Why the Crypto Collapse Matters

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How could a $32 billion company evaporate overnight? This is what anyone watching the sudden collapse of FTX, a hot cryptocurrency startup that went bankrupt last week, might be puzzled.

It will take time and multiple federal investigations to fully understand what went on behind the scenes at FTX, a Bahamas-based crypto exchange. But the impact is already being felt. Lawmakers are asking for more control. Crypto die-hards are trying to distance themselves. Critics of this sector of finance are making themselves heard. And for those of you who had, until now, managed to ignore the rise and rise and rise of crypto as a phenomenon? First of all, good for you. And second, you might want to watch this one unfold. I will explain why shortly.

But first, here’s the simplest explanation I can manage of what happened: FTX allowed individuals and businesses to buy and sell digital currencies, holding billions of dollars in deposits of clients. FTX founder Sam Bankman-Fried also created an investment fund that trades cryptocurrencies called Alameda Research. The companies were supposed to be separated, but this year Alameda needed cash and apparently tapped into deposits from FTX customers. Then, this month, FTX customers grew concerned about their deposits and rushed to withdraw them, triggering a bank run and pushing FTX into bankruptcy.

The apparent mixing of funds between Alameda and FTX is highly suspicious and could lead to criminal fraud charges and prosecution. The Securities and Exchange Commission and the Department of Justice are investigating. I want to explain today why the disintegration of FTX is more than just a financial catastrophe for a man.

Three reasons

1. Crypto has gone mainstream in the pandemic. Regulation has yet to catch up.

Cryptocurrencies were among the overlapping investment fads including meme stocks, trading cards, NFTs, and sneakers that had people seeking speculative investments in recent years. But not all buyers understood the level of risk involved.

If a bank fails, the government can step in and bail it out. A hallmark of crypto is that it is largely unregulated, buyer beware. Hacks cannot be reversed, misplaced funds cannot be recovered by calling customer service, and a failing crypto exchange is unlikely to get a government bailout. Investors have few protections.

Risky bets on several crypto projects once deemed valuable have already led to death spirals this year, incinerating billions of dollars of investor money. But FTX and Bankman-Fried stand out. He appeared on magazine covers, made jokes about regulators, grew his profile in philanthropy and politics, and even sponsored a sports arena in Miami. He made hundreds of investments in small crypto projects and aggressively bailed out those that failed.

Evangelists of cryptocurrencies and their underlying technology promote them as investment vehicles that eliminate the need for trust in people and institutions. But Bankman-Fried was keen to foster trust: investors, journalists, politicians and charities. Now he’s an outcast, and he’s put the entire crypto industry under scrutiny.

2. The collapse of FTX is tied to the broader pullback in the tech industry.

Bankman-Fried is already drawing comparisons to Bernie Madoff. And just as the Madoffs Ponzi scheme collapsed during the 2008 financial crisis, the collapse of FTX comes amid a broader setback for the tech industry. Tech stocks crashed. Venture capital funding is drying up. Nearly 800 tech companies have laid off more than 120,000 workers this year, with cuts hitting Meta, Amazon and Twitter.

Technology’s tough times can be attributed to interest rates for borrowing money. For more than a decade, rates were low, prompting investors to chase away risk and pump money into high-growth tech companies. Today, rates are rising, just as the pandemic-fueled growth of the past two years is fading. Rate increases have hurt tech company valuations and access to capital, including those focused on crypto.

What to know about the collapse of FTX

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What is FTX? FTX is a now bankrupt company that used to be one of the largest cryptocurrency exchanges in the world. It allowed customers to exchange digital currencies for other digital currencies or traditional money; it also had a native cryptocurrency known as FTT. The Bahamas-based company has built its business on risky business options that are not legal in the United States.

Who is Sam Bankman Fried? He is the 30-year-old founder of FTX and former CEO of FTX. Once a golden boy of the crypto industry, he was a major donor to the Democratic Party and known for his commitment to Effective Altruism, a charitable movement that urges adherents to donate their wealth in efficient and logical ways.

How did the FTX problems start? Last year, Changpeng Zhao, the chief executive of Binance, the world’s largest crypto exchange, sold his stake in FTX back to Mr. Bankman-Fried, receiving a number of FTT tokens in exchange. In November, Mr. Zhao said he would sell the tokens and expressed concerns about FTX’s financial stability. This decision, which lowered the price of FTT, spooked investors.

What led to the collapse of FTX? Mr. Zhaos’ announcement drove the price down and spooked investors. Traders rushed to pull out of FTX, resulting in an $8 billion shortfall for the company. Binance, FTX’s main rival, offered a loan to save the company, but then pulled out, forcing FTX to file for bankruptcy on November 11.

Why was Mr. Bankman-Fried arrested? FTX’s collapse sparked Justice Department and Securities and Exchange Commission investigations focused on whether FTX improperly used client funds to support Alameda Research, a crypto trading platform Mr. Bankman-Fried had helped get it started. On December 12, Mr. Bankman-Fried was arrested in the Bahamas for lying to investors and committing fraud. The next day, the SEC also filed civil fraud charges.

3. There’s more to come.

FTX’s bankruptcy filings list over a million creditors. In addition to people who used the platform to store their cryptocurrency investments and investors who directly supported the company, many crypto funds and start-ups had assets locked up there.

Investment managers who have dabbled in crypto should really consider whether they should have relatively new, relatively unproven and relatively unregulated assets in their retirement plans, said Marcia Wagner, founder of the Wagner Law Group, a company focused on employee benefits. There are certain types of assets that frankly don’t belong.

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