2022 has been an awakening year. Few expected the year to end with the top exchanges, groups, hedge funds, and platforms in crypto either dead or on life-support.
From the ashes of this year will come maturity, better due diligence, improved best practices, and regulations. Blockchain technology is still full-steam ahead. However, the players have been reshuffled, and new rules will be made to limit third-party risks.
As we wrap up the year, taking a hindsight look at what happened is filled with insights we can learn from.
The Rise of FTX
Within three years of its inception, FTX became one of the largest cryptocurrency exchanges globally, with an approximate valuation of $32 billion. Its founder and CEO, Sam Bankman-Fried, is renowned for using aggressive marketing and political lobbying to help FTX reach the top. Besides, he has facilitated numerous deals totaling more than $1 billion since the start of 2022 to bail out various cryptocurrencies.
Why Did FTX Fall?
The events of November 11, 2022, shook the cryptocurrency world as FTX filed for Chapter 11 bankruptcy proceedings, pushing down its value from $16 billion to practically zero within a couple of days. As a result, the already volatile crypto market lost billions in value, dropping to below $1 trillion.
The crisis started with a CoinDesk scoop on November 02, 2022, that revealed irregularities with FTX’s functioning. Alameda Research, FTX’s sister firm, held positions worth $5 billion in FTT (FTX native token). Besides, the investment was also in FTT and not any fiat currency. Thus, it raised concerns about the undisclosed leverages and solvency issues of organizations owned by Sam Bankman-Fried.
The Sequence of Events That Led to FTX Bankruptcy
Here is the FTX Bankruptcy timeline.
● On November 06, 2022, Binance announced that it proposes to offload its entire FTT token position, worth around $529 million. Binance justified its decision by stating it was a risk management exercise.
● As a result, FTX started experiencing a liquidity crisis, with customers demanding withdrawals worth $6 billion. Consequently, FTT’s value decreased by nearly 80% in two days.
● Binance announced on November 08, 2022, that it would bail out FTX. However, it backed out of the deal on November 09, 2022, citing concerns over customer funds mishandling.
● Securities regulators started turning the screws on FTX, as the Securities Commission of the Bahamas (SCB) froze FTX Digital Markets, and the California Department of Financial Protection and Innovation initiated investigative actions on FTX.
● Sam Bankman-Fried resigned as CEO on November 11, 2022, and FTX filed Chapter 11 bankruptcy proceedings the same day.
● Within hours of this announcement, FTX declared that it was a victim of unauthorized transactions and decided to shift its digital assets to cold storage for security. Analysts suspected a theft worth $477 million from FTX.
● The Securities Commission of the Bahamas took over control of FTX’s crypto assets on November 18, 2022, while instructing the exchange to move its assets to the regulator’s wallet.
● On December 22, 2022 Sam Bankman-Fried was officially indicted on eight counts of financial crimes with bail set at $250 Million.
The Consequences of FTX Bankruptcy
The FTX bankruptcy will not end with the closure of the exchange. It will have far-reaching implications because FTX had investments in various crypto exchanges and organizations. Secondly, the FTX bankruptcy crisis has affected businesses like Genesis Trading.
The FTX collapse has damaged institutional and individual investor trust at levels we haven't seen since 2018. In addition, we expect the US SEC (Securities and Exchange Commission) to tighten its cryptocurrency regulations and formulate new laws governing digital exchanges and tokens.
Collateral Damage: The Impending Bankruptcy of Other Crypto Companies
The FTX bankruptcy proceedings have shaken the crypto world because several other crypto companies have survived mainly due to significant financial support, loans, or alliances with FTX. Besides BlockFi Inc, it has also affected the operations of crypto brokerage firms like Genesis Trading.
BlockFi Crisis - What is it?
The FTX Collapse claimed its first victim in the form of BlockFi Inc., a reputed crypto lender. Following the FTX bankruptcy filing on November 11, 2022, BlockFi Inc. filed its petition for bankruptcy under Chapter 11 on November 28, 2022.
The signs of the crisis were visible as early as November 11, 2022, when BlockFi halted withdrawals from its exchanges. BlockFi owes more than a billion dollars to its three most significant creditors, including a $100 Million fine to the US Securities and Exchange Commission. While BlockFi has assets and liabilities between $1 billion and $10 billion, time alone will tell how it will repay its more than 100K creditors.
Following the FTX line of credit of $400 million, BlockFi’s exposure to FTX has increased significantly.
Here is a list of BlockFi’s prominent liabilities.
● BlockFi owes nearly $729 million to Ankura Trust Company, its trustee organization, for BlockFi interest accounts.
● BlockFi already had significant exposure to hedge fund 3AC, which was affected by the collapse of Terra’s UST stablecoin.
● BlockFi owes nearly $275 million to West Realm Shires Inc, the parent company of FTX.
● It owes more than $100 million to the US SEC.
While BlockFi has substantial tangible assets, nothing would remain after the bankruptcy proceedings.
Genesis Trading – Impending Bankruptcy
The FTX fiasco has resulted in investors offloading their FTT tokens urgently, leading to a price crash. Genesis has substantial exposure to FTX because of its trading relationships. Therefore, the FTX bankruptcy has an adverse effect on Genesis’ functioning. The establishment hedged and sold collateral, causing a loss of $7 million on the day of the FTX bankruptcy filing.
Though Genesis has assured traders of its stability, tensions prevail, with the establishment exploring restructuring possibilities.
Genesis Trading - Restructuring Exercise
Reports indicate that Genesis Global Capital has hired investment bank Moelis & Company, a restructuring adviser, to explore options for avoiding a bankruptcy filing. The FTX fall has resulted in Genesis seeking between $500 million to $1 billion from investors for an urgent bailout.
While Bloomberg Report indicates Genesis has $2.8 billion in outstanding loans, 30% of the lending is to its parent company and other affiliated units. In addition, while Genesis Trading has halted withdrawals, it states that its products continue to operate as usual.
While Genesis has yet to announce bankruptcy, the crypto market is in heavy turmoil.
The US SEC and CFTC (Commodity Futures Trading Commission) are investigating the fallout. The US Department of Justice is also launching its probe. The regulatory authorities are probing how FTX managed its customers’ money and lending activities. The Texas Securities Board has also launched its investigations.
The FTX fiasco has affected customer confidence and forced regulators to scrutinize these exchanges deeply. Below is a closer look at the risks associated with third-party custodians.
Risks of Third-Party Custodians
A Chapter 11 bankruptcy does not allow the quick recouping of assets of the bankrupt entity. Therefore, all customers must wait for bankruptcy procedures to conclude and for the court to determine how much assets they recover.
Unfortunately, few precedents are available in Chapter 11 bankruptcy procedures involving crypto organizations. The experience of Voyager Digital and Celsius Network shows that the crypto assets would be pooled together and divided to pay all creditors pro rata. Under such circumstances, the customers’ claims are considered unsecured and rank low in priority. Therefore, third-party custodians have the least priority over the realization of assets.
In the middle of turmoil, the new FTX management team led by John Ray, is working through a recovery plan that's likely to take years. It is also trying to recover the $372 million withdrawn without authorization on the bankruptcy filing date. However, it is a small fraction of the digital assets required to pay back customers. In addition, reports indicate that Sam Bankman-Fried has secretly stashed up $10 billion in customer funds to sustain his associated trading company, Alameda Research. However, nearly $1 billion of these funds has vanished.
Where Does This Leave Bitcoin?