Lessons From The FTX Collapse
One man and one company stole all the news headlines and the crypto world’s attention in November. The FTX crypto exchange filed for bankruptcy during the first week of November, while its founder, Sam Bankman-Fried, went from a new J. P. Morgan to a resident in the crypto hall of shame.
I took some time to write this post because I wanted to write about the lessons that I learned from the FTX event instead of simply going over what happened. I'll only briefly summarise the events and leave some sources for the keenest readers. Let's dive in!
Some Background
The FTX crypto exchange joined an extensive list of companies that failed this year due to poor risk management and dropping liquidity on the 11th of November. The bankruptcy filing came after several intense days during which we saw the following:
A rival exchange, Binance, selling $530 million of the FTX's native coin — FTT, sending the crypto market plummeting (the 8th of November)
Followed by the same day's announcement from Binance expressing interest in buying FTX
FTX looking for a $4 billion cash injection (the 9th of November)
Binance walking away from the deal to acquire FTX (same day)
BlockFi pausing client withdrawals (also on the 11th of November) (FTX bailed out BlockFi in the summer)
FTX filing for bankruptcy
The bankruptcy filing documents include FTX US, Alameda Research and around 130 affiliated companies. According to Financial Times, the exchange held only $900 million of easily sellable assets against $9 billion of liabilities.
Ironically, FTX was bailing out and acquiring companies that collapsed at the start of the summer, and some compared this with how J.P. Morgan bailed out some banks in the 1907 crisis.
As you can see, the news developed quickly, and besides attending a professional training course and then having a week of holiday, I chose to observe the events and learn from them.
Not Your Keys, Not Your Coins
The first and, by far, the most critical lesson from the FTX saga is that you have to be prepared to lose your bitcoin if you hold it on an exchange. Any Bitcoin backer will tell you — "not your keys, not your coins." This phrase means that to have complete and sole control of your bitcoin, you must transfer them from an exchange to a self-custody wallet. It's a challenging task. You need to invest time learning the ropes and then implementing everything into practice. Luckily, the internet is a beautiful place, and the Bitcoin community is welcoming. There are many resources and guides on the internet (YouTube, Reddit, blog posts etc.) that can teach you and help you self-custody bitcoin. I found "The Zero Trust System" from Arman The Parman incredibly insightful and eye-opening. Parman has more guides on Bitcoin, its fundamentals, as well as on privacy and storage on his website. The resources are endless. I'll leave some of those that I found and used during my own Bitcoin journey (sharing is caring:))
Jameson Lopp's Bitcoin resources [LINK I]
"Bitcoin Security" [LINK J] rabbit hole from Swanbitcoin
Collection of essays from Parker Lewis [LINK K]
A journey to self-custody bitcoin is daunting, but it may help you sleep well at night. According to Reuters, between $1 billion and $2 billion of customers' funds have disappeared from FTX. Only time will tell if the FTX's customers will get their coins or money back.
One more thing before we move on (a warning, if I may). Having a wallet will not guarantee that your coins are safe; you need to be careful and vigilant and do your own research. This brings me to the second lesson.
Do Your Research
Who would've thought a year ago that one of the largest crypto exchanges by daily trading volume, with large and prominent investors backing it and a name on the Miami Heat Arena, would go bankrupt?
The list of investment and venture capital (VC) funds invested in FTX included high-profile names, such as Sequoia Capital, BlackRock, SoftBank, Singapore state-owned fund Temasek, Tiger Global and the Ontario Teachers' Pension Plan. As a result, most of them had to write down their investments into FTX to zero, costing their clients money. Sequoia Capital (an early investor in WhatsApp, Instagram, and Airbnb) issued a letter to its investors on the 10th of November saying they are "marking [the] investment [in FTX] down to $0."
Jesse Powel, CEO of the crypto exchange Kraken, pointed out during the "What Bitcoin Did" podcast that these VCs should be kept accountable. He said that the lack of proper scrutiny and due diligence from the VCs hurt other FTX investors and customers, who relied on the VCs' as a stamp of approval and counted on their expertise. The launch of FTX in 2019 when crypto prices were rising played well into its valuation, hype, and fund-raising with limited due diligence from some venture capital firms, who blindly wrote checks.
FTX has numerous celebrity backers too. Some have joined the exchange CEO as co-defendants in the class action lawsuit.
Let the corporate lawyers and judges figure out who is responsible. This event highlights the importance of thorough individual research rather than the blind following of the crowd with a fear of missing out. It is hard to form an opinion about a novel topic. This is where learning and widespread research of different views and opinions become essential. As we will talk about later, crypto is a Wild West where one must always keep their eyes wide open.
Altcoin And A Pinch Of Salt
I've written several times about issues with cryptocurrencies other than bitcoin — alternative coins (altcoins). On top of the event being described, we saw the collapse of TerraUSD and Luna coins back in May, which sparked a liquidity crisis in the industry and sent the market into disarray. The demise of FTX was also caused by an altcoin, yet only partially.
