The fall of FTX: a tragedy in three acts

Satoshi Nakamoto’s white paper imagining
Bitcoin was born in November 2008 as a direct response to the near-collapse of
Wall Street. Now the crypto industry it spawned may be experiencing a “Lehman
moment” of its own.

FTX, one of the leading crypto exchanges, looks
to be insolvent. Binance, the largest exchange, may buy it for pennies on the
dollar, or it could let FTX and its parent company, prop trader Alameda
Research, twist in the wind.

The entire episode played out on Twitter.
Following tweets blow by blow gives the drama a veneer of transparency.
Binance’s founder, Zhao “CZ” Changpeng, has tried to claim the high ground by
tweeting his firm’s decision to sell all of its holdings of FTX’s governance
token, an act of transparency, he says.

The reality is different: this is a
spectacle born from opacity and regulatory arbitrage, and the public forum has
been weaponized in the service of shadowy power plays.

Act One: Terra/Luna

This week’s events are Act Two in a
three-act drama, tragic for many, comedy for some.

“Getting popcorn out for the next few
days”, said an industry salesman on Wednesday, November 9, on a crypto WhatsApp
group.

“What a joke,” said another. “It leaves the
casual observer thinking that no one in crypto can run a business without
needing to be rescued at a moment’s notice.”

He is referring to the end of Act One, which transpired in March with the collapse of Terra/Luna, a stablecoin. Many large crypto firms that held Terra (the stablecoin) or its governance token, Luna, then went bust, including brokerages BlockFi and Celsius, and hedge funds Three Arrows Capital and Voyager Fund.

Governance tokens

Terra failed because its “tokenomics” could
not survive a fall in the value of bitcoin – but bitcoin’s value had been
falling fast. Terra relied on algorithms rather than hard reserves to track the
value of the US dollar, and on its governance token, Luna, to manage cash in
and out.

Governance tokens, if they have a function, is akin to air miles. They are meant to reward a protocol’s users, but instead of letting people trade them in for flights, these tokens offered high yields to users for “staking” the token, that is, investing money in the system.

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At one point Luna projects were paying up
to 40 percent in interest. This was never sustainable or close to realistic.
Air miles work as vouchers, not as junk bonds. These yields came from Ponzi
dynamics, but the fall in bitcoin prices reflected net cash withdrawals from
the cryptoverse.

Act One ended with Sam Bankman-Fried offering
the troubled firms support, either as loans or buying their equity. This calmed
the markets, although in the end, SBF never actually put money into any of
these troubled companies. Alameda and FTX do retain some options to acquire the
equity of some of these companies in 2023. But their investors and customers
have been mostly wiped out.

Tether

But Act One did not begin with the Terra/Luna
crash. It has a lengthy prologue that involves Tether (known also as USDT), the
biggest crypto stablecoin. Tether is issued by a company called iFinex, which
is also the owner of Bitfinex, a crypto exchange. iFinex in turn is owned by a
Hong Kong-registered holding company, DigFinex. (No relation to DigFin.)

iFinex is the epitome of opaque. It has
existed in various guises since 2013 and exists as a series of shell companies.
Its two founders, J.L. Van der Velde and Giancarlo Devasini, are almost
invisible. They mint Tether as a stablecoin, which is meant to always have a value
of 1USDT=$1.

Tether is supposed to maintain this value
thanks to reserves, but iFinex has refused a proper audit or any kind of
reporting or accountability that would be expected of a financial institution. No
one knows how iFinex or Tether manage operations or reserves.

Tether became relevant in 2020 when its
market cap began to rise on the back of huge demand across the crypto
community. The stablecoin was a useful tool for exchanging for fiat currencies,
pricing other digital assets, and serving as collateral to facilitate trading. Tether’s
market cap peaked in April 2022 at $83 billion: it is systemically important to
the entire crypto market.

One year ago, in November 2021, Protos, a crypto
research website, released findings from its research into who buys Tether from
iFinex. It found Alameda Research and Cumberland Global, another market maker
owned by trading company DRW, were responsible for 55 percent of total Tether
sold into the market. These two firms in turn sold Tether to exchanges such as FTX,
Binance, Huobi and OKEx, which offer the stablecoin in pairs trading against
many other crypto assets, and need a steady supply.

