The FTX Collapse, Crypto Market Crash, and How to Better Protect Your Investment

Even if you don't pay attention to crypto markets, you may have heard about FTX, one of the largest crypto exchanges and tied for #2 and #3 with Coinbase. If you do pay attention to crypto markets and have crypto investments, you most certainly have heard some of the news by now. There's a lot of information, and misinformation, flying around, so below is a brief summary.

First, though, there are a couple important statements to make very clearly. 

Public Service Announcement

There are two major takeaways from this event (as well as from the Terra crash 6 months ago that caused the collapse of Celsius, Voyager and other crypto entities):

1. As an American citizen, do not use exchanges that are not permitted to operate in the United States. Some of the US-permitted exchanges include Coinbase, Binance US, Kraken, and Gemini, among some others. This is not a recommendation for any specific exchange, other than one that is permitted to operate in the US and follows US regulations. However, keep in mind that just because you are using a centralized crypto exchange that is permitted to operate in the US, that doesn't mean there isn't a risk of  insolvency or other risks with that exchange. Earlier this year there were centralized crypto exchanges that did have liquidity and insolvency issues, namely Celsius, Voyager Digital, and BlockFi. Do your research on any exchange before using it. Furthermore, this kind of situation is not unique to the crypto industry. What is happening now is reminiscent of the issues that plagued the traditional US (and global) financial system in 2008. Many are calling this crypto's Lehman Bros. moment.
2. Not your keys, not your coin. You'll see and hear that phrase a lot in the crypto community. Bottom line, do not leave any crypto on an exchange if you are not going to be actively trading. Get a cold wallet and transfer your crypto to your cold wallet after you make your purchase. For more information about cold wallets, read the Escient Financial Insights article Cryptocurrency Wallets. Of course, if you have invested in crypto inside a retirement account, or if you want to, this may become more complicated. Escient Financial can provide advice on how to handle those situations.

Now, on to a brief summary of this week's events...

SBF vs CZ (or FTX vs Binance) and the Collapse of FTX

Sam Bankman-Fried (aka SBF), the CEO of FTX, has been making the rounds in Washington D.C. in recent months in an effort to assist with putting regulations in place for the crypto industry. A recent leak of a bill that SBF lobbied for and helped draft led many in the crypto community to believe that SBF was going behind their backs to implement regulation that specifically benefitted FTX.

Last week, a balance sheet showing Alameda Research's assets and liabilities was leaked online. Alameda Research is a trading firm founded by SBF and has close ties to FTX. Although the balance sheet showed that Alameda Research had more assets ($14.6 billion) than liabilities (about $8 billion), much of the assets were comprised of FTT tokens and FTT collateral. FTT tokens are tokens created by FTX and are used by FTX users to receive discounted trading fees on the FTX exchange. Alameda also appeared to be holding more than 60% of the total FTT token supply. Other assets consisted of large amounts of Solana (SOL) tokens and other tokens that were considered to by less liquid because of the large sums that Alameda Research held. The concern here would be if Alameda needed cash from those assets, they would be dumped on the open market, causing asset prices to decrease significantly and rapidly before even Alameda Research could sell them. Thus, it would be possible that Alameda Research wouldn't receive as much money for those assets as the balance sheet showed should they need to be sold in a liquidity crisis.

After seeing the balance sheet, many people in the crypto community also began to question the ties between FTX and Alameda Research. There are suspicions and rumors than FTX had taken cash deposited by customers and sent it to Alameda Research as FTT tokens to be used as collateral for large loans in the hundreds of millions of dollars, or that Alameda Research had directly used customer deposits to fund its trades, which it had lost value with due to the bear market. It should be noted that in the past 6 months Alameda Research and FTX have spent billions of dollars in providing liquidity and emergency funding for exchanges that were adversely affected by the Terra system collapse, as well as different acquisitions, including Voyager Digital. It should be stressed here that none of this has been proven, and currently are just suspicions and rumors.

