Why did crypto exchange FTX collapse?

Binance's withdrawal of its FTX offer has capped a whirlwind two days in which the world's largest crypto exchange agreed to bail out its troubled rival in the face of a liquidity crunch.

Fears were triggered, in part, after Binance said it would sell off all its holdings of FTX's exchange token FTT.

FTX struggled to meet a surge of withdrawals in recent days as the crypto market teetered on the heels of another meltdown following a $2 trillion crash earlier this spring.

In a stunning move yesterday, Binance signed a letter of intent to buy its second-largest rival, which was last valued at $32 billion.

But this morning, Binance decided to scrap its letter of intent to buy FTX, according to a company spokesperson.

"As a result of corporate due diligence, as well as the latest news reports regarding mishandled customer funds and alleged U.S. agency investigations, we have decided that we will not pursue the potential acquisition of FTX.com," the spokesperson told CoinDesk.

Shortly thereafter, FTX CEO Sam Bankman-Fried told investors that the exchange needed $8 billion to continue operating, or would risk having to file for bankruptcy.

The US Department of Justice is reportedly looking into FTX after its collapse, with Binance's concerns about FTX's books an issue likely to be flagged by investigators.

What happened to FTX?

30-year-old billionaire Bankman-Fried had been under fire for a few weeks since making some unpopular statements about crypto regulation. Shortly after, the balance sheet of FTX's sister company, Alameda Research, was leaked.

Bankman-Fried reportedly owns about 90 percent of the trading firm, and last week CoinDesk revealed that FTX and Alameda’s ties are so close that there was a co-mingling of funds: Over $2 billion of Alameda’s borrower collateral is denominated in FTT, a crypto token that FTX launched to raise funds for the exchange. FTX gave a huge chunk of that token to Alameda, and lenders allowed Alameda to use it as collateral.

“[It] shows that 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,” wrote Ian Allison in the CoinDesk report.

Widely regarded as one of the best-run crypto firms, FTX’s finances then started unravelling in a fashion that had many observers compared to the collapse of Lehman Brothers, which triggered the 2008 financial crisis.

What both FTX and Alameda ignored is that the FTT token was highly illiquid. So when Alameda and FTX experienced liquidity crunches over the last few days and lenders came to collect, they couldn’t sell the token to repay debts. Then rumours of insolvency for FTX’s customer deposits kicked off.

That’s where Binance came in. Back when FTX was starting up, Binance was one of its earliest investors. After the leaking of Alameda’s balance sheet, Binance announced it was publicly exiting its holding of $2.1 billion in FTT tokens.

With Binance ready to market dump billions in FTT, things went from bad to worse for FTX and Alameda as rumours of a bank run spread. FTX was forced to service loans against FTT that were about to go bust, while Alameda began exiting positions with heavy losses seemingly to cover customer deposit withdrawals.

On Monday night, crypto research firm Nansen reported that over half a billion dollars had flowed off the exchange over the previous 24 hours.

It became apparent the liquidity crunch had turned into full-on insolvency. Then, Binance dropped the bombshell that it decided to acquire FTX.  

“This afternoon, FTX asked for our help,” Zhao said on Twitter on Tuesday, describing how Binance had struck the deal to buy FTX. An apologetic Bankman-Fried, in an internal note to FTX employees, said that the company experienced around $6 billion of net withdrawals over the last 72 hours.

And less than 24 hours later, Binance backtracked their offer after conducting their due diligence. 

Depending on how distressed FTX is, the acquisition price might be as low as $1.

Fall from grace

Nic Carter, a partner at Castle Island Ventures, said on a Blockworks Research Spaces of Bankman-Fried: “You don’t go from being worth $32 billion one day to being acquired by your biggest competitor the next without having done something wrong.”

Bankman-Fried, who was personally worth $16 billion earlier this week, has now seen his fortune gutted by 94 percent, making it the biggest single day drop in a billionaire's fortune compared to their total net worth.

It’s a mighty fall for one of the world’s youngest billionaires, who had also emerged as one of crypto's most powerful figures over the last couple of years.

He was industry's strongest voice in the halls of Washington DC, spending substantial amounts on lobbying to shape crypto regulation in Congress. He was also a major political donor, contributing $5.6 million to support Joe Biden’s 2020 election campaign.

Back in May when the crypto market crashed, Bankman-Fried stepped in and backstopped struggling firms, launching a bid to acquire Voyager Digital, which filed for bankruptcy in July.

But FTX’s empire might not be so easy to purchase. 

Bankman-Fried is in the process of closing a $1.4 billion deal to buy the assets of Voyager via an arm separate from Binance’s acquisition, and may also be one of the bidders for Celsius, a crypto bank that filed for bankruptcy earlier this year.

It also holds multiple sports sponsorships collectively worth hundreds of millions of dollars, from the naming rights to the Miami Heat’s arena to a deal with the Mercedes-AMG Formula One team.