The fallout from the failure of FTX and Alameda Research

“This afternoon, FTX asked for our help. There is a significant liquidity crunch.”

When I woke up this morning and saw this tweet by CZ of Binance, I was floored. I knew there were concerns about FTX, and I even tweeted yesterday that I was derisking all long crypto exposure and moving funds to my cold wallets as a precaution. However I didn’t think the worst outcome would happen so swiftly.

I’m writing today not to summarize what happened, but to speculate on what happens next. If you want a summary of what happened, @jonwu_ has a nice thread:

jonwu.eth @jonwu_

FTX was the world's 3rd largest crypto exchange. Today it's said to be insolvent and in the midst of an acquisition by Binance. Here's everything you need to know about Alameda Research and the collapse of FTX: 👇

I believe the last 48 hours are just the first chapter of this crisis. The “acquisition” is only a non-binding Letter Of Intent that is subject to CZ’s due diligence on FTX’s assets and liabilities. I am assigning less than a 20% probability that the acquisition actually goes through, and if it doesn’t, there will be further contagion in crypto that will send most crypto markets to new cycle lows. *30 min into writing this article, Coindesk reports that Binance is strongly leaning toward scrapping the deal.”

Most crypto exchanges run on a fractional reserve system, like banks (the exception might be US regulated exchanges like Coinbase, but I’m not even sure about that). They don’t have enough liquid assets to cover all withdrawals if everyone withdrew their deposits all at the same time, and therefore rely on a confidence game to stay solvent (as opposed to traditional banks, which can turn to the Federal Reserve as the lender of last resort). This means that everytime SBF says in public that client deposits are backed 1:1, that’s simply untrue. In fact, he was saying this lie right until the shit hit the fan, in this tweet which has since been deleted.

Let’s do some rough math on whether it makes sense for Binance to acquire FTX. Crypto twitter is saying there were $6B in withdrawal requests to FTX yesterday, and there are probably billions more in customer deposits that are counted as liabilities on the balance sheet. Let’s assume FTX and Alameda Research have very few liquid assets available to meet customer withdrawals, so the only remaining assets left on the combined entities’ balance sheet are illiquid locked and unlocked tokens and VC investments. That means Binance needs at least $6B of spare cash lying around, ready to cover FTX’s liabilities the moment they acquire them. I doubt they have $6B, and even if they did, that cash would be held in reserve against Binance’s own depositors, not available to meet FTX’s liabilities. