What happened FTX? A deep dive | Invezz

Oh Sam, what have you done?

Sam Bankman-Fried only turned 30 this year, having already amassed a fortune of more than $20 billion. Driving a trusty Toyota, however, he followed “effective altruism”, intending to give away the vast majority of his fortune.

This week he kept his word. Just not the way he planned.

How is Binance involved?

FTX, one of the big three cryptocurrencies alongside Binance and Coinbase, were only launched in 2019. Their rise was staggering, and earlier this year they overtook Coinbase in terms of volume, placing as the world’s second-largest cryptocurrency exchange.

Binance helped to incubate them. Last year, they cashed out their equity to the tune of $2.1 billion. Only thing was, they didn’t take it as cash because, you know, this is crypto and that would have made too much sense. Instead, they took it as a split between stablecoins and FTT.

What is FTT? Well, FTT is the native token of FTX and it’s also where the trouble all begins.

If you’re curious as to why Binance would hold the native token of its biggest rival, FTX, you should be. It doesn’t make much sense, given that FTT will be so intrinsically linked with FTX’s performance.

It is typical of the poor diversification and incestuous financials that we often see in cryptocurrency. During the summer, when Luna imploded (deep dive of that carnage here), it took a load of companies with it because so many were exposed to the Luna token. Overleveraged and all investing in each other, when the music stopped and the lights came on, it became very evident that half the room was naked.

Things were well and good for a while With FTX and Binance’s holdings of FTT. And then last week, CoinDesk published a story about Alameda Research.

Who is Alameda? They are a trading firm founded by Sam Bankman-Fried (SBF). Yes, the same SBF who heads up FTX. Again, you will likely see a lot of these words in the coming days: circular, correlated, tangled, incestuous.

The story said that Alameda’s balance sheet was full of FTT tokens. Indeed, I plotted the composition below of the $14.6 billion assets at the time. As you can see, FTT makes up at least 40%, including $3.7 billion of unlocked FTT. Oh, by the way, the market cap of FTT at the time was $3 billion, with a fully diluted market cap of $7.9 billion. Not good.

These large numbers meant that Alameda’s balance sheet was grossly overstated. FTT is a token printed out of thin air, and SBF ran both companies. Talk about a conflict of interest…

While SBF insists that Alameda doesn’t get preferential treatment, the fact that they sent their liquidity to FTX in the first place is a big factor as to how FTX built up liquidity so quickly and became such a large player, having only launched three years ago.

Alameda is a liquidity provider on FTX but their account is just like everyone else's. Alameda's incentive is just for FTX to do as well as possible; by far the dominant factor is helping to make the trading experience as good as possible.

— SBF (@SBF_FTX) July 31, 2019

But the revelations about Alameda’s balance sheet being full of FTT spooked Binance CEO Changpeng Zhao (CZ). So much so that he announced he was dumping it all, baulking at the amount Alameda held, how illiquid it was and the fact it was being used as collateral against so many loans.  

As part of Binance’s exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have came to light, we have decided to liquidate any remaining FTT on our books. 1/4

— CZ 🔶 BNB (@cz_binance) November 6, 2022

What happened FTX?

This is where things get murky. A flood of withdrawals started coming out of FTX, which makes sense as people worried about the solvency of the exchange. Like I said, poor crypto investors have been through the tumble dryer this year and this was very close to the bone.

There had long been questions over the relationship between Alameda and FTX, and looking at Alameda’s $8 billion of liabilities against the above asset log had people concerned. It wasn’t clear what the $8B of liabilities were denominated in, but if they were in fiat currency like USD, then alarms bells would be triggered.

This FTT token was a low liquidity token, trading with daily volumes averaging $25 million over the last six months. It wasn’t even listed on most exchanges. There is no way it could be monetised quickly (if at all) should liabilities suddenly be called in at Alameda.  

And then, the plot twist. FTX suspended withdrawals.

