6 min read

FTX's collapse and its lessons

FTX, the world's second largest cryptocurrency exchange with a market capitalization of US$32B imploded last week. What happened, and what can we learn?
FTX's collapse and its lessons

FTX, the world's second largest cryptocurrency exchange with a market capitalization of US$32B imploded last week. If you have been following the story, you probably have capital invested in crypto.

After all, this year has been full of crypto implosions as the entire industry collapsed from the cascading effects of deleveraging, margin calls and forced selling.

Earlier this year, the incident surrounding Terra/LUNA UST wiped out many individuals and lending institutions like Celsius Network, Voyager and Hodlnaut - who borrowed to lend at 20% APY on Anchor Protocol, only to realise that it claimed yields backed by nothing but its token that had an infinite supply.

It didn't only affect those who deposited into Anchor directly, but also those who deposited in other lending institutions or VCs that deposited into Anchor Protocol. We saw the failure of 3 Arrows Capital (3AC), and other companies that lent funds to 3AC.

Liquidity mismatch, panic withdrawals and a "bank run" led to many centralized lending desks freezing user deposits to preserve liquidity during the liquidation process.

The industry survived, until last week, when FTX announced suspension of withdrawals and bankruptcy. The impact of FTX's collapse can be felt more widely, as it impacted far more users - including the vast majority of retail investors who had funds on the exchange doing nothing.

But it's not just everyday users that are feeling the pain. Many firms, including large players like Genesis Global Capital and BlockFi have funds trapped in FTX. This has huge downstream implications - especially since many CeFi intermediaries like Gemini Earn funnel retail deposits to these players, which are also now frozen.

What happened at FTX that caused this widespread contagion? Well, details are all over the place, and multiple investigations are ongoing. But initial evidence points towards something like:

  • In 2019, Alameda Research, a small hedge fund, started raising debt from investors promising "15% returns with no risk"
Alameda's pitchdeck when raising capital
  • FTX Exchange launched later that year, with Alameda and FTX disclosing an arm's length relationship with FTX being Alameda's market maker
Screengrab of the relationship between FTX and Alameda in FTX's pitchdeck
  • Throughout DeFi summer in 2020-2021, FTX invested aggressively or launched multiple DeFi projects on Solana including Serum and Oxygen Protocol
  • At the same time, Alameda moved away from delta neutral trading strategies towards riskier directional trading bets
  • Alameda invests in these projects, releases a small float of tokens to market, artificially pumps the value of the circulating supply of tokens and creates an illusion of high fully diluted valuation (FDV) for the tokens
  • At the same time, FTX lists perpetuals for the tokens
  • Alameda locks in profits by shorting them, artificially pumping the value of its balance sheet
  • Alameda continues its crazy investment spree in DeFi, using the inflated value of its collateral to borrow money for investments - including customers funds
Screengrab of Caroline Ellison explaining to employees that Alameda had used loans to make capital investments
  • Earlier this year, FTX increased its marketing spend on various sponsorship deals and political donations, increased brand awareness and even tried to push a bill towards delegitimizing DeFi, sparking extensive controversy and debate
  • CoinDesk reports claiming to have acquired Alameda balance sheet, showing that majority of its assets are held in FTT and other Solana ecosystem tokens
Coindesk report that broke the news story
  • CZ, CEO of Binance, announced that it would be liquidating US$580m of FTT on its books in light of recent revelations
  • Alameda announces that it is happy to buy all of Binance's FTT token at US$22 per token
  • Investors were spooked, and started withdrawing funds en masse with half a billion dollars worth of withdrawals leaving FTX within a few days
  • FTX attempted to control capital flight by announcing that it is "heavily regulated", has "GAAP audits", has "more than US$1B of excess cash" and "strong history of safeguarding client assets" - the tweet has been deleted
  • FTX began freezing withdrawals on Nov 8, claiming that Binance has expressed interest to acquire FTX
  • One day later, Binance suspends the deal
  • FTX announced Chapter 11 bankruptcy on November 11

The bankruptcy was only the beginning of woes for the industry...

  • Liquid Global Exchange suspended fiat and crypto withdrawals
  • BlockFi paused withdrawals
  • Genesis Global trading announced it will temporarily suspend redemptions and new loan originations in the lending business
  • Gemini Earn announced it will not be able to faciliate redemptions due to Genesis Trading pausing redemptions
  • ...and perhaps more to follow

What can we learn from all of this?

There are a few takeaways from this episode. I mean, if you still have funds in crypto and are looking to invest long-term, then keep your funds off any exchange.

Since 10 years ago, multiple exchanges have failed - losing customer's funds alongside - MtGox, BTC-E, Cryptopia and now FTX. The saying not your keys, not your coins remains an evergreen advice.

Second, CeFi lending is broken - touting 8%-10% APY on deposits without understanding how the yield is sourced is a huge risk. In order to pay 8-10% APY to depositors, the borrower needs to pay more! When the house of cards collapses, don't be the last to get out.

Third, the industry is fueled by leverage. When debt is cheap and interest rates are low, the demand for leverage goes up, creating strong tailwinds that lifts up all boats. However, when the cycle turns, like what we are seeing today, the deleveraging cycle is equally quick and painful.

Despite the painful lessons, crypto hasn't died. The survivors of every cycle have reinforced conviction of its potential, and new investors join at the trough of each cycle.

To thrive is to survive.