FTX used to be the second largest crypto-exchange in the world. The exchange was valued at over $32 Billion and had attracted investments from many well known investors and hedge funds. Within a two day span, everything changed and FTX ended up filing for bankruptcy. What happened?
What happened was a good old bank run. A research report came out that questioned the strength of FTX’s balance sheet. Did they really have the assets to back up all clients assets? When clients heard of this, they created a run on FTX. The majority of FTX clients lost all of their crypto. Crypto assets are not backed by the FDIC insurance that supports deposits at U.S. banks. There also isn’t a regulatory body that is a lender of last resort for crypto-exchanges. If the exchange doesn’t have the assets, then the clients are out of luck.
So what were the warning signs?
The biggest thing to remember is that nothing is ever free. If you find a great deal that seems too good to be true, it probably is. The first warning sign at FTX was that they were paying clients 8% interest on any assets held at the FTX. When the biggest banks in the world are paying 0%, you should be suspicious when someone promises 8%.
Another warning sign is generic for all crypto-exchanges. They are not regulated. They are not required to have any oversight. At FTX, they did have an auditor, but the fact that the auditor for FTX is based in the Metaverse (a virtual world) should have raised eyebrows. When you think of unregulated companies, you should think of the wild west. You may think that they are following the rules, but without regulation, they don’t have to and they might not be. It is impossible to know.
In the case of FTX, despite stating in their client account agreement that they would not loan out client securities, they gave a portion of their client’s assets to their trading firm Alameda Research. They did this in order to generate the 8% interest that they owed clients. When some of those bets lost, they sent over additional funds. When the research report questioned their balance sheet and their ability to repay clients, the bank run was on and FTX was caught.