In a rapidly evolving situation that seems to change by the hour, the large crypto exchange Binance said it would no longer pursue an acquisition of FTX, the world's fifth-largest crypto exchange by year-to-date volumes.

The price of the world's largest cryptocurrency, Bitcoin (BTC 0.14%), surged yesterday on the news that Binance planned to bail FTX out. But the news that Binance is bailing on the deal sent Bitcoin cratering, with its price falling more than 15% at one point, though it has recovered about 10% since last evening. 

The FTX meltdown has undoubtedly rocked the entire crypto industry and shaken investor confidence, but is the market overreacting? Should investors consider buying the dip on Bitcoin? Let's take a look.

What happened

In case you missed the drama, earlier this month, CoinDesk published a scathing report that suggested that FTX's sister trading firm, Alameda Research, both of which are owned by Sam Bankman-Fried, has its balance sheet "propped up" by billions of dollars worth of FTX's in-house tokens called FTT (FTT 3.79%), rather than have sufficient fiat currency asset balances or tokens from unrelated cryptocurrencies. 

Person looking at multiple computer monitors.

Image source: Getty Images.

This sparked all sorts of questions, such as whether Alameda was using the FTT (which FTX potentially has the ability to "manufacture" out of thin air) as collateral and how much exposure FTX had to Alameda and FTT. Investors grew concerned that if the price of FTT declined enough, FTX could have solvency issues. While Bankman-Fried did his best to dispel these rumors and Alameda's CEO Caroline Ellison added that the company had $10 billion of assets not discussed in the CoinDesk report, it did little to ease investor concerns.

First, Binance CEO Changpeng Zhao said he planned to liquidate $2 billion of FTT he owned. Then customers began withdrawing their funds, and FTX saw a whopping $6 billion of withdrawal requests in 72 hours, leading to a liquidity crunch.

This was when Bankman-Fried announced that it would sell FTX's non-U.S. operations to Binance to shore up the liquidity crunch, pending due diligence. But it didn't take long for Binance to realize that acquiring FTX would be too burdensome, and the company walked away from the deal.

Why Bitcoin is being impacted

Crypto is volatile on a good day, so big meltdowns of companies that are at the center of and play a critical role in the crypto ecosystem are not good for the industry, which is still relatively new. As the pioneer of cryptocurrencies and blockchain technology, it is no surprise to see Bitcoin struggling on the news.

A big part of the investment thesis behind crypto is that digital currencies are going to become ubiquitous, so it's obviously a blow when one of the largest crypto exchanges, which serves as a major source of liquidity to common crypto investors finds itself in a liquidity crunch. 

Bankman-Fried has been considered a leader in the crypto community, and FTX has signed a number of huge sponsorship deals with sports teams, so seeing it could potentially fold in a few days' time is going to make the market uneasy. Furthermore, the incident has really hammered the up-and-coming altcoin Solana (SOL -0.02%) It is backed by Alameda Research, which may have to liquidate its holdings of the token.

Events like this are also an open call for regulators to swoop in. Zhao said himself that potential investigations from regulators are one of the reasons Binance is choosing not to pursue the deal. He added that this event could lead to more regulatory scrutiny and ultimately make it harder for new crypto exchanges to obtain licenses.

Did the market overreact?

I don't necessarily think the market overreacted here because we have seen big drops in the crypto market when other big events like this have happened, including the bankruptcies of Celsius and Voyager, as well as the collapse of the algorithmic stablecoin terraUSD.

But I also don't really see how this changes the broader thesis on Bitcoin, specifically. After all, the downfall of FTX appears to be due to liquidity issues and potentially some nasty rumors started by competitors. While this may dampen investor sentiment and crypto liquidity in the near term, there are plenty of other exchanges crypto investors can use to buy and sell crypto. I do not see it leading to the end of crypto trading long term.

I do think the crypto market will eventually stabilize and that we will come out of this mess with more regulation, which isn't always a bad thing. I still see a bright future for Bitcoin over the long haul and think this is a good buying opportunity, as long as you are aware that conditions may be volatile in the near term.