- Jeff Burke
The End of Crypto?
Updated: Feb 16
For those of you paying attention, there was a major event in the world of crypto over the past several weeks. FTX, one of the leading crypto exchanges filed for bankruptcy and caused waves throughout the entire space. You may remember FTX as one of the several crypto related companies that overtook ads during last year’s Super Bowl. FTX featured ads with celebrities including Tom Brady recruiting people to the platform, Stephen Curry promoting how easy it was, and, in a now extremely ironic campaign, Larry David as the naysayer saying this won’t work and he’s never wrong about this stuff. FTX even got naming rights for the Miami Heat basketball arena. They made a big public splash and less than a year later are bankrupt and facing numerous lawsuits.
What happened? What does this mean for the future of crypto? Can we trust crypto?
*** This story is still evolving with new facts coming out daily. This is not intended to be a journalistic piece about the downfall of FTX with precise fact checking so I apologize if some of what I state here ends up being proven to be something else. Instead, this is intended to be a general commentary about the overall crypto environment and how it may impact investors using FTX as an example of the risks involved.
First, let’s examine what happened. FTX was a major cryptocurrency exchange meaning it provided a marketplace for others to buy and sell crypto. This is like stock exchanges such as the New York Stock Exchange and NASDAQ. These exchanges are where all of the stock trades actually occur.
One significant difference between stock and crypto exchanges is that in many cases crypto exchanges also can act as custodians of investor funds. Custodians are the ones who actually hold the investor’s funds. A custodian has to keep records of each client’s account and has to be funded so that when clients go to withdraw funds the custodian can meet the customer’s needs. When it comes to our stock market, we use companies like Vanguard, Fidelity, Charles Schwab, banks, and many others to serve in this role as custodians. Crypto though relies on the exchanges themselves or individuals to store the coins in cold storage or a personal wallet of sorts.
When it comes to crypto, the largest exchanges such as Binance, Coinbase, and FTX may play the role of custodian as well. This means the investor opens an account, deposits funds, and then uses those funds to buy and sell crypto. The customer then uses the same companies to buy and sell crypto using their exchanges.
What went wrong?
In short, FTX hit a major liquidity crisis meaning they were short of cash. As I described above, this should not be an issue for a custodian as they need to keep the client’s funds separate so they can accommodate withdrawals. So why did FTX run into this issue? They took customers’ deposits and used them for other purposes, propping up other parts of their business. FTX had a sister company, Alameda Research, that was involved in riskier trades and needed support.
FTX also created its very own cryptocurrency, FTT. FTX lent the cash they had on hand from customer deposits to Alameda. Alameda in turn lent that money with some of these loans secured by the FTT coin. With the cash not being on hand, the balance sheet of each business was largely propped up by the value of the FTT coin.
As with other cryptocurrencies, there can tend to be a large amount of volatility with the values of these coins and they are not the equivalent of cash. Instead, they fluctuate with the market. FTX was in a position where if they needed cash they were largely dependent upon selling FTT to raise the cash. According to Marketwatch, FTX held about $16 billion in customer assets. The value of FTT dropped as FTX was faced with $5 billion in withdrawals.
As a result, FTX was faced with an $8 billion shortfall and FTT had lost too much of its value to make up the difference. And just like that, you have a company that is bankrupt.
FTX went looking for help to stabilize the business. Binance, the largest crypto exchange, said they would step in but after due diligence in looking at the financials, they decided to back out. FTX was left with no choice but to file for bankruptcy. There are approximately one million creditors of FTX waiting to see if they will get any of their money back.
What does this mean for Crypto?
Crypto has always been a volatile space and, as a whole, the value of the crypto space has taken a big hit this year. A year ago, the market value of all cryptocurrencies hit $2.9 trillion, and as of this writing that was down to less than $900 billion. The explosion of the crypto market began during Covid and continued growing through 2021 and has contracted this year even more than the stock market.
One of the big issues facing the crypto space has been a lack of regulation. The SEC oversees the traditional investments and our stock markets and has made noise that they want oversight over crypto investments and markets but that hasn’t happened yet. The failure of FTX will most likely increase the urgency of regulation as the government will want to try and protect customers from another similar event.
This is a big blow to the reputation of crypto. It raises doubts over the safety of investors’ deposits and if custodians and exchanges are funded appropriately. It remains to be seen if the ripple effect from FTX will spread to other exchanges and custodians. How much FTT is out there that is now almost worthless that someone was holding as collateral? Any exchange or custodian that is securing customers' deposits in other cryptos may come under fire.
Can we trust crypto?
This is the million dollar question. FTT was trading at roughly $25 in early November, by November 8th it was trading between $5 and $6, and by November 12th was under $2 where it stands at the time I write this.
Well established coins like Bitcoin and Ethereum are much less likely to collapse in value but there are thousands of other coins out there that are either lightly supported or have an unknown purpose. Cryptocurrencies are very different from stocks. In theory, the value of a company’s stock is tied to its financial performance. You are paying for the future profits of the company so the better the profits, the higher the price, and vice versa. Crypto coins on the other hand can be used as a form of payment but also serve a function such as facilitating contracts or holding digital records for health care and other transactions.
From an investor’s perspective, the question is how much do you pay for a given crypto coin as an investment? We can measure a stock price by the P/E ratio (the price of a stock divided by the earnings per share) but how do you measure the value of crypto? A crypto coin isn’t valued by a company’s profits, instead, it is based on how much someone is willing to pay for the scarcity of a coin or the utility the coin can provide and that is very difficult to quantify.
Supporters of crypto will say this is the result of a single bad actor. But there have been several of these bad actors now recently. Just this past May, we had the collapse of LUNA and Terra coin resulting in a $60 billion crash. There is increased pressure now on other exchanges to prove they have the proper reserve amounts to secure customer deposits.
The reality is until the SEC or FTC comes in and provides some oversight in the space there will be doubts and a cloud will hang over the custodians/exchanges to prove they are on sound financial footing. The oversight that is needed though runs counter to crypto’s mission to become a decentralized financial system disruptor. Hence, is this the end of crypto as we know it?
Time will tell if crypto can properly self-police and continue as a new financial system, if it can continue with oversight to still be a way to revolutionize the financial industry, or if the oversight needed to make the space safe for consumers and investors tears apart the very fabric of what crypto envisioned it could be.
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