The FTX Collapse: Explained

Intro

One of the most significant events in the history of cryptocurrencies was the collapse of FTX. So, what is the background of FTX? How did it quickly rise in popularity and become one of the largest cryptocurrency exchanges? What caused it to fall? And what effect will it have on DeFi and crypto? This article includes answers to these and other questions.

Rise of FTX and Sam Bankman-Fried(SBF)

Sam Bankman-Fried, sometimes known as SBF, is the protagonist of the FTX narrative. SBF earned a physics degree from MIT in 2014 and began working full-time at Jane Street Capital, a renowned proprietary trading company in traditional finance. Sam left Jane Street in 2017 after three years of trading and started Alameda Research, a quantitative trading firm specializing in the cryptocurrency market. It's interesting to note that Sam, a passionate supporter of effective altruism, vowed to donate his riches as effectively as possible while he was still alive. This would have been one of the driving forces behind his decision to pursue a career in cryptocurrency after learning that it offers even better income potential than his job at Jane Street.

Alameda's beginnings are very successful. Sam and his team identified a significant possibility for arbitrage caused by price differences between Bitcoin traded on American and Asian exchanges. The arbitrage allowed the company to make quick money and broaden its reach into new markets, like DeFi. Sam didn't consider his highly successful trading company to be enough. He decided to open the FTX cryptocurrency exchange in April 2019. It was a difficult task. It didn't seem like there was enough room for another operator in the exchange ecosystem with hundreds of rivals and leading exchanges like Coinbase or Binance already snatching up the vast majority of crypto consumers.

After a gradual start, the FTX volume began to increase quickly in late 2020. Having a competent market maker who could provide liquidity to the exchange—none other than Alameda itself—accelerated expansion. The liquid derivatives market attracted a lot of knowledgeable traders and businesses seeking to limit their exposure to the market. Sam chose to leave Alameda and name two of his close associates, Caroline Ellison and Sam Trabucco, as co-CEOs to devote all of his attention to expanding FTX. Seeing the success of FTX, SBF began spending a lot of money on marketing, including naming rights for the FTX Arena in Miami, commercials featuring Tom Brady and Larry David, and influencer marketing on well-known YouTube channels, to mention a few. Sam continued his fund-raising in the meantime. Between June 2021 and the start of 2022, FTX raised a massive $1.8 billion from renowned investors including Sequoia Capital, SoftBank, and Tiger Global, gaining ever-increasing credibility. SBF, which has an estimated net worth of $20 billion, became one of the youngest multi-billionaires in history when the value of FTX soared to $32 billion. His way of life attracted a lot of interest as well. Vegan, driving a Toyota Corolla, frequently dozing off on a bean bag at work, and residing in an apartment with other coworkers. These characteristics weren't typical for a young billionaire.

Sam was viewed as a trading and financial genius by many, including the media. Sam's rapid cash growth and eccentric lifestyle began gaining an increasing amount of media attention. Sam instantly gained a reputation as the face of cryptocurrency when Forbes and Fortune magazines both claimed he may be the next Warren Buffet or J.P. Morgan. SBF was involved in politics and lobbying in addition to spending a lot of money on marketing. He obtained a lot of high-level meetings with regulators and legislators and donated about $40 million, largely to the Democratic party. By developing a regulatory framework that would further strengthen FTX's position in DC at the expense of DeFi, he attracted a lot of attention in the cryptocurrency community. DeFi Frontends should be governed similarly to broker-dealers in the US, according to the study. The DeFi community wasn't thrilled about this, and many people voiced their disapproval of the proposed regulation's current status.

Collapse of FTX and Sam Bankman-Fried(SBF)

As the discussion around DeFi regulation continued, the media began to focus on another issue. According to a leaked balance sheet of Alameda, published by CoinDesk, even though the firm has a large amount of cash, most of it comes from just one token, FTT, which is FTX's token and is primarily used to cut trading fees on the exchange. There was a serious issue here. Only a small part of the entire supply of FTT tokens was regularly traded because of its extremely low float. On top of that, FTX, Alameda, and other connected businesses possessed the great majority of the coins. Caroline, the CEO of Alameda, soon stated that the balance sheet that had been released didn't accurately depict the company's financial situation.

