FTX Collapse Explained. And Why It Will Happen Again.
The founder of FTX is Sam Bankman Fried. He’s a former MIT graduate that went on to work at a New York based trading firm called Jain Street.
While working there, he discovered and arbitrage opportunity in Bitcoin. That basically means that the same asset was trading at a different price in two markets. The Bitcoin price was higher in the United States than it was in Japan and he traded as much is $25 million per day to take advantage of the opportunity.
In 2017 Bankman Fried used the money that he made from Bitcoin trading to start a company called Alameda research. The company mostly consisted of friends from MIT and former work associates Jane Street. Alameda ended up playing a critical role in a crash of FTX. I’ll come back to a later.
At this point in time, Bankman Fried mentioned that he believed in effective altruism. He described it as trying to figure out what practical things you can do with your life to have as much positive impact as you can on the world.
In 2019 Bankman Fried started FTX. FTX is a cryptocurrency derivatives exchange. It’s like a stock exchange accepted it’s made for trading crypto assets. It’s important to note that FTX also created its own cryptocurrency that traded under the symbol FTT.
Bankman Fried created FTX after noticing the most crypto platforms were just servicing inexperienced retail investors. He saw an opportunity to create a competitor that offered more advanced financial products like futures and options trading for crypto and tokenized stocks that could track the value of shares in companies like Tesla.
The investment community liked the idea and Bankman Fried managed to raise $2 billion from multiple investment banks and hedge funds including Blackrock.
In 2021 there were reports indicating that FTX was averaging 10 billion a day of trading volume from approximately 1 million users. In the meantime, as all of this was happening, FTX didn’t even have a real board of directors.
At this point in time the FTX marketing machine was also peaking. FTX acquired the naming rights to a stadium in Berkeley and anther stadium Miami. They set up an advertising partnership with the Golden State Warriors and the Mercedes Formula One team. Multiple celebrities started endorsing FTX – including Tom Brady, Steph Curry, Naomi Osaka, and Larry David. A report from NBC mentioned that the celebrities also received equity in FTX. And some people have reported that Tom Brady might have invested his entire $650 million fortune into FTX.
At this time, Sam Bankman Fried’s net worth was estimated to be $26 billion. A lot of people have been talking about the fact that he donated $5 million to Joe Biden in 2020 and $50 million to Democratic politicians running in the 2022 midterm elections. Of course, we know that the people that mention this are politically motivated because, a lesser known player in FTX, Ryan salami, donated $23 million to Republican politicians so, the people working in FTX were donating to both sides of politics.
Political donations are the main driver of all political corruption and it’s one of the main reasons that direct democracy is better representative democracy. If you want to learn more abut Direct Democracy check out the other videos on my channel and the links in the description.
In the meantime Alameda research had transformed into a business that operated like a crypto hedge fund. They managed money on behalf of crypto investors. One of the promotional documents from 2019 convinced a lot of people to invest by promising a 15% annualized fixed rate return. 15% returns are common. They happen all the time so that’s not a problem. But there’s no way to promise or guarantee that it will happen. The part is a problem.
Over time, Alameda received $10 billion dollars in FTX customer funds. There’s nothing wrong with money flowing into FTX because it’s an exchange – that’s what supposed to happen. But none of that money should be going from FTX to Alameda because that money belongs to the customers that deposited these funds into FTX. This is a clear violation of multiple rules and laws.
In the meantime, the US Federal Reserve started raising interest rates in an attempt to fight inflation. When interest rates move higher it means that investors can achieve a better return on riskless assets like treasury bonds so that means that funds will flow out of assets that do have risk, like stocks and crypto, and into riskless assets like bonds. This is why you often hear the expression risk on and risk off. Of course, the higher the perceived risk of an asset, the bigger the downside.
A lot of crypto assets started falling off a cliff and Alameda research saw an opportunity. They could buy them at very low prices and achieve two objectives – bail them out and make a huge profit when they recovered. But the crypto collapse was still unfolding so, instead of making a profit on these trades, they made a loss. One example was this loan that FTX provided to Voyager.
In order to cover losses from these failed trades, Bankman Fried transferred $4 billion of FTX customer funds to Alameda. Of course this was all visible in FTX wallets, so he tried to make sure that people weren’t alarmed by sending out a tweet to reassure them that nothing bad was happening. It’s important to note that the $4 billion that was transferred was not cash. It was $4 billion worth of FTX’s own token, FTT. Of course, this plan could only work if FTT maintain its value – but I didn’t.
