What Happened to FTX

A layman's explanation of why this crypto exchange's demise is such a big deal.

There's a whole lot of news about FTX and a whole lot of opinions about what it means and a whole lot of actual drops in cryptocurrency values attributed to it.

So for those not already in the know, or those who want to make sure they have the story straight, I shall attempt to explain this whole FTX mess as simply as possible

A note to financial pros and those who are really into cryptocurrency. You are going to be tempted to "well actually" me a few times here. And while I welcome your expertise, do keep in mind I'm oversimplifying a few things on purpose, to make sure the widest number of people understand. Thank you for your understanding.

Let's start with a few basic things you need to know to understand the story at all.

First - A cryptocurrency exchange is a place where people can buy and sell various kinds of cryptocurrencies. Exchanges make it easy to send digital currencies to other folks, but also to "cash out" in multiple currencies.

Big examples of cryptocurrency exchanges are Coinbase, Binance and of course, FTX.

FTX is a company headquartered in the Bahamas, founded in 2019 by Sam Bankman-Fried. It runs a cryptocurrency exchange internationally, called FTX, and one in the US called FTX.US as well as a few other subsidiaries.

The problems were focused on the international exchange. So from now on, when I refer to FTX, I mean the international one.

Bankman-Fried also founded a separate company called Alameda Research, which is not an exchange but a trading firm. It pursues risky investments for high returns. It's not legally related to FTX, except sharing a founder.

Those are the basic facts of the story, but let's also cover some important info about these kinds of businesses. An exchange and a trading firm are different. An exchange is supposed to hold a client's money, and make it easy to exchange it. Exchanges make their money on transaction fees.

On the other hand, a trading firm borrows money and makes investments, hoping that its investments will pay off, so it can pay off its debts and make a profit.

In traditional markets, an exchange has to keep client funds separate from other company assets. They can't invest client's funds. If they do, they get fined. However, cryptocurrency exchanges are not subject to the same regulations.

What happened with FTX?

Essentially word got around that FTX didn't have enough money on hand to cover its obligations. Reportedly it had around $16 billion in customer assets but had had loaned around $10 billion of that to its sister company Alameda Research, and that Alameda's investments weren't looking like they'd pay off. Whether this is true or not almost doesn't matter. People believed it.

And so the toilet paper phenomena began. A lot of folks decided to get their money out, just in case there was a run on FTX because of the rumor about Alameda. Thus causing a run on FTX. About $5 billion worth of withdrawal requests happened on Sunday. FTX could only fulfill around 80 percent of those. Which caused FTX to have to pause withdrawal requests which of course fueled the panic even more.

As Fadi Massih, vice president at Moody’s Investors Service, said: “The lack of regulatory oversight and the sector’s overall opacity facilitate risky financial strategies, exposing firms to an environment in which rumors of illiquidity can become self-fulfilling prophecies.”

Can FTX get out of this?

It almost did. Bankman-Fried said the company needed about $8 billion to get liquid. So it started pitching companies on a takeover. Give us the $8 billion to make it through and you get a chunk of the company to profit from in the future. One of the biggest exchanges, and an investor in FTX, Binance, temporarily agreed to do that, contingent on looking over FTX's finances. In less than 48 hours of looking however, Binance determined that FTX's problems were “beyond our control or ability to help.”

OK so Binance got cold feet. What about another bolder company? Binance isn't FTX's only investor after all. BlackRock, Canada’s Ontario Teachers’ Pension Plan, SoftBank, and hedge fund billionaires Paul Tudor Jones and Izzy Englander are all investors too. And FTX reportedly pitched non-investors as well, including Coinbase."

They got no takers. Quite the opposite. On Thursday, one of FTX's investors, Sequoia, officially marked its $214 million investment in FTX as worth zero. That's a step you take to help your tax burden (and other things) if you're certain an investment is not going to bring a return. Not the message a potential savior wanted to hear.

Bankman-Fried took to Twitter Thursday to essentially pitch the world. He said FTX's total holdings were enough to satisfy its debts. Now you may well ask how that could have been true if FTX needed $8 billion to stay liquid. Remember that a holding isn't the same as cash. So what Bankman-Fried was asking for was sort of like needing a payday loan. A check is coming and you'll get back on track, you just need to pay that electric bill before the lights go out.

It didn't work. On Friday Bankman-fried resigned from his position as CEO and FTX filed for Chapter 11 bankruptcy. John J. Ray III, a lawyer that served as chairman during Enron's dissolution, took over as CEO. FTX has begin reviewing its assets in order to monetize them for shareholders. The bankruptcy filing estimates there are 100,000 creditors and assets are estimated to be between $10 and $50 billion. No word on what will happen to all those frozen customer accounts. Ask the folks with accounts from MT. Gox, who have been waiting since 2014 for a settlement. The bankruptcy covers FTX and Alameda Research. It also includes FTX.US, which Bankman-Fried had insisted was immune to the problems of the international version of FTX. The only parts of FTX not involved in the bankruptcy are FTX Digital Markets in the Bahamas, options platform LedgerX, FTX Australia and FTX Express Pay.

Why is this causing so many cryptocurrencies to tank?

FTX not only owes money but it had also loaned money. The Wall Street Journal notes the example ion crypt lender BlockFi which stayed afloat after a rescue loan from FTX in July. BlockFi paused withdrawals Thursday evening. And of course FTX owes crypto firms money too. If it defaults on those debts, suddenly a lot of other firms have problems in their liquidity since a big chunk of money they expected to come back to them from FTX over time will no longer be coming. That could trigger a cascade. A similar scenario played out when Terra had problems in May and June, but FTX is bigger than Terra. Sea. Lot of folks are dumping crypto to shield themselves from getting caught with their assets frozen. Which is driving down the prices. The good news? Moody's doesn't think it will spill over into traditional financial markets.