Well, it happened again. The company FTX, a global crypto exchange led by (now former) billionaire Sam Bankman-Fried, has collapsed with the magnitude of an atom bomb. I’m old enough to remember the collapse of algorithmic stablecoin Terra / Luna… All of six months ago.
These disasters seem to occur with increasing frequency. Billions of dollars, gone. Livelihoods ruined. And regulators have all the efficacy of a wine cork saving the Titanic. I mean, how does one regulate an industry for which there is no regulatory framework?
What the hell happened?
FTX is (was?) a cryptocurrency exchange and a main competitor to China-based Binance, the world’s largest exchange. Two days ago, Binance announced their intention to acquire FTX to save it from a liquidity crunch, rocking the world of decentralized finance. Binance entered into a non-binding agreement to acquire, but within 24 hours withdrew their offer after reviewing the financials of FTX and realizing US investigators had taken interest (shoutout to the Feds for the impeccable timing).
The collapse of FTX, valued at $32 billion in January of this year, was in hindsight an unavoidable fate. Amid rising interest rates and a poor macro environment, crypto markets suffered steep losses. Bankman-Fried used FTX client funds to save other crypto firms and make a slew of risky bets, and some of these deals—including with his own trading firm Alameda Research—led to insurmountable losses. According to one report by Reuters, Bankman-Fried transferred $10 billion worth of client funds to Alameda without telling FTX executives or the clients themselves. All $10 billion is gone.
It gets even worse. Alameda Research, in a desperate “make-it-back” trade, started shorting the US-dollar pegged stablecoin Tether (USDT), reportedly acquiring 70% of outstanding tokens. If Alameda succeeded and Tether tanked, it is not unreasonable to suspect that someone as connected as Bankman-Fried enjoyed an information advantage over the market. If you’re scratching your head thinking this sounds like insider trading, bingo! In the equity markets which are regulated by the SEC, this type of behavior could land even the most powerful executive in prison. But as I said, no concrete regulatory framework exists. There is no precedent for these events. As of this writing, Tether has frozen FTX holdings at the request of law enforcement while investigations get underway.
Reading about this disaster and the billions of dollars that changed hands like monopoly money, it’s easy to forget that when you read billions, those are client funds. Real people investing real money into the digital currency markets, trusting a company that was ostensibly as established as any other. A random Twitter user asked the question “so where did the $8-10 billion go?” and I saw the best response to this mystery—
“When someone asks where the money went, imagine a neighborhood of 100 houses, one sells for $1 million. Everyone thinks there is $100 million worth of equity in the neighborhood. Then every other house sells for $100,000. At most, the equity in the market was $9.9 million.
There never was $100 million. It was always imaginary.”
Make loans and risky trades based off that perceived equity, and you arrive at what FTX was doing. When the markets were at all-time highs, it was easy to act like the JP Morgan of crypto. When it all came crashing down, the firm was left with a significant liquidity shortfall in the event of a mass withdrawal. Sure enough, on Sunday November 6th following rumors that FTX stood on shaky financial footing, withdrawal requests topped $5 billion, dwarfing the typical volume on any given day.
Regulators Have Options
For all the arguments in favor of decentralization, low regulation, and breaking from the traditional banking system, we’re finding out why banks are regulated. Regulators could take meaningful steps to prevent an FTX-level meltdown, focusing on basic consumer protections and mitigating the systemic risks posed by consolidation among large, dominant private companies. Some ideas come to mind—
The SEC could regulate the crypto markets just as they do any other security. The industry vehemently disagrees with this approach, but arguments that a cryptocurrency is somehow fundamentally unique from any other financial asset are tenuous at best. An alternative is to treat cryptocurrencies like commodities, and the industry debate between these paths is ongoing.
They could require that firms maintain proper collateral and ensure a client’s ability to redeem funds at a reasonable threshold.
Regulators already “stress test” the big banks (known as GSIBs – Globally Systemic Important Banks) to see how their liquidity positions fare across various market conditions. There is no compelling reason for regulators not to approach major crypto exchanges in a similar way.
These companies want us to believe that they represent a promising, decentralized frontier of finance. First, the reality is that they share many similarities to traditional banks, just in unregulated form. Second, a few large crypto exchanges dominating the competition is the very definition of centralization. And finally, consider the fact these companies are often led by billionaire founders with a god complex and a utopian, “tear down the system” view of the role of decentralized finance. The result is an industry that presents real—and growing—systemic risks to the global financial system.
It’s unfortunate, considering there are promising, legitimate use cases emerging across the digital asset ecosystem - for example, stablecoins backed 1:1 by US dollars, or NFTs allowing the verifiable ownership of digital assets like art, music, and most recently even physical real estate. Companies like Circle and Coinbase offer models for responsible, safe growth—be boring, and take your time. When regulation does arrive, they and their peers will be the survivors. But with every FTX-style episode, we draw ever closer to the entire industry earning a scarlet letter.
As for Mr. Bankman-Fried? He tweeted a 700-word apology thread on Twitter a couple hours ago, but unfortunately for him you can’t tweet the fraud away. You know it, I know it, and at this point the FBI probably does too. At a minimum, it appears he mishandled client funds and then misled employees, investors, and the public about the state of his company.
From $13 billion net worth and showing off his new Miami office, to a negative net worth, a bankrupt company, and potential jail time… in just 72 hours. For ruining what could be thousands of his customers’ lives, sympathy is in short supply.
As a final note, this story evolves by the minute, so I will try to update this post with factual corrections as needed.
Cheers,
Ryan
*Update: As of this morning, Friday Nov 11, Sam Bankman-Fried resigned as CEO and FTX along with all of its subsidiaries filed for Chapter 11 bankruptcy.*