Rise and Fall Crypto’s Golden Boy: How to Drop $16 Billion in a Single Week?

It is a well-known fact that the world of cryptocurrencies is fast-paced, where wealth and bankruptcies can be created, it would seem, in a blink of an eye. In early November 2022, the second largest cryptocurrency exchange, FTX, had roughly a $30 billion valuation; by November 14, it filed for bankruptcy proceedings, pulling with it roughly 100 companies that were directly or indirectly connected to it.  FTX is now one of the numerous rags to riches to rags stories in the crypto world, damaging the reputation of crypto and blockchain projects. 

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FTX

Illustration: Milica Mijajlovic

FTX was an exchange akin to the New York Stock Exchange, where users stored, bought, and traded their cryptocurrencies. It was founded in 2019 by Sam Bankman-Fried (SBF), who was just 28 at the time. He used aggressive marketing schemes to grow the popularity of his exchange by, among other things, buying ads at the Super Bowl and buying up the naming rights of the Miami Heat, an NBA team.   

After the stratospheric rise, the company and its CEO are now facing a class-action lawsuit in Florida that alleges that Bankman-Fried created a cryptocurrency scheme designed to take advantage of investors. The lawsuit features some of the biggest celebrities, such as Steph Curry, Shaquille O’Neal, Naomi Osaka, and Kevin O’Leary. At the moment, it is unclear how the lawsuit will play out; however, it will be interesting to understand what preceded the crash and what might follow.  

Who is Sam Bankman-Fried (SBF)?  

Bankman-Fried’s story in the investing world started after he graduated in Physics from the prestigious Massachusetts Institute of Technology in 2014, after which he joined Jane Street Capital as a trader. There he specialized in arbitrage trading strategies of exchange-traded funds (ETFs). Arbitrage trading basically entails buying an asset in one market and immediately selling it in another for a higher price, locking in what some deem risk-free profits. His exposure to cryptocurrency came in 2017 when Bitcoin (BTC) was gaining traction in mainstream finance, shooting past $10,000 per coin.    

At that time, the crypto trading infrastructure was in its infancy stage, where despite the high demand from investors, the number of sophisticated exchanges was limited, and SBF saw his opportunity. He noticed that the arbitrage opportunities in crypto were huge, and he made his initial money deploying a Japanese arbitrage trade, where he bought BTC in the US and sold it in Japan for a 10% profit.  

FTX – From rise to collapse 

Once the money started following in from his operation, SBF decided to found a trading firm Alameda Research in November 2017. At its peak, Alameda earned $3-4 million per day in the digital trading space. Furthermore, he followed up his success by building an exchange for crypto trading to fill the vacuum left by the lack of a sophisticated, well-diversified crypto exchange. Thus, FTX was born, where the name stems for “futures exchange,” relating to futures trading in traditional finance, which traders use to bet where the prices will go in the near future on more traditional assets.  

In the early days of the exchange, liquidity was a major issue; attracting it was usually a big problem, which is why most languished in mediocrity. An exchange lacking liquidity will not have users, and an exchange without users will not attract liquidity, creating a vicious circle from which most exchanges fail to get out. SBF’s solution was using Alameda Research to kick-start liquidity for FTX. The exchange was initially opened in Hong Kong for regulatory reasons, to be moved to the Bahamas later. At its peak, FTX was the second largest crypto exchange immediately after Binance, with Coinbase hot on its heels.  

In early November 2022, news outlets reported that a major part of Alameda’s assets were crypto coins released by FTX. A few days later, news broke out that FTX had been loaning out users’ assets to Alameda without their consent and issued its own currency for Alameda to use as collateral. This spurred the regulators to scrutinize FTX for potentially violating securities law, leading to a bank run on FTX. Large crypto investors, including Binance, started selling off crypto held on the FTX exchange, leading Alameda and roughly over 100 other firms to file for bankruptcy.    

What about the users, will they be indemnified? 

Among the individual users and investors that held assets on FTX, there were more traditional investment firms that also held assets with FTX. Sequoia Capital, a venture capital firm, and the Ontario Teacher’s Pension held millions on the exchange, and both have written off these investments with FTX as lost.  

crypto exchange

Photo Illustration: Freepik

When it comes to bank failures, the government usually ensures the customer deposits, in some cases even up to $250,000, but there is no mechanism for depositors insurance in crypto investing, as the space is mostly unregulated. Eric Snyder, head of the bankruptcy department at the law firm Wilk Auslander spoke with CNN and explained what a bankruptcy entails and how users can get their funds back.  

“The numerator is the assets, the denominator’s liability. You divide one into the other, and the [result] is what everybody gets. But if people are pulling out all the assets, then there’s not going to be much of a numerator.” 

In essence, Snyder is implying at the bank run that pushed FTX over the edge, indicating that there might be actually very little, if anything at all left for users, when its all said and done.  

Where was the mistake? 

First and foremost the mistake that SBF made is intertwining FTX and Alameda, which led to significant losses and allegedly user’s funds being used to prop up Alameda’s ballance sheet. While both Alameda and FTX were struggling with liqudity, the bank run by users and larger institutions pushed FTX deeper into the hole.  

Furthermore, SBF was known for his philanthropist nature where he rushed in to save some of the failing exchanges and crypto lenders, this includes among other things a $500 million loan deal with the defunct cryptocurrency lender Voyager Digital; apparently, FTX paid $1.4 billion for its assets.  

While it is difficult to pin point a single decision that led to the collapse, a string of bad deals and bad decisions ultimately led to FTX failing, and users yet again losing millions in the crypto sphere.  

Who is to blame? 

Financial destruction at such a large scale can rarely be blamed on a single individual. Venture capitalists (VCs) and investors in crypto are in part culpable, since it could be argued that these parties either did not perform their due diligence or there was miscommunication between them and what FTX presented.  

VC circles usually work in pretty closely to create excitement around certain investments, to lure new participants in order to boost the price of an asset. Data shows that VC investing in cryptocurrencies jumped from $1 billion in 2017 to $33 billion in 2021. When it comes to large investments in the crypto exchanges these VCs often control the issuance of the tokens of an exchange. The number of tokens they can produce is “unregulated”, and the protocol governing them can be changed easily.  

Comment
byu/Far-Scholar9028 from discussion
inCryptoCurrency

This represents a skewed form of an initial public offering (IPO) without any regulation, basically valuing the crypto they create at zero, once they chose to pull out their money. Finally, if someone has to take the blame for the fall of FTX, it should be first and foremost the VC investors who created the cassino like exchanges, with the games and chips, thus luring unsuspecting users and investors to gamble away their hard earned money.  

Certainly, there are others to blame, most of all regulators who are powerless or unwilling to create a system that could protect users. And in the end users themselves who in search of a quick and easy scheme to make money decide to invest in tokens and exchanges whose practices were shady from the beginning.  

Dino Kurbegović is a project coordinator and an investor and technology enthusiast with years of experience in managing complex projects. His journey into content writing began in 2014, covering finance, investing, crypto, technology and complex technical topics.