FTX (a short for "Future Exchange") was a crypto-exchange founded in 2019 by Sam Bankman-Fried and Gary Wang. To fully comprehend the narrative of FTX's collapse, it is crucial to know Sam Bankman-Fried's background and understand the structure of FTX.

Sam is an entrepreneur that graduated from the Massachusetts Institute of Technology and worked at Jane Street Capital, a proprietary trading firm. In 2017 he left the company to create Alameda Research, a crypto-currency quantitative trading firm. In 2019, Sam decided to create his own crypto-currency exchange, namely FTX. Due to differences in regulations between countries, FTX had to create a new entity called "FTX.us" to operate in the United-States. Overall, FTX and Alameda Research were closely related as Alameda was providing liquidity to FTX. To be more precise, Alameda was acting as the main market maker for the FTT token. Alameda Research was trading cryptocurrencies and was specialised in exploiting differences in prices across different countries by buying a crypto in one country and sell it a higher price in another country. The firm was also using debt to leverage its trading activities. FTX and the FTT token acted as a liquidity provider for Alameda, however, when prices started to fall, things started to get very complicated for Alameda Research and FTX.

Although it was a relatively new exchange, FTX rapidly grew in popularity to become one of the biggest crypto exchanges in the world along with Binance, Coinbase and Kraken. For instance, in 2021, FTX generated $1 billion in revenue and managed $719 billions of annual volume. In early 2022, FTX was valued at around $32 billion following a $400 million fundraise.

On appearance, FTX had everything to keep growing and was a reputed crypto exchange used by over 5 million users across the world. Sam Bankman-fried was seen as a generous billionaire giving a lot to charity and was very much appreciated by the crypto community. Like Binance, FTX also had its own crypto currency, named "FTT". In 2022, its token had a market cap of around $4.6 billion. However, as we will see throughout the article, things turned dark for FTX in the end of 2022, and led to the bankruptcy of the company and the fall of the billionaire Sam Bankman-fried, whose personal fortune rapidly went from $16 billion to zero.

1.2. The Battle of the Giants: Binance and FTX and the Tragic End for One

Before taking a deep dive into the collapse of FTX, we must first understand the elements that led to the disaster. One of the first key elements dates to 2019, when according to Reuters, Binance, who, in a search for diversification, bought 20% of FTX for $100 million.

In 2021, FTX decided to buy back its shares owned by Binance to prevent the competing exchange from taking unfavourable corporate decisions as an important shareholder. In exchange for its shares, Binance received $2.1 billion from FTX, in the form of BUSD (a Binance dollar-backed stablecoin) and FTT (the token of FTX). At that time, FTX was thriving and became a serious competitor for Binance.

2021 was an amazing year for FTX, and so was 2022, until November 2022 when things started to get suspicious for the exchange. On November 2, 2022, Coindesk, a reputed crypto media, published an analysis of Alameda Research's balance sheet for Q2 2022. At first glance, everything looked all right; the company had $14.6 billion assets and $8 billion liabilities. However, if you took a closer look at the assets' composition, one could see that Alameda held $5.8 billion of FTT, which represents almost 40% of its assets. Yet, reports indicated that FTX only had around $6 to $40 million of daily volume for the token. This is very low in comparison to the amounts the company had in reserve and led to liquidity issues.

Overall, even though the company had on paper enough assets to cover its liabilities, it did not have enough liquidity to do so. That is to say that should FTX experience serious withdrawals, the company would not be able to cover all of them since most of its assets were not liquid. Why? Simply because to cover its liabilities, the company would have to sell a large amount of FTT token, which would negatively affect its price, and lower the value of its remaining FTT holdings. Furthermore, the trading volume for FTT was relatively low, so there was not a lot of liquidity, and FTX would not be able to sell large amounts any way. Following this information, the price of the FTT token was still relatively stable. Nonetheless, things accelerated as of November 6, when the CEO of Binance, Changpeng Zhao (CZ) declared that Binance would sell its remaining FTT tokens.

Following that statement, on November 7, around $5 billion worth of crypto was withdrawn from the FTX platform. Due to these massive withdrawals, FTX was on the verge of suffering a major liquidity crisis, given that the exchange would be unable to cover all withdrawals should it continue at this rate. Following this massive fear from customers, a lot of people sold their FTT tokens, which saw its value falling by 80% in only two days.

On November 8, Binance stated that after conducting due diligence, the company might buy FTX. However, because of the latest bad news regarding FTX mismanagement of customer funds and the due diligence process, Binance stated the next day that they were no longer interested in buying FTX. As the price of FTT kept falling, the exchange had to freeze withdrawals as it became unable to assume them. Eventually, on November 11, the crypto exchange FTX filed for bankruptcy under Chapter 11 (a law allowing a company to momentarily protect itself while the company seeks to find all its available assets.

