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By: Luke Zavoli
In 2019, Sam Bankman-Fried launched FTX, a cryptocurrency exchange backed by marquee investors, and in three years, grew FTX into the third largest cryptocurrency exchange – valued at $32 billion. This past Friday, November 11, 2022, FTX filed for bankruptcy, sending the cryptocurrency industry into chaos.
So, what happened? How did a $32 billion exchange with backings from BlackRock, Softbank, and other top investors suddenly implode? While much remains unknown, FTX’s leaked balance sheet, its bankruptcy filing, and Alameda Research’s balance sheet provide insight. (For context, Alameda Research is a quantitative trading firm founded by Sam Bankman-Fried in 2017). FTX’s eventual bankruptcy began with a CoinDesk report released on November 2, 2022, which cited Alameda Research’s balance sheet. The CoinDesk report indicated that Alameda’s assets to be $14.6 billion, including $3.7 billion of unlocked FTT (FTX’s token) and $2.16 billion of FTT collateral. Crypto investors and partners of FTX began questioning why more than one-third of Alameda’s assets were tied up in FTX’s exchange token. On November 6, 2022, a mere four days after the CoinDesk report was released, Binance (the largest cryptocurrency exchange) liquidated all of its FTT holdings, resulting in a 7.6% decline in the FTT token that same day.
Shortly after, FTX’s balance sheet, dated to November 10, 2022, was leaked by the Financial Times. The leaked balance sheet revealed the exchange had nearly $9 billion in liabilities with only $1 billion in liquid assets. Alongside FTX’s liquid assets were $5.4 billion in assets labeled “less-liquid.” The vast majority of the “less-liquid” assets were holdings in FTT and cryptocurrencies of the Solana ecosystem, which were heavily supported by FTX. Shockingly, FTX’s bankruptcy filing indicates it had liabilities of $10 billion – $50 billion at the time of filing (November 11, 2022).
In response to the leaked balance sheet and FTX’s bankruptcy filing, many of FTX’s (one million plus) users attempted to liquidate their holdings or transfer their assets to other exchanges. However, given FTX’s lack of liquid assets and sufficient crypto reserves, these transactions could not be completed, leaving its users with no options to recover their funds.
Recently, several reports surfaced suggesting Sam Bankman-Fried secretly transferred billions of customers funds from FTX to Alameda using a “backdoor” to avoid triggering red flags. Consequently, Federal Prosecutors in New York are now investigating the exchange’s collapse, and authorities in the Bahamas, where FTX is based, launched a criminal probe into the exchange. Interestingly, on the same day it filed bankruptcy, FTX was suddenly hacked and lost north of $600 million from its crypto wallets. The hack was confirmed by FTX General Counsel Ryne Miller on November 12, 2022.
What can we expect from FTX’s collapse? After FTX’s stunning and rapid meltdown, many in the crypto community are calling for exchanges to prove they have sufficient assets in reserve to offset outstanding liabilities. To promote transparency and assure users, several exchanges, including Kraken, Coinbase, and Binance, recently published proof-of-reserves. We will likely see other legitimate crypto exchanges follow suit. Investors should critically evaluate whether an exchange through which they invest in any cryptocurrency has sufficient reserves and technical safeguards to protect their investment and issue payment if they choose to withdraw. Alternatively, the safest way to ensure the security of any cryptocurrency remains cold storage, such as a hardware wallet disconnected from the internet and cryptocurrency exchanges.
Additionally, many regulators are calling for Congressional action and regulation of digital assets and the related exchanges in the United States. Sen. Cynthia Lummis called the FTX collapse the “clearest example yet of why we need clear rules of the road for digital asset exchanges in the United States.” House Financial Services member Patrick McHenry said, “It’s imperative that Congress establish a framework that ensures Americans have adequate protections while allowing innovation to thrive here in the U.S.” While there is not an overarching and centralized regulatory framework in the U.S. for cryptocurrency, digital assets, and the related exchanges, there will almost certainly be a push to establish such. Given the current global crypto market cap of roughly $1 trillion, and FTX’s collapse – impacting nearly one million users and many billions of dollars – we should anticipate some form of centralized regulation of digital assets in the U.S. within the next few years with a goal of protecting consumers.
For more information on this topic, contact Luke Zavoli or your local FMG attorney.