33 - The fall of FTX
Shout out to my friend and colleague John Schneider for some great edits. Opinions expressed are solely my own.
Over the past week we saw one of the most monumental moments in crypto history. No, we are not talking about Bakkt’s acquisition of Apex crypto which was huge, but rather the fall of the digital asset exchange FTX. FTX is (was) the second largest exchange in the world by volume and majority owned by crypto icon Sam Bankman Fried (SBF). Over the course of this bear market, FTX with SBF at the helm served as a financial backstop for most of the crypto market. In the past 3 months alone, FTX has shelled out over $1.5B to provide credit to or outright acquire crypto lending and trading firms Blockfi and Voyager. Onlookers believed SBF was unstoppable, with Fortune describing him as “The next Warren Buffett, and Jim Cramer calling him “the new J.P. Morgan.” That perception is gone, and the fallout is enormous.
Who are the players
SBF was born in California in March 1992 to two Stanford law professors. He graduated from MIT and started his career in 2012 as an international ETF trader at Jane Street Capital. His first foray into the digital asset industry was in 2017 when he founded the quantitative trading firm Alameda Research. Alameda gained fame by successfully taking advantage of what is known as the “Kimchi premium” where prices for assets in Asian markets, Korea, and Japan specifically, are higher than those in the United States. At the height of this strategy, Alameda was reportedly moving north of $25M a day between US and Asian markets.
In May 2019, SBF co-founded FTX Trading Ltd (FTX Trading), an Antigua and Barbuda-based digital asset trading firm, with Gary Wang. FTX Trading primarily focused on capturing the international market by launching exchange subsidiaries in countries such as Switzerland, Japan, Ireland, and Germany– just to name a few. A year later in May 2020, SBF co-founded West Realm Shires, a Delaware based company which does business as “FTXUS”. All of these companies are together known as the “FTX Group” and consist of 134 different entities spanning the globe (high level visual).
Over the course of his time in the digital asset industry, SBF worked hard to win over regulators and Washington DC. In 2020, SBF held the title of second largest donor to the Joe Biden presidential campaign by donating a cool $5.2 million to help him get elected. In the 2022 midterms, SBF and his deputies upped their game by donating $69 million almost entirely to candidates on the Democrat ticket. In-between these elections, SBF made numerous trips to Capitol Hill, including testifying before the House Committee on Financial Services and meeting with high ranking regulators such as CFTC commissioner Caroline Pham. Not even a month ago he went so far as to write his own Possible Digital Asset Industry Standards. It has been clear for years that SBF not only wanted to own the digital asset space but have a major role in how it was governed in the future.
What happened
The FTX Group’s troubles started when, on Wednesday November 2nd, a Coindesk article was published claiming that the team had obtained private documents showing a massive part of Alameda Research’s balance sheet consisted of FTT, a token issued by FTX. You can think of FTT as a loyalty token where those who hold it receive special features, such as lower trading fees, when using FTX. Alameda’s CEO Caroline Ellison, who many believe is SBF’s girlfriend, denied this assertion, but the seeds of doubt had been sown.
On Sunday, November 6th, Chengpeng Zhao (CZ) , co-founder and CEO of the world’s largest digital asset exchange, Binance, announced via Twitter that the company was exiting their position in FTT. CZ and Binance had been early investors in FTX, so their position was sizable –at the time estimated to be $2.1 billion; and the move spooked the market. Alameda even offered to purchase the FTT for $22 per token in an attempt to stabilize the price. Many in the industry speculated that CZ was exiting the position because of comments made (since deleted) by SBF about CZ’s ability to come to Washington DC; but it could have been equally likely that the Coindesk article shined a light on structural issues at FTX that CZ was unwilling to overlook.
