After a tumultuous few days FTX looks to be facing imminent collapse, the poster boy of the crypto world has almost overnight become the pariah, while almost single handedly setting the industry back years by destroying trust in what is trustless. It is worth highlighting a key point in the Satoshi Nakamoto white paper — “making payments over a communications channel without a trusted party”. There is nothing trustless in a centralised exchange, history seems to be repeating itself.

The events as they unfolded

It is worth just running through the events to help build a picture of what has happened. Coindesk broke a story on 2nd November about FTX (the exchange) and Alameda (the trading firm US$14.6bn) which are two separate businesses both owned by Sam Bankman Fried. The worry started when it became clear from the Coindesk report that Alameda’s holdings are made up largely of the $FTT token issued by FTX (US$5.8bn), US$1.2bn on Solana and US$2bn in equities. In total Alameda also has US$7.4bn of loans, US$2.2bn of which is collateralised by $FTT, while it is unclear who lent the remainder.

It has been alleged that Alameda is using $FTT as collateral against borrowing client assets. If true, this allegation would suggest something similar to: FTX prints the $FTT token, Alameda buys or premines $FTT at a very low price, Alameda posts $FTT back to FTX as collateral, borrowing “real” assets from FTX’s customer deposits.

This allows both FTX and Alameda to demonstrate to auditors they have legitimate credit agreements. This also would suggest a transfer of customer funds to Alameda’s prop trading business.

Enter CZ (Changpeng Zhao), the CEO of Binance, announcing he was selling all of their US$530m $FTT holdings — citing “revelations” about FTX, this spooked the market, leading to the dramatic ~80% declines over the last few days. CZ then offered to buy FTX, but that didn’t stop prices from falling due to rumours from an FTX employee stating the exchange would fail its due diligence process.

Implications for the markets

$FTT has remarkably low circulating liquidity relative to Alameda’s $FTT holdings which represent around ~3x that, so if Almeda wanted to sell there wouldn’t be enough buyers, applying the extreme declines in prices that we have witnessed. Messari data highlights there are roughly 200 addresses actively transacting FTT tokens which is remarkably low in comparison to other tokens. The data provider also highlights there was a big rise in $FTT issuance in September 2022 which may have been a bailout for Alameda.

At present holders of assets on the FTX exchange cannot withdraw after US$6bn of outflows in 72 hours, this will be resolved in the “near future”. Account un-staking could trigger another wave of sell outs in 2 weeks when assets currently locked to earn yield are made liquid. This feels very much like the exchange equivalent of a bank run which hasn’t been helped by the events of Luna still being on investors’ minds.

It highlights the vulnerability of centralised exchanges, are clients holdings of assets bankruptcy remote like they are in most crypto exchange traded products now? This is difficult to answer, however the fear of exchange insolvency risk may cause agitated investors to shift their usage toward decentralised exchanges, which generally do not custody client funds. It is possible that we see an increased polarisation in the industry, where assets flow to either physically backed exchange traded products or hardcore decentralisation DeFi & exchanges.

It also questions the validity of an exchange having a token. What is the $FTT utility? If only to help reduce fees then this hardly seems like enough justification for one, and could be interpreted as a vehicle to capitalise Alameda.

Broader contagion

Fundamentally Bitcoin has no connection to the FTX debacle, but sentiment swings tend to affect all in crypto. We saw the largest liquidations of longs in Bitcoin futures since the 3 Arrows Capital collapse in June 2022 while prices have declined 19% from its November high. So far this isn’t the same as the declines that were seen in June where it declined 43% peak to trough which took 12 days to play out, so far this crisis has lasted 5 days.

Solana has suffered greatly, having fallen 60% over the last 5 days, this is understandable given Alameda holdings represented 20% of circulating supply, although this shouldn’t affect the underlying fundamentals of Solana.

Exposure of equities into the collapse of FTX remains unclear. However the market has sent some strong signals, with share prices from names such as MicroStrategy, Silvergate, Coinbase and Galaxy Digital declining sharply as events unfolded. Today, Galaxy Digital published results showing that the business had a total exposure of $76.8m of cash and digital assets into FTX, which compares with assets under management of $2bn and $1.5bn in liquid assets. However, Coinbase have currently stated that they don’t have “any material exposure to FTX or FTT” and aim to work closer with regulators which can be a longer term tailwind.

This episode may result in further ramifications for the wider cryptocurrency market, including a potentially protracted period of investor scepticism and lower crypto prices. These feed into equities in the form of short term increases in transaction based revenue due to spikes in volume and volatility but continue to put pressure on longer term commission fees at exchanges and a longer period of challenging economic conditions for miners, which are already struggling with a squeeze between high hashrates and low Bitcoin prices. However, in the long run there may be positives for the industry, in the shape of better regulation, transparency and trustworthiness between parties in this space.

Regulatory pressure is only likely to accelerate, but we see this as a positive, the cleaning up of grubby practices that affect consumers is sorely needed in this industry. Recent scandals, including alleged FTX practices, severely undermine all the credible work being done in this asset class.

We don’t think we are quite at the dotcom bubble point where all the purposeless dot.coms fall to zero, but FTX is a big scalp, and the survivors will likely take the spoils and dominate.