Other major buyers of Tether include crypto
hedge funds such as Three Arrows Capital, Heka and Delchain. These huge
holdings of Tether have been key to the market dominance of these market makers
and funds. Their importance, in turn, makes Tether a necessary element of the crypto
ecosystem. Alameda is big because Tether is big which is because Alameda is
big.

Tether was not involved in the Terra/Luna
bust, although it did wobble, briefly losing its $1 peg. Its market cap has
fallen modestly, but its role in the ecosystem has not changed. What will have
changed is the nature of the people using it. But for now: back to the aftermath
of Terra/Luna.

Act Two: Alameda/FTX

It is possible that SBF was eager to prop
up Three Arrows, Voyager etc because his own companies were exposed to them.

FTX, which got its start in part thanks to
investment by Binance, became a multi-billion dollar company and a face of the
industry, sponsoring American sports teams, for example. Later, Binance wanted
to sell its stake in FTX, and accepted to take $2 billion worth of FTT – the
exchange’s governance token that FTX uses for trading fees. Binance might have
thought it owned a yielding asset, but it just owned air miles.

But there was no sign of trouble. FTX and Binance weathered the Terra/Luna collapse and came out looking like pillars of stability. Volumes in Binance’s coin, BNB, hit all-year lows in October, as did SOL, ether (ETH) and even bitcoin (BTC).

The drama unfolds

Trouble began on November 2^nd when
Alameda’s balance sheet was leaked, revealing a $3.66 billion position in FTT,
making this its largest asset – plus another $2.16 billion of FTT as collateral.
Why was Alameda holding so much of its sibling company’s token – so many air
miles?

Matters spiraled out of control this week. Zhao
Changpeng revealed on Twitter that Binance held $580 million in FTT – and said
he was selling everything.

CZ also suggested that Sam Bankman-Fried had
been badmouthing him to US regulators. SBF is known for his stance that the
industry needs regulation, and he has been currying favor with powers that be,
floating ideas such as how to use flash lending and automated market-making
(features unique to crypto) for commodities markets.

Binance does everything it can to be both
gigantic and to be unregulated, and undomiciled.

Maybe CZ thought Sam was trashing him.
Maybe he just doesn’t like a big competitor that’s lobbying for regulation. Or
maybe this is just a screen, and he realized that Sam’s numbers didn’t add up –
so he decided to get out before the mob rushed the doors.

On Tuesday Sam tweeted all is well and Alameda’s CEO, Caroline Ellison, tweets they will “happily” buy FTT, suggesting $22 is a good price. (As of this writing, FTT is at $4.47.) Initially perpetual futures funding rates recovered, suggesting maybe the market was ready to accept SBF’s assurances.

The twist of the knife

But then, as noted by Matrixport’s Thielen, a group of FTT tokenholders publicly demanded SBF prove that Alameda was good for what it owed.

This demand came from BitDAO, a
decentralized autonomous organization that raises money to invest in various
crypto projects. It had swapped its own BIT Token for FTT, in a deal in which
both sides pledged to hold the other’s tokens for several years. But now BIT
prices were collapsing, and the users behind the DAO (which include Bybit,
Pantera, and the billionaire Peter Thiel) wanted to make sure it wasn’t SBF who
was selling off their token, presumably to raise funds to meet FTT redemptions.

CZ, with exquisite timing, tweeted that Binance held $8 billion of ether (the token behind the Ethereum blockchain) in cold wallets – a way of saying, “We have reliable assets and lots of them.” This after telling the market he was selling FTT. The reference to cold wallets implied that perhaps other exchanges did not hold customer assets in cold wallets (ie, not readily available to trade).

Which led market participants to wonder if their assets had been segregated from FTX’s. Because the firms that collapsed in Act One had blithely commingled customer and proprietary assets, so when they went bankrupt, their customers were screwed. Similarly, the risk of being a bagholder for FTT grew too intense.

Capitulation

That same day, the 8^th, the run
on FTX accounts began, with more than $1 billion withdrawn in 24 hours. The selling
action spread to other tokens that Alameda was known to have large positions in.
These included Sol, the governance coin of Solana, a popular blockchain; and
Matic, the token of Polygon, a blockchain interoperability protocol. Meanwhile
trading volumes in bitcoin and ether soared, as investors sought safe havens.

SBF tweeted on Wednesday morning that he
would now enter an agreement with Binance, and CZ tweets, “FTX was in trouble.
We bought them to save them.” Although “bought them” is negotiable, just like
SBF’s commitment to buy BlockFi. And “in trouble” had plenty to do with CZ’s
tweets about dumping FTT.

Crypto analyst Charles Hayter of CryptoCompare said that FTX’s reserves of stablecoins have plummeted, while FTX recorded a huge outflow of bitcoin and record withdrawals. Meanwhile traders are shorting FTT, further crimping liquidity across all major exchanges.

From the crypto WhatsApp group, one trader
noted, “SBF…had no handle on ‘value’ with his generous bailout and has
clearly mismanaged liquidity liability…running a hedge fund is harder than it
looks.”

Act Two will end this week with Sam
Bankman-Fried’s estimated net worth plunging from a Forbes-magazine high of $26
billion to under $1 billion (and possibly less); with Binance dictating the
fate of vanquished rival FTX; with BTC and ETH prices falling; and with SBF
hoping for a pause in market conditions to find new sources of funding for
Alameda. He will need luck.

Act Three: aftermath

If the Lehman Brothers analogy is to hold,
then the Terra/Luna collapse maps to Bear Stearns’ collapse in early 2008. If
FTX is the Lehman Brothers of this story, there is more to run. Lehman wasn’t
the only major firm to blow up in 2008.

Will Binance actually acquire FTX?

Maybe not. Sam Bankman-Fried made a lot of
noise this spring about supporting insolvent companies but never stumped up the
cash.

Gracy Chen, managing director of Bitget, doubts
Binance will want to own FTX. FTX doesn’t have a US license, so buying it doesn’t
bring an easy US compliance solution. There’s no need to pay for FTX customers,
because many of them will migrate to Binance anyway. And FTX doesn’t have
technology that Binance needs.

Rather she thinks Bankman-Fried will use
the deal to try to find other sources of funding, while Zhao will keep FTX alive
just long enough to restore some stability – at which point he can kill it, if he
wishes.

But the optics of massive centralization in
a business that’s supposed to be about decentralization will make Binance look
bad. In fact, it already does, says Chen: “It looks like CZ had a complete victory,
but Binance will eventually pay the price for damaging the long-term interests
of the industry.”

Will the damage be contained?

As of late Wednesday, the shocks remained
manageable. Thielen of Matrixport noted that traders were liquidating
positions, leading to a jump in Tether volumes. “Important to note that market
cap of stablecoins has not declined,” he wrote, “a sign that there has been no
major fiat offramp (yet).”

But there is a likelihood of more deleveraging
and pain across the market. Bitcoin fell by 5 percent on Wednesday, to $17,500;
ETH was down 9 percent and shares in Coinbase (the US listed crypto exchange)
were also down.

The biggest pain was in other tokens that Alameda
had positions in, such as SOL, which began Wednesday at $31 and had dropped to
$16.5 by early evening. Now that Binance has de facto control over FTX, why
would it support SOL, which it sees as a rival to its own blockchain (and its
coin, BNB)?

If this is just about Alameda’s books, the
crisis could abate. But if it leads to revelations such as commingling of
customer assets and deposits, or reckless risk management and fatal
related-party transactions – none of which would be new to the crypto industry
– then a vicious selloff could ensue. And Sam Bankman-Fried can expect an
avalanche of lawsuits and regulatory investigations.

What about Tether?

Our account of Act One meandered into
Tether, which didn’t play a role in the Terra/Luna collapse and hasn’t played
one in the FTX/Binance saga either.

But as mentioned, Tether is the glue
holding the marketplace together. Trades in Tether pairs make up more than 50
percent of all daily average trades across crypto, according to Statista. Yet it
is fundamentally unstable. It is the biggest red flag in crypto. What would
have to happen for Tether to “break the buck” and lose its dollar peg? And if
that were to happen, what would that mean for every major market player?

Alameda will not be in a position to serve
as a conduit between Tether and the marketplace. Others may step in, but Alameda
plays a huge role.

