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Nov 2022

Research Commentary: What the FTX saga means for the future of crypto

by Hashdex Research
9 min read
Nov 22, 2022

Research Commentary: What the FTX saga means for the future of crypto


TL;DR

  • A mixture of illiquid assets, improper asset-liability management, ethical issues, and an opportunistic move from a major competitor, exposed activities carried out by FTX and Alameda Research, triggering a huge selloff in the crypto market.

  • Binance, FTX’s biggest rival, signed a letter of intent for a strategic transaction, but stepped away after its corporate due diligence. FTX then filed for Chapter 11 bankruptcy.

  • Contagion is reaching crypto-native assets and projects in Alameda's and FTX Ventures’ portfolios, and threatening insolvency for other centralized service providers in crypto. 

  • Hashdex had no exposure to FTX, FTT, or Alameda. Since 2018, we have obsessed over building infrastructure and processes that protect investors from events like FTX. 

  • Despite pessimism in the market, crypto fundamentals remain strong, with this year’s developments pointing to a continued development and further adoption of digital assets.


 

On November 8, crypto was caught off-guard with a severe market shakeout caused by two intertwined centralized entities: FTX and Alameda Research. In the months leading up to these events, crypto seemed to be decoupling from traditional asset classes, with bitcoin’s short-term volatility on par with major indices (such as the S&P 500 and the Nasdaq 100). However, as details around FTX’s combination of illiquid balance sheet assets, improper asset-liability management, and ethical issues with clients’ funds emerged—and Binance made its opportunistic offer to buy FTX—strong volatility returned to crypto assets. 

 

First signs of trouble: markets speculate on FTX solvency

 

FTX, a centralized crypto exchange (CEX), and its sister trading firm, Alameda Research, are owned by Sam Bankman-Fried. “SBF” became one of crypto’s most influential figures over the past couple of years due to media attention and his public policy engagement. On November 2, an article by CoinDesk revealed an internal document from Alameda which showed that a large part of its balance sheet ($3.7B at the time of disclosure) was composed of FTT, a utility token issued by FTX that gives its holders discounts on exchange trading fees and allows for leveraged trading products on their platform. FTT’s utility is limited to FTX, and its market value has generally been largely dependent on the series of buy-backs that FTX had been doing on a quarterly basis. The internal document also brought to light that Alameda was using FTT as collateral for loans, which naturally could put it under significant pressure if FTT’s price dipped. 

Given that Alameda and FTX are sister companies, the CoinDesk article made market participants wonder whether selling pressure affecting the balance sheet of Alameda could also impact FTX. In particular, on November 6, Changpeng “CZ” Zhao, the CEO of crypto’s largest CEX Binance, publicly announced that “due to recent developments that came to light,“ his exchange had “decided to liquidate any remaining FTT” on their books. These tokens were paid to Binance in 2021 as part of their exit from an early investment in FTX. CZ’s announcement sounded the alarm for the Alameda situation, triggering a major selloff in FTT and leading to a client run on FTX. At first, SBF stated that his exchange was fine and clients’ assets were safe, but he later deleted this claim on Twitter. By early November 8, on-chain analytics showed that FTX withdrawals had stopped. A few hours later, SBF announced that FTX was signing a letter of intent (LOI) for a strategic transaction with Binance, confirming market suspicions that the relationship between FTX and Alameda was far closer than just having the same founder.

 

Binance steps in then out, FTX files for bankruptcy

 

CZ had initially declared that Binance had signed a LOI to acquire its rival FTX, in what would have been the merge of the two largest crypto exchanges in global traded volume. Although there was still uncertainty over whether the takeover would move forward, this deal would have made the largest crypto exchange even bigger. However, after doing its corporate due diligence, Binance announced they would not pursue the acquisition. After Binance relinquished interest in taking over FTX, there wasn’t much SBF could do other than the inevitable: file for bankruptcy. 

 

On November 11, FTX moved to file for Chapter 11, along with more than 100 affiliated corporate entities affiliated with FTX, including, but were not limited to, Alameda Research and FTX.US. In that regard, it was initially thought that FTX had more than 100,000 creditors, according to a bankruptcy filing made by Alameda. Even though this number was concerning in itself, a CNBC article quoted lawyers for the company saying “there could be more than one million creditors in these Chapter 11 Cases.” In light of the events that led to the demise of its empire, FTX also announced that SBF had stepped down as active CEO.