This immediately threw up PTSD for crypto investors, for whom the suspended withdrawals of companies like Celsius and Voyager Digital earlier this year was all too fresh – the final step on the one-way ticket to bankruptcy town (a deep dive of that meltdown can be read here).

Binance to acquire FTX

And then it got even crazier.

CZ came out and blew the doors off the whole thing, announcing Binance were acquiring FTX.

This afternoon, FTX asked for our help. There is a significant liquidity crunch. To protect users, we signed a non-binding LOI, intending to fully acquire https://t.co/BGtFlCmLXB and help cover the liquidity crunch. We will be conducting a full DD in the coming days.

— CZ 🔶 BNB (@cz_binance) November 8, 2022

Less than 48 hours after announcing they were divesting their FTT exposure, they decided to go and buy the whole thing. CZ swooped in as the withdrawal requests kept getting denied by FTX, saving the embattled exchange from insolvency.  

Akin to Google taking over Facebook, the number one cryptocurrency exchange had eaten up the number two cryptocurrency exchange. While many will point to this as a huge win for Binance, I look at it as a loss for the entire industry. What an incredibly damaging blow to the entire space, seeing the second biggest exchange go up in flames and so many losing so much again.

Why could FTX not honour withdrawals?

But hold on.

People are talking about a run on the bank causing this mess. SBF tweeted out that it was a “liquidity crunch”.

But what does this mean? FTX is not a bank, and therefore a run on the bank should not trigger anything. Customers deposit cash into FTX and buy crypto. The crypto sits there – FTX is a custodian. It should be pretty simple.

FTX is not a fractional reserve bank lending funds out. If a bank saw this level of withdrawals – with estimates all over the place but likely in the billions – they would likely be illiquid too. That is how fractional reserve banking works.

But again, FTX is not a bank. It should not be lending assets out, nor earning a return on them. And if you don’t believe me, see the below tweet from SBF himself outlining this.

That was Monday. Oh, and yesterday the tweet was deleted by SBF. Woops. And while we are on it, the below tweet was also deleted.

See how this is getting scary?

Which takes us to now. And the biggest question is what exactly was SBF doing with client assets? I’m no lawyer, with my legal knowledge limited to the first two seasons of the TV show Suits, but if SBF was sending client funds to Alameda where he was using them to earn a return, that to me sounds like fraud.

People are understandably pointing to Luna and the villain there, Do Kwon. But that was a different beast entirely. Luna (and Terra / UST) was a DeFi ecosystem with a failed model that ultimately death spiralled to zero.

FTX is not DeFi. FTX is a centralised exchange which appears to have been playing dirty with client assets. This should be a simple equation. Customers should deposit funds into FTX and buy crypto. That crypto should sit there. It should not be moved elsewhere, loaned out or used as capital for any sort of activity – by Alameda or other.

What happens next?

The token, FTT, has spiralled down and it faces a battle to survive.

Of course, Alameda is likely toast as a result – even if it survives. The token is down 75% nearly overnight, and was trading at $45 in March. Alameda collateralised loans with FTT (again, see aboe balance sheet), which it was (by proxy) creating out of thin air. And now the circular economy has collapsed.

As for the client assets in FTX, this is the disturbing part. I really hope customers get their money back, but it is hard to say right now. Likely this ends up going through a long court process, and hopefully they get as much back as possible, but right now we do not know what the size of the hole is.

There is also uncertainty around CZ and Binance. If the acquisition of FTX goes through – and that is a big if – then he could have a part to play in all this.

We don’t know what FTX did with client funds. I will follow this piece up with an analysis into the on-chain flows to try ascertain whether FTX was sending anything to Alameda. Honestly, it’s the only theory I have.

Like I keep saying, FTX is not a bank. It should not be subject to a liquidity crisis. Assets shouldn’t even be backed 1:1, assets should just be…there.

But things went very wrong here. Yet again, it’s another very dark day for crypto in a year that keeps throwing them up.

And once more, it’s the retail investors who may pay the biggest price.