Wild West in action: FTX’s fall from grace

Events surrounding the demise of the exchange have rocked the digital assets markets, triggering $6 billion of withdrawals in three days and forcing Bitcoin to a two-year low.

The events of the last week surrounding digital asset rivals FTX and Binance have unearthed great chasms of unregulated territory within the digital assets markets and sparked major concerns around their financial stability.

FTX suffered a crippling devaluation after a surge of client withdrawals at the end of last week, following news that US Securities and Exchanges Commission had been investigating the firm’s handling of client funds and crypto-lending practices. FTX founder Sam Bankman-Fried (SBF) lost roughly 94% of his estimated $15 billion+ fortune.

Binance chief executive officer, Changpeng Zhao (CZ), simultaneously announced on social media plans to sell off his FTX holdings and over $500,000 worth of the exchange’s token FTT, further drumming down the exchange’s share price. Binance exited FTX last year having been an equity stakeholder since 2019.

The events were followed by news on Tuesday that Binance was expected to bail out FTX through the acquisition of its non-US holdings, however, in another major U-turn, Binance pulled out of the deal on Wednesday.

“We can probably take parallel here with the Archegos events,” founder of Macrodesiac, David Belle, told The TRADE. “Goldman sold off the Archegos prime brokerage holdings before anyone else and Credit Suisse was left holding the bag. CZ and Binance jumped because they had to.”

The collapse of FTX has sparked concerns around the regulatory oversight of digital assets exchanges and their linked trading and custody subsidiaries, as well as a major liquidity scare that in turn has seen investors back away from the exchange. Series B investor Sequoia Capital confirmed earlier today that it had written down its approximately $210 million investment in the firm to $0, releasing a notice to investors confirming its exposure to FTX was limited. Other unrelated players have also begun distancing themselves from the exchange, including Cboe Digital which distributed a note to its community reiterating its practices of segregating customer assets from its own as per CFTC regulation.

Bitcoin’s price also fell below $16,000 earlier today for the first time in two years as investor confidence took a dive amid the events.

FTX declined to comment.

Wild West

FTX’s fall from grace has left many querying how it could be possible for its alleged behaviour to go unnoticed by both investors and regulators. The close relationship between Alameda Research, FTX founder SBF’s trading firm, and the FTX exchange has also come under the firing line, despite claims from SBF that the two are separate companies. Alameda Research was founded in 2017 and FTX was founded two years later in 2019.

According to various reports, the exchange had been using client deposits to actively trade with. Alameda Research reportedly had more than $5.8 billion of FTT, an FTX token, on its books, by far the largest contributor to its $14.6 billion assets. Around half of FTX’s equity was reportedly also backed by the FTT token which had an outstanding supply of around $3 billion, meaning it would be virtually impossible to liquidate at the price marked on Alameda’s books.

“It’s rampant fraud,” added Belle. “It wasn’t that they didn’t realise, this was literally from the outset of the creation of FTX a fraud. The optics of a crypto trading firm having such large holdings of a token issued by an exchange co-founded by someone who set up said trading firm is clearly far from optimal.”

Alameda was also reportedly using uncollateralised lending pools to avoid pre-funding requirements by letting companies take out loans in order to trade, rather than having to pledge their own assets. To minimise risk, investors trading digital assets need to hold money on the digital asset exchange prior to doing a trade, in a process called pre-funding. This is a retail-focused workflow and the practice remains a significant barrier for institutional adoption.

The events around FTX and its use of investor funds could now spark a regulatory debate around whether the practice of using uncollateralised lending is workable or whether the pre-funding requirement should be addressed in another way.

A lack of regulation in the “Wild West” digital asset markets remains a key barrier to entry for institutional involvement in digital assets. Traditional institutions in particular have extensive legal and compliance processes in place that mean and risk associated with crypto trading and currency must be better understood before they can involve themselves in the digital assets markets. The European Union approved the legal text for its landmark Markets in Crypto Asset Regulation (MiCA) in October: however, the vote to concrete the proposals has been delayed and an implementation date is yet to be decided upon.

One umbrella

A key area of focus from regulators will likely be the use of subsidiaries or linked companies under the same umbrella as the exchange.

“The integrated or vertical business model can be exceedingly conflicted,” Larry Tabb, head of market structure research for Bloomberg Intelligence, told The TRADE. “By incorporating brokerage, market making, exchange, and clearing under the same structure, creates complications. As these businesses are segmented, there becomes a need to ensure each business can stand on its own from not only a profit perspective but from a risk management perspective.”

FTX is not the first firm to fall under the regulatory spotlight for activities related to linked companies. Foreign exchange brokerage FXCM was expelled from the US and served a $7 million civil monetary penalty in 2017 because of similar practices of routing client flow to a firm in which they held a majority stake in between 2009 and at least 2014.

“It’s exactly the same case if not worse in FTX’s case. They were sending flow to Alameda but then they were also actually using client deposits to make loans, trading against their clients,” added Belle. “They actually went a few steps ahead of FXCM who is now expelled from the US and the owners and founders aren’t allowed to be in financial services roles there.

“There should be some pretty bad repercussions from this [for FTX].”