While all of this was unfolding, one person was watching more closely the most. His name is Changpeng Zhao, or CZ. He is the founder of Binance – the largest crypto exchange in the world. Sam and CZ knew each other. Six months after launching FTX, CZ bought 20% of FTX for approximately $100 million. Sam later decided to buy back that FTX stock for $2 billion – but it wasn’t paid in cash, it was paid in FTX’s token, FTT.
Overtime, FTX grew into a significant competitor and the two founders had different views about how the industry should evolve and operate. Now that FTX was struggling, CZ saw an opportunity to take down a competitor. He owned $2 billion worth of FTT so he knew that he could crush the FTT price by dumping his stake into the market.
The price of FTT collapsed by 80% over the next two days. Sam sent out a tweet saying that a competitor is trying to attack FTX but everything is fine. People were getting nervous about FTX and started withdrawing their funds from the exchange.
But, FTX had already secretly transferred billions of its reserves to Alameda and didn’t have sufficient reserves to cover the withdrawal requests from customers.
They had $9 billion of liabilities and $900 million in liquid assets. If you don’t understand the accounting in the financial world, customer funds have to be listed as a liability on your balance sheet because it’s money that you have in your possession but you owe to the customer. The $9 billion of liabilities was money owed to customers.
Sam knew that his empire was about to collapse so he called CZ and negotiated a deal to sell FTX to Binance.
Binance is a whole other story. US justice department is investigating allegations that they have been involved with money laundering and criminal sanction. There are reports that Binance helped Iranian firms trade $8 billion since 2018 despite US sanctions. Of course Binance is not an American company so it has the ability to tell the US to go fuck itself.
Not long after Binance announced that they would buy FTX, they made an announcement saying that they were not going to go ahead with the deal. Binance say that they discovered a bigger gap between assets and liabilities than they were expecting so they killed the deal.
On November 11, Sam Bankman Fried resigned and sent out a Tweet stating that FTX and Alameda are filing for bankruptcy. It triggered a crash in the crypto markets that wiped out $150 billion of value in three days.
The first question that we should be asking is whether FTX failed as a result of an inability to execute a business plan whether it failed due to illegal or unethical business practices. It didn’t take long for reports to surface about $1 billion worth of customers cryptocurrency vanishing from FTX. Blockchain detectives are obviously trying to figure it out but, there’s no more news as at the time of this video.
The FTX bankruptcy involves 134 affiliated companies across the world and total liabilities could be as high as $50 billion. If you want some context, Enron’s liabilities were $23 billion. The reason I mention Enron is because FTX’s new CEO in bankruptcy is the former Enron bankruptcy lawyer.
Okay, so, went wrong and how do we stop from happening again? When FTX customers started withdrawing their funds, FTX didn’t have enough cash to give everybody their money back.
It’s important to understand that this scenario is the equivalent of a run on a bank. This is what happened back in 2008 and this is why Congress passed a bill to bail out the banking industry. Why am I bringing this up? Because I see a lot of people saying that FTX collapsed because there was no regulation.
You need to remember that almost every US bank does NOT have sufficient cash reserves to cover customer withdrawals. If everybody wanted to withdraw their funds from a a major US bank, that bank would collapse. If FTX was regulated like a US bank it still would have collapsed. I’m not saying that crypto exchanges should not be regulated. They should be regulated – but I’m also just saying that it won’t solve all problems.
In the meantime, it’s important to understand that crypto investors generally fall into two categories.
One category consists of people looking to make a quick buck by watching stupid YouTube videos made by people that provide crypto price predictions without having any understanding of financial markets or crypto technology.
Even though these people are clueless, and they really are clueless, they still play an important role in the development of crypto because they contribute to volume trading and that makes markets more efficient and it makes price discovery more reliable.
The other category consists of people that value the ability of crypto to democratize the entire financial industry and many other industries – as well as decentralizing the financial world, so that governments cannot exert so much financial control over us. Every year that goes by, the governments of every developed country incrementally increase the level of control they have over us.
This is obviously a massive issue that can be completely address with Direct Democracy. Crypto will play a smaller role but it’s still an important role.
So, what needs to be done?
One – governments need to regulate crypto exchanges
Two – crypto developers need to continue working on creating crypto trading platforms that operate with trustless trading mechanisms that won’t allow any interference by any individual or government.