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If you've been following the news over the last few weeks, you'lll have seen a multitude of reports in the media about the collapse of FTX. One of the biggest centralised crypto exchanges in the world went down in a rapid and dramatic fashion. Its founder and CEO, Sam Bankman-Fried, once a poster child for the crypto industry, with a net worth of $26 billion and a proponent of crypto regulation, is now facing an investigation by the US attorney’s office, with potential charges for fraud and embezzlement.

If you're far from the weeds of the cryptosphere and wondering what all of this means, here's a simple(ish) overview of what happened and why it matters.

Let’s start by saying that cryptocurrency is a highly volatile and risky asset class. There's also very little to no regulation around crypto in most countries around the world at present. Since the rise in popularity of crypto during the pandemic years, the regulators started paying closer attention to the industry. But, apparently, it was not close enough…

What went wrong?

FTX was a centralised crypto exchange, meaning it took deposits from customers (both retail and corporate), held the funds in custody on customers’ behalf and facilitated buying, selling and leveraging transactions. It made money by charging fees on those transactions.

Although FTX has only been around since 2019, it quickly became one of the largest centralised crypto exchanges. It was also one of the more trusted exchanges in the space.

The founder of FTX, Sam Bankman-Fried, had also founded a crypto-trading firm called Alameda Research back in 2017. Alameda was not an exchange, it was trading on its own account and essentially acting as a market maker, meaning it was creating liquidity. Although the two companies were meant to be separate, allegations suggest there was a commingling of funds and billions of dollars in customer deposits were transferred from FTX to Alameda - something that should not have happened.

Additionally, FTX created their own token called FTT, which was traded in an open market and priced at around $22 before the collapse. However, in early November, a CoinDesk journalist published an exposé article alleging that a large chunk of the FTT token supply was held by Alameda. According to the article, Alameda Research was holding close to $4 billion worth of FTT tokens on its balance sheet, meaning between the two companies, the value of FTT was artificially inflated. This also raised concerns about Alameda’s solvency.

There were a lot of other details that were part of the unravelling of this story but, essentially, when investors in FTX realised that its token’s value was artificially inflated, they started selling fast, trying to offload their holdings in the FTT token, causing the price to plummet.

On the back of the same news about the FTT token, customers who had their funds on the exchange started rapidly withdrawing their funds, questioning the solvency of the now-troubled exchange. And rightfully so, as within two weeks, FTX filed for bankruptcy, causing millions of customers to lose their funds held by the exchange.

What are the important takeaways?

1. Whilst crypto is a volatile and unregulated space, it's important to distinguish that, in the case of FTX, the collapse was also largely due to the alleged fraudulent actions by the people in charge of the exchange (i.e., transferring customer deposits from FTX to Alameda). Lack of regulation meant there was no clearly defined framework within which to operate. But the alleged fraudulent actions went above and beyond any standard practices used by most exchanges. The case of FTX is being compared by many in the finance industry to the collapse of energy company Enron back in 2001, which also involved fraud.

2. The collapse of FTX was not caused by any underlying failure of the blockchain technology – it was caused by the behaviours of individuals. Blockchain technology and the concepts of decentralisation aim to solve this very problem of too much power being held (or centralised) in the hands of one company or individual. Centralised exchanges operate a very traditional financial model of being an intermediary or a middleman in facilitating the trading of cryptocurrencies. Many people choose centralised exchanges over decentralised trading because the process is easier and simpler to understand. But, in their essence, centralised exchanges are not aligned with one of the core pillars of Web3, which is decentralisation and moving away from the highly intermediated systems of today towards direct peer-to-peer transactions.

What does this mean for Web3 and crypto?

First and foremost, the collapse of FTX was devastating for the many people and companies who lost their funds as a result. It also made a sizeable dent in the reputation of the entire crypto industry.

However, the silver lining of this fiasco is that regulation of the crypto space will likely speed up, meaning the rules will be clearly defined by the government and the space will become safer, particularly for retail customers. Some of the biggest regulatory changes in the traditional finance industry took place after the global financial crisis of 2007 (i.e., the collapse of Lehman Brothers), resulting in the highly regulated banking system we know today.

It will also likely increase innovation in the decentralised finance and self-custody space, improving user experiences and solving the existing frictions in the onboarding process. People and companies who want to trade crypto will be more likely to use decentralised exchanges that don’t take custody of customer funds and where transactions are peer-to-peer, public on the blockchain, and executed via smart contract technology without reliance on an intermediary.

Finally, it's important to differentiate cryptocurrency from the overall capabilities of blockchain technology. Cryptocurrency is only one part of a much bigger technological innovation made possible through blockchains. The innovation taking place in finance, music, art, culture, media, sport, and other industries where blockchain technology is creating new and exciting opportunities.

You can learn more about the FTX collapse in this report by The Wall Street Journal.

Want to learn more about Web3 and the opportunities presented by blockchain technology? Check out AllBright’s free resources.

Disclaimer

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