FTX Fiasco – Risks Demystified

It took less than ten days after a damning report by a news portal, for FTX – the deep-pocketed big brother of crypto industry, the self-styled lobbyist for crypto industry regulation and the aspiring crypto market leader – to collapse into bankruptcy. Sam Bankman-Fried, once the poster-boy of crypto, now appears to be at the receiving end of crypto world’s collective angst and frustration. Information, analysis and allegations that emerged over the days seem to portend a cataclysmic interplay of market risks, credit risks and operational risks that brought about the downfall of the crypto titan.

“On November 6, 2022, reports began circulating that FTX was facing significant liquidity concerns and that consumers would likely be affected. In response to these reports, FTX customers withdrew approximately $5 billion from the exchange—the exchange’s largest ever single-day withdrawal. On November 8, despite a public declaration by Bankman-Fried that FTX had enough assets to cover clients’ holdings, FTX paused customer withdrawals. On the same day, Bankman-Fried announced that he had struck a deal with rival cryptocurrency exchange Binance to sell FTX. On November 9, Binance announced that it was pulling out of the deal. On November 11, FTX announced that FTX, FTX US, Alameda Research, and approximately 130 other affiliated entities were declaring Chapter 11 bankruptcy and that Bankman-Fried resigned as CEO”. The above excerpts from Friday’s Press Release issued by the House Committee on Oversight and Reform summarize the turbulence that crypto world went through over the past few weeks.

Ever since the liquidity and solvency crisis at FTX, one of the largest crypto market players, exploded on the world scene, it has been sleepless nights for investors. It is not only investors who have taken an equity exposure on the FTX group that have suffered, but varied stakeholders within and outside the crypto world have already suffered losses or are bracing for it in the days to come. This includes those who lent money to the FTX group and investors who handed over their cryptocurrencies to the exchange for custody. Investors in cryptocurrency market, crypto market players who had been promised liquidity support by the group, franchisees who had inked or had planned to ink business partnerships, businesses promised advertisement revenues, and charities and outreach initiatives identified for funding by the group stand affected.

The trust deficit that the crypto industry is facing now appears to be a direct fallout of the FTX debacle. The lingering fear of a fresh contagion and the fear of regulatory tightening are also attributed to the ill-fated FTX.

Risk, in financial parlance denotes the degree of uncertainty and/or potential financial loss inherent in any investment decision. Profit is the reward for risk taking and the positive correlation between risk and return implies a higher potential for profit or loss as risk increases. Crypto investors know this more than anyone else, as it is the extreme volatility unseen in other financial markets that has drawn many an investor to the crypto world. A Working Paper recently released by the Bank for International Settlements established that it was the rise in prices of Bitcoin and not the dislike for traditional banks, or the search for a store of value or distrust in public institutions that led to an increase in crypto adoption. Crypto market cap had increased from $345 billion at the end of September 2020 to close to $3 trillion in early November 2021 before falling to $858 billion by June 2022.

The turbulence caused by the FTX episode caused crypto market cap to plunge more than 20 percent. Overall crypto market capitalization which was above $1 trillion on October 31 has fallen to $789 billion by November 21. During the same period, the prices of FTX Token (FTT), the native token of the FTX cryptocurrency exchange plunged more than 95 percent. 16th ranked Solana (SOL) which was reportedly a big portion of the assets held by Alameda Research has declined 63 percent. Bitcoin has declined 23 percent whereas Ethereum’s losses were higher at almost 30 percent.

Despite the huge impact on crypto prices, the FTX episode isn’t singularly a market price risk event. The adverse price movement in crypto market reflects the market’s shock and dismay at the unravelling of the actual liquidity and solvency position at FTX group, which was quite in divergence from what markets were hitherto led to believe. The new revelations indicated a catastrophic confluence of credit risks, market risks and operational risks in varied forms and differing magnitudes.

As stated in the Press Release issued by the House Committee on Oversight and Reform, FTX reportedly loaned roughly $10 billion in customer funds to its affiliated crypto trading company, Alameda Research Ltd., which in turn used the borrowed funds to make “risky bets.”

We know not for sure whether it was the leveraged trading or the macro- economic headwinds or the Terra Luna collapse or anything else that caused the trading bets of Alameda Research to go awry. We also do not know whether it was the bets placed on highly illiquid assets that proved its undoing. Whatsoever, it appears to be a classic case of market risk. Market Risk can manifest as Price Risk or the risk of adverse movement in prices due to unfavorable market conditions or Liquidity risk which is the inability to encash assets when required or without an extreme cost.

From the point of view of the cryptocurrency exchange’s customers, FTX, loaning customer funds to an affiliated trading company is a typical manifestation of custody risk. Custody Risk is the risk of loss of cryptocurrencies held in custody caused by the insolvency, negligence or fraudulent action of the custodian, in this case, FTX. Customers who had entrusted their cryptocurrency holdings to The FTX cryptocurrency exchange for custody could not withdraw the same as the exchange allegedly deployed it elsewhere without their consent.

The Conflict-of-Interest Risk when custodian and trading functions are owned and managed by the same team appears to have resulted in a whopping diversion of funds from the FTX cryptocurrency exchange to the trading arm i.e., Alameda Research. The functional separation among market intermediaries that is a characteristic of traditional markets, is missing in the digital assets market.

Regulatory Risk or the absence of clear and appropriate regulations governing the industry is also a major factor for the unfolding of a financial collapse of this magnitude. The risk of dealing with unregulated entities and the absence of territorial jurisdiction for digital assets has compounded the fallout of this failure.

Operational Risk, or the risk of losses caused by flawed or failed processes also seems to have been in full display at FTX. Going by the media coverage, the House Report further states that “Since then, new reporting has emerged suggesting that Bankman-Fried implemented a custom-built “backdoor” in FTX’s book-keeping systems so that he could move money without triggering internal compliance or accounting red flags at FTX.”

The submission by John Ray III, the new CEO of FTX also appeared to reiterate the high incidence of operational risks. In his filing before the bankruptcy court, the turnaround CEO has stated that never in his career has he seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as has occurred in FTX. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, the situation was unprecedented, he submitted.

Alameda Research also filed for bankruptcy on the same day as FTX. Credit Risk or the risk of loss caused by a borrower not repaying funds crystallized in the books of FTX which had loaned out a whopping sum to its sister concern.

Those who loaned out money to FTX and its connected entities face the risk of loss as the FTX entities have filed for bankruptcy. The crystallization of losses triggered by the Credit Risk would depend on whether FTX has the resources to pay back the lenders.

Equity investors in FTX related entities stand to lose their money as the capital is eroded. Many investors like Sequoia, Temasek, Softbank have reportedly already written off the equity investments, taking a hit in their books due to an Equity Price Risk.

The bankruptcy jurisdiction fight that followed the Chapter 11 filings by the FTX group has also triggered a new kind of Legal Risk. Attorneys for FTX had filed a declaration in the Delaware court stating that the mysterious movement of funds after FTX filed for bankruptcy protection were at the behest of the Bahamas government. The Securities Commission of The Bahamas had later confirmed that it directed the transfer of all digital assets of FTX Digital Markets Ltd. to a digital wallet controlled by the Commission, for safekeeping.

If FTX held only a small portion of its multi-billion-dollar liabilities in liquid assets and if the allegations of fraud are proved, the FTX bankruptcy would go down in history as a classic case of Market Risk and Fraud Risk induced Default Risk. Crypto well-wishers would be hoping the FTX saga does not trigger Systemic Risk, the risk of instability affecting the industry as a whole.

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