Why Did FTX Collapse?

Adam Johnson

Why did FTX collapse?

There are a multitude of reasons why FTX went under. The cryptocurrency exchange FTX filed for bankruptcy and its Chief Executive Sam Bankman-Fried resigned, signaling a downfall that has stunned crypto insiders and sent shock waves through the industry.

The collapse of the third-largest cryptocurrency exchange is stunning. A fortune was created and lost in almost unfathomable ways.

Why Did FTX Collapse? Valuation Drops $32 Billion

As one of the world’s largest cryptocurrency exchanges, FTX enables customers to trade digital currencies for other digital currencies or traditional money, and vice versa. The company is based in the Bahamas and was founded and run by Bankman-Fried, who drove it to a valuation of $32 billion and then saw it descend into bankruptcy.

The company had built its business on risky trading options. The crypto industry overall has increasingly been the target of regulatory scrutiny on Capitol Hill and across the globe but the oversight fell woefully short.

Why Did FTX Collapse? Binance’s Chief Sold His Stake Last Year 

Traders use FTT, a native FTX cryptocurrency token, for operations like paying transaction fees. Last year, Changpeng Zhao, the chief executive of Binance, sold his stake in FTX back to Bankman-Fried, who paid for it partially with FTT tokens.

On Nov. 2, the crypto publication CoinDesk reported on a leaked document that appeared to show Alameda Research, the hedge fund run by Bankman-Fried, held an unusually large amount of FTT tokens. Alameda’s need for funds to run its trading business was a big reason Bankman-Fried created FTX in 2019. But the way the two entities were set up meant that trouble in one unit shook up the other as crypto prices began to drop in the spring.

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Binance announced on Nov. 6 that it would sell its FTT tokens due to recent revelations. In response, FTT’s price plummeted and traders rushed to pull out of FTX, fearful that it would be yet another fallen crypto company.

FTX scrambled to process requests for withdrawals, which amounted to an estimated $6 billion over three days. The company faced a liquidity crunch, lacking the money to fulfill requests.

Why Did FTX Collapse? Ill-fated Deal between Binance and FTX

On Nov. 8, Binance stated it had reached an agreement to bail out FTX by buying the company. But, Zhao added in the announcement that Binance has the discretion to pull out from the purchase at any time.

In the concurrent announcement, Bankman-Fried said the deal would protect customers and allow FTX to finish processing its withdrawals. But on Nov. 9, Binance announced it would not buy FTX, saying it had arrived at that decision as a result of corporate due diligence. It also cited regulatory investigations and reports of mishandled funds.

Binance’s statement said, “We have all seen over the last several years that the crypto ecosystem is becoming more resilient and we believe in time that outliers that misuse user funds will be weeded out by the free market.”

Why Did FTX Collapse? Red Flags Missed 

Every bull market creates a willing suspension of disbelief, but the massive fee incentives of the investing business went from extreme to hidden in a shroud of mystery.

Institutions managing hundreds of billions of dollars apiece are under constant pressure to achieve the annual returns of 8% or more they’ve conditioned their investors to expect. Venture-capital firms and hedge funds have large amounts of money to pour into any startup.

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When money is managed for other people, the only thing a bull market arguably inflates faster than wealth is a person’s ego. The more often one has been right about something, the more he or she will expect to be right about everything.

So, why did so many smart people advocating for a bright crypto future either turn a blind eye or become shills for the industry pioneers who failed to follow reasonable and customary financial controls? The answer is that when prominent investors are paid to promote something to the masses, those who should be the first to find malfeasance become the ones with the most incentive to remain trusting and turn their heads the other way as risk-taking mounts.

Why Did FTX Collapse? The Bottom Line

FTT tokens plummeted when Binance sold its tokens due to regulatory concerns and the risk of questionable additional crypto supplies hurting the market. This created a massive liquidity crunch in which FTX could not fulfill requests.

FTX failed with regulators on the sideline and prominent crypto advocates not calling out the sketchy behavior displayed by the company’s leaders. The allure of exceptional returns and low fees appeared to prove irresistible to FTX management. The company’s business model became unsustainable and hurt many individual investors and customers who thought they could rely on management to serve their best interests rather than misuse their precious funds.

Adam Johnson writes for www.stockinvestor.com.

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