Zakariyya Tewari and Robbie Morris
FTX and the future of crypto
Updated: Mar 26
We revisit the shocking collapse of FTX, once the world's top crypto exchange, and the deceitful actions of its ex-CEO Sam Bankman-Fried. This article attempts to unravel the intricate web of fraud that cost investors $8 billion and explores the consequences for the crypto industry. We conclude by questioning whether decentralised finance and increased transparency could prevent such disasters in the future.
As one of the largest and most influential financial fraud cases in recent memory, the collapse of crypto exchange FTX is a stark reminder that even the most successful companies are vulnerable to human wrongdoing. The case of the self-proclaimed "most generous billionaire" Sam Bankman-Fried (SBF), FTX's former CEO, has unveiled a curtain of lies that fooled over a million investors, resulting in a loss of $8 billion in assets. Further investigation into SBF's journey to disgrace provides some dark insights into fraud, the nuances of cryptocurrency as an industry, and how behavioural pitfalls can pull apart a system, regardless of how well-built and stable it may seem.
Sam Bankman-Fried was considered the good guy in an industry full of nefarious characters. He was regarded as a genius; by 25, his packed resume included achievements such as graduating from MIT, philanthropy and founding his hedge fund, Alameda Research. His many behavioural quirks (like playing video games during conferences and interviews) were waved off as a side effect of his genius. He also stuck to conventional finance as much as possible while working with crypto, which people liked. Moreover, he had a clear track record regarding scams in the past and seemed to have built his wealth legitimately through crypto arbitrage (buying and selling on different exchanges). The money was invested in his hedge fund and eventually his crypto exchange, FTX, an abbreviation for Futures Exchange. At its peak, it was, by some metrics, the number one cryptocurrency exchange globally.
The reasons behind FTX's remarkable growth are manifold, but above all was their ironic message of client-focused transparency. In July 2021, it was reported FTX was amassing trades worth a total of $10 billion daily, and in January 2022, FTX's valuation peaked at $32 billion. With FTX, Bankman-Fried could lay back and make money through fees; a conventional method in the crypto exchange world.
In November 2022, the exchange collapsed within a few days. So where, and more importantly, how did it go wrong? At first glance, it began the same month when Binance's CEO Changpeng Zhao (CZ) tweeted that they would be liquidating all FTT, FTX's token, on their books. Rumours of a leaked balance sheet from Alameda research had been circulating, stating that a large percentage of the company's solvency depended on FTT. Changpeng made the (correct, as it seems now) guess that Alameda's massive holdings of FTT were an illegitimate result of their close connections with FTX. As Binance began selling, the token's price crashed, tumbling from $25 to less than $5 within 24 hours. FTT was essentially a share of the FTX exchange itself, representing FTX's wealth. As the price rapidly declined, those who held money in the exchange began to worry about its liquidity. A bank run of sorts followed, where users scrambled to take their money out of FTX until, eventually, the exchange ceased withdrawals.
However, the real reasons behind FTX's downfall are more complicated than a single tweet by a competing CEO. Had nothing been going on behind the scenes at FTX, the situation would not have spiralled out of control as it did. After FTT plunged in the short term, it would bottom out and eventually recover. FTX and Alameda Research were holding a large percentage of the total FTT out there, playing on the idea that buying large quantities of your token would artificially inflate its market cap, fooling investors into its intrinsic value. After the exchange stopped withdrawals, SBF claimed it was simply a liquidity issue – the money was still there, and only time was blocking the rest of the assets. Unfortunately, liquidity issues become solvency issues very quickly when there is little time to liquidate assets, especially when selling billions of the same token.
Binance CEO’s tweet on Liquidating FTT
As more information came to light, it became increasingly unlikely that liquidity was SBF's only problem, and instead, CZ's prediction had been correct. There was a backdoor where billions of FTT were siphoned between FTX and Alameda Research. FTX had been commingling funds and had been insolvent for months before they imploded. A leaked FTX balance sheet from SBF showed around $1 billion in liquid assets against $9 billion in liabilities. Suddenly, SBF's supposed liquidity problems looked more like a front for other fraudulent activities. It's hard to say exactly what these funds were used for, but we know some of it was private venture investments, luxury real estate purchases and political donations. According to sources, Alameda Research secretly received $10 billion from FTX customer funds, which SBF claims was "not his intention".
Prevention of schemes like this is difficult when the most influential people in the industry are fraudsters. The psychological obstacles that prevent people from learning from similar historical examples cause risk management failure. In many cases, those who create something new end up making breakthroughs beyond the scope of the industry; think Steve Jobs and the iPhone. SBF was an entrepreneurial genius that disregarded the numerous failures and collapses in crypto before him. He was hardworking, socially skilled, and intensely motivated, but he failed to diverge from the shortcomings of those who came before him.
Daily closing price of Terra Luna from February to May 2022
Could DeFi have prevented the FTX disaster?
One suggestion is to move from centralized finance (CeFi) to decentralized finance (DeFi). In DeFi exchange systems, there is no intermediary; instead, users control their assets. Following the collapse, many are pointing to the long-term benefits of moving towards a complete DeFi ecosystem for cryptocurrency, highlighting that the FTX collapse has exposed the severe weaknesses of CeFi. Despite this, there remains a need for more liquidity in the DeFi market today. The reasons behind this include the user experience (much more challenging to handle, especially for people from non-technical backgrounds, and larger orders have a slower transaction speed), smart contract risks (protocol attacks, platform governance failures) and systematic risks, among other drawbacks. In addition, it may also be important to emphasize that FTX is a unique case; numerous large centralized exchanges, such as Coinbase, do not have a native token.
Data transparency in the Blockchain Graphic
Data transparency is one of the main issues with centralized exchanges. Blockchain is an inherently transparent technology where transactions between wallets can be traced and publicly available. This is not the case when interacting with an exchange, and even if it was, top-level blockchain analysis firms state it would still be impossible to detect fraud at the level we saw in FTX.
In mid-2020, the FTX's Chief Engineer, Singh, made a "secret" alteration to the exchange's code base that enabled the commingling of customer funds, preventing Alameda Research from automatically selling its financial assets if it loses too much money, allowing it to borrow from FTX continuously. The engineer committed the change with the note, "Alameda liquidation prevented." According to former executives, only Singh, SBF, and a few other members knew about this change–the digital dashboard that was used to track customer assets on FTX within the company was programmed so that it would not reflect Alameda's withdrawal of customer funds. The lack of traceability of funds is the only way something like this would ever work.
FTX and CoinDesk Index Timeline
The impact of the FTX collapse
Regardless of the reason, the impacts following the FTX collapse on cryptocurrency were widespread and devastating. The entirety of the crypto market took an immediate hit, with coins like Bitcoin dropping a further 19% and Ether 24% within just one week of the collapse. In addition to the bankruptcy of firms like Genesis, Galaxy Digital, and Voyager Digital, the problems with FTT have also been particularly damaging. However, the effects did not prove to be deteriorating for everyone. Hard wallet firms such as Trezor and Ledger Enterprise claimed to have tripled in revenue in the last three days of the collapse. This may have been predominantly driven by the alleged hack of FTX (resulting in an additional loss of $477 million), causing customers to store their assets with as much protection as possible. Hard wallets are cold storage that keeps your private keys offline, reducing exposure to hacking. The hard wallet market is expected to continue its growth, with the global market predicted to reach a valuation of $1.1 billion by 2027.
Merkle Tree-based Proof-of-Reserves
To avoid a repeat of the FTX collapse, companies and regulators need to take steps to ensure the security and transparency of crypto exchanges. One potential solution is the creation of an industry recovery fund for future crypto failures, as suggested by Binance. In addition, there is a strong demand for Merkle Tree-based Proof-of-Reserves: snapshots providing evidence of the company's assets supporting customer deposits. Binance also incorporated zk-SNARKs into its proof-of-reserves verification. Some argue that these audits could have prevented the entire downfall in the first place. But we disagree.
Furthermore, Bitcoin proponent Samson Mow mentioned: "First, blockchain analysis doesn't really do anything, and second, they are not focused on fraud and suspicious transactions at the exchange level. Their customers are the exchanges, and you don't bite the hand that feeds you." Ultimately, the solution is rooted in transparency and proper infrastructure, something FTX may have claimed but failed to provide.