Impact of FTX's Collapse Will Go Far Beyond Its Customers

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Sam Bankman-Fried lent his trading firm Alameda Research $10 billion of his FTX exchange customers' money, according to the Wall Street Journal.

The startling number, which a source "familiar with the matter" said represents more than half of all funds deposited on FTX, exposes the depth of the formerly No. 2 cryptocurrency exchange's troubles as it seeks to avoid bankruptcy. FTX holds, or held, $16 billion of customers' funds, that source added.

In his conversation with that person, Bankman-Fried reportedly described the loan — which he apparently kept secret from other executives —  as a "poor judgment call," in the WSJ's words.

The U.S. Justice Department, Securities and Exchange Commission and Commodity Futures Trading Commission may describe it in other terms, as all three are reportedly investigating the debacle.

The popular and increasingly high-profile Bankman-Fried's two-company empire's troubles began with a Nov. 2 report by CoinDesk that the vast majority of Alameda's assets consisted of the FTT cryptocurrency issued by FTX.

That snowballed quickly, with concerns leading to a run on FTX, as investors tried to withdraw at least $5 billion on Sunday Nov. 6. By the next day, the price of FTT was collapsing, losing more than 80% of its value by Nov. 8.

Facing a "liquidity crunch," Bankman-Fried agreed that day to sell FTX to rival exchange Binance — which pulled out of the deal on Nov. 9. That same day, FTX halted withdrawals.

Having lent billions to Bankman-Fried's high-risk trading company, FTX faced a liquidity crunch that turned into a shortfall as the price of FTT collapsed. He is reportedly still trying to save FTX, telling investors that he needs $8 billion to cover all customers' funds.

With Bankman-Fried having turned himself into one of the most visible crypto industry lobbyists in Washington, D.C., pushing for a laxer oversight regime, FTX's collapse will also likely add firepower to SEC Chairman Gary Gensler's campaign to force cryptocurrency exchanges to register as securities brokers. Brokers are required to keep customers' funds fully segregated, to prevent their loss in case of the company's own financial woes.

'I F**** Up'

Bankman-Fried unleashed a long mea culpa thread on Twitter on Thursday, beginning with an apology and an admission that "I f***** up, and should have done better."

On Nov. 10, a banner announcement on the FTX US website warned that "trading may be halted on FTX US in a few days. Please close down any positions you want to close down. Withdrawals are and will remain open."

FTX international's fate remains unclear, although bankruptcy seems to be an increasingly likely outcome. It would join a slew of crypto lenders like Celsius and Voyager Digital that became insolvent following the $48 billion imposition of the Terra/LUNA stablecoin ecosystem in May.

CoinDesk reported on Thursday that a few users had been able to withdraw funds from FTX, but it's not clear that this is broadly available as FTX's website still says it cannot process withdrawals.

Meanwhile, the damage has spread beyond FTX into the broader industry, with the largest stablecoin, Tether's USDT, losing its dollar peg — dipping nearly two cents to $0.9815 before regaining its peg. Beyond that, Tether said that it has frozen $46 million worth of FTX's USDT on the Tron blockchain following a request from law enforcement.

And, much of the entire crypto industry was dragged down, with Bitcoin falling briefly into the $15,000 range. It has since rebounded to about $17,300 at the time of publication.

Three Big Problems

There are several big issues in play here beyond the impact of FTX's collapse on its investors.

First, there is the impact on the credibility of the cryptocurrency industry in general, which has been strained by the year-long collapse in the price of Bitcoin and other tokens, a run of massive hacks and the spectacular implosion of the Terra/LUNA stablecoin ecosystem in May.

Second, there is the impact it will have on regulators, who have been growing increasingly aggressive with the industry.

Third, there is the impact it will have on the political battle to create a regulatory framework for cryptocurrencies in the U.S., currently paused for the midterm Congressional elections held Tuesday.

Crypto Credibility Hit

The cryptocurrency industry has been broadly hit by the crypto winter, which had seen Bitcoin lose some 70% of its value in the past 12 months even before the impact of this week's events.

Then it took a big hit in May with the collapse of the UST stablecoin and its partner token LUNA, which destroyed $48 billion in investments in the space of a week following a run. That led to the collapse of an important crypto hedge fund, Three Arrows Capital, which in turn led to a slew of bankruptcies among crypto lenders, with more retail investors losing billions of dollars.

On the crime front, there have been a string of crypto hacks, notably the $625 million Ronin Network bridge hack and more than 125 more that have seen more than $3 billion stolen in 2022 — including $718 million in October alone, blockchain intelligence firm Chainalysis reported. The Ronin hack, carried out by North Korean government hackers according to the U.S. Department of Justice, led the Treasury Department to place sanctions on the Tornado Cash mixing service, which was allegedly used to hide those funds.

