tron Blockchain founder and a major stakeholder in Huobi Exchange, Justin Sun at the time. The company had paused sign-ups for new users at the time and was drafting a management and payroll structure. He then concluded by imploring them to fight for the survival of the company.

FTX Group files for Bankruptcy

On 11th November, FTX Group Comprising 134 firms including Alameda Research and FTX US finally filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code in the District of Delaware. 4 FTX subsidiaries were however exempted from the proceedings including LedgerX LLC, FTX Digital Markets Ltd, FTX Australia Pty Ltd, and FTX Express Pay Ltd and so continue to exist.

SBF resigned as CEO of FTX tendering an apology and admitting that he could have done things better.

What did SBF and FTX do wrong?

What We Know and What We Think We Know

Over time, SBF had frequently denied close ties between FTX and Alameda but this tells us quite the opposite. FTX had been providing loans to Alameda to the extent of risking customer funds to keep Alameda afloat by acting as a lender to the trading firm and rehypothecating customer deposits. These loans were collateralized by illiquid “printed-out-of-thin-air” FTT. According to reports, Alameda had gone broke about the same time as 3AC in July but was only saved by the timely intervention of FTX. This event purportedly led to several key figures leaving both firms. The CEO of Alameda at the time, Sam Trabucco quit “to prioritize other things in life” while the President of FTX US, Brett Harrison resigned from the role. They both moved into advisory roles within the firms.

It was also reported that prior to the non-binding agreement with Binance, SBF had shuttled across connections on Wall Street looking to raise quick bucks to mitigate the ensuing panic at the time but was turned down. He then had to resort to “in-house” financing options by reaching out to CZ and Justin Sun. After talks with CZ fell through, talks with Justin Sun intensified and looked very likely to go through only to also hit a dead end at the death.

What Are The Numbers?

Zane Tackett who claims to be head of Institutional Sales at FTX Global gave an inside view of what the assets and liabilities of FTX looked like. $8.8 billion in customer assets backed by $900 million in liquid assets, $2 billion in less liquid assets, and $3.2 billion in illiquid assets. This totals $6.1 billion of assets on paper reflecting a gigantic $2.7 billion hole. Alameda Research listed an estimate of $10 – 50 billion in both assets and liabilities. 

The aftermath of the FTX saga

Proof of Reserves and the Case for DeFi

The collapse of FTX has led to a public outcry for transparency within the centralized finance sector of the crypto industry and the players within this sector have proactively responded. Binance released its proof of the reserves to show a total asset value of $69 billion. In detail, it consists of 475,000 bitcoins ($7.8 billion), 4.8 million ethers ($5.57 billion), 17.6 billion USDT ($17.4 billion), 601 million USDC ($607 million), as well as close to 21.7 billion of its own stablecoin BUSD (worth $21.9 billion) and 58 million of its BNB tokens (worth $16 billion). BitMex also published a reserve of 75,742.4 bitcoins against a customer deposit liability of 75,617.1 bitcoins.

Meanwhile, the decentralized finance sector has used the opportunity to make a case for itself given the inherent transparent nature of decentralized financial services. “Not your keys, not your coins,” they say alluding to the fact that their centralized counterparts usually pool user assets together in concentrated hot wallets which poses the risk of either an internal or external exploit or both.

FTX Investors and Creditors

Investors in FTX will consequently have to re-evaluate their investments and one of them, Sequoia Capital — a venture capital firm — has written down its $217 million investment in FTX to zero. The Ontario Teachers’ Pension Plan Canadian teachers have also come out to say it has a $95 million investment in the crypto exchange. The separated couple – NFL star, Tom Brady and fashion model, Gisele Bundchen recently threw in cash into FTX for 0.15% and 0.09% of the company respectively. Other notable investors include Tiger Global Management,  SoftBank, Temasek, Paradigm, and entities tied to billionaires Paul Tudor Jones, Daniel Loeb, and Israel Englander.

SBF’s net worth on the Forbes Billionaires List has also been updated from $16 billion to $3.

More Regulatory Scrutiny

It is expected that regulatory frameworks for the crypto industry across the globe will tighten going forward to protect consumers of crypto products and truthfully the industry needs this to restore deteriorating customer confidence. In the wake of the implosion, A spokesperson for the Commodity Futures Trading Commission announced that the agency was closely monitoring the Binance-FTX acquisition deal while the Wall Street Journal reported that the Securities and Exchange Commission and the Department of Justice are actively investigating the FTX bankruptcy. Tether reportedly froze about 46 million USDT in an FTX address at the request of law enforcement. 

Political figures in the US have also weighed in with Senator Elizabeth Warren labeling crypto as all smoke and mirrors while Senator Cynthia Lummis decried the potential acquisition of FTX by Binance as inappropriate. 

On Trapped Assets

After FTX suspended withdrawals for users, SBF continued to re-iterate that users of FTX US, its US subsidiary, were not in any way affected by what is going on and can keep using the platform. However, with the bankruptcy filing, FTX US users join the pack of FTX customers who have to wait till court proceedings conclude for any chance at reclaiming any of their assets.

Justin Sun assured holders of the Tron Blockchain (TRX) tokens on the exchange that he was in communication with the FTX team and promised to salvage all TRX tokens stuck on the exchange. The price of TRX rose sharply and was trading at a 137% premium on FTX relative to other markets. The price of BNB too rose to a 43% premium on speculation that CZ would do the same for BNB holders. Worthy to mention that at the time of writing, Justin Sun’s promise had not materialized nor had CZ made one.

Internal Teams

FTX employees, according to the company’s capitalization table, held 20,858,124 shares, or about 3% of FTX in the company’s option pool as of August. In January, FTX employees owned as much as $950 million worth of stock. Now it’s likely worthless. Will they get that money back? No one knows. 

FTX Legal and Compliance Team has reportedly resigned after the bankruptcy news came out. Its Future Fund Team in charge of providing grants and financing to “effective altruistic” projects has also left the firm. FTX US also resigned from the Crypto Council for Innovation, a Washington DC firm that lobbies for the crypto industry.

Ripple Effect Across Crypto Markets

The contagion is now widespread as prices of several crypto assets have dropped massively. On the news of FTX filing for bankruptcy, the entire crypto market declined by 2.4% from a market cap of $913 billion to $891 billion in a few minutes. This brings the total percentage drop since the FTX saga started to 19% from $1.1 trillion.

Skepticism will breed across the industry which 8 years later has not recovered from the bankruptcy of Mt. Gox only to be hit by this. It is also understood that Bored Ape Yacht Club — the group behind several successful NFT collections — has its treasury in Blockfolio which is owned by FTX.  Blockfolio is currently not processing withdrawals too.

A Final Hack

Early on November 12th, a backdoor exploit was opened and used to drain hundreds of millions of customer funds from wallets in FTX. Reports claim it could be a disgruntled developer from FTX, as most employees got paid directly on FTX and held most of their capital on the platform. Alternative reports suggest it could be the disgraced CEO, SBF, making a run for the hills. 

An important note is that the only people impacted by this, which seem to be thousands of customers, were people who held their tokens on the exchange. A centralized exchange, regardless of the company, is never a good idea to hold your tokens. They can be great platforms to begin an investing journey and are even the simplest way to purchase and trade tokens. After accumulating a small position, tokens should be transferred to a personal cold wallet. A vital ethos of Web3 is becoming your own bank, and as the saying goes “Not your keys, not your coins”.

If you enjoyed this article, you may also enjoy…

A Look Into The Books of Alameda Research

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Battle Of the CEXs, Binance v FTX

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