What Happened at FTX?
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Before its demise in November 2022, FTX was the No. 2 cryptocurrency worldwide.
Founded by Sam Bankman-Fried, a self-styled evangelist for cryptocurrency with strong ties to TradFi investors, FTX sported a valuation of $32B following a funding round in January 2022. Yet after doubts arose about the exchange’s balance sheet and symbiosis with Alameda Research, a crypto investment fund also controlled by Bankman-Fried, FTX lost the confidence of investors and rapidly unraveled.
On Nov. 11, the Bahamas-based company filed for bankruptcy protection in the U.S.
Its implosion damaged many other crypto ventures, including BlockFi and Genesis. And it raised questions about the sustainability of crypto as a whole. Now that the dust has settled, what are the lessons of the FTX fiasco?
In 2017, Sam Bankman-Fried founded Alameda Research in Berkley, California, with Tara Mac Aulay.
As a “quant trading” firm, Alameda Research was designed to find investment opportunities by analyzing price differences between cryptocurrencies and fiat currencies in a trading strategy known as arbitrage. Exploiting the spreads between prices in different markets has long been a trading strategy in crypto.
For example, due to bureaucratic red tape, Bitcoin’s price was often higher in Japan and South Korea. This phenomenon, known as kimchi premium, provided an opportunity to trade Bitcoin for massive profits.
Bankman-Fried industrialized the scale of the trades by using algorithmic programs. He described Alameda’s arbitrage trading in the following manner:
“Many found a way to do it for a small size. Very, very hard to do it for big size, even though there are billions of dollars a day volume trading in it because you couldn’t offload the Korean won easily for non-crypto.”
It didn’t take long for problems to arise as other traders pursued similar strategies, putting pressure on Alameda’s positions. In April 2018, Mac Auley raised red flags and quit Alameda, .“due to concerns over risk management and business ethics,” according to Mac Auley.
Alameda Research pressed on, and in time, it became interdependent with FTX, an exchange Bankman-Fried set up in 2019.
From the outset, it appears that FTX was founded as an outgrowth of Alameda and that assets would flow between the two entities. This symbiosis would eventually lead to the collapse of both ventures.
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As profits from the kimchi arbitrage waned, Alameda changed from a quant trading firm into a crypto market maker. The move was advantageous because market makers serve as indispensable players in financial systems.
For instance, Citadel Securities ensures that various stock brokers, such as Robinhood, enable their users to instantly trade stocks by providing liquidity to execute their trades. The challenge is market makers must be well-funded to provide liquidity.
Alameda relied on FTX to provide liquidity.
At the same time, Bankman-Fried emerged as the face of crypto in the mainstream media, and on Capitol Hill, by granting interviews, sponsoring conferences, and embracing a form of philanthropy called “effective altruism,” or EA. FTX also acquired naming rights for professional sports venues such as the arena where the Miami Heat basketball team plays its home games, and on Formula One racing cars.
By January 2022, FTX had attracted more than 1M customers. It had also won over many of the most prestigious venture capitalists in the business, including Sequoia Capital, Tiger Global, and Temasek, the Singapore sovereign wealth fund.
Even so, questions about the interdependent relationship between FTX and Alameda hung over the exchange.
Glassnode’s research demonstrated that FTX worked with Alameda as its internal market-making division. In the stock market, there are rules and regulations that market makers must follow when acting as exchanges, such as ensuring fair and orderly markets and protecting against fraud and manipulation.
With the free flow of funds between FTX and Alameda, it appears that the two entities worked together.
Another crypto analytics firm, Argus, showcased that Alameda accrued 18 crypto coins for its portfolio. Worth around $60M, they were all listed on FTX and raised questions of frontrunning.
This is a practice in which a trader or an exchange with advanced knowledge of pending transactions, such as a large order to buy or sell a particular cryptocurrency, acts on the information.
After a token is listed on an exchange, its price tends to temporarily skyrocket. As a result, token holders may dump their positions to pocket big gains. As FTX’s market maker, Alameda had the ability to scan users’ buy/sell orders, which may have provided it with an advantage in guessing the market’s direction. This is unlawful in the traditional capital markets. It’s safe to say investigators will probably probe FTX and Alameda to see if the two firms were frontrunning their clients.
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Bankman-Fried also introduced FTX’s own homegrown token — FTT, and set up an exchange on Solana called Serum, with its own coin. These altcoins may have been used in wash trading. This is tactic trading whales use to simulate market activity and bolster the value of coins, so investors buy them.
These altcoins helped drive FTX’s fortunes. At the same time, Bankman-Fried appears to have Based on this fake valuation, SBF leveraged user funds to borrow in order to buy off companies.
FTX used customer funds to trade with via Alameda. In turn, Alameda used FTX’s FTT tokens as collateral for their leveraged investments. This went so far as to FTX exempting Alameda from margin calls.
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But this strategy created a vulnerability for FTX. What if the price of FTT goes down when there is a selloff pressure?
This is best exemplified by FTX’s acquisition of Voyager Digital for $1.4B. This crypto broker was one of many Bankman-Fried’s acquisitions, earning him the moniker “modern-day J.P. Morgan” as a reference to the banker buying smaller banks to stabilize the financial system.
Although the media reported these bailouts favorably, it is very likely that Bankman-Fried bought Voyager Digital’s crypto assets in an effort to forestall their liquidation.
By hanging its balance sheet on a homegrown token, FTT, FTX was vulnerable to any information that might raise doubts about its strength. And that doubt arrived on Nov. 2 when CoinDesk reporter Ian Allison reported information showing that 40% of Alameda’s $14.6B balance sheet rested on the FTX token.
These exchange coins are meant to be utility tokens that bring various benefits, such as getting a discount on trading. FTT’s value was drastically inflated.
‘It’s fascinating to see that the majority of the net equity in the Alameda business is actually FTX’s own centrally controlled and printed-out-of-thin-air token.’
Cory Klippsten, CEO of investment platform Swan Bitcoin
Binance CEO, Changpeng Zhao (CZ), immediately swung into action. Binance, the No. 1 cryptocurrency exchange worldwide, was a FTX frenemy. Binance had invested in FTX in 2019.
“Binance has also taken a long-term position in the FTX Token (FTT) to help enable the sustainable growth of the FTX ecosystem, aligning with the broader scope of the partnership.”
Yet, Zhao had bristled as Bankman-Fried lobbied lawmakers in Washington to regulate crypto in specific ways that may have been adverse to Binance.
No sooner had the FTT story hit the tape than Binance, citing the need to curb risk, said it would begin selling its $500M stake in FTT tokens. The move undermined confidence in FTX and Alameda and triggered a 96% collapse in the price of FTT.
FTX’s homegrown token FTT cratered in the space of days in November. Source: TradingView
The selloff also triggered a $6B wave of withdrawals by customers from FTX. With liquidity gone, Bankman-Fried halted users’ withdrawals, effectively ending FTX’s operation.
For a day or two, Xhao entertained the idea of buying FTX but nixed the move after a look at the exchange’s liabilities.
Now the fate of FTX, and the billions of dollars in assets of more than 1M customers, is the hands of the bankruptcy courts. In the meantime, the U.S. Justice Department, the U.S. Securities and Exchange Commission, and other regulators are investigating potential malfeasance at FTX and Alameda. While Bankman-Fried has admitted he “f*cked up,” he has denied committing fraud.
Yet there seems little doubt that his management of FTX is the worst calamity to befall crypto. John Ray, the newly appointed CEO of the exchange and a specialist in corporate restructurings, said FTX was a “complete failure of corporate controls.”
“From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented,” Ray said in a court filing.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.