Chaos in the Cryptoverse

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As FTX imploded in a matter of days, what ramifications will this have on the cryptocurrency universe?

Remember Enron? The infamous energy trading company that was once a high-flying powerhouse? If you do, you’ll also remember that they were taken down by criminal financial engineering and chicanery that was straight out of a sordid novel. It was likely the largest, most complicated, and most notorious accounting scandal of all time, as its shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees lost billions in pension benefits, all brought on by institutionalized, systematic, and creatively planned accounting fraud.

Echoes of that financial bloodbath rung out across the cryptoverse as FTX, the cryptocurrency exchange formerly helmed by Sam Bankman-Fried (SBF), which had over one million users and was the third-largest crypto exchange by volume at its peak in 2021, went into freefall, resulting in a Chapter 11 bankruptcy filing in November. While the criminal element of FTX’s meltdown was the misappropriation of ~$10B of customer deposits, the parallels didn’t end there. Alameda and FTX were built on false asset values driven by deceptive self-dealing. So was America’s most notorious corporate fraud. Bizarrely, after all is said and done, Enron’s former lawyer is the new CEO of FTX.

More than that though, a core similarity is the role played by publicly-traded, equity-like assets ultimately linked to the performance of the firm in both cases. Like some kind of bizarre financial osmosis, these internal assets flowed between entities that were nominally or even legally separate, but that in fact served the same masters. This financial house of cards, in the form of balance sheets beefed up by phony underlying valuations, came apart rapidly as soon as the falsely-inflated assets began to waver.

If one were to draw comparisons to other corporate unravellings, one could say that the collapse of FTX was an all-star combination featuring the insanity of Theranos’ ruination, the downward velocity of Lehman Brothers, and the staggering scale of Enron. But the question remains; the Enron scandal forever colored how industry onlookers and participants saw the space. So how did this come to pass? And what implications will FTX’s implosion have for cryptocurrencies on the whole?

Crypto’s Bear Sterns moment

For those that have been living under a rock, here’s the somewhat short version. Believe us where we say there’s a lot more where this came from.

With the word ‘Bank’ in his name, it was inevitable that SBF got into trading and all things financial, working at a quant trading firm before founding a crypto hedge fund (Alameda Research) and a crypto exchange (FTX) in 2019. The relationship between these two entities was always a bit fuzzy, but we’ll come to that later. Binance, the world’s largest crypto exchange fronted by Changpeng Zhao (who we shall call CZ, because everyone else does) was one of the earliest investors in FTX, investing $100m in FTX in exchange for 20% of the firm.

With everyone indulging in tokens (digital assets built on a blockchain) across the cryptoverse, how could FTX miss out on the fun? And so, it came to be that FTX created an underlying token called FTT, which — let’s face it — has zero underlying value beyond any perceived value attributed to it (this is true of almost any crypto token). This whole FTT business is critical, so keep it mind, and we’ll come back to this too. We promise it’ll be worth it.

With FTX’s success, SBF’s profile rose significantly. The exchange gained a valuation of $32B, and SBF’s personal wealth swelled to $16B, and he became a crypto crush for many. Flush with funds, FTX splashed the cash, spending $300m+ on marketing to woo retail investors including stadium naming rights (Miami Heat, which has since dropped FTX), sports partnerships (Steph Curry, Tom Brady) and Super Bowl ads (Larry David), alongside becoming a major donor to Joe Biden’s presidential campaign, and again in the 2022 midterms, largely in primaries.

This PR blitz worked a charm; FTX became the 2nd or 3rd largest crypto exchange in the world. By fall 2021, FTX was a serious competitor to CZ’s Binance, and he wanted to pull out of FTX. SBF bought his stake for $2B+, but FTT tokens (remember them?) formed a big part of the deal.

Cut to 2022. As the Fed started to raise rates to curb inflation, volatile assets such as crypto started to feel the heat. As funds and brokerages struggled to stay afloat, SBF rode in like a white knight and offered bailouts. In fact, SBF’s hedge fund Alameda Research was also struggling, but he bridged this by “borrowing” customer deposits at FTX (between $5B to $10B) to plug the hole at Alameda. To summarise the “how” of it all:

  • Alameda buys FTT at a throwaway price at launch, in 2019
  • FTT soars on the back of FTX’s strong performance
  • Alameda posts FTT back to FTX as collateral, borrowing billions from FTX’s customer deposits

Remember how we said tokens don’t hold any value outside of that perceived by investors? Now, imagine the investor with the ability to make or break that perception is CZ, who holds a big bag of FTT after his exit from FTX. And that’s exactly what happened. The moment he offloaded his holding (in excess of $500 mn.), the markets were spooked.