Everything started with a report by Coindesk about Alameda Research — a hedge fund owned by the FTX founder — balance sheet. It showed that crypto tokens comprised of over 70% of assets ($14.6 billion total) — $5.8 billion of FTX's own coin called FTT, $1.2 billion of Solana and $3.37 billion in the small illiquid altcoins. The fund had only $134 million in cash, while liabilities (primarily loans) totalled $8 billion. The report shed a light on the red flags of the hedge fund because what looked like a big and successful operation was made of "make-belief" assets.
Holding 23% of assets in illiquid assets and around 40% in the sister company’s coins is not very prudent, primarily when your FTT holding represents roughly 160% of the total FTT market supply (supply as of the 1st of November), according to CoinGecko. If you try to sell a portion of these coins to meet equity redemption, for example, you crush the prices of the coins, making the remaining token worthless.
The Coindesk report started a crisis of confidence in the FTT, and a few days after, Binance announced the sale of its FTT token holding, spurring the sale of the token and crushing the market. As the FTT price went down, Alameda ran out of liquidity as its asset side quickly shrank, leading to insolvency. On top of that, FTX customers rushed to withdraw their funds until the exchange halted the withdrawals a few days after Binance's announcement. FTX needed more funds on hand to meet the redemptions. As it turned out, Alameda also used the FTX customers' funds for trading purposes without anyone's knowledge. Besides, FTX tried rescuing its sister by lending further customers' deposits to Alameda to cover the massive balance sheet hole.
Solana token, the second largest asset on the Alameda balance sheet, lost 47% of its value due to the FTX train wreck. Sam Bankman-Fried was a big promoter of the coin, which brings me to the lesson.
Many altcoins mask themselves under fancy promises to revolutionise finance, outcompete Bitcoin and offer astronomical returns. Yet, in reality, these are ways for the founders and developers to get rich quickly.
I will leave it here as I don't want to turn this post into another "Bitcoin vs altcoins" discussion.
Bitcoin's Thesis Is Unchanged
How can we talk about crypto and not dedicate a section to Bitcoin? Bitcoin lost 20% during the week when FTX collapsed, and it has yet to recover the losses as of the time of writing.
Yet, nothing has fundamentally changed about the Bitcoin network and its monetary characteristics. It is still the most scarce asset in the world and an unstoppable payment system. The FTX saga showed a problem with bad actors in the industry, not necessarily with crypto itself and definitely not with Bitcoin.
In my "Cypto Winter On A Summer Day” post, I wrote:
Mass deleveraging is healthy for the Bitcoin ecosystem because it allowed correcting the errors that the market accumulated in the recent cycle in a free-market fashion. The industry got rid of imprudent and fraudulent companies which gambled with investors' money and misused them for fake projects with the help of free-market forces. The market has cleansed itself of inefficient companies. The trustworthy companies that weathered the storm have strengthened and will likely be held in more favourable regard by investors and will have access to funds to continue working for the good of the space.
A JP Morgan analyst wrote that the dramatic collapse of FTX could move crypto "two steps forward" and could ramp up institutional adoption of crypto as the current events will accelerate crypto-related regulations, according to ZeroHedge.
The analyst also noted that this year's mayhem resulted from centralised players' collapses, not decentralised protocols.
It will take time for Bitcoin to develop an immunity to events like those we saw over the past six months. Many of the well-established industries went through a similar phase.
Jamie Catherwood from the Investors Amnesia blog drew the parallel between crypto today and the 19th-century railroad boom.
Like crypto markets today, the 19th-century railway industry was utter chaos and plagued by volatility. Consequently, conducting any type of investment or lending activity in this space was inherently risky. However, the heightened levels of volatility, fraud and manipulation did not stop billions of dollars pouring into the railway industry throughout the 1800s.
Jamie Catherwood points out that financial institutions in the 19th century also had issues with proper risk management and diversification of exposure. Large firms collapsed back then because of significant bets on the railroad stocks and giving out risky loans for speculation. The railroad frenzy culminated in the panic of 1857.
Similar to the present day crypto, speculators took out loans from banks to invest in railroads, which worked fine as long as the stock prices went up. In addition, banks accepted railroad stocks and bonds as collateral for additional loans. Speculators couldn't borrow money to repay loans because the collateral value fell.
Afterwords
It looks like the bankruptcy saga is still ongoing. As I was writing this post, the crypto lender BlockFi filed for bankruptcy, and the digital asset broker Genesis is looking to raise additional funds to avoid going bankrupt, too.
These events are unfortunate, but we must let the market go its own way to make itself more efficient and robust. Meanwhile, we can learn how to self-custody the coins and realise the need to understand what we are stepping into when it comes to funds and portfolio management.