What the heck is going on in the crypto world?
By now, you've likely heard about the epic unwinding of the major exchange FTX. But how does the fourth-largest crypto exchange in the world go from a valuation of $40 billion to bankruptcy in a matter of days? Should crypto investors be wary of other firms, like the leading U.S. exchange, Coinbase (COIN +3.98%)?
As with everything in the crypto universe, it's complicated. But to understand how FTX came crashing down, you have to unpack its relationships with two other companies: Alameda Research and Binance.
Image source: Getty Images.
FTX's questionable relationship with Alameda Research
Alameda Research is a trading firm also founded and owned by FTX founder Sam Bankman-Fried (or SBF, as he's often called). The company acted as a market maker for FTX. A market maker is a financial firm that provides liquidity to an exchange.
These firms have immense portfolios of assets and agree to be the default buyer or seller of assets on the exchange at prices they set. They make a small profit by setting their selling price slightly higher than their buying price (also known as a bid-ask spread).This can be difficult to conceptualize, but what's key here is that market makers are the reason you can place a trade and see it instantly reflected in your portfolio.
On Nov. 2, crypto news site CoinDesk published an article flagging that Alameda's balance sheet carried an abundance of FTX Token (FTT +2.03%) -- FTX's native coin. The article author, Ian Allison, described the situation like this: "Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto."
Nearly $6 billion of Alameda's $14.6 billion in assets were made up of FTT coins. And a significant portion of that $6 billion was being used as collateral for massive loans. FTX essentially created an asset out of thin air and then used it as collateral to fund a market-making business, effectively tying the fates of the two companies together.
That Bankman-Fried owned both an exchange and the market maker of that exchange is, on its own, ethically questionable. But some of the suspected transactions between the two companies go beyond that to approach fraud. According to several reports, Bankman-Fried allegedly moved $10 billion in customer funds from FTX to Alameda, with as much as $2 billion completely unaccounted for between the two firms. Now, both the DOJ and SEC are investigating these transactions for possible criminal activity.
Binance drove the final nail in the coffin
Bankman-Fried has a somewhat contentious relationship with Binance founder Changpeng Zhao. Binance was an original investor in FTX, and the two crypto billionaires have taken shots at each other on Twitter over the years. Zhao has suggested that Bankman-Fried's incessant lobbying for crypto regulation stands to disproportionately benefit FTX. .
In 2021, Binance sold its 20% stake in FTX back to the company and accepted a large amount of FTT as a portion of the payment. These tokens sat on Binance's balance sheet for about a year, as Zhao has stated it's company policy to hold competitor coins to avoid the appearance of "attacking" other industry players.
But after the CoinDesk article highlighted Alameda's seeming overexposure to FTT, Zhao announced that Binance would "liquidate" its entire position, estimated to be worth over $580 million at the time.
As part of Binance's exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have came to light, we have decided to liquidate any remaining FTT on our books. 1/4
-- CZ 🔶 Binance (@cz_binance) November 6, 2022
This caused a mass panic among FTT holders, and the token crashed from $26 to around $1.50. Reacting to the liquidity crunch, Bankman-Fried began looking for investors to bail the company out, even approaching Binance. For a brief moment, it seemed Binance might just pull FTX out of the grave as it signed a nonbinding letter of intent to buy the company.
But this quickly fell through:
As a result of corporate due diligence, as well as the latest news reports regarding mishandled customer funds and alleged US agency investigations, we have decided that we will not pursue the potential acquisition of https://t.co/FQ3MIG381f.
-- Binance (@binance) November 9, 2022
The internet had a field day theorizing that this was a sophisticated, masterfully orchestrated plan by Zhao to take out one of his biggest competitors, though he has repeatedly denied this. Even if Binance hadn't sold its stake in FTT, it was really just a matter of time before the massively over-leveraged FTX came crashing down.
Why Coinbase customers can sleep soundly
As a Coinbase customer, I wondered if something like this could happen to the leading U.S.-based exchange. But there are several key differences between the two firms, which reveal why Coinbase is much more trustworthy than FTX.
First and foremost, Coinbase operates in the United States. FTX, meanwhile, was headquartered in the Bahamas, where crypto regulations are more relaxed. Coinbase is also a publicly traded company, which means it's required to share its financials every three months. FTX didn't have to publicly share its financials; we only learned about the company's bad balance sheet because it was leaked.
Finally, there are no apparent conflicts of interest between Coinbase and its market makers. In fact, the company uses automated market making (AMM), which significantly decentralizes the process.
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Key Data Points
DeFi is in desperate need of transparency
They say sunlight is the best disinfectant, and the FTX debacle certainly supports that. Fortunately for Coinbase customers, the company seems to prioritize transparency.
But in the unpredictable world of crypto, the safest way to ensure your investments are secure (that they can't be hacked, stolen, or lost) is through good old-fashioned cold storage.
Bankman-Fried has tried to spin this collapse as the result of a planned attack by a rival. But even if Zhao killed FTX, Bankman-Fried's fiscal recklessness - not to mention potential fraud - put the bullet in the chamber.