Jeremy Allaire, who runs Circle, issuer of Tether’s competitor, USDC, tweeted his despair at the FTX affair. USDC has been more forthright about its reserves in US government bonds and cash, managed by third-party asset managers and custodian banks. But a wipeout would hurt USDC too.

“Seeing a major industry peer and their
loyal customer base impacted like this is god awful,” he tweeted about FTX.

But Allaire makes the point that the
current crisis isn’t just about the industry’s big players fighting for dominance.
It’s more fundamental: he blames the crisis on “Lack of transparency, lack of
counterparty visibility, and project treasuries and balance sheets anchored in
speculative tokens.”

He puts some of the blame on US regulators.
“The lack of clear regulatory guidelines in the US has encouraged more risks”
and encouraged the rise of offshore players. (One could include Tether among
them.)

Allaire called for the industry to drop CeFi – that is, to get rid of the centralized entities such as exchanges that crypto bros imported from the traditional world of Wall Street.

DeFi versus CeFi

The DeFi world has remained aloof from all
of these crises, suggesting it is better suited to blockchain and is shielded
from the obvious conflicts and greed of CeFi players. At the same time, the
industry needs clear regulation to clamp down on market manipulation and fraud.

It also needs rules around disclosure. CZ’s
tweets this week have been cloaked of language about “transparency” but the
reality is that Binance is one of the most opaque entities in the industry.

That goes for other players too. There is
no regulation that would require FTX or Alameda to report their financial
statements. Therefore it was left to a leak to reveal Alameda’s
vulnerabilities, which were exacerbated by CZ’s tweets in the name of “transparency”.

(CZ tweeted that Binance doesn’t use BNB as
collateral, and said that exchanges should not operate like fractional-reserve
banks. Instead they should run on “merkle-tree proof of reserves”. A merkle
tree is a computing technique to store data so it can be shared. Binance doesn’t
actually do so, and neither does anyone else, but CZ said it might in the future.)

This left the industry at the mercy of crypto magnates’ Machiavellian dealings. CZ had several opportunities to quell turmoil, such as buying FFT at the $22 as asked (begged?) by Alameda’s CEO. He chose to kneecap his rival and damn the fallout. Is this going to endear him to regulators? Is the tragic figure in this play Sam Bankman-Fried – or Zhao Changpeng?

The sequel

This leads to the future of the industry. It has been clear to DigFin that “crypto” is dead and that the industry’s value is in transforming TradFi, which means regulation and the promulgation of central-bank digital currencies or turning stablecoins into regulated forms of deposits.

Licensed exchanges

Some players have positioned themselves for
such a moment. Coinbase in the US is one. Another is OSL, the licensed crypto exchange
in Hong Kong (a unit of the listed BC Technologies).

OSL’s head of trading, Wayne Trench, said on Wednesday, “Many of the participants need to change the way they operate.” OSL’s license requires it to segregate client assets, maintain insurance on digital-asset balances, surveille transactions, and conduct customer suitability tests. It is also audited by PwC.

Disclosure

Another necessary change is to require certain types of disclosure, including financial statements and, in the case of stablecoins, thorough transparency on reserves. That the industry has been learning about material information through the self-serving tweets of crypto bros is a disgrace (although…also entertaining).

Institutional diligence

These are essentially arguments for the institutionalization
of the crypto space. But institutions have to also play their part. FTX’s main
shareholders include BlackRock, Sequoia Capital, Temasek and Ontario Teacher’s Pension
Plan.

Some of them may prefer to invest in FTX as opposed to holding crypto tokens directly because it’s an easier fit for their reporting and risk teams. But it doesn’t look as though any of them asked about Alameda’s balance sheet. A simple glance would have revealed the huge exposure to FTX’s air mile points. Why did these institutions all fail?

The new world

This isn’t a moral argument between TradFi and crypto. It’s about creating the necessary safeguards, with empowered referees, to protect investors and commit to the integrity of the market. Those safeguards are imperfect in TradFi but at least they exist.

Crypto has some things to teach the TradFi
world too. But the benefits of innovation will never be realized until some
basics are established – by regulators, financial institutions, and crypto industry
leaders.