The Wrong Lesson from the Fall of FTX
Sam Bankman-Fried doesn’t discredit decentralized finance. He shows why it’s needed.
When Johannes Gutenberg developed the printing press, he placed Europe at the bleeding edge of what would become both a political and economic revolution. The printing press undermined old monopolies on information and lowered the barriers to the pursuit of knowledge.
While Europe embraced prosperity, the Ottoman Empire banned the printing press in 1485 as it threatened the Empire’s religious legitimacy. It would take the Ottomans nearly three centuries to finally adopt the new technology.
The cryptocurrency ecosystem faces similar challenges to the early days of the printing press, especially since the precipitous downfall of the world’s second largest cryptocurrency exchange, FTX, and its crypto-mogul CEO and founder, Sam Bankman-Fried. Coverage of the collapse conflated “old fashioned embezzlement” with a technology that has the potential to build a freer, more secure, and transparent financial system—cryptocurrencies and decentralized finance (DeFi).
DeFi, like the printing press, empowers the individual. It eliminates the control of traditional financial institutions and provides the individual with tools for financial freedom. FTX was not an ally to these efforts and returned crypto back into the hands of centralization. It is vital that the two are not confused, especially in Washington.
Examining core aspects of FTX’s labyrinthine structure, in particular its relationship with the proprietary trading firm Alameda Research, also founded by Bankman-Fried, reveals what did—and did not—lead to FTX’s collapse. With this understanding, one sees that its collapse is not a reflection of cryptocurrency itself. In fact, crypto and specifically DeFi are the solution.
The story of FTX’s rise and fall begins with the formation of Alameda Research, a proprietary trading firm focused on cryptocurrency markets, in 2017. Alameda was Bankman-Fried’s first major venture and focused on investing in startups and trading assets in order to make profits, just like a traditional hedge fund. As FTX’s primary early source of liquidity, Alameda would play a critical role in the eventual collapse of the FTX ecosystem.
FTX was a centralized cryptocurrency exchange (CEX) based in the Bahamas that offered users direct exposure to cryptocurrencies and tradable derivatives, like futures, perpetual futures, and options. Retail users would deposit money into FTX (or so they thought) and then use the funds to buy or sell tokens and other products that FTX offered. In the case of centralized exchanges like FTX, firms maintain custody of users’ cryptocurrency, much like assets held by brokers and their custodians in the traditional financial system.
FTX also issued its own token, FTT, which offered FTX users a slew of benefits, including lower trading fees and the ability to use FTT as collateral on the exchange. Many described this token as the “backbone” of FTX because it provided the exchange with a great deal of liquidity. The token’s value grew from less than $4 in December 2020 to $85 in September 2021, which helped fuel FTX’s valuation from $400 million to $9 billion in the same time period.
Alameda’s market-making activities in FTX’s early days proved critical to FTX’s success, but they also created conflicts of interest that would ultimately be exploited by the firms’ joint management. On the one hand, Alameda’s trading activities on FTX during its early operations “bootstrapped” liquidity on the exchange, enticing customers to FTX and in turn further deepening the liquidity of its markets. At the same time, Alameda was FTX’s largest customer. The joint management of those two firms raised concerns that the exchange was offering preferential terms to its largest “customer.” These concerns would prove valid.
Alongside Alameda, another key role in FTX’s collapse was played by one of its earliest investors: Binance, the largest centralized crypto exchange in the world.
In December 2019, just seven months after FTX’s launch, Binance invested an undisclosed amount of money into FTX. As a part of this deal, Binance also agreed to purchase FTT. About two years later, Binance sold its equity investment back to FTX in return for $2.1 billion of assets, a portion of which was FTT. After this transaction, Binance held around 23 million FTT tokens, or about 25 percent of the token’s total supply. This position meant that by November 2022, two entities—Alameda and Binance—held over 75 percent of the FTT tokens in circulation. Once Binance realized Alameda’s true position in FTT, it assumed Alameda had to be using FTX funds in some way to speculate or prop up the price of FTT.
By November 2022, these relationships set the stage for the rapid collapse of FTX, now understood to be effectively a Ponzi scheme. First, Bankman-Fried founded and managed both the “house” (FTX exchange) and its largest “player” (Alameda), which created opportunities to exploit FTX’s other customers. Second, FTX issued FTT with a low circulating but high total supply, allowing the relatively illiquid market of FTT in circulation to support a large (and misleading) valuation for all FTT, much of which Alameda had used as collateral for loans, including “loans” from unknowing FTX customers. Finally, one of FTX’s primary competitors, Binance, held a large percentage of FTT in circulation, meaning the sale of its position would cause massive disruptions in the relatively illiquid market for FTT.