The collapse is going to have broad consequences, Binance's Zhao predicted. "FTX going down is not good for anyone in the industry… confidence is severely shaken," he tweeted on Nov. 9. "Regulators will scrutinize exchanges even more. Licenses around the globe will be harder to get."

Another fallout of the FTX collapse is that at least 11 major exchanges including Binance, Crypto.com, Gate.io, Kraken, KuCoin, Poloniex, Bitget, Huobi, OKX, Deribit and Bybit have all announced plans to publish proof-of-reserve statements regularly, or have pointed out that they already do. As a publicly traded company listed on Nasdaq, Coinbase effectively does this.

Calling FTX's failure "a critical moment for the entire industry," Crypto.com CEO Kris Marszalek, tweeted that:

"It should be necessary for crypto platforms to publicly share proof of reserves. Transparency is more important than ever… Restoring trust in our category will take time, but it's incumbent on us to send a strong message to the world that there are trustworthy crypto platforms."

Regulatory Outlook

The Securities and Exchange Commission and state securities regulators have been getting increasingly aggressive about their contention that virtually all cryptocurrencies are securities this year, notably fining BlockFi $100 million for failing to register its crypto lending operation under the Securities Act.

At the beginning of the year, SEC Chairman Gensler warned cryptocurrency exchanges that the SEC would be targeting them for failing to register with the SEC as securities brokers. The industry has strongly challenged that, most notably in payments firm Ripple's ongoing legal battle with the SEC — which sued it for illegal securities sales of XRP.

"I've asked staff to look at every way to get these platforms inside the investor protection remit," Gensler said on Jan. 19, Bloomberg reported. "If the trading platforms don't come into the regulated space, it'd be another year of the public being vulnerable."

With FTX having imploded, that will likely jump to the top of the SEC's crypto agenda. Indeed, Gensler told CNBC on Nov. 10 that the crypto field as a whole is "significantly non-compliant" and that while the best solution is for exchanges to register and comply with what he said are "very clear" regulations, "the runway is running out."

Certainly it seems to be climbing up the CFTC's agenda, with Commissioner Kristin Johnson telling CoinDesk TV that with a regulatory gap that limits regulators' authority, Congress should not let "a good crisis go to waste." She added:

"Now more than ever, it is clear that there are major consequences when cryptocurrency entities operate without robust federal oversight and protections for customers."

That's not necessarily a bad thing, Coinbase exchange CEO Brian Armstrong said on Twitter, despite his frequent and harsh criticism of the SEC.

Calling the lack of such a framework one of the biggest problems the industry faces, he noted that FTX "was an offshore exchange not regulated by the SEC," adding that the lack of clarity has driven American investors and 95% of all trading activity offshore."

Political Power

The crypto industry has been having a fair amount of success in pushing its agenda in Washington, D.C., this year, where a number of bipartisan bills seeking to regulate the industry have been introduced.

Those pieces of legislation, including the Responsible Financial Innovation Act by Sen. Cynthia Lummis (D-Wyo.) and Kirsten Gillibrand (D-N.Y.) and the Digital Commodities Consumer Protection Act by Senate Agriculture committee's chair, Sen. Debbie Stabenow (D-Mich.) and ranking minority member, Sen. John Boozman (R-Ark.) generally seek to give the CFTC more authority over the cryptocurrency industry at the expense of the SEC — which fits well with the political agenda crypto lobbyists have been pushing.

The highest profile of these has been Bankman-Fried, who had pledged to spend more than $100 million on the 2024 election cycle and has been a frequent presence on Capitol Hill. On Nov. 10, The Block reported that FTX US had resigned from the Crypto Council for Innovation, a lobbying group.

With the implosion of FTX added to the Terra/LUNA stablecoin collapse and crypto lender bankruptcies, the industry's aim to get a more hands-off regulatory regime has been dealt a serious blow.

Saying "I don't think I've ever experienced anything like this," Blockchain Association Executive Director Kristin Smith told Protocol this week that the FTX collapse "is a step backwards in terms of the advocacy in Washington."

Many members of the House and Senate interested in crypto regulation put out statements calling for speedy legislation, with Sen. Boozman saying that the "events that have transpired this week reinforce the clear need for greater federal oversight of the digital asset industry."

He added that he and Sen. Stabenow would be reviewing their bill "to ensure it establishes the necessary safeguards the digital commodities market desperately needs."

House Financial Services Committee Chair, Rep. Maxine Waters, (D-Calif.), said FTX's problems show that "now more than ever, it is clear that there are major consequences when cryptocurrency entities operate without robust federal oversight and protections for customers."