Imagine being a famous and talented painter, you just finished a masterpiece, and you put the painting up for auction. The painting sells for $1 million dollars, and you think to yourself “wow, I may be onto something here with this painting.” All good so far, nothing out of the ordinary. Now imagine you paint 20 more of the same painting and keep them all to yourself. You now declare your net worth to be $20 million dollars (because the first one sold for a million, so why wouldn’t the others?). There’s an obvious problem here. Sitting tucked away in some vault it may feel like the paintings are worth $20 million but put that second one up for auction and you’ll realize no one wants to pay a million dollars for the second edition. This example is harmless enough, after all it’s just one artist tricking themselves into thinking their rich beyond their wildest dreams. But imagine if that artist took out a huge loan based on the theoretical value of those 20 paintings. Now, as long as they can keep paying back what they owe each month, still no issues, but as soon as they’re forced to sell one of those painting to pay back the loan… uh oh, that painting isn’t actually worth what they thought it was, and it turns out they couldn’t even afford that loan in the first place. In the real world, this could never happen, the loan underwriter would take one look at those 20 identical paintings and say those aren’t worth $20 million dollars, denying your loan application. Unfortunately for the thousands of people who recently lost money in the FTX crypto exchange debacle, the checks and balances of the traditional financial system haven’t quite made it into the world of cryptocurrency.

In the example above, a single artist created a bunch of fake money by declaring their paintings to be worth $1 million dollars each. What Sam Bankman-Fried (SBF), the CEO of FTX Cryptocurrency Exchange did was create a crypto token called FTT, sell a portion of the total supply on the open market, and then kept the rest on FTX’s balance sheet, declaring it to be worth millions of dollars. This in itself isn’t the craziest thing in the world, in fact it’s not all that out of the ordinary in the crypto space. In theory, everyone knows that the declared value of these assets vastly outweighs what they could be sold for on the open market. Just like the paintings, every time SBF takes a FTT token off the FTX balance sheet and sells it on the open market, the total amount of tokens available to buy increases, thus decreasing the value of each individual token. So, to recap, it’s fine to say those FTT tokens are worth millions of dollars, as long as you realize that you can’t actually get those millions of dollars by selling the tokens. So far SBF and FTX haven’t done anything illegal or immoral, but as often happens when talking about millions of dollars, greed eventually led to some questionable (at best) decisions. To understand what happened next, we have to dive into FTX’s sister company Alameda. Alameda was a hedge fund created by SBF that actively traded in the crypto markets in order to make a profit, at its core it was no different than any traditional hedge fund. Alameda would take loans from other big players in the crypto industry and use those funds to add size to their trades, theoretically allowing for more profits. This entire system however, started to unravel in May of this year when a different cryptocurrency unrelated to FTX/Alameda crashed to zero (I won’t go into specifics here, but the coin in question was TerraLuna’s UST), causing several prominent crypto companies to declare bankruptcy. This seriously spooked all those companies that had been loaning Alameda money for their trading business and caused several of them to request early repayment of some, or all of their loans. Unfortunately for Alameda, 2022 had been a rough year for trading cryptocurrencies, they hadn’t been making any profits, let alone enough to repay all of those loans. So, in order to avoid going bankrupt, SBF and FTX gave Alameda favorable terms on new loans so that they could pay back what they currently owed. The underlying thought behind this whole idea was that eventually the crypto industry would enter another bull market, and Alameda would be able to make all this money back through trading. The inherent connectedness of FTX and Alameda make these loans questionable, but when you took a look at FTX’s balance sheet it seemed like they had significantly more capital than had been deposited by customers, giving them plenty of room to make these loans and still have the money to pay back any customer that wanted their money. And in theory, this was the case. But in reality, a significant portion of the money on FTX’s balance sheet was tied to FTT, and you’ll remember that FTT is only theoretically worth millions of dollars, as soon as you start to sell it for cash, its real value is significantly less. So FTX loaned Alameda some of this theoretical FTT money, but their creditors were never going to accept just FTT as repayment for their loans, because they know in reality it’s worth quite a bit less if they needed to sell it for cash. SBF thought about this and concluded that they would also loan Alameda some of their customer deposits, specifically the ones in the most highly traded cryptocurrencies, allowing for Alameda’s creditors to sell them right away for close to face value. The reason behind this decision was that FTX still had plenty of assets on their balance sheet to cover all customer deposits, even if they had loaned out some of the actual deposits. They loaned Alameda Bitcoin that customers had deposited but thought to themselves that if a customer wanted to withdraw their Bitcoin, all they had to do was use some of that FTT they had in order to make the customer whole. If SBF and FTX were able to successfully maintain customer trust in their exchange, and a large portion of customers simply left their deposits to either increase or decrease in value along with the market, they could’ve potentially gotten away with it. They were imagining a scenario where the entire industry goes into a bull market, and Alameda quietly pays back those customer funds with the enormous trading profits that they would inevitably make (the inevitableness of which being in serious question by anyone not employed by the firm). Unfortunately, they never quite got the chance to turn that fantasy into reality.

