The crypto world has been rocked by the sudden and dramatic implosion of one of the largest exchanges, FTX. Familiar financial news outlets offered blow-by-blow coverage, and even celebrity gossip magazines ran the news on their front pages. And, of course, Elon Musk tweeted about it.
While investigations into the cause are ongoing, early evidence suggests a potent combination of extensive fraud and profoundly poor management practices. Expenses were approved with emojis, for example.
US regulators, rumored to be preparing to extend FTX’s market access to American retail users, were shocked to learn that FTX client funds were used to purchase luxury Caribbean properties for individual executives. Over $1 billion dollars were loaned from the company’s funds to Sam Bankman-Fried, the CEO and founder.
The magnitude of the purportedly $10 billion balance sheet hole has rippled across the industry, resulting in liquidity and insolvency issues for firms that previously seemed invulnerable. Industry experts have only just started trying to understand what caused the collapse and what happens next. The mere existence of the crypto industry seems to hang in the balance.
Let’s take a quick look at what happened, what happens next, and how companies can protect themselves.
What Happened?
Sam Bankman-Fried, or SBF, founded a crypto hedge fund named Alameda Research and FTX, a crypto exchange. SBF was well-known in the industry. He presented himself as a financial savant, an advocate for industry regulation, and a champion of effective altruism.
Under SBF’s leadership, FTX received high-profile investments from professional firms and celebrities alike. They spent lavishly on Super Bowl ads, stadium naming rights, and Formula 1 sponsorships. Bankman-Fried was even invited to Congress to testify and advise on crypto legislation.
Behind the scenes, Alameda had suffered trading losses and, in order to stay solvent, borrowed funds from its sister company FTX. As collateral, Alameda pledged billions worth of a crypto token that FTX itself was solely able to issue. When a balance sheet leaked, it revealed that FTX had a shockingly high amount of these tokens backing its equity valuation, and a classic bank run began.
Companies that invested in or loaned money to FTX are now facing the prospect of a near-total loss of funds. For example, in a domino effect, the lending arm of crypto investment firm Genesis Global Trading recently suspended redemptions and new loan originations in the wake of FTX’s collapse. Because Genesis was a key partner in the Earn program for crypto platform Gemini, allowing users to deposit their coins in exchange for regular interest payments, the inability to fulfill customers' withdrawal requests amid liquidity issues for Genesis completely shut down the program for Gemini. Credit contagion has metastasized through the industry, and many exposed firms have gone under.
What Happens Next?
As the bankruptcy process comes into sharper focus, affected firms will better understand the magnitude of their losses and users may still recover some nominal amount of their funds. However, nothing can change how the FTX failure has and will erode trust in established industry names.
Regulators, lawmakers, and corporate participants may also recognize the story as a familiar one, albeit with a different narrative point of view. For those audiences, this is a classic tale of an unregulated, opaque market. The solution is obviously more legislation, more rules, and more budget.
For crypto industry participants who have been around for many years, this is a familiar story of how even supposedly regulated exchanges are unsafe and insecure. This is even more evidence of the need for decentralized solutions that blockchain can promise. The FTX collapse may be unprecedented in scale, but it is at least a familiar story.
While the reality is likely a bit of both, that won’t change how the ongoing debate about crypto regulation evolves. Lawmakers will demand answers, hearings will be held, and harsh proposals will be drafted. Industry participants will warn that any regulation is too harsh and will destroy a transformative technology.
At last, a middle ground will be found. Some companies will find that their business models are untenable under the new regulatory regime and close-up shop. Firms that aren’t gambling with customer money and trying to one-up everyone will emerge as winners in a more orderly market. A streaming platform will make a ton of money with a series that explains what happened, and the FTX bankruptcy will be added to new editions of finance textbooks.
Is This the End of Crypto? Doubtful.
There are still many bright, well-funded, and enthusiastic people building in the crypto universe. The underpinning technology is being trialed by central banks and banking consortiums for everything from foreign exchange to the inter-company treasury.
In the consumer-facing world, brands like Nike are doubling down on Web3 and NFTs. Crypto rewards continue to be a focal point for customer loyalty, especially with branded cards. Bank of America expects young, wealthy investors to allocate billions to the asset class over the next decade. Companies with established brands are well-positioned to grab market share from the failures.
Crypto isn’t going anywhere, but it will change.
It has never been more clear that firms need to make sure they’re not building with the wrong partners. For firms that are not familiar with financial technology and best practices, these events make it especially difficult to assess risks and opportunities.
Choose wisely. Here’s what you need to know:
- Understand the product, especially where the revenue and yield come from. If you don’t know where the yield comes from, you are the yield.
- Do your due diligence and dive deep into the flow of funds. Competent, well-regulated companies are happy to explain their internal controls and policies. Always ask about how user funds are handled.
- Find a partner that will answer ALL of your questions.
Is Crypto Calling for Better Regulation?
As a wake-up call for regulation and a mandate to perform an enhanced level of due diligence when investing and partnering with financial service providers or crypto exchanges, the demise of FTX is more than proof that unregulated financial organizations are a danger to brands, companies, and customers alike.
To gain further insight into FTX from a regulatory perspective, read Proof Proper Regulations and Sound Practices Matter by Luis Trujillo, Chief Compliance & Risk Officer at Alviere.
Have questions about crypto, or security and compliance? Ready to see what Alviere can do for you? Reach out to us today.
