Business, as usual.

FTX was founded by Sam Bankman-Fried (#SBF) in April 2019. The 2021 bull market saw FTX rise to prominence to become the second largest exchange in the world, overtaking earlier established competitors like Gemini , Coinbase and Kraken Digital Asset Exchange .

Earlier in November 2017, #SBF also founded the hedge fund Alameda Research . While FTX and Alameda Research are not formally under the same corporate entity, both firms are affiliated informally with the latter being a huge market maker on FTX , with huge holdings of FTT on its balance sheets.

FTT is FTX ’s pseudo-equity #token that is generally associated with the value of the #crypto exchange. If you’re trading on FTX , FTT gives you discounts on trading fees, commissions and other rewards, similar to the BNB token on Binance .

In the wake of #crypto banks going down in July 2022, FTX was widely seen to have cemented its leadership, launching offers to bail out entities like Voyager , Celsius and BlockFi . Meanwhile, #SBF became a full-on media persona.

FTX was initially housed in Hong Kong, but then moved to the Bahamas. Furthermore, FTX consists of two businesses. There is FTX.com and FTX.us. The latter services customers in the United States. The former services customers in the rest of the world. All of these characteristics have something to do with regulatory #arbitrage. That’s why, supposedly, FTX.us is safer than FTX.com.

If we think about a #cryptocurrency exchange, it is pretty simple to think about the business model. The exchange stands ready to buy and sell cryptocurrency. Every dollar and every #crypto token in a customer’s account should be backed by a dollar and a crypto #token on the asset side of the exchange’s balance sheet. The company charges a transaction fee. The transaction fees are how the firm generates revenue.

Of course, the exchange could also do other stuff. They could let people borrow and buy cryptocurrency with their borrowed money. Someone deposits $5 and says, “I want to buy $10 worth of this #cryptocurrency.” To do that, the exchange needs to have $10 to buy the cryptocurrency, but the customer only gave them $5. So the exchange has to borrow $5. This is called #leverage. Conceivably, the firm can borrow on better terms than an individual and earns income from the interest rate differential.

This also creates all sorts of risk. What happens if the #cryptocurrency goes down in price? Well as long as it can be sold for more than $5, the exchange is fine. But what happens if the price of the #cryptocurrency crashes rapidly such that the position is liquidated below $5? In this case, both the exchange and the customer take a loss. The exchange has to pay the $5 back plus interest even though it liquidated the asset for less than $5.

To deal with this risk, one thing that we could do is make sure that we have extra cash on hand. In addition, we could make sure that they are financed with a lot of equity (limit personal #leverage). Thus, when the firm takes losses like in the example above, it can pay back its own loan with the proceeds from the sale plus some of the cash it has on hand. The loss is born by the shareholders, not the other accountholders.

Another thing that we could try to do is #hedge our position. If the exchange does this, however, it puts its customers at risk. If the company isn’t properly hedged, then the exchange could become insolvent. Customers lose money.

However, even if we want to pursue the #hedging strategy, there is no reason that the hedging strategy would have to be done?directly?by the exchange. Instead, one could set up a hedge fund that lends to the exchange and does all of the hedging (hence the name). This would certainly be more desirable than having the exchange hedge directly because this effectively separates the hedging risk from the exchange. If the fund hedges improperly, then the hedge fund blows up and loses the money of its investors, but the exchange is unaffected.

The relationship between Alameda Research and FTX was a bit opaque. The two entities obviously have different names, but there is a question of how separate they really are. For example, it is possible to have two entities that exist separately from one another as described. However, it is also possible to have two entities that effectively operate as one. The primary difference is that in the latter scenario, the customers are unwillingly providing funding to a hedge fund that looks like a separate entity, but really isn’t. Their funds are at risk in a way that would not be true if there was a clear divide between the firms.