2. Beyond FTX: Implications and Future of the Cryptocurrency Market

In the upcoming sections, we will provide a general overview of the risks and benefits associated with using centralized cryptocurrency exchanges, building on the lessons learned from the FTX case.

2.1 The Dark Side of Centralized Exchanges

Centralized exchanges have long been criticized for the way they manage their accounts. The surge in cryptocurrency advertising began during the 2021 bull run, with crypto ads appearing on almost every available surface in the world of sports. This includes naming deals for stadiums, team uniforms, and even liveries for Formula One racing cars. According to a report by Messari, Crypto.com spent over $200 million on marketing during the first half of 2021 alone. This represented a significant portion of the company's revenue, with the report estimating that marketing expenses accounted for nearly 27% of Crypto.com's total revenues for the period. Despite being a bold strategy, it was possible to bring profits to the company if the client acquisition cost was lower than the revenue that those customers will generate for the company over their lifetime.

However, when the market turned and we entered in the bear market, Crypto.com announced a 260-employee lay-off, equating to a 5% cut of its workforce, showing that it may not have been the most effective strategy. In general, this also highlights the need for centralized exchanges to carefully consider their priorities and the trade-offs between investing in marketing to attract new customers and maintaining a secure and reliable platform for existing users. Only with balance between growth and stability exchanges can build a sustainable business over the long term.

Other criticisms of centralized exchanges include their lack of transparency, which requires users to trust the exchange to hold their funds and execute trades on their behalf. Over the years, there have been cases of exchanges being hacked or engaging in fraudulent activities, which has eroded users' trust in the industry. Additionally, exchanges are not always transparent about their security practices or the measures they have in place to protect users' funds, making it difficult for users to make informed decisions about which exchanges to use and how much to trust them with their assets. This lack of transparency puts users' assets at risk.

Moreover, some centralized exchanges have been accused of engaging in manipulative practices such as wash trading and front-running, which can distort the market and harm investors. For instance, In October 2021, the United States Commodity Futures Trading Commission (CFTC) filed a complaint against BitMEX, accusing the exchange and its owners of engaging in illegal trading activities, including wash trading and a form of front-running known as "pre-arranged trading." The CFTC alleged that BitMEX used these practices to manipulate the price of cryptocurrencies and to profit at the expense of its customers. As a result of the allegations, BitMEX agreed to pay a $100 million penalty to the CFTC and to implement significant changes to its business practices, including increased oversight and compliance measures.

2.2 Cryptocurrency Exchange Failures: Can Regulations Prevent Another FTX?

The crypto industry is divided between those who believe in the importance of regulation for market confidence and those who prefer to remain outside any regulatory framework in line with the decentralized nature of crypto and Defi.

In the past, centralized cryptocurrency exchanges have attempted to maintain their operations in order to ensure stability and trust among their users by implementing policies and self-regulatory checks due to the lack of support from policymakers and a constant fear of government crackdowns. However, such measures can be considered at least doubtful since they are not backed or supervised by an external entity.

Recently, an increasing number of cryptocurrency exchanges have experienced difficulties and have been unable to meet customer demands for withdrawals. Examples include Celsius Network, Voyager Digital, BlockFi, and AAX, which have filed for bankruptcy. Furthermore, cryptocurrency lender Genesis has announced a temporary suspension of redemptions and new loan originations.

The fall of FTX brought the issue of cryptocurrency exchange failures to the attention of the government, highlighting the need for regulatory oversight in this evolving industry. Despite the challenges of regulating a fast-paced market, governments and regulators are making efforts to keep up with the changes. However, the application of existing financial regulations to cryptocurrencies varies by country and may not be sufficient to address all issues. For instance, Europe already has a regulatory framework that aims to establish uniform rules for crypto assets called "Markets in Crypto-Assets (MiCA)".

2.3 FTX's Downfall — The Wake-Up Call for Centralized Exchange Traders

When using a centralized exchange, it is important to take certain precautions to minimize the risks associated with these platforms. Thorough due diligence is essential before using an exchange, which may include researching the exchange's history, ownership structure, security measures, and regulatory compliance. It is also helpful to read reviews and opinions from other users to get a sense of their experiences.

Vigilance is key when monitoring for red flags on a centralized exchange. Sudden and unexplained outages, delays in deposit or withdrawal processing, or a lack of transparency regarding the exchange's ownership or operations could all be signs of underlying issues.

Diversification of assets is another way to mitigate the risks associated with centralized exchanges. By spreading your assets across several exchanges, you can minimize the impact of any problems that may arise of just being in one.

Regular audits are also important to identify any potential issues with the security and performance of centralized exchanges. This may involve engaging third-party auditors to conduct security assessments or running tests to ensure that the platform is functioning as expected. In addition to regular audits, another important measure that centralized exchanges can take to protect their users is implementing a "proof of reserve" system. This involves publishing addresses on the blockchain to show that the exchange holds the funds that it claims to have. Following the FTX crash, some centralized exchanges started to adopt this system to increase transparency and build trust with their users. This can help to prevent situations where exchanges may not have sufficient funds to cover user withdrawals or are engaging in fraudulent activity.

Finally, getting involved in the cryptocurrency community and staying up to date on industry news and developments can be helpful in staying informed about potential issues and taking steps to protect your assets.

3. Decentralization: Is it the solution?

The FTX crash has shown us that it is more important than ever to own your cryptos. Leaving your cryptos on centralized exchanges may seem like an easy and secure way to hold your cryptos, and although majority of large, centralized exchanges have high-security procedures, the lack of transparency regarding their ways to manage your cryptos internally can lead to disasters such as the FTX one. But what does it mean to own your crypto? It means that you and only you can access your funds as long as you keep your private key secure. And this is the catch; you and only you are responsible for securing the access to your wallet. If you ever lose the access to your wallet, there is no going back. There is a famous saying in the crypto community which states: if you lose the key, you lose the coins.

In order to store your cryptos, you can use two different kinds of wallets: hot and cold wallets. Both are decentralized, but there is an important difference. A hot wallet allows you to own your private key, but this type of wallet is permanently connected to the internet. Whenever you make a transaction, you accept or reject it directly via your computer/phone on the wallet's interface. Should a hacker access your computer/phone and your wallet, he would be able to drain your funds. A cold wallet represents a physical access to your private key on the blockchain. The most famous example of cold wallet is Ledger and their ledger keys. Your cryptos are not stored in the ledger key itself, rather, they stay on the blockchain. The ledger key then represents the access to your funds on the blockchain. Whenever you make a transaction with a cold wallet, you also accept or reject it with the hardware wallet, which adds a layer of security. It is still crucial to store your seed phrase in a very secure way because should a malicious actor steal it, the individual could access your funds even though it does not possess the hardware wallet.

Overall, decentralization embodies the concept of self-reliance in securing your funds, rather than entrusting a third party with that responsibility. It emphasizes the need to take full responsibility for controlling access to your funds.

Now, we would like to further some uses cases of decentralisation. Indeed, lots of people use centralized exchanges not only to store their funds, but also to use services such as lending, borrowing and staking. However, these services are also available on decentralized applications. This is called 'Decentralized Finance'. Below are the main services provided by decentralized finance applications.

- Staking: It refers to a user locking its crypto on a blockchain to participate in securing the network, receiving rewards in exchange. Staking is only available on Proof of Stake blockchains such as Ethereum or Avalanche.

- Lending & borrowing: Lending is the process of lending your crypto to a platform, which will then allow other users to borrow them. Lenders receive in exchange fees from borrowers. As a borrower, you deposit crypto as a collateral and then borrow a certain amount. All loans in decentralised finance are over-collateralized.

- Swapping: One of the main and primary functions of decentralized exchanges is to allow the user to swap one crypto for another.

- Liquidity providing: In order to allow swaps from one crypto to another, these platforms need liquidity. Therefore, in exchange for a percentage of the swap fees (plus in some cases additional rewards in the form of the platform's own token), decentralized exchanges allow users to provide their crypto in what is called 'liquidity pools', where a user deposit two or more crypto in equal weights (50/50 in most cases).

As of March 2023, there is a total of approx. $40 billion locked in decentralized finance protocols. Although decentralized exchanges represent billions of dollars of trading volume per month, it is true that centralized exchanges still have a bigger part of the chart (in February 2023, trading volume of DEXs represented only 7% of CEXs trading volume).

In definitive, due to the complexity of decentralisation, centralized exchanges are necessary as they represent a great bridge from traditional finance to crypto for beginners. However, one must be aware that given the lack of clear regulation and the discrepancies in regulation between countries, most centralized exchanges remain opaque, and users must remember that once they deposit funds to a centralized exchange, they do not own the funds anymore. In that regard, decentralized options such as hot and cold wallet are great allies to keep the control of your funds, only if the users truly understand the technical nature of owning their keys.

NBC Content & Research Team — Alexandre Falconnier & Lucas Bem