FTX: Why the Exchange Collapsed and How Could It Be Avoided?
On Nov. 11, 2022, cryptocurrency exchange FTX filed for bankruptcy protection under Chapter 11 after a brief rise to prominence and a rapid decline. Sam Bankman-Fried's $16 billion net worth was nearly zero after the company's valuation plummeted from $32 billion to bankruptcy within days.
What Was FTX's Business Model?
FTX is a Bahamas-based cryptocurrency exchange founded by Bankman-Fried and Gary Wang. A lot of people buy cryptocurrency by transferring money to an exchange, which trades currencies at a floating rate. FTX's regulated exchange offered that service, and they took a cut on every transaction. There was a great deal of profit made on the international exchange, where traders would profit from price swings in crypto assets.
Aside from maker fees, taker fees, NFT fees, and margin borrower interest, FTX also charges interest on its institutional loans and charges merchants who accept cryptocurrency.
The Fall of FTX :
Documents leaked to CoinDesk suggested Alameda, the group's hedge fund, was using FTT to make risky loans – effectively trading using company scrip. When rival exchange Binance revealed it was selling its holdings of FTT, panic ensued on the exchange as other customers scrambled to withdraw their funds. The company's CEO Sam Bankman-Fried admitted that it lacked adequate assets to meet the demands of its customers.
Binance's FTT Selloff :
The world's largest cryptocurrency exchange, Binance, announced on November 6 that it was preparing to sell 23 million FTT tokens worth $529 million. Binance CEO Changpeng Zhao liquidated the exchange's FTT position. As part of its risk management strategy, Binance takes the move after Terra's (LUNA) crypto token collapsed in 2022.
Binance to the Rescue :
A liquidity problem arose after CoinDesk's report. Bankman-Fried tried to assure investors that FTX assets were stable, but customers immediately requested $6 billion in withdrawals. In two days, FTT's value dropped by 80%. Binance announced on November 8 that it had entered into an agreement to purchase the non-U.S. operations of FTX for an undisclosed sum.
Binance Backtracks on Deal to Help FTX :
Binance called off a planned acquisition after due diligence revealed serious concerns. The deal would have seen Binance take FTX. However, the exchange backed out of the deal just one day later on Nov. 9, citing "irregularities" in the way FTX was handling customer funds.
Frozen Assets on FTX Exchange Caused Ripple Effects :
After Bankman-Fried announced it would need $8 billion in capital for the exchange, the Bahamas securities regulator froze its assets on Nov. 10. In a tweet, Bankman-Fried admitted FTX's non-U.S. exchange was short of funds. He said FTX miscalculated leverage and liquidity because of poor internal labeling.
FTX's CEO stepped down on Nov. 11, replaced by John Ray III. FTX also filed for Chapter 11 bankruptcy protection, revealing 130 affiliated companies. As stated in the bankruptcy filing, FTX has assets between $10 and $50 billion and liabilities between $10 and $50 billion. FTX's cryptocurrency assets were taken over by the Securities Commission of the Bahamas (SCB) on Nov. 18.?
Crypto Industry Rocked by FTX Bankruptcy :
There have been several setbacks this year for the cryptocurrency industry. First, there was the hack of Axie Infinity, resulting in a loss of $625 million, and the company has struggled to recover ever since. Then, there was the Luna crypto network collapse, which was deemed the largest crypto crash ever, wiping out an estimated $60 billion in value. And now, we have the latest FTX bankruptcy involving the misuse of customer funds, further eroding confidence in cryptocurrencies.
The crypto market was already bad before FTX collapsed. Since reaching astronomical highs in November 2022, Bitcoin has gone from $69,000 to around $18-20 thousand. The crash, however, impacted investors more than traders.
Could It Have Been Avoided?
FTX crash could have been avoided had the company been rated by a reputable rating agency. Rating agencies help to interpret information from crypto asset issuers and provide an objective evaluation of the investment.
Without a rating, investors are left to their own resources when trying to assess the riskiness of an investment. Rating can help increase confidence in an investment and attract more institutional investors.
In the case of FTX, the lack of transparency and inaccurate rating may have led to some investors underestimating the risks involved in investing in the exchange.
A rating report from a reputable agency like Crypto Asset Rating Inc. (CAR Inc) would have helped FTX assess the risks associated with its platform and take steps to mitigate them. In the absence of such a report, FTX was relying on its own internal analysis of the risks involved in operating its platform. However, this internal analysis failed to identify the potential for a major market crash, resulting in heavy losses for investors.
CAR is a US-based crypto asset rating agency that provides a framework, insights, and evaluations of cryptocurrency assets. Their goal is to create a more transparent crypto market. In order to do this, they rate crypto assets based on various risks. This allows investors to better interpret information from crypto asset issuers. CAR also provides valuable insights into the financial health of a company and its prospects for future growth.
CBW - External Analyst