Despite her assertion, the cryptocurrency market remained skeptical of the situation and there was a lot of talk about Alameda's potential insolvency. Due to the recent significant collapses of Terra/Luna and Three Arrows Capital, market participants were very alert to any rumors of probable insolvency. Even more unexpected was the next action that triggered FTX's demise. Aside from the well-known FTX investors from the most recent fundraising rounds, such as Sequoia Capital or Tiger Global, one of the first FTX investors, Binance, remained somewhat under the radar. At the end of 2019, Binance made a smart early investment in FTX.

As FTX began to increasingly compete with Binance, CZ, the CEO of Binance, decided it was time to sell its FTX stake. It's interesting to note that FTX chose to use a combination of stablecoins and their own token FTT to repay the investment rather than choosing to do it in dollars. As a result, Binance became one of the largest FTT token holders. The possibility of Alameda's bankruptcy caused CZ to determine it was time to sell its FTT holding. The decision was made public on Twitter by CZ, who said that Binance will try to lessen the market impact of their FTT withdrawal by gradually selling the tokens. This made the already poor FTT price action worse and encouraged selling even more. Alameda's CEO intervened and declared that the company was prepared to purchase all of the FTT tokens still in circulation for a set price of $22. SBF tweeted a few possibly ill-considered things as a result of the circumstance, which only served to inflame the situation.

Under the hood, it appeared like SBF and CZ were very tense with one another. This tension was probably caused by FTX's active lobbying for favorable legislation, which may have been bad for DeFi and its rivals like Binance. A significant bank run on FTX was brought on by market players who were alarmed and expedited their withdrawals of funds from the exchange. FTX suspended their withdrawals when the amount of cash leaving the company over just 72 hours hit $6 billion. Along the way, there were even more pleasant surprises. Sam suddenly revealed that a non-binding letter of intent between Binance and FTX had been signed, indicating that Binance is interested in fully acquiring FTX.com after conducting due diligence. The declaration sent shockwaves across the entire cryptocurrency market, and within a few hours, every major media organization was covering the story. However, a day later, Binance decided to withdraw from the offer after performing a detailed examination of the FTX and Alameda books and discovering a significant multi-billion dollar hole. Sam decided to ultimately give up on trying to raise additional funding after a couple more failed attempts on November 11 and announced his resignation as exchange CEO in addition to filing for Chapter 11 bankruptcy. This would apply to FTX.com, Alameda, and FTX.us, which up until this point were not thought to be impacted by the circumstance.

A new CEO was chosen under Chapter 11, John J. Ray III, who had previously guided embattled energy giant Enron through bankruptcy. In the meantime, CZ stated in a letter to his staff that he hadn't intended to bring down FTX and that he had accidentally revealed the gap in their financial statements. Regardless of motive, CZ's acts will go down in crypto history as some of the smartest ones. A few additional crucial details emerged after the bankruptcy was declared. The 134 legal entities that made up FTX and Alameda most likely served to further muddle the transfer of money between the two businesses. Additionally, FTX lacked a board of directors and even a chief financial officer, which was undoubtedly one of the biggest red flags. We're still waiting for the complete story to come to light, but as of right now, it appears that Alameda's insolvency—which most likely occurred at some point during the 3AC saga—was what primarily caused the hole in the FTX balance sheet. Additionally, it appears that FTX's accounting systems contained a backdoor that prevented the proper reporting of the transactions between FTX and Alameda, making it impossible for the auditors and other staff members to spot the issue early.

On November 12th, the remaining exchange balances abruptly began to decline, adding further fuel to the flames. It was evident later that day that the trade was being abused. Whether the attack was carried out internally or externally is yet unknown. In reflection, it is clear that SBF's power play to distract attention from the bankruptcy of his own company, FTX, involved fund-raising, political contributions, aggressive marketing, and even bailing out other failing businesses.

