It is the week of November 12th and this week we saw the surprising implosion of the global cryptocurrency exchange FTX. This week reminded me of key lessons from my bank regulation consulting days at PwC, following the 2008 financial crisis.
History does not repeat itself but it sure does rhyme. Just like in the 2008 financial crisis, the core issue with FTX this week was its risk management practices in lending.
FTX was considered one of the industry’s most trusted institutions, given its role as the “crypto lender of last resort” during this summer’s crypto crash. (FTX won the assets of crypto brokerage Voyager Digital from bankruptcy court, paying about $1.4 billion.)
Sadly this week, FTX faced its own liquidity crisis, triggered by global crypto exchange Binance’s sale of FTX’s native token, FTT. It is important to know that this liquidity crisis only impacted FTX’s International business, FTX US was not impacted. Nevertheless, the markets responded with a massive sell-off. To make matters worse, Binance offered to buy FTX to address the crisis but then changed their mind citing due diligence challenges –which has created more downward pressure on market values.
Why Did This Happen?
The real story here is why it happened. FTX’s management decided to lend billions of dollars of customer assets to fund the activities of FTX’s affiliated trading firm Alameda Research. Sources say Alameda may owe FTX as much as about $10 billion. Sadly it is unclear if those customers' funds will be returned, however, the FTX team has publicly committed to working toward this. In traditional markets, brokers can not trade with client funds, but cryptocurrency regulations are still in flux so this practice is not illegal currently.
What Can We Learn From This?
The use of leverage across the world of cryptocurrency is incredibly dangerous and this week gave us a play-by-play about why.
If there is a bright side to this story – it is that cryptocurrency regulators now have a clearer view of the risks to the system and a concrete path toward investor protection in the space.
At the end of the day, I believe that these catastrophic events are a good thing since these periods of pain and loss will result in stronger, more resilient cryptocurrency companies, a mature regulatory environment, and a more efficient cryptocurrency ecosystem as a whole.