Looking back at this whole debacle, the day where the potential failure of FTX became the inevitable failure was on November 6th, when the CEO of Binance (another crypto exchange) tweeted that they were selling all of their FTT tokens on the open market. Binance held a significant amount of FTT, more than enough to plummet the price of the token should it all be sold at once. FTX and Alameda knew that if the price of FTT fell too much they would no longer have the theoretical funds to cover their customer deposits, so they made an offer to privately purchase all of Binance’s FTT for $22 per token, which would have been significantly more than Binance could have hoped to get on the open market. This offer, rightfully so, caused some real concern as people started to speculate that FTX needed the price of FTT to stay above $22 or else they would be subject to margin calls (a creditor forcing you to pay back your loan due to the decrease in value of the collateral you put up). When Binance rejected the private offer to purchase their FTT it caused further panic, and when SBF went on a tweeting spree declaring that there was nothing to worry about and that FTX had plenty of money to cover customer deposits, that caused more panic still. Fast forward a few days, and FTX customers are asking for their deposits back in droves, yet SBF still maintains that nothing is wrong. Another few days pass and FTX halts all withdrawals from the exchange, making it impossible for customers to get access to their funds. Eventually SBF comes back to twitter, declaring that they’ve reached a deal to sell FTX to one of their main competitors Binance, hinting that this will magically solve all issues. This, of course, was not a done deal, and was still pending due diligence on the part of Binance. Eventually, the CEO of Binance declares that after examining FTX’s balance sheet, they can no longer agree to purchase the exchange. SBF tweets “I’m sorry. That’s the biggest thing, I f****d up, and should have done better.” A day later, FTX files for bankruptcy, and SBF finally admits that while FTX may have the theoretical assets to repay customers, they lack the ability to turn those assets into the cash needed to actually repay their customers.

When it’s all said and done, FTX lost billions of dollars, and many of their customers lost every cent they trusted them to hold. The shell game that FTX was playing with customer funds was only the surface of the issues, in the weeks after declaring bankruptcy, a whole host of fraudulent, immoral, or downright incompetent business decisions were uncovered at both FTX and Alameda. SBF will testify before Congress’ House Committee on Financial Services on Tuesday, December 13th, presumably to provide more insight into exactly how all of this happened. Unfortunately, until the various legal proceedings conclude, we probably won’t know exactly what happened at FTX. For now, the industry turns towards effective regulation, hoping to ensure that something like this never happens again.


Written by:  Ben Bulchik

These are the opinions of Ben Bulchik and not necessarily those of Cambridge, are for information purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. The strategies discussed herein are not designed based on the individual needs of any one specific client or investor. In other words, it is not a customized strategy designed on the specific financial circumstances of the client. However, prior to opening an account, Cambridge will consult with you to determine if your financial objectives are appropriate for investing in the model. You are also provided the opportunity to place reasonable restrictions on the securities held in your account.