FTX Collapse a Dose of Reality for Crypto

11.16.2022 The rise of crypto was a response to the 2008 financial crisis, as a growing faction of investors lost confidence in the traditional banking system. Now, it appears, the crypto world is grappling with a crisis of its own. FTX.com, at $32 billion one of the nation’s leading crypto exchanges, along with Alameda Research LTD, its affiliated trading firm, filed for bankruptcy last week in the face of massive withdrawals by their customers. The exodus came amid a plunge in FTT, the digital coin issued by the exchange. FTX evaporated in a week. Investors and employees were equally duped. The company boasted blue-chip investors, including Paradigm, SoftBank and Singapore’s Temasek. Venture firm Sequoia Capital, one of FTX’s earliest backers, has marked its stake down to zero. FTX’s nearly one million customers are wondering whether they will get their money back. And everyone else is wondering what this means for the sector as a whole.

FTX went from nowhere to a household brand in the span of four years, achieving a $32 billion valuation and blue-chip status among crypto exchanges. The FTX logo was featured on the Miami Heat’s basketball arena, on Major League Baseball umpires’ uniforms, and the firm even ran a Super Bowl ad last season. But ties between FTX and Alameda, its crypto trading firm, led to the company’s downfall. Founded in 2017, Alameda was a quant trader that operated out of the limelight, reportedly producing $1 billion in profit last year. It is alleged that Alameda used client funds in their quantitative trading strategies.

FTT, FTX’s digital token, plunged 80 per cent in a 24-hour period. The magnitude and the suddenness of the collapse has shaken the crypto market and could spread into a crypto contagion. Crypto brokerage Genesis announced it is suspending redemptions at its lending business after facing what it described as “abnormal withdrawal requests,” according to Bloomberg. Genesis’ lenders include Gemini Trust Company, the cryptocurrency platform run by the Winklevoss brothers.

While the demise of FTX is still being investigated and its broader impact is still playing out, the Fed’s tightening cycle was certainly a factor in the crypto sector’s troubles. By raising overnight rates during 2022 from zero toward four per cent, the Fed wrung out speculation from the market and ushered in the spectacular decline in crypto token values. Several conventional tokens collapsed, stable coins became unstable and crypto companies such as Celsius Network and Three Arrows Capital went bust. Bitcoin, the sector’s most widely watched token, is trading at $16,500, down from nearly $61,000 in the last 12 months.

Sam Bankman-Fried, the 30-year-old founder of FTX and Alameda, claimed to embrace transparency and decentralization, two tenets underpinning crypto. But in his case, both of these claims were myths. The relationship between FTX and Alameda shows that large segments of the crypto market remain opaque, interlinked and concentrated. Ironically, the failure of Lehman Brothers amid the financial crisis launched crypto’s popularity as a way of holding wealth outside the traditional banking system. That fantasy has now met reality.

While it’s too early to predict a widespread crypto cascade, this year’s events carry broader implications for investors. The first is regulation. The wild world of unregulated crypto creation and trading will likely be reined in. Already, the SEC is investigating whether FTX mishandled customers’ funds. It is alleged that assets on the FTX exchange were used by Alameda, the company’s affiliated trading partner, leaving Alameda owing FTX nearly $12 billion. In traditional markets, pairing an exchange and a trading firm is a conflict of interest that exposes customer funds to risky trading strategies. The opaque and unregulated crypto world allows conflicted combinations to coalesce, and so it appears inevitable that broader regulation of the crypto markets is coming.

This years’ experience represents a stunning setback for proponents calling for crypto as an asset class.  It appears increasingly unlikely that digital currencies could secure a place as a strategic asset class in institutional asset allocations. The case for crypto as a portfolio diversifier has been undercut as Bitcoin is poised to suffer its third 80 per cent drawdown since 2014. Until the space is regulated and standardized, the crypto market structure is far too risky for institutional investors.

For those who believe the FTX meltdown is this cycle’s Lehman Brothers, Former Treasury Secretary Laurence Summers has a different take, telling Bloomberg, “A lot of people have compared this to Lehman. I would compare it to Enron.” Bottom line: crypto markets need to grow up before they can command attention and respect from the mainstream investment community.