Impact on Crypto Industry

The failure of FTX is already having an impact on other businesses and the wider crypto industry, in addition to resulting in the loss of funds from investors and customers. A layer 1 blockchain called Solana was adversely impacted by FTX's demise. A few key things played a major role in this. First off, with over $1 billion in Solana SOL token holdings, FTX, Alameda, and SBF were major sponsors of the ecosystem. The coin's price fell by approximately 40% in a single day as a result of the market anticipating probable SOL selling pressure.

Second, Alameda-backed wrapping assets on Solana like bitcoin and ether immediately lost value, disrupting the loan markets. Another business that was adversely impacted by the FTX failure was BlockFi. BlockFi received assistance from FTX in July 2022 in the form of a $400 million loan arrangement. The BlockFi team said in a statement that withdrawals have been halted following the FTX collapse. Additionally, we can probably anticipate hearing about additional affected companies shortly. The loss of faith in the cryptocurrency sector, already damaged by Terra and Three Arrows Capital, is another significant effect of the FTX collapse.

Unfortunately, each time a significant event like this occurs, it turns more people against cryptocurrency and breeds more skeptics of the technology. Concerns about possible regulatory repercussions of the FTX failure are also present. The episode might be used by the regulators as justification for strict regulation across the board, which could be harmful to further adoption. The collapse of Alameda has also led to a period of low liquidity in the cryptocurrency markets. Alameda was among the largest market makers in CeFi and DeFi, but aside from them, we can now observe other market makers lowering their market exposure by diminishing their market-making efforts. Hopefully, this will only last a little while until all the details surrounding the FTX collapse and its consequences are made public.

Further power concentration in the exchange sector will result from the failure of one of the largest exchanges. Only a few big names will be available to customers. Many exchanges decided to start producing proof of reserves of their assets to increase transparency. This can aid in spotting obvious misbehavior, but it is not a solution. Sadly, the proof of reserves does not reveal all of the ongoing liabilities, making it impossible to use it to fully assess the exchange's viability.

What's Next for DeFi and Cryptocurrency

The already damaged reputation of the cryptocurrency industry was further harmed by the collapse of FTX. It makes sense to respond to the query at this point. What is the future of cryptocurrency? We cannot just presume the absence of further, new harmful players inside the ecosystem, that much is clear. Before making use of their position, some of them may have spent years establishing their credibility. There appear to be two main directions to take. One focuses on increasing control, centralization, and regulation to essentially recreate the power structures from old finance. Additionally, this route reinforces arbitrary access to financial services based on your nationality and financial background.

The alternative route, known as DeFi, is a little more intriguing and focuses on on on-chain transparency, self-custody, fair access, and self-regulation through protocols whose mechanics can be fully understood from the code that can be audited by anyone. Additionally, these two pathways may run in parallel. DeFi will continue to be free and accessible to everyone because of its transparency and self-custody features, unlike centralized corporations that hold consumer payments.

Defi must figure out how to make it simple for new people to sign up, that much is certain. This entails enhancing the non-custodial wallet user experience and enhancing the security of dealing with DeFi protocols. It's also important to note that throughout the collapse of FTX, the great majority of other chains—including Ethereum, DeFi, and even others—performed as expected. The largest decentralized exchange in DeFi, Uniswap, has been operating without a hitch for more than 4 years, handling a daily trade volume of more than 1 billion dollars on average.

Summary

To summarize this post, it's critical to keep in mind that Bitcoin launched the crypto sector, which was designed with the value of self-custody and transparency in mind. I want to emphasize that the FTX collapse cost many people their whole life savings. I wish them luck in their efforts to recover the funds during the bankruptcy proceedings. Moving forward, we should be cautious of new leaders who might seize power fast before fleeing in disgrace. Additionally, I'd like to see more people join DeFi and take control of their asset custody.

This has its difficulties, but I think they can be overcome with time. What are your thoughts on the collapse of FTX and the future of cryptocurrencies? Post a comment below.