Regardless of the reason, CZ began to liquidate the FTT, causing SBF to respond. At first, he accused CZ of unfairly attacking the exchange (Tweet has since been deleted but see screenshot below); but within 24 hours on November 8th, both parties announced that Binance had entered into a nonbinding letter of intent to fully purchase FTX. It seemed like CZ and Binance had forced the hand of SBF and FTX, emerging victorious from a battle between two crypto giants. More importantly, it signaled to the market that FTX, while cash strapped, was going to be fine.
Unfortunately, that impression faded quickly. The next day Wednesday November 9th, Binance announced that “[a]s a result of corporate due diligence, as well as the latest news reports regarding mishandled customer funds and alleged US agency investigations, we have decided that we will not pursue the potential acquisition of FTX.com.” Over the next two days, panic ensued. Behind the scenes FTX was scrambling to find a lender or a buyer to help them stay afloat. FTX had already stopped allowing customer withdrawals from their platform, but many speculated that the contagion would affect other companies within the FTX group including FTXUS.
These fears gained credibility when on Thursday November 10th, BlockFi stopped allowing customers to withdraw funds. BlockFi, who had run into their own troubles a few months prior, was able to operate thanks to a $400M line of credit they had received from FTXUS. Stopping withdrawals implied that FTXUS was also suffering. All this came to a crescendo at the end of the week when on Friday November 11th, the FTX group, not just FTX Trading but almost all SBFs 130+ different companies, filed for Chapter 11 bankruptcy. Adding insult to injury, it appeared on Saturday morning that FTX was hacked with hackers taking many of the digital assets that were under the companies’ control.
A collapse of this magnitude does not occur to companies with strong fundamentals and leadership. The fact that Binance went from a potential acquisition to backing out of the deal so quickly implies that there are some glaring issues with FTX’s finances. On Saturday, it was confirmed by the Financial Times and picked up by other news outlets that FTX only had $900 million in assets compared to $9 billion in liabilities. Most of the industry believes that the hole was caused by SBF’s using FTX exchange customer funds to finance losses from Alameda. In fact, there has been speculation that SBF even created an accounting backdoor so as not to alert the compliance department or auditors of illicit transfer of customer funds.
The takeaways
What does all this mean for SBF, FTX, and the crypto industry? At the beginning of November, SBF was worth approximately $16 billion all of which evaporated in a matter of days. SBF is currently being detained by Bahama’s authorities in his penthouse apartment on the island. As the story unfolds, we will learn more about what his role was in what is now being referred to as the FTX fraud. What is abundantly clear is that the whole FTX group was doing things that were at least unethical and negligent and, at worst, criminal.
The FTX group filed for Chapter 11 bankruptcy which, unlike Chapter 7, allows the company to continue operations as it negotiates restructuring terms with creditors. Filing for Chapter 11 implies that the FTX group will be able to continue operations to pay back the debt, something that based on the current facts, is suspect. Also remember that not all entities involved are US based, and therefore will have to go through different bankruptcy proceedings depending on their jurisdiction. Combine that with all the investments that each of these entities have made over the past four years, and the legal proceedings will take years, if not decades.
One of the major benefits of filing for Chapter 11 is that the company’s management should, in theory, have more say as to how to restructure (ie. What assets to sell). The customers of FTX must now wait and see what the outcome will be; but as of today, hopes of recovering even a fraction of user funds is slim. Some analysts are even saying that based on the financials released, at most customers would see 5 cents on the dollar.
Everyone in the digital asset industry is suffering from a feeling of extreme disappointment. In one fell swoop, a single organization set the young industry back years. Major investors were duped and completely whipped out having to mark their FTX investment to zero. There have been a lot of “I told you so’s” from those who have never liked digital assets. Others have used the opportunity to espouse the virtues of self-custody and decentralized finance (Defi). Regardless of where you stand, the events that have transpired are sad. Many people have lost their money, and those closely associated with FTX have lost their respect. Regulators will be using this as an opportunity to assert dominance over the industry. Regulation is needed; but in times like these, regulators tend to overexert authority and pass ill-informed measures. Hopefully that does not happen here. Time will tell.