What is a cryptocurrency exchange?
If you want to trade in cryptocurrencies such as bitcoin or ethereum, the easiest way to do so is via a cryptocurrency exchange. They work largely like a normal stock exchange. A user passes on his order and the exchange operator buys or sells. In return, the crypto exchange receives a commission on that transaction. The digital currencies end up in the wallet of the user.
At a crypto exchange you can purchase crypto with regular currencies such as euros or dollars, but you can also exchange one crypto currency for another. At almost every exchange you can trade in the most famous crypto coins. The largest exchanges in terms of trading volume are Binance, OKX, Upbit and Coinbase and, until recently, FTX.
Is FTX different from other crypto exchanges?
FTX is a cryptocurrency exchange registered in the Bahamas. Its founder is 30-year-old American businessman Sam Bankman-Fried. The exchange was known as one of the most reliable. Many saw Bankman-Fried as a poster boy of crypto traders who do behave responsibly. For example, he argued for certain regulation of the sector, unlike many competitors.
At FTX you can trade in all kinds of cryptocurrencies, for which it charges a commission. But FTX also has its own cryptocurrency: FTT. That is called a token. FTX is not the only one with its own coin, the largest crypto exchange Binance also has a token.
When you buy a token, you get something in return, such as a discount on the commission or priority on purchases of new crypto coins. The advantage for the crypto exchange is, among other things, that it can have more liquid assets at its disposal.
But FTX also acts as a kind of bank. You can borrow cryptocurrency or just money from the exchange against collateral. FTX is not unique in that regard.
Why can that have major consequences?
What sets FTX apart from many other crypto exchanges is the collateral you can use there: FTX’s own token. Because its value fluctuates, so does the value of the collateral. If the value of the token falls sharply, the value of the collateral also evaporates.
And that is a problem if customers can no longer repay their loans, and others come to claim their money. Then FTX does not have the liquid assets to actually return customers their own money.
If FTX had other financial buffers then it would be less likely to run into trouble. But the own token was both the collateral and to a large extent the financial buffer.
Okay, but if the proprietary token’s value doesn’t drop, there’s not much going on. Why did that value drop?
News site CoinDesk revealed, based on a leaked document, that most of FTT is owned by Alameda, a hedge fund also owned by FTX boss Sam Bankman-Fried. That while the companies are officially completely separate from each other.
Alameda has a total investment portfolio of $14.6 billion. 40 percent of that value comes from owning FTT. After that revelation, the boss of Binance, the largest crypto exchange in the world and competitor to FTX, announced that he would sell all FTT owned by Binance. At that time, Binance’s portfolio was valued at $500 million.
Since relatively little FTT is being traded, that would flood the market. A lot of supply of a product means that the price falls. And so many investors withdrew their money from FTX — a total of $6 billion — fearing the company would collapse. The collapse thus became a self-fulfilling prophecy, like a classic bank run.
There was little left of the FTT price and the liquid buffers of FTX after that. Binance then said it wanted to acquire FTX, but after studying the books, it withdrew.
Does what happened here say anything about FTX or the crypto market as a whole?
Not all crypto exchanges are like FTX. Binance boss Changpeng Zhao tweeted what he sees as the biggest pain points: as a crypto exchange, never use your own token as collateral, and never borrow money yourself to lend it: ‘Keep a large reserve’.
CoinBase has also rushed to say that this can never happen to them. They only earn from commission, not from lending crypto. All the money that a customer asks for back is in his possession at any time.
Ironically, earlier this year, FTX emerged as the savior of many failing crypto firms. But that may also have started the decline of the company, says crypto specialist Teunis Brosens of ING: ‘It seems that Alameda has suffered losses on those acquisitions and that they are partly covered with loans from the crypto exchange. But the main problem is that it was not transparent, and that affects investor confidence.’
According to Brosens, more regulation of the crypto market is needed, which leads to more transparency: ‘It should not have been a problem that Alameda owns so much FTT.’
With crypto coins themselves, the problem is not here, he says: ‘You shouldn’t throw the baby out with the bathwater now.’
What are the consequences of the fall of FTX?
That is not entirely clear yet, says Brosens: ‘The dust has yet to settle.’ But this may affect the entire crypto market. Not only did FTX collapse, the price of cryptocurrencies such as Bitcoin also fell sharply. According to Brosens, this has to do with the fact that confidence in the crypto market also suffered a blow earlier this year, including when crypto bank Celsius went bankrupt. As a result, the price of cryptocurrencies fell. Brosens: ‘A broader group of investors may now think: this market is too exciting for me.’
There is a chance that investors will lose their money if crypto prices fall further, and FTX goes bankrupt. Because the crypto market is barely regulated, there is also no guarantee system like with regular banks. However, Brosens does not think that the rest of the economy will be affected by the crypto vicissitudes: ‘Although some traditional financial parties have invested in FTX, the broader involvement from the traditional economy is limited, via shares or loans to crypto companies. So I expect little contamination.’