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What does the end of the Bitcoin exchange mean for the crypto market?

The bankruptcy of the Bitcoin exchange FTX raises fundamental questions about the future viability of the crypto industry.

Sam Bankman-Fried, founder of the bankrupt crypto exchange FTX, has given up operational management, but continues to let off steam on Twitter.

Lam Yik / Bloomberg

As is often the case with major fraud scandals, the collapse of Sam Bankman-Fried’s crypto empire had become apparent – if you had looked closely. The list of grievances at FTX is long. Almost everyone involved has failed: primarily Bankman Fried, its business partners, but also investors, regulators and FTX customers. An attempt to explain the debacle in nine questions.

1. What is the history of crypto exchange FTX and its sister company Alameda Research?

The American Sam Bankman-Fried was not even 30 years old when he founded the crypto exchange FTX in California in May 2019 with a Chinese business partner. At its peak in 2021, FTX had over a million customers speculating in cryptocurrencies. The Bahamas-based company has at times been valued at over $30 billion by investors.

From the start, FTX worked closely with trading firm Alameda Research, which Bankman-Fried had founded two years earlier. As a sister company of FTX, Alameda made money from complex and often risky speculation in the crypto market and acted as a so-called liquidity provider for FTX.

2. Why did FTX collapse?

Much about the crash of FTX is only known in outline. The association between FTX and the trading house Alameda Research was one of the main reasons why the crypto exchange became the target of a “bank run” and had to file for bankruptcy shortly afterwards.

According to current knowledge, FTX lent its sister company tens of billions of dollars in customer funds to carry out risky speculative transactions. Apparently, Bankman-Fried and his comrades-in-arms also personally approved billions of dollars in loans.

The first media reports about dubious business practices at FTX and Alameda Research appeared as early as September. But in the end it was one short report of the industry portal Coindesk In early November, which set off a chain reaction.

Coindesk had been leaked the balance sheet from Alameda Research, which indicated that FTX and its affiliate were far worse financially than Bankman-Fried had led the public to believe. Accordingly, on the assets side of the Alameda balance sheet there were unusually high levels of FTX’s own crypto token FTT, with which its own trading activities were secured or leveraged. From the point of view of industry observers, this was a concentration of risk that could not arise in traditional finance for regulatory reasons.

A tweet by the CEO of competitor Binance, Changpeng Zhao, caused the unrest on the market to get out of control: FTX’s competitor announced that it wanted to liquidate its entire holdings of FTT tokens. As a result, FTX clients withdrew billions of dollars in assets within days. Finally, the platform, which had become insolvent, blocked all payments.

Bankman-Fried was still trying to save his imploding empire. But he found no financiers who wanted to take over the construct. On November 11, FTX and Alameda Research filed for bankruptcy. CEO Bankman-Fried resigned from all his functions. Hundreds of thousands of FTX customers have to fear for their assets deposited on the platform.

The chain reaction that led to the FTX collapse

The chain reaction that led to the FTX collapse

John Ray, who is serving as CEO of FTX in the bankruptcy proceedings, told a court hearing on Thursday that he had “never seen such a failure of corporate governance and such a lack of trustworthy financial information in his forty-year career was». Lawyer Ray is known for his role as liquidator in the wake of the Enron energy fraud and accounting scandal in the early 2000s.

3. What role did crypto guru Sam Bankman-Fried play?

SBF, as he is known in the crypto scene, was the public face of FTX as the founder. His guru-like demeanor in a t-shirt and shorts added a lot to the platform’s rock star image. FTX ran commercials at the Superbowl featuring performances by sports and Hollywood stars, secured the naming rights to a football stadium, and became one of the largest donors to the Democratic Party.

When, in the course of the interest rate turnaround, the prices of many cryptocurrencies came under pressure and numerous crypto companies ran into business problems, Bankman-Fried played the rescuer and stepped in as a “lender of last resort”. What also set him apart from the rest of the industry was his commitment in Washington D.C. to greater regulation of the crypto market.

Many crypto investors are now accusing SBF of being a scammer. He is currently in the Bahamas. In an interview via SMS with a journalist from the US online portal Vox, he recently admitted that his efforts for more regulation were “essentially PR”. In this light, his commitment to “effective altruism” seems rather implausible.

It is still unclear to what extent Bankman-Fried can also be held personally accountable for the downfall of FTX. According to media reports, US law enforcement agencies are in talks with the authorities in the Bahamas about extradition.

4. Do FTX clients have a chance to see their money back?

The odds are bad. If there is anything to be had, victims will have to wait years for money. According to sources, at least $1 to $2 billion in client funds have been “lost” outright. This does not include the $8 billion deficit that Alameda Research is said to have incurred through its trading activities. The total loss for customers and investors is likely to be several billion dollars.

