The world of cryptocurrency is renowned for its volatility but is now facing one of its biggest setbacks yet. Last week, the popular cryptocurrency exchange FTX collapsed, and put a pause on users being able to withdraw their funds. But why did this happen?
A cryptocurrency exchange is a market for users to buy and sell different cryptocurrencies, and swap these for cash. FTX was not a currency in itself, but a medium of exchange, working in the same way as the Nasdaq or the New York Stock Exchange. That being said, FTX has its own native coin, FTT, which gives users a discount on the fees they pay to trade cryptocurrencies, with more FTT held leading to bigger discounts for users.
In order to maintain solvency, an exchange must hold enough liquidity to pay out to its users if they all decide to withdraw their funds. This is where FTX went wrong. They were loaning users money to their affiliated trading firm, Alameda Research, partly because they had suffered a run of losses after failed investments and allegedly partly so that they could buy up FTT, which would become its largest asset. This would increase demand for FTT and increase the market cap for FTX. An anonymous source told the Wall Street Journal they had lent about $10 billion when their customer assets only totalled $16 billion.
The main problems started when this information was leaked, and Binance (one of FTX’s main competitors) declared its intention to liquidate all of its FTT tokens. The threat of this was enough to crash the price of FTT, which would in turn lead to huge losses for Alameda. With Alameda’s portfolio crashing, FTX would no longer have the liquidity to allow every user to withdraw their funds, as it would be too highly leveraged. As previously mentioned, this goes against the requirements for a firm to remain solvent.
The announcement that Binance was selling its FTT led to what was effectively crypto’s answer to a bank run, with so many people trying to withdraw their funds that FTX had to put a hold on withdrawals. FTX co-founder Sam Bankman-Fried took to Twitter to announce the company needed $8 billion in capital to pay back all of their users.
Binance went from villain to hero when they announced they would be acquiring FTX, subject to an inspection of the company. This deal would have been for pennies on the dollar, as FTX had no choice but to sell to raise the capital needed to pay back its users. However, after closer inspection, Binance pulled out of the deal citing ‘the latest news reports regarding mishandled customer funds and an alleged US agency investigation in a statement on Wednesday the 9th of November. This would turn out to be a fatal blow for FTX, with what was previously one of the largest cryptocurrency exchanges in the world filing for bankruptcy on the morning of the 11th of November, along with Alameda.
Effects of this have been felt elsewhere, with most cryptocurrencies crashing. The most popular one, Bitcoin, fell 22.84% (at the time of writing). Maybe of more importance is the damage that events like these do to crypto in general, only adding to their reputation for being volatile, risky investments that any smart investor would stay away from. It has truly been a rocky road for cryptocurrency investors, and the future certainly looks bleak.