Why are cryptocurrency exchanges collapsing?

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The collapse of FTX, one of the world’s largest cryptocurrency exchanges, has caused a lot of turmoil in the highly speculative digital asset market. FTX founder Sam Bankman-Fried’s fortune dropped from nearly $16 billion to nothing in a matter of days when his cryptocurrency empire filed for bankruptcy protection in the US on November 11. How did the stock market lose its profitability overnight?

What was the structure of FTX and what was its business model?

In corporate terms, FTX was a chaotic network of over 100 different companies, united under the common ownership of Bankman-Fried and his co-founders Gary Wang and Nishad Singh. In his bankruptcy filing, John Ray III – a U.S. bankruptcy specialist who previously oversaw Enron’s collapse – described it as four main “silos”: the venture capital arm that invested in other businesses; a hedge fund that traded cryptocurrencies for profit; and two exchanges, one ostensibly set aside and regulated for the U.S. public, and one international exchange.

Revenue streams were as diverse as the business, but the core of the group was the stock market. Most people buy cryptocurrency by transferring money (“fiat”) to an exchange such as FTX, which acts as an exchange for currency pairs at a floating exchange rate. The regulated FTX exchange offered this service and the company charged a commission on each trade, but the big bucks were in much more aggressive international exchange trading where traders tried to profit from crypto asset price fluctuations by lending money to increase their potential profits (or losses).

What was the cause of the fall?

All “thanks” to a token called FTT. In fact, it was a share in the FTX exchange that the company issued itself and promised to buy back using part of its profits. However, documents leaked to news site CoinDesk suggested that Alameda, the group’s hedge fund, used the FTT to make risky loans – effectively trading using company scripts. The discovery prompted the main holder of FTT, rival exchange Binance, to announce that it was selling its shares, sending the exchange crashing as other clients scrambled to withdraw their funds.

The exchange was unable to accept bank transfers, so customers sent money to Alameda and FTX credited their accounts. But the actual money was never transferred.

What does the fate of FTX tell us about cryptocurrencies?

The crypto industry has drawn various conclusions from this situation. Some argue that the collapse is a triumph of “decentralized finance” (DeFi), which uses computer code to create versions of financial services that do not rely on trust or a central party.

Some people will get their money back, but no one will get everything. Even Bankman-Fried is convinced that an $8 billion capital injection would be needed to keep every depositor healthy. However, it is said that there is not a single document detailing all the company’s depositors.

There are already signs of a side effect. BlockFi, a cryptocurrency lender rescued by FTX in the summer of 2022, has halted customer withdrawals, admitting it has “significant exposure to FTX.” Soon after, cryptocurrency exchange Genesis “made the difficult decision to temporarily suspend buyouts” from the company’s lending business after a series of withdrawals from the service.

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