The information that was leaked, combined with dissatisfaction of SBF's lobbying activities regarding regulations for the crypto industry, prompted Changpeng Zhao (aka CZ), the CEO of Binance (the largest crypto exchange in the world), to announce that he was going to sell their $2.1 billion of FTT tokens on the open market. Binance had received the FTT tokens as part of a deal when it was an original investor in FTX. Alameda Research offered to buy the FTT tokens from Binance for $22 per token as an over-the-counter (OTC) sale instead of on the open market. An OTC transaction is a sale or transaction completed off of exchanges to avoid adversely impacting the open market pricing. CZ refused the offer and Binance proceeded to transfer their FTT tokens from a cold wallet to the Binance exchange and sell their FTT tokens on the open market. This caused a significant and rapid drop in the price of the FTT token. FTX and Alameda Research attempted to protect the price of the FTT token at $22 by selling off its other assets and using the money it received from those sales to buy FTT tokens on the market. Buying large amounts of an asset generally causes the price to rise. The attempt worked for a short amount of time, but eventually the effort failed and the price plummeted to as low as about $1.08.

At the same time, FTX users began withdrawing their assets from FTX en masse. The FTX exchange saw $5 billion in withdrawals on Sunday, and more on Monday before it had to halt withdrawals due to running out of liquidity. That means FTX ran out of assets that users could withdraw from the exchange. Essentially, FTX had become insolvent and unable to give users their assets or money back.

It was then announced on Tuesday that Binance would be buying FTX to supply it with funding and allow users to get their assets and money back. That deal fell through on Wednesday after Binance performed its due diligence on FTX's finances and found there was no way for them to help FTX. Rumors have now been going around that FTX has an $8 billion hole in its balance sheet and is seeking emergency funding from investors to restart operations and allow users to withdraw. The rumored amount being sought so far ranges from $1 billion to $9.4 billion.

All FTX entities have filed for bankruptcy, including FTX US. If you have assets on FTX US (or any other FTX service) it is recommended you withdraw what you can immediately. Furthermore, per the above (and below) recommendations, it is highly recommended to not keep any assets on any centralized crypto exchange.

Although CZ has denied that he deliberately caused the collapse of FTX, and the loss of billions of dollars of users assets and money, many in the crypto community believe it was deliberate, noting that CZ has many years of experience with trading crypto and would have known that announcing and then dumping Binance's FTT tokens on the open market would cause a crash in the FTT price and a bank run on FTX. There is no proof that it was a deliberate attack against FTX to cause a liquidity crisis and insolvency situation though.

Where Things Stand Now & Key Takeaways

The crypto markets in general saw significant declines with Bitcoin falling to its lowest price in 2 years on Wednesday, Ethereum falling to around $1,100, and Solana falling more than 50% in 24 hours. Most crypto assets have bounced back, but are still at lower prices than they were before this started. It will likely take weeks for this all to fully play out and for the full details of what happened behind the scenes to come to light.

It Must Be Repeated...

If you are in the United States, be sure to only use exchanges regulated by the United States and permitted to operate in the United States.

Also, the general recommendation is: don't keep your crypto assets on exchanges (even those regulated by the United States) if you aren't actively trading. Not your keys, not your coin. If you were an FTX user, but kept your crypto on a cold wallet, you would have lost very little or nothing at all since you would have possession of your own crypto on your own wallet. The value would have gone down, but you would still have possession of your crypto. The is the main reason why Escient Financial does not manage crypto investments for clients and leans toward self-custody options, and provides education and guidance on how to do so. Although there are fees involved with transferring crypto between an exchange and cold wallet, it's a small price to pay for the safety of having your crypto in your own possession. If you are for some reason keeping your crypto on an exchange, it could be a good idea (if possible) to spread your crypto across multiple exchanges.

Centralized Finance Affected, Not DeFi

It is notable that the collapse of crypto services and exchanges this year (Celsius, Voyager, FTX, and others) have all been centralized exchanges, and were caused by poor judgement and poor risk management. DeFi (decentralized finance), which runs on code instead of human decisions, was not affected by these issues that were caused by the collapse of Terra Luna and UST earlier in the year and FTT this week. In fact, during the Celsius insolvency and collapse, it was the DeFi lenders that were paid back in full before Celsius was forced to declare bankruptcy. Celsius was essentially forced to pay back its DeFi loans or risk losing everything. DeFi offers ways to trade crypto, earn yield, and other uses for cryptocurrency that is not left on an exchange. More on DeFi another day.

Crypto is Still New