The process is made more difficult by the fact that it is difficult to identify and delimit the affected assets due to the lack of trustworthy financial information. In addition, the activities of FTX extend over a network of around 130 companies spread across several jurisdictions in the USA, the Caribbean, Europe and Asia. Each country where bankruptcy is filed has its own procedures. Investors invested through a major Swiss crypto platform seem to have been largely spared so far.

5. Which Crypto Providers Could Drop Next?

In the week after the FTX collapse, it was revealed that other platforms such as BlockFi, Crypto.com Galaxy Digital, Genesis Trading, Multicoin and other well-known names were involved in what was once the fourth-largest trading platform, FTX. However, they did so to vastly different degrees. BlockFi and Genesis have prevented their customers from withdrawing money, but no new bankruptcies have been announced so far. That could change in the coming days and weeks.

Competitors such as Binance or Coinbase do not appear to be under immediate threat, even if, like FTX, their “capital cushion” consists of digital assets whose intrinsic value is disputed. Binance relies on the fact that around a third of the assets are held in so-called stable coins. Their value is tied to a regular currency like the dollar. The proprietary token that Binance issues, BNB, is not used as collateral for proprietary trading and is kept off the balance sheet, according to Binance boss Changpeng Zhao. Other providers who issue their own tokens use them similar to FTX on the assets side of their balance sheets.

The venture capitalists who invested in FTX during the hype phase are not threatened in their existence, but are nevertheless damaged. Among these investors are prominent names such as Singapore’s sovereign wealth fund, Temasek, as well as large private investors such as Cornerstone, Sequoia and Softbank. They will probably have to write off most of their investments in FTX.

6. Is the crypto market dragging the financial market into the abyss?

So far there is no evidence that the turbulence in the crypto market has spread to the regular capital market. This can also be seen from the different market developments. While Bitcoin crashed in the wake of the FTX collapse and lost around a fifth of its value in the past four weeks, the stock markets continued their current upward trend.

The risk of contagion is likely to be limited to the crypto market, which also has to do with the manageable size of the market. The market cap of the crypto market is estimated at around $874 billion, which is only around 2 percent of the US stock market by comparison. There are also few interfaces between the two markets. A direct connection exists via stablecoins, which are backed by traditional currencies off the blockchain.

7. Is it safe to invest in cryptocurrencies?

Security is a rare commodity in the crypto market. The tradable coins and tokens are difficult to value and are subject to high price fluctuations. In unregulated trading places, inadequate risk processes and criminal activities such as hacker attacks, fraud and theft are part of everyday life. The FTX case reminded investors of this and recently led to outflows from centralized trading platforms such as Binance, Coinbase or Kraken.

The withdrawn assets found their way into less risky products such as crypto ETFs or ETPs: These bundle several cryptocurrencies into one tradable fund. According to an evaluation by UBS, there were inflows there last week. A substantial part of it is now held privately or has been moved to the traditional capital market, such as gold.

The collapse of FTX has exposed the systemic weakness of centralized crypto exchanges. In essence, these contradict the principle of the decentrally organized blockchain. So-called decentralized crypto exchanges such as Uniswap or Pancakeswap received a boost this month. With these decentralized exchanges, the customers remain in possession of the wallets. Trading venues operated by a regulated asset manager or a licensed bank should also benefit.

8. Is the adjustment screw further tightened?

Yes. Calls for stricter regulation are coming from all sides. Even the head of the largest crypto exchange Binance, Changpeng Zhao, who has previously been critical of regulation, is in favor of new rules. The USA should be the first country to tighten the screw. A new crypto law that is currently being negotiated in the US Congress should now be a lot stricter. In Switzerland, providers who regulate themselves will have a harder time. Control by the supervisory authority Finma should establish itself as a minimum standard.

The industry itself is also becoming active. Some providers are promoting a “Proof of Reserves” procedure, i.e. for the proof of reserves. Some platforms such as Kraken have already introduced this and undergo cryptographic accounting every six months, which is checked by external auditors.

9. Does the crypto market have a future?

The crypto world was shaken to its foundations by the FTX collapse. Cryptocurrencies will not disappear because of this. Meanwhile, industry consolidation will accelerate. Other providers are likely to become insolvent and others to be bought up. Going forward, investors will take a closer look at crypto startups. In addition, because of the higher interest rates, less capital is available for the sector. This will become a problem for many debt-financed providers in the next round of financing.

Large and small investors will also prefer regulated crypto providers. But the second-round effects of the FTX bankruptcy, such as stricter regulation, forced professionalism, more critical investors and the promotion of decentralized business models, should advance the land consolidation and ultimately benefit the crypto sector.

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