The Lehman Moment in the Crypto Market: Why is the FTX Crisis Critical?

Is the FTX crash the crypto industry’s Lehman Brothers moment? The collapse of FTX came as a surprise to many. However, as more information pours in, it seems like FTX’s liquidity crisis started sooner than previously thought.

How did the FTX crisis develop?

The world’s third-largest crypto exchange, FTX, started with a $400 million Series C funding type. It later increased its valuation to over $32 billion. Ten months later, it went bankrupt after Binance’s buyout bid failed.

Sam Bankman-Fried founded FTX with multiple major brand and sponsorship stakes and billions in fundraising. Because of this, he was seen as one of the biggest global crypto players. The financing of the crypto exchange has never been questioned, given that it bailed out multiple lenders during the crypto epidemic in the second quarter of 2022. However, in the second week of November, things took a wild turn.

It started with a report on Alameda Research’s illiquid FTX Token (FTT) holdings and the discrepancy in FTT’s market cap. FTT tokens have a liquid market cap of approximately $3.35 billion, while Alameda has FTT in collateral and debt leverages at a cost of approximately $5.5 billion.

Following the report, Binance CEO Changpeng Zhao announced that he liquidated all FTT assets. Binance received roughly $2.1 billion in cash equivalents in Binance USD (BUSD) and FTT. However, more than the purges, it was the catch phrase of Zhao’s tweet. He said they do not support individuals who “lobby behind their backs against other industry players”. In this context, he made the following statement:

Liquidating our FTT is post-exit risk management only. We learned this from LUNA. We’ve had it before. But we’re not going to pretend we’re making love after the divorce. We are not against anyone. However, we will not support people lobbying from behind against other faction players.

Zhao’s cunning against Sam Bankman-Fried and his lobbying efforts against the decentralized finance (DeFi) market created a panic in the market. Subsequently, it led to heavy selling of FTT. Bankman-Fried said the next day that everything was fine in the stock market and that a competitor had created a FUD. But that didn’t help Bankman-Fried’s lawsuit or FTT’s fall as the token continued to bleed. As such, the price dropped below $20 and put pressure on FTX.

Crypto industry’s Lehman Brothers moment: FTX collapse

Just one day after reassuring the crypto community that all is well and that FTX has the funds to support clients’ holdings, Bankman-Fried announced that FTX is in a deep liquidity crisis and is working on a plan to sell its global exchange to Binance. About 48 hours later, Binance said that after looking at FTX’s internal ledgers, it realized that the situation was too advanced for it to be able to help, and that it withdrew from the contract.

Another report stated that Bankman-Fried requested $8 billion in emergency funds to compensate for user withdrawals, and user funds were also misused.

$8 billion deficit on balance sheet vs % market cap of FTX / Source: True Insights

Looking at the numbers, it’s clear why Binance decided to withdraw from the contract. The $8 billion deficit represents almost 20% of Binance’s market cap after the crash.

Rob Viglione, CEO of Web3 infrastructure company Horizen Labs, said that the ongoing scenario could never happen in classical finance, as the United States Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve system provide regulatory oversight and act as a turning point.

When Bankman-Fried said the stock market was liquid, it could indeed have been the truth. The only problem with the exchange was that it was heavily liquid in FTT. He was using it heavily as collateral. Jonathan Zeppettini, Decred’s head of strategy, describes the crypto industry’s Lehman Brothers moment as an FTX epic.

“Never use a token that you print as collateral”

It turns out that the biggest culprits for FTX’s decline are its partner firm Alameda Research and its token FTT. While crypto lenders such as Three Arrows Capital and Celsius struggled to deal with the Terra crash, Alameda managed to weather the crisis. However, now, it seems that the problem started to brew for the company in the second quarter. A run of 173 million FTTs on September 28, which was worth about $4 billion at the time, indicates that FTX may have saved Alameda from the crypto-contagion and knew enough that the 173 million deserved FTTs will be released in September.

According to on-chain data, the FTT token supply increased by 124.3% on September 28, when 173 million FTT tokens were created under the 2019 contract with Alameda as the buyer. Alameda then sent the entire newly minted FTT back to an FTX address. This has led many to believe that this is a loan repayment. Rumors later abounded that FTX had saved Alameda using unreleased FTT as collateral.

Lucas Nuzzi, head of crypto analytics firm Coinmetric, believes that FTX not only helped collapse Alameda, but subsequently saved 173 million FTTs from liquidation. This theory was later confirmed by a Reuters report suggesting that Bankman-Fried transferred at least $4 billion in FTX funds, which were secured by assets including FTT and shares in the Robinhood Markets Inc trading platform. Some of these funds were customer deposits.

Background of the FTX collapse and its impact on the crypto branch

Eric Chen, CEO and co-founder of DeFi research form Injective Labs, says that FTX’s unregulated native token FTT-based obligations have reached a point where it’s impossible for the exchange to come back. Regarding the bet, he makes the following statement:

FTX was in a position where its liabilities far exceeded its assets. In fact, it was reported a few days ago that Alameda’s balance sheet was not very healthy. Alameda is closely affiliated with FTX. The firm also held a valuable portion of its assets in FTT. As the cost of FTT began to fall rapidly, Alameda was likely unable to meet its obligations any longer. This led to a great whole in the FTX balance sheet.

Alameda had an “unlocked FTT” of $3.66 billion at the end of June. It also had approximately $15 billion in assets, with $2.16 billion in FTT collateral. Joshua Peck, founder and chief investment officer of crypto hedge fund Truecode Capital, told Cointelegraph:

They apparently used this token to transfer client funds from FTX to the Alameda hedge fund, also owned by Bankman-Fried, in exchange for collateral they could create out of nothing. It appears that customers would not be at risk if Alameda were able to return the funds. However, it is clear that they made illiquid investments. Therefore, client funds could require the sale of a set of interest from tokens locked in smart contracts. Many are now almost free if sold at market price today.

The fall of FTX is one of the biggest self-inflicted wounds for the crypto industry. If FTX had been as transparent as its CEO had previously claimed, it would have been possible to prevent this tragedy. In addition, a possible investigation into FTX’s US sister company is also on the agenda. The FTX crisis highlights the lack of centralization in the crypto ecosystem, which is ironically rooted in the decentralization ethos. In the absence of clear regulatory guidelines, many more giants like FTX will explode on their own. By the time these fiascos come to light, it’s too late to save the company from disintegration.

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