 

A presumed FTX hack takes place

 

In light of this scenario, markets remained stressed but at least there was tentative consensus about the situation progressively leaning toward more stability. However, not long after FTX filed for Chapter 11, hundreds of millions of dollars were withdrawn from FTX overnight, in what the firm said was “unauthorized transfers.” The multiple wallets supposedly drained from FTX combined for an alleged $650 million. Given these developments, investors remained apprehensive and a great deal of speculation regarding the environment around FTX and SBF prior to this downfall started to arise. 

According to an article by CoinDesk, “The whole operation was run by a gang of kids in the Bahamas.” Among SBF’s nine housemates are FTX co-founder and Chief Technology Officer Gary Wang, FTX Director of Engineering Nishad Singh, and Caroline Ellison of Alameda (SBF’s trading business at the center of the current chaos and reportedly received $10 billion of customer money). 

 

The risk of contagion

 

This situation has shaken the confidence of crypto asset investors, impacting the price action for the whole asset class—Bitcoin and Ethereum included. It’s also having a stronger price impact to the downside for other major projects that had risen to notoriety in the past crypto bull run. The leaked FTX balance sheet showed Solana’s native token SOL as one of Alameda’s key holdings which would likely need to be sold to generate cash for Alameda under insolvency. Alameda was an early Solana investor, and FTX is a major company backing the development of the technology and a key partner for several projects in the Solana DeFi ecosystem. SOL’s price has been severely impacted since the unwinding of events, with the token currently1 sitting at around 93% below its 2021 all-time-high, and having a one-week decline of ~50%. 

Following the realization of Alameda’s insolvency, Tether USD (USDT)—the largest dollar stablecoin in crypto by market capitalization—briefly lost its peg to the USD, reaching a low of $0.98 late last week. There was some speculation that Alameda could be trying to short USDT using DeFi protocol Curve Finance to exchange USDT for other stablecoins, such as USDC and DAI (MakerDAO’s stablecoin). This caused an imbalance in DeFi liquidity pools, making USDT briefly unpeg with respect to USDC and DAI. USDT volumes in centralized exchanges are naturally a lot bigger than Curve's, so an important part of this USDT movement might have come from elsewhere. 

Furthermore, a recent report by The Block Research also mapped out Alameda’s and FTX Ventures’ portfolios, showing that the two companies had 255 public investments across eight different categories, including crypto-native projects in DeFi, Web3, and NFTs, and centralized crypto infrastructure in trading and brokerage. Their portfolios exhibit major players in the industry, including Polygon, one of the leading providers of a suite of different scaling solutions for Ethereum, and 1inch, an aggregator of decentralized exchanges (DEX) in DeFi.

Contagion risks have also spread through other CeFi companies, with further impacts driven by the fact that FTX was the buyer of last resort for major players that went bust during the Terra/LUNA and Celsius crises earlier in 2022. Among these is BlockFi, which recently halted withdrawals and is potentially filing for bankruptcy as well. Other companies and hedge funds have announced publicly that they had assets held in FTX on behalf of customers to generate yield on crypto or as part of asset management strategies, in which case their liabilities with clients assets won’t be able to be honored until FTX situation comes to a solution. Finally, Genesis, a leader in crypto lending and liquidity provision—including for Grayscale’s flagship product GBTC—has recently suspended redemptions and new loan obligations. All these events show that an objective picture of contagion effects is still far from obvious. We’ll keep track of all that’s currently happening and make sure we get Hashdex’s investors up-to-date as soon as reliable information is provided to the public. 

 

Centralized exchanges and their utility tokens face distrust

 

As another consequence of the unfolding of FTX’s insolvency, the market rightfully started a bigger scrutiny of operations and asset-liability management by all major centralized service providers in crypto, particularly when it comes to CEXs, that account for most of the traded volume in the asset class. Binance’s CZ publicly stated that higher transparency is a must for centralized service providers in the crypto ecosystem, mentioning that his exchange would start doing so-called proof-of-reserves (PoR) showing on-chain, public information on the amount of crypto assets they hold.

While this is certainly an advancement when it comes to market oversight, PoR procedures might be controversial, given that an insolvent exchange can quickly sweep funds from elsewhere to take a snapshot of their reserves and send it back to another exchange and only show a snapshot of the assets they presumably hold on behalf of their clients. Rumors regarding this suspicious activity by some major players came to light when Crypto.com sent 320,000 ETH to Gate.io allegedly by mistake, receiving the funds back some time later, sounding the alarm that some CEXs may be faking their PoRs.

Additionally, given the influence that FTT had in the downfall of Alameda and FTX, utility tokens of CEXs have started to be faced with distrust by market participants, particularly so for those which either have a very limited utility—similar to what FTT had inside FTX—and with a supply that is a large share of their own issuers. This includes Crypto.com’s CRO, Huobi’s HT, and Binance’s BNB, with threats that one (or more of them) could be the trigger for an FTX-like situation in the coming weeks and months. Of these three examples, BNB might be the one least to fear, given it’s the native token that powers the BNB Chain—similar to ETH on Ethereum—and is currently the second largest Layer-1 by on-chain activity in DeFi.2 Of course, care must be taken with any exchange token, so this whole picture can quickly change going forward. 

 

What it means for the future of crypto

 

The recent events have made investors and external observers raise several questions regarding crypto assets. This includes questions around how Alameda and FTX have been able to come this far without any major regulatory intervention, as well as questions about the value of blockchain technologies. While disbelief and criticism are dominating discussions in this space right now, we believe these events are key illustrations of exactly the kind of problems Hashdex is here to solve.

Episodes such as the one involving FTX and SBF clearly show how beneficial it can be to invest in crypto assets through simple, regulated, and secure products. The Alameda/FTX situation was triggered by poor asset-liability management, with severe conflicts of interest and ethical issues revolving around the intertwining of the companies and their leadership. FTX had a significant part of its business residing outside the jurisdiction of US regulators, meaning most of the company’s shady operations couldn’t be easily tracked or go through proper regulatory oversight. Again, similar to Celsius, Three Arrows Capital, Voyager, and BlockFi, what we’re currently experiencing is a consequence of centralized finance (CeFi) players in crypto running their businesses outside of properly regulated territory. In contrast, Hashdex strives to be a leader in providing best-in-class regulated products in crypto, and our obsession over risk is a key piece of the puzzle for crypto investing, where professional auditing, governance, and institutional custody procedures—together with a stringent due diligence of our partners—ensures that FTX-like events can’t have any direct effects on our products’ assets or operational infrastructures. As a result, Hashdex didn’t have any exposure to Alameda, FTX, or the FTT token. Further, we are committed with regulators to advance robust regulatory frameworks for the digital asset space all across the globe.

It’s safe to say that crypto volatility has come back full steam. But it’s also worth reassuring two important facts: (i) crypto has always been an 80+% annualized volatility asset class and (ii) Bitcoin and Ethereum—crypto’s blue-chips and most battle-tested projects—have overcome much worse drawdowns in the past. 

As we’ve been stressing over the past several months, our investment case for crypto has been positively developing at a fast pace in an otherwise bad year for prices: Bitcoin is strengthening as utility and institutional adoption keep growing, Ethereum has gone through its most ambitious upgrade without a hitch, scaling solutions are innovating to bring crypto to billions of users, and DeFi blue-chip projects continue to attract investment and amass new levels of user adoption, with Uniswap recently overtaking Coinbase in ether daily traded volume. 

These data points give us strong fundamentals to lean on, and make us confident there will be many more positive developments to happen in the coming years. We are also confident that the crisis triggered by Alameda and FTX will likely be remembered as a key lesson for the whole industry and regulators, which—similar to Mt. Gox—has the potential to bring fundamental leaps to one of the most disruptive technologies in development today.

 

[1] CoinMarketCap, Solana, accessed November 16, 2022.

[2] Defillama, DEX statistics by blockchain, accessed November 16, 2022.

 

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