Daylight Robbery : The Downfall of FTX

Syaqif Saifulizan & Nur Farhanah Ahmad Rizal

has so far proven to be a tricky year for cryptocurrency. Despite Bitcoin and Ethereum reaching all-time highs in 2021 followed by the popularisation of the non-fungible token (NFT), this year in many ways, humbled the industry. ‘Crypto Winter’ – usually defined as poorly performing crypto markets –lasted all year and of the top 10 hacks the industry has seen, six occurred in 2022. What unravelled next sent ripples worldwide and showcased the possible robbery of the decade.

On November 11, FTX, a cryptocurrency exchange platform filed for bankruptcy as the company’s valuation plunged from $32 billion to nothing in a few days, dragging the CEO, Sam Bankman-Fried (SBF)’s net worth to fall from $16 billion to near ZERO. At the time of writing, SBF faces an abundance of civil and criminal charges and was arrested in The Bahamas on the request of the U.S. government. So how did SBF find himself in hot waters? How did the once-third largest crypto platform fall from grace?

"We allege that Sam BankmanFried built a house of cards on a foundation of deception while telling investors that it was one of the safest buildings in crypto," said Gary Gensler, the Chair of the U.S. Securities and Exchange Commission.

Sam Bankman-Fried advertised FTX as a safe and easy way to enter and invest in the crypto market, paying for television commercials featuring superstars like the former World No.1 tennis player, Naomi Osaka and NFL quarterback Tom Brady. FTX received capital from numerous high-profile investment firms such as Sequoia Capital, BlackRock and Singapore’s own national sovereign wealth fund, Temasek. Yes, the equivalent of Malaysia’s Khazanah Nasional Berhad.

At the heart of Bankman-Fried’s fraud are the deep ties between FTX and Alameda Research LLC, a hedge fund that SBF co-founded. It is alleged that SBF orchestrated a years-long fraud to conceal the undisclosed diversion of FTX customers’ funds to Alameda from FTX’s investors. In layman’s terms, SBF shifted incoming money from investors to take loans for its partner firm, Alameda Research. Customers’ funds were used at Alameda to make undisclosed venture investments, lavish real estate purchases, and large political donations.

It is important to understand that FTX and other crypto exchanges are not banks. In complete realism, these firms should not do bank-style lending. FTX had specifically promised customers that it would never lend out or otherwise use the crypto they entrusted to the exchange. Hence, even a very acute surge of withdrawals should not create a liquidity strain. In contrast, funds were intimately linked to Alameda – theft at a neatly unprecedented scale.

In November, the market went into a tizzy following the reports from CoinDesk on a leaked document that appeared to show that Alameda Research held an unusually large amount of FTT tokens, the native token in the FTX ecosystem. It goes to show that the trading firm rests on a foundation largely made up of a coin that a sister company invented, and not an independent asset like another crypto or a fiat currency.

FTT used to generate massive growth and revenue for FTX, as investors strung along the offered rewards, trading discounts and VIP status in exchange for ownership of the token. Investors were promised ‘guaranteed liquidity’, insinuating that the risk of FTT purchase was practically nonexistent. However, only a tiny portion of FTT was traded in public markets, with FTX and Alameda conquering its vast majority. This reflects that the holdings were effectively illiquid –absurd to sell at the open market price. Per contra, SBF accounted for its value at that imaginary market price.

FTT tokens were used as collateral for Alameda’s loans – typically Alameda’s pledge to secure repayment to FTX. Alameda was borrowing from FTX, and using the exchange’s in-house cryptocurrency, FTT token to back these loans. This included loans of customer funds from FTX to Alameda. The usage of FTT aroused questions, as it contradicted the reality of FTX and Alameda being independent entities. Had they been genuine independent firms, the act of making FTT tokens as collateral would have been difficult or expensive.

Following this shocking revelation, Binance announced that they were selling more than $500 million worth of FTT, sparking a sell-off that sent the digital coin’s value plummeting. Investors were quick to pull out their money and even Temasek, Singapore’s state investment firm also announced that they were writing down the value of its entire investment worth $275 million from FTX. FTX scrambled to process the overwhelming request for withdrawals from its tokens, which amounted to an estimated $6 billion over 3 days. The once mighty crypto platform would enter a liquidity crunch as it lacked the money to fulfil the requests.

More managerial problems

unravelled as Alameda’s exemption by FTX was discovered. Mid 2020,FTX’s chief engineer tweaked a secret change to the cryptocurrency exchange’s software. Alameda Research was immuned from a feature on the trading platform that would have automatically sold off Alameda's assets if it was losing too much borrowed money. This auto-liquidation exemption ingrained into the tweaked FTX code was one of the ways Bankman-Fried diverted its customer funds to Alameda. This allowed Alameda Research to keep borrowing funds from FTX irrespective of the value of collateral securing those loans. Based on the U.S. Securities and Exchange Commission, the tweak in code denoted a ‘virtually unlimited line of credit’ for Alameda – a fraud that was charged against Bankman-Fried. The next two years revealed that the billions of dollars that FTX secretly lent to Alameda didn’t come from its own reserves, but rather from other FTX customers’ deposits.

As much as Sam Bankman-Fried portrayed himself as a well-intentioned but naive kid who got in over his head and made a few miscalculations, it is questionable that the blunder causing FTX’s downfall was completely overlooked. The downfall of FTX has shocked the rather nascent industry, leaving queries of what the future holds for cryptocurrency.