The Fallout

SBF’s own declarations that “FTX is fine” only added oil to the fire, and customers made an incredible beeline for their funds. FTX customers withdrew $6B in just 2 days, and FTX had to limit withdrawals to stop haemorrhaging money. By day 3, things became dire, and it was FTX that needed saving, with Binance seemingly all set to acquire the company he first invested in, pending due diligence.

A day after that, CZ and Binance walked away from the deal after kicking a few proverbial tires, realised the wheels would fall off this carriage once they saw the unholy intermingling of user deposits with the hedge fund. CZ and SBF’s previous acrimony (the two regularly exchanged barbs on Twitter) meant that Binance was quick to recognise FTX had some kind of Achilles Heel, and were swift to exploit this chink in the armour. Nothing else could explain why SBF was having to sell to his biggest competitor. It was a sign that things were very deeply wrong at FTX.

Soon, SBF told investors that he needed $8B to make customers whole, and all hell broke loose. Bitcoin, Ethereum, and other major cryptocurrencies went into free-fall, plumbing depths not seen for two years, wiping out all gains made in that period. In all, this episode erased more than $200 billion from the combined price of Bitcoin, Ethereum and others.

And that, ladies and gentlemen, is a summary of the worst few days in the history of crypto.

 Speaking ahead of the bankruptcy filing of FTX and all related entities, John J. Ray III, FTX’s new CEO, said in a statement that Chapter 11 is “appropriate to provide FTX Group the opportunity to assess its situation and develop a process to maximize recoveries for stakeholders.” But that’s easier said than done; there are 100k+ creditors with assets in the range of $10 billion to $50 billion, as well as liabilities in the range of $10 billion to $50 billion. Squeezing the money out of the corpse of FTX could prove to be difficult, with a Financial Times analysis shows that FTX has $9B in liabilities against less than $900m in liquid cash…and the largest liquid position was $470mn of Robinhood shares owned by an SBF vehicle not listed in Friday’s bankruptcy filing.

This runaway train of crazy doesn’t stop here; over $600m+ in customer deposits went missing from FTX account, which was labeled as a hack. At the moment, it looks like $450m was stolen, with $200m retrieved by a white hat hacker.

Where does crypto go from here?

A cloud of contagion hangs over crypto, fueled by the nuclear explosion that was FTX’s spectacular dismantling. The value of the overall crypto sector dropped 12% over a day to $911 billion, according to CoinMarketCap. JPMorgan’s strategists say the FTX debacle could transform the industry.

Regulatory pressures will also likely spike in the aftermath of this, an unwelcome move in an industry that has had precious little oversight. This could be brought on by SBF’s wilful deception; he implemented a “back door” in FTX’s bookkeeping system, baked in by bespoke software, in order to circumvent auditors. This allowed SBF to execute commands that could alter the company’s financial records without alerting other people, including external auditors. More critically, it meant that the movement of some $10 billion in funds to Alameda did not trigger internal compliance or accounting red flags at FTX.

The ripple effects of this could be felt far and wide, with previously enthusiastic financial institutions now exercising far more caution. That means many will slam the door on the idea of trading crypto futures or derivatives, and the possibility of reconsidering their crypto position as a whole.

And worse may be yet to come, with CZ highlighting “clear sign[s] of problems” at crypto.com, after they “accidentally” transferred more than 300,000 Ethereum, worth $360 million, off its exchange. This maelstrom of madness could well suck more exchanges into its vortex, putting everyone on red alert.

If you are holding any position in crypto, seek clarity on how its hold, and what are your options if the exchange becomes illiquid or bankrupt. In any case, investing in such a volatile asset class isn’t for everyone, so the better informed one is, the stronger their position. As Warren Buffett once said years ago when asked about cryptocurrencies, it “draws in a lot of charlatans who are trying to create exchanges or whatever it may be. It is something where people of less than stellar character see an opportunity to clip people who are trying to get rich because their neighbors are getting rich buying this stuff that neither of them understands. It will come to a bad end.” Prophetic words from the Oracle of Omaha.

As investors and industry participants are left to pick up the pieces, CZ was quick to fill the void as crypto’s new saviour, even going so far as announcing a fund to aid crypto firms in crisis (remind you of someone?). He took to Twitter to announce the fund for major firms, saying, “Five years later, when we look back at this, the industry will become stronger because of this. Crypto is not going away. We are still here. Let’s rebuild.”

How much is left to rebuild is up for debate. For now, the curtains have been pulled off on crypto’s charade, and not everyone likes what they see.

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