On November 2, crypto news site CoinDesk revealed that Alameda held a $5 billion position in FTT, or over half of the total circulating and “locked” supply of the tokens. In the piece, CoinDesk reported that Alameda’s balance sheet was “full of FTX—specifically, the FTT token issued by the exchange that grants holders a discount on trading fees on its marketplace. While there is nothing per se untoward or wrong about that, it shows Bankman-Fried’s trading giant Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto.”
Given the close relationship between FTX and Alameda, Alameda’s vulnerable balance sheet raised worries about the strength of FTX. Customers began withdrawing their assets from the exchange en masse while SBF unsuccessfully attempted to allay their concerns, writing in a now deleted tweet that “FTX is fine” and “FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries).” We now know that this statement was false. FTX clients’ assets had been effectively invested in Alameda without their knowledge or consent, and as the price of FTT collapsed, their money evaporated. In all, almost $8 billion dollars worth of customer assets, assets which should never have been at risk to begin with, had been lost.
On November 11, Bankman-Fried stepped down as CEO and was replaced by John Ray, the bankruptcy attorney who led the energy trading firm Enron through its bankruptcy proceedings during its collapse. While investigations continue and Sam Bankman-Fried awaits his trial, it has been revealed that FTX was essentially taking customer assets to engage in speculative activities via Alameda. When the artificially inflated price of FTT fell, Alameda’s massive position was in jeopardy and billions of dollars of customer funds were drained.
As this series of events reveals, the FTX story is not one of novel risks somehow inherent to crypto at large. Customers of FTX, as a centralized exchange, faced the same problems that customers of traditional financial institutions face: They were reliant on human discretion and had to trust institutions to act responsibly and ethically.
Cryptocurrencies and decentralized finance protocols envision a different model of finance: one detached from reliance on fallible humans and risks inherent to activities like fractional reserve banking. These software protocols are designed to obviate the need for centralized institutions in the first place.
To distinguish between these centralized institutions and the decentralized realm of crypto, one must understand its history and objective of creating trustless financial infrastructure open to all. Step back and rewind fifteen years. The 2008 financial crisis had many consequences, one of which was a technological response to the failures of financial institutions and government.
On October 31, 2008, an unknown developer going by the pseudonym Satoshi Nakamoto published the Bitcoin white paper. As Nakamoto later stated in a blog post:
[blockquote]The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.[end block]
According to Nakamoto, the need to trust centralized third parties like commercial banks with holding and managing our money is one of the primary vulnerabilities of the fiat system.
Using a unique data structure called a blockchain, Nakamoto eliminated the need to trust intermediaries by developing Bitcoin, a decentralized and trustless network, with its own cryptocurrency, also named bitcoin.
Bitcoin users are connected through a peer-to-peer network. A P2P network does not use a centralized server and is instead composed of a network of two or more computers (nodes) who share authority to validate and store data. In this manner, no single entity can decide who can or cannot participate in the network, nor have full control of the data it stores. It is democracy embodied in digital form.
A blockchain can be thought of as a public “spreadsheet,” for anyone to use and audit, that records data and changes to that data. Each member of a blockchain network has their own copy of said “spreadsheet,” so if Alex decides to send one token to Katheryn, the group recognizes the transaction as authentic and records it on their copies of the “spreadsheet,” updating the data the blockchain tracks. The recorded history of transactions that is on a majority of “spreadsheets” is deemed the “true” record and agreed upon as such.
A blockchain also takes this a step further, including a variety of transactions on one block that is then linked together to past blocks by cryptographic identifiers known as hash functions. A block displays both its own hash value and the hash value of the previous block, creating a chronological chain. Once transactions are agreed upon and placed on the ledger, they become immutable. As it is nearly impossible for a bad actor to take control or convince a majority of the network to agree upon their fraudulent transaction, security is a fundamental benefit of this decentralized network. There is no central point of failure for a bad actor to attack.
Another vital security mechanism of decentralized network-based digital assets is users’ ability to hold their own digital assets by using wallets that connect to a blockchain through the internet and provide an interface for communicating with the network. Wallets eliminate the need to trust intermediaries to safely hold their assets in custody, meaning users are no longer susceptible to security breaches on a central server or mismanagement of assets by intermediaries—vital security measures FTX customers did not have.