A consolidated balance sheet represents the equity of the firm which is the difference between the assets of the firm and its debt. Thus, when asset values fluctuate, the gains or losses accrue to the shareholders who own that equity. Losses on the asset side of the balance sheet reduce the value of the equity. If losses are big enough, they wipe out all of the equity and the firm is insolvent. That means that even if it sold off all of its assets, it couldn’t pay back all of its debt.

The interesting thing about the leaked balance sheet is that Alameda Research had $14.6 billion in assets. On the liability side was $7.4 billion in debt. Thus, the firm had net equity of around $7 billion. Just as important was the fact that the asset side of the balance sheet included $3.66 billion of FTT tokens and $2.16 billion of FTT collateral. In other words, a significant chunk of the firm’s equity was FTT tokens, which is just a made-up token that has no use case or value outside of FTX .

As a result, if everyone were to wake up one day and decide that, “actually, these FTT tokens are pretty worthless” and tried to sell them, the price would decline quite rapidly. Possibly, the price would go all the way to zero. This is a big problem because that would wipe out most of Alameda Research ’s equity.

Whether this is a big deal or not for the customers of FTX depends on the relationship between Alameda Research and FTX . If Alameda Research was just lending money to FTX , an Alameda Research insolvency would not affect FTX or its customers. Alameda Research would simply shut down and the people holding its liabilities would lose money. This is the simple scenario.

Another scenario is that if Alameda Research was using these FTT tokens as collateral for loans and the price declined significantly, then they might get #margin called. This would require liquidating other assets in order to meet the margin call.

Unfortunately for Alameda Research , most of their other assets are in cryptocurrency like #Solana’s SOL token. In fact, many of the #SOL tokens were “locked.” The corresponding fire sale that would be required to meet the margin call would increase the likelihood of Alameda Research becoming insolvent even if the falling value of the FTT tokens alone did not.

If the line between Alameda Research and FTX was not clear, all of this could put FTX and its customers at risk. This only matters if they are co-mingling funds and if everyone wakes up one day and says “you know, this #token is worthless, maybe I should sell it.” And what are the odds of that?

Pretty good, actually.

#CZ, the founder and CEO of Binance , was holding a great deal of FTT tokens. Binance was actually an early investor in FTX . As FTX grew, Binance decided to divest its ownership. Part of the buyout that was given to Binance was paid in FTT tokens.

So, on November 6, #CZ decided to sell $500+ million worth of FTT tokens. Whatever are the reasons that motivated the sell off, #CZ said that this was just proper risk management in light of the information that had recently been made public.

This sort of magnitude of sell pressure would obviously cause the price of FTT tokens to fall quite dramatically. This is not only because it might be difficult to find buyers for this many tokens, but the very expectation that price of this worthless #token was going to fall might be sufficient to create even more selling as people try to sell before #CZ’s tokens hit the market.

It quickly became apparent that Alameda Research had been using these tokens as collateral for loans because they offered to buy these tokens back for $22 - an oddly specific, lower price than the then-current market price. This didn’t work and the price broke the $22 level.

Meanwhile, #SBF was claiming that everything was fine and that a competitor was spreading false rumors. However, by the next day, there were reports that customers of FTX.com were experiencing difficulties with withdrawals. At that point, it became evident that Alameda Research and FTX (at least its international entity) must have been co-mingling funds. Then, on November 8, in a startling turn of events, #SBF and #CZ announced that Binance had signed a non-binding letter of intent to buy FTX.com, pending due diligence.

However, it is yet to find out if Binance will even move forward with the deal, and if so in what conditions and terms. What will come out of all this? What are the consequences for misconduct? Will regulators and judicial authorities continue to go after software code and let human misbehavior go blank?

#Crypto is full of brilliant, passionate, caring leaders dedicated to building technology that takes power away from predatory institutions and gives it to the people. Their voices are the ones policymakers need to hear. The future of the industry and #DeFi depends on the reliability of its technological infrastructure and of its players. Freedom and innovation should not encounter obstacles, but the growth of this ecosystem requires a constant self-assessment and a good amount of constructive criticism.