Last week’s crypto crash explained

The crypto world was shaken last week after a series of events over eight days led to the collapse of one of the largest crypto exchanges in the world, FTX. Still to be seen is how many companies were impacted by last week’s events, how many more will go bankrupt, and how long will it take for the industry to move forward from this and regain customer confidence.

Some investors may have thought that crypto winter was over and spring was just around the corner, but last week’s events are a sign that winter still must play out its course. Since the all-time highs almost a year ago, at the time of writing, bitcoin is down approximately -75%, the crypto market cap is off -73%, and crypto equities (companies that operate in the crypto economy) were down -72% over the year to end October, as measured by the Bitwise Crypto Innovators Index.

In this article, we’ll seek to answer some of the key questions crypto investors are facing now, with some helpful comments from Matt Hougan, Chief Investment Officer at Bitwise Investments.

What are FTX and Binance?

FTX and Binance are crypto exchanges.

FTX “caters primarily to international customers and has a strong presence in derivatives and leveraged products,” Hougan said. Binance is the largest crypto exchange in terms of daily trading value in the world.

What happened to FTX, and how is Binance involved?

FTX, one of the largest crypto exchanges, has collapsed. It all started with a leaked report.

On November 2nd, a report revealed that the trading firm Alameda Research, founded by Sam Bankman-Fried, suggested the company held approximately US$5.8B out of US$14.6B of its assets in FTX’s exchange token, FTT. This led to questions about the relationship between the two firms.

On November 6th, Binance CEO, Changpeng Zhao (CZ) said they were going to liquidate their FTT holding due to “recent revelations that have come to light”. He was believed to be referring to the Alameda balance sheet findings. The following day a ‘bank run’ ensued on FTX out of fear the exchange may go bust. Due to the run, FTX faced a liquidity crunch and made a move to sell to rival exchange, Binance. CZ acknowledged that there was a non-binding letter of intent to acquire the exchange. However, within 24 hours, CZ announced that the deal was dead due to “issues beyond our control and the ability to help.”

Reports emerged that over US$8B was needed in emergency funding to cover the liquidity crunch. The FTX website urged against depositing further funds to the exchange and was unable to process withdrawals. Companies such as Sequoia Capital started writing down assets exposed to FTX and FTX-affiliated companies.

On November 11th, according to a press release, FTX Group filed for bankruptcy protection in the US. Included are FTX.com, Alameda, and approximately 130 additional affiliated companies. Sam Bankman-Fried, CEO and Founder, resigned, handing control to bankruptcy lawyer, John Ray III, who oversaw the Enron Corporation bankruptcy.

Through Twitter, Zane Tackett, the former head of the institutional arm of FTX, confirmed that the exchange had liabilities of US$8.8 billion. FTX Digital Markets, FTX Australia, FTX Express Pay and LedgerX (which does business as FTX US Derivatives) are not included, the release said.

“In the short term we have some long days and hard work ahead of us,” Ray told employees in a message verified by CoinDesk. He called the bankruptcy filing “the beginning of a path forward.”

On the same day, all Alameda employees resigned collectively after a group meeting. This occurred the day after Sam Bankman-Fried said that the firm’s operations would shut down soon.

How did this all happen?

“Crypto exchanges are supposed to work simply. Customers deposit assets so that they can trade, and the exchange holds those assets safely in custody. That way, if customers ask for their money back, the exchange can give it to them.

FTX seems to have deviated from this script. Although we don’t know the precise details, it appears to have lent customer assets to—or otherwise invested them with—its affiliated trading arm Alameda Research (or other potential firms), which may have then engaged in risky and/or illiquid trades. Everything appeared to be fine until this week - when rumours of FTX’s insolvency caused customers to demand their money back en masse from the exchange. FTX couldn’t come up with the cash to meet customer withdrawals, so it had to sell itself to Binance in an emergency deal,” Hougan said.

What does this mean for crypto equities?

Last week’s event will impact crypto equities both directly and indirectly. It will take a while to see all the repercussions unfold. There are companies that have exposure to FTX and/or affiliated FTX companies. Those exposures will have to be written down and could impact company valuations and profitability. There are also companies such as Voyager Digital that were being bailed out by FTX. In addition, companies laying down the infrastructure are directly impacted by the price of bitcoin and other cryptocurrencies, or the volume and how much activity takes place.

The exchanges that are left will need to instil confidence in their users and rebuild their trust. A handful of exchanges are already stepping forward to show proof of what they hold and what they are doing with customer funds. Questions are being asked about what may not have been disclosed, what they are doing with the crypto they are supposed to be holding for clients in custody, and whether they can show proof of reserves.

The crypto industry will have to rebuild the trust of users to give them the confidence to interact with various companies and protocols.

FTX had millions of users who have a right to be disappointed. Whether FTX disclosed to users all relevant risks comes into question.

The positive from this is that regulation is coming. Institutions, corporates, and retail have been waiting for regulation to get clarity on what can and can’t be done. The public is disappointed, and this should be the impetus for regulators to move swiftly. The “wild west” days of crypto are coming to an end and crypto should see more guardrails, strict risk control systems, and audits to ensure transparency to the public.

Questions that remain unanswered…

1. How much (if any) illegal activity was taking place at FTX and how many employees knew about it and were involved?
2. How deep will the contagion run? Several companies will be deeply impacted by last week’s events. 
3. How quickly will the regulators come in and put regulations in place to ensure this does not happen again?
4. What will these new regulations look like?
5. How long will it take to gain the trust and confidence back from users of the exchanges? (Over US$1.3B of bitcoin was pulled off exchanges in the four days after the run on FTX)
6. Will capital investment into crypto projects slow down, given venture capitalists have been burned?

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