The collapse of FTX demonstrates how unstable the cryptocurrency market really is

It’s quite simple for an empire you built with joke money to disappear overnight. That is the easiest explanation for the collapse of the once-dominant cryptocurrency exchange FTX, which filed for bankruptcy on Friday. At the start of November, FTX was in charge of one of the most valuable cryptocurrency exchanges in the world, and Sam Bankman-ownership Fried’s stake in the business was estimated to be worth over $16 billion. Bankman-Fried is no longer the CEO of FTX, his stock is currently worth about nothing, and many of the company’s clients are unsure of when they will receive their money back.

So what took place? Fundamentally speaking, FTX was victim to the equivalent of a bank run: its clients lost faith in it, became concerned about the security of their investments, and rushed to withdraw their money. Given that the value of the company depends on people using its trading platform, this was obviously very terrible for FTX’s operations. But FTX is not a bank; it is an exchange. You might have reasoned that once it had returned people’s money and had the assets belonging to them on hand, it would have been able to weather the storm.

But you would have been mistaken. According to Reuters, FTX had lent at least $4 billion in customer cash to a cryptocurrency trading company named Alameda Research, which Bankman-Fried also owned. And Alameda, which has suffered significant losses as cryptocurrency prices have fallen precipitously in recent months, was unable to repay those debts, at least not right away. Customers tried to withdraw their assets, but FTX was missing them. bankruptcy follows.

In that regard, you could see FTX’s demise as just a typical financial swindle, in which the CEO of one firm used client monies to try to patch holes at another one he owned. These were all unpleasant, and possibly criminal, things. The fact that so much of the “money” involved in this story was essentially generated by FTX in the form of its own crypto currency, FTT, is what distinguishes and makes the FTX story noteworthy. The majority of FTX’s own capital was made up of FTT. Additionally, billions in FTT were used as collateral for the loans it provided to Alameda.

In other words, FTX was lending Alameda billions of dollars under the security of its fictitious currency so that Alameda could place wagers on other fictitious currencies. In that regard, the value of the company was the result of what you could call a mutual hallucination. Everyone consented to act as though FTT was truly valuable because doing so would allow FTX to keep the balls in the air.

The issue was that FTX’s empire was doomed to fall once people stopped pretending. And that’s what happened last week when Binance—one of FTX’s main rivals—announced that it would be selling its entire interest in FTT. As a result, the value of FTT fell by more than 80% in only two days after the announcement.

This decreased the value of FTX, and because a sizable portion of Alameda’s assets were held in FTT, it also decreased the value of Alameda’s collateral and its capacity to repay FTX. As a result, FTX’s finances became more precarious, which in turn led to customers wanting to withdraw their funds from FTX and making them wary of holding FTT. It was a classic case of a financial death spiral that was effectively set off by Binance’s assertion that the emperor was naked. Additionally, it was expedited by the fact that neither FTX nor Binance publishes audited financial reports, leaving clients of FTX with little to no knowledge of the firm’s balance sheet.

Undoubtedly, a financial institution’s reputation affects how well it is doing. But if your entire company may fail in a couple of days due to one of your competitors selling off its holdings in your token, you have to question how stable your company was to begin with. FTX was a legitimate business as an exchange (and will presumably emerge from bankruptcy intact). However, the irrational prices affixed to it, which made Bankman-Fried a multi-billionaire, were largely based on misconceptions about the value of crypto assets.

At this point, it goes without saying that cryptocurrency traders already know—or at the very least, should know—that the value of their holdings is largely dependent on the whims of the crypto community. The startling thing about FTX’s collapse is that it raises the possibility that enterprises that cater to the cryptocurrency market may experience a similar fate: They are most valuable when people behave as though a dream is genuine. Which is fantastic—until everybody chooses to get up.