If you’ve been reading any financial headlines recently, you’ve likely caught wind of the turmoil in the crypto world. At the center of this turmoil is the collapse of FTX, a cryptocurrency exchange headquartered in the Bahamas that was recently one of the largest and most well-known in the space. It is now drawing eerie comparisons to the scandals of Enron and Bernie Madoff. So what caused it to collapse?
What is FTX?
FTX was an online exchange where customers could deposit cash to buy and sell various cryptocurrencies such as Bitcoin. The Wall Street Journal reports that until November 2022, it was one of the five largest crypto exchanges in the world.
It had large advertising deals, such as a flashy Super Bowl LVI commercial in February 2022, the naming rights to the NBA arena in Miami, and various celebrity spokespeople appearing in ads, such as Tom Brady, Stephen Curry, Shaquille O’Neal, Larry David, and others.
At the center of FTX was its founder and now ex-CEO, Sam Bankman-Fried (a.k.a. “SBF”). Until this past month, SBF had been gaining steam as one of the main players in the crypto world. Earlier this summer, he attempted to bail out a couple of smaller failing crypto exchanges, leading some to compare him to the likes of J.P. Morgan Sr. of the early 1900s.
He also gained a political presence in Washington as one of the largest Democratic donors in the 2022 midterm elections.
He built a public persona as the spokesperson and steadying force in a volatile crypto industry. However, it turns out he was orchestrating a reckless and fraudulent scheme within his FTX platform that would ultimately bankrupt the company and leave its customers wondering if they would ever be able to recover their deposits.
What Went Wrong?
When you deposit or buy assets on an exchange like FTX, you are under the basic assumption that the exchange is holding those assets for you in your account. And when you wish to withdraw from the account, you assume the exchange will be able to provide liquidity and fulfill your request. But, unfortunately, FTX was not backing its’ customer deposits with enough liquid reserves.
When one of FTX’s biggest investors decided to sell their stake in the exchange, a chain of events led to the collapse. When other FTX customers caught wind of the large selloff, it prompted a “run on the bank” with mass FTX customer withdrawal requests. FTX was forced to halt such requests due to a lack of liquidity. After that point, the company’s financial troubles became public knowledge, SBF stepped down as CEO, and FTX filed for bankruptcy.
To make matters worse, it then became clear that FTX had been funneling large sums of customer deposits into another of SBF’s companies: Alameda Research, a crypto-heavy quantitative trading firm that SBF claimed was completely separate from FTX customer funds.
As the crypto market has declined this year, it is speculated that Alameda’s aggressive and risky trading strategies were causing heavy losses and potential solvency issues. The ethical (and potentially criminal) issue is that FTX customer deposits were used to prop up the struggling Alameda Research’s losses so they could continue trading.
What Happens Next?
FTX customers have no choice but to wait for bankruptcy court proceedings to determine if their withdrawal requests will be made whole, which could be a long and drawn-out process. Lawsuits have already been filed, and criminal investigations may be underway regarding the defrauding of FTX customers.
The implications for the broader cryptocurrency industry are ongoing and difficult to assess. The collapse of one of crypto’s major exchanges is a blemish on the very short track record of an industry that many sophisticated investors already view as the wild wild west with limited regulation and oversight. It highlights the need for more regulation in the crypto space, as clearly, there is still a path for bad actors to take advantage of others.
If you’ve read our previous posts about crypto investing, you’ve already received cautionary advice about this new and unregulated asset class of cryptocurrency. However, that’s not to say there isn’t value in holding cryptocurrencies or with the technology behind blockchain. The FTX collapse could serve as a pruning that is helpful for the industry’s long-term health—weeding out the bad actors in route to a safer environment for participants.
Anthony Harcourt, CIMA, is a Portfolio Manager at Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.BedelFinancial.com or email Anthony at firstname.lastname@example.org.