Once Bitcoin revealed this technology’s revolutionary possibilities, the market demanded services beyond peer-to-peer transactions such as the exchanging, lending, and borrowing of digital assets. It was only a matter of time before decentralized finance, or DeFi, emerged. Like Bitcoin, DeFi has lowered the barriers of entry for anyone in the world to freely transact and use financial infrastructure without the encroachment or abuse of authoritarian regimes and financial intermediaries. All anyone needs to participate in the global economy is an internet connection.
DeFi is built on a similar foundation as Bitcoin but with expanded capabilities enabling financial services beyond just payments. One important mechanism is known as a smart contract—software deployed on blockchains that will automatically execute the terms of an agreement upon the fulfillment of certain predefined conditions. A simple example is a smart contract that holds digital assets and is programmed to send those assets to some recipient wallet on a date ten years in the future. Once that date is reached (the predefined condition), the smart contract automatically executes the transaction.
A more complicated example is a decentralized exchange. Decentralized exchanges are one subset of DeFi protocols through which users can exchange a variety of digital assets. Instead of relying on brokers, centralized exchanges, or clearing houses, decentralized exchanges are software programs deployed on public blockchains that use smart contracts to self-execute the terms of an agreement, in this case the exchange of one asset for another.
Unlike decentralized exchanges, centralized exchanges like FTX perform their operations by taking custody of customers’ assets, much like traditional financial institutions. Their operations are not transparent, and their balance sheets are not visible. Therefore, vulnerabilities associated with trust-based systems are replicated, as painfully evidenced by the collapse of FTX.
Decentralized exchanges provide several critical advantages. First, a decentralized exchange user never relinquishes custody of her assets. The users connect their wallets to the protocols’ smart contracts and never give up control. They do not have to worry about anyone commingling their funds, embezzling them, or using them for risky investments.
Another important advantage is that, because a blockchain is a public ledger showing balances, transactions, and smart contract codes, the DeFi protocols are auditable by design. The security of underlying code can be reviewed in real time. This transparency allows users to make informed choices about which protocols they want to use.
In contrast, the opacity of centralized exchanges’ operations makes it virtually impossible for customers to assess their financial stability or security. A potential customer has limited tools to differentiate between a financially stable centralized exchange and one on the brink of bankruptcy. Looking back on the FTX and Alameda relationship, Alameda was trading against FTX’s own customers while also effectively stealing their assets. Meanwhile, decentralized exchanges are software; they cannot have conflicts of interest.
This brings us back to the failure of FTX. It was a centralized exchange, no different than a traditional financial institution, which held consumer assets and abused customers’ trust. That unethical behavior led to the loss of billions for consumers and a broad defaming of all things crypto in the media.
Two things about the FTX debacle merit spelling out. First, this catastrophic downfall was not caused by some vulnerability inherent to digital assets. There is a good reason that bank runs and the 2008 financial crisis are the comparisons most often used to describe what went wrong at FTX—these are issues from which we have long suffered. Ultimately, FTX was the end product of faulty business practices in an environment that made it easier to obfuscate mismanagement of assets. Centralized financial institutions, be they in traditional markets or digital asset markets, are reliant on the integrity of people.
Second, and perhaps counter to the post-FTX alienation of “crypto” in mainstream media, FTX provides a sobering reminder of the importance of decentralization as a tool for solving centuries-old problems. Decentralized exchanges’ trustless nature protects them from the pitfalls of corporate malpractice. Throughout the turmoil, despite the market downturn, DeFi protocols have continued to operate without disruption by virtue of allowing consumers to maintain control over their assets.
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Can we honestly say the FTX collapse could have been avoided through decentralization? It all depends on how pure and resilient that decentralization is. What we can say is that FTX was not an accurate representation of the core innovation of digital assets. We should not let a conflation of centralized intermediaries like FTX and truly novel decentralized systems slow innovation in the development of technology that could better protect consumers in the future.
The policy response to FTX should focus on empowering further innovation and experimentation in DeFi to mitigate the risks associated with traditional, intermediated finance models, as it is paramount that American innovators are met with support that welcomes the human imagination and nourishes its creativity.
Tomorrow’s solutions will not be formulated in an office in Washington, nor within the corridors of Wall Street. They will not be developed by those solely set out to make a profit by any means necessary. Instead, they will be discovered and developed by people with hopes of freedom and prosperity, set out to provide an alternative to a system that has served too few for centuries and at an unacceptably high cost.