The Lehman Moment in the Crypto Market: Why is the FTX Crisis Critical?

Is the FTX crash the crypto industry’s Lehman Brothers moment? The collapse of FTX came as a surprise to many. However, as more information pours in, it looks like FTX’s liquidity crisis started sooner than previously thought.

How did the FTX crisis develop?

FTX, the world’s third-largest crypto exchange, kicked off with a $400 million Series C funding round. It later increased its valuation to over $32 billion. Ten months later, it went bankrupt after Binance’s buyout bid failed.

Sam Bankman-Fried founded FTX with multiple major brand and sponsorship partnerships and raising billions. That’s why he was seen as one of the biggest global crypto players. The funding of the crypto exchange has never been questioned, given that it bailed out multiple lenders during the crypto epidemic in the second quarter of 2022. However, things took a wild turn in the second week of November.

It started with a report on Alameda Research’s illiquid FTX Token (FTT) holdings and the discrepancy in FTT’s market cap. FTT tokens have a liquid market capitalization of approximately $3.35 billion, while Alameda had approximately $5.5 billion worth of FTT in collateral and debt leverages.

Following the report, Binance CEO Changpeng Zhao announced the liquidation of all FTT assets. Binance received roughly $2.1 billion in cash equivalents in Binance USD (BUSD) and FTT. However, more than the purges, it was the wording of Zhao’s tweet that stood out. He said they don’t support people who “lobby behind their backs against other industry players”. In this context, he made the following statement:

Liquidating our FTT is just post exit risk management. We learned this from LUNA. We have supported before. However, we’re not going to pretend to have sex after the divorce. We are not against anyone. However, we will not support people who lobby behind their back against other industry players.

Zhao’s cunning against Sam Bankman-Fried and his lobbying efforts against the decentralized finance (DeFi) market created a panic in the market. Then, it led to the massive sale of FTT. Bankman-Fried said the next day that everything was fine in the stock market and that a competitor had created a FUD. But that didn’t help Bankman-Fried’s case or FTT’s fall as the token continued to bleed. Thus, the price dropped below $20 and put pressure on FTX.

Crypto industry’s Lehman Brothers moment: FTX collapse

Just a day after reassuring the crypto community that all is well and that FTX has the funds to support clients’ holdings, Bankman-Fried announced that FTX is in a deep liquidity crisis and is working on a plan to sell its global exchange to Binance. About 48 hours later, Binance said that after looking at FTX’s internal ledgers, it realized that the situation was too advanced for it to be able to help, and that it withdrew from the deal.

Another report stated that Bankman-Fried sought $8 billion in emergency funds to compensate for user withdrawals, and user funds were also misused.

$8 billion deficit on balance sheet vs % market cap of FTX / Source: True Insights

Looking at the numbers, it’s clear why Binance decided to withdraw from the deal. Because the $8 billion deficit represents almost 20% of Binance market cap after the crash.

Rob Viglione, CEO of Web3 infrastructure company Horizen Labs, said that the ongoing scenario could never happen in traditional finance, as the United States Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve system provide regulatory oversight and act as a turning point.

When Bankman-Fried said that the stock market was liquid, he might indeed have been right. The only problem with the exchange was that it was heavily liquid in FTT. He used it extensively as collateral. Jonathan Zeppettini, leader of strategy at Decred, describes the crypto industry’s Lehman Brothers moment as an FTX epic.

“Never use a token that you print as collateral”

It turns out that the biggest culprits for FTX’s decline are its partner firm Alameda Research and its token FTT. While crypto lenders like Three Arrows Capital and Celsius struggled to deal with the Terra crash, Alameda managed to weather the crisis. However, now, it looks like trouble began to brew for the firm in the second quarter. A transaction of 173 million FTT on September 28, which was worth about $4 billion at the time, indicates that FTX may well have saved Alameda during the crypto contagion and well aware that 173 million well-deserved FTTs will be released in September.

According to on-chain data, the FTT token supply increased by 124.3% on September 28, when 173 million FTT tokens were created through the 2019 contract with Alameda as the buyer. Alameda then sent the entire newly minted FTT back to an FTX address. This has led many to believe that this is a loan repayment. Rumors later abounded that FTX had saved Alameda using unreleased FTT as collateral.

Lucas Nuzzi, president of crypto analytics firm Coinmetric, believes that FTX not only helped collapse Alameda, but subsequently saved 173 million FTT from liquidation. This theory was later confirmed in a Reuters report suggesting that Bankman-Fried transferred at least $4 billion in FTX funds, which were secured by assets including FTT and shares in the Robinhood Markets Inc trading platform. Some of these funds were customer deposits.

Background of the FTX crash and its impact on the crypto industry

Eric Chen, CEO and co-founder of DeFi research form Injective Labs, says that FTX’s uncontrolled native token FTT-based obligations have reached a point where it is impossible for the exchange to return. He makes the following statement on the subject:

FTX was in a position where its liabilities far exceeded its assets. In fact, it was reported a few days ago that Alameda’s balance sheet is not very healthy. Alameda is closely linked to FTX. The firm also held a significant portion of its assets in FTT. As the value of FTT began to decline rapidly, Alameda was likely no longer able to meet its obligations. This led to a great whole in the FTX balance sheet.

Alameda had an “unlocked FTT” of $3.66 billion at the end of June. It also had approximately $15 billion in assets, with $2.16 billion in FTT collateral. Joshua Peck, founder and chief investment officer of crypto hedge fund Truecode Capital, told Cointelegraph:

They apparently used this token to transfer client funds from FTX to the Alameda hedge fund, also owned by Bankman-Fried, in exchange for collateral they could create out of nothing. It appears that customers would not be at risk if Alameda were able to return the funds. However, it is clear that they are making illiquid investments. Therefore, client funds could require the sale of a set of interest from tokens locked in smart contracts. Many of them are now nearly worthless if sold at market value today.

The fall of FTX is one of the biggest self-inflicted wounds for the crypto industry. Perhaps it would have been possible to prevent this tragedy if FTX had been as transparent as its CEO had previously claimed. The drop is also pending a possible investigation into FTX’s US sister company. The FTX crisis highlights the problem of centralization in the crypto ecosystem, which is ironically rooted in the decentralization ethos. In the absence of clear regulatory guidelines, many more giants like FTX will explode on their own. By the time these fiascos come to light, it’s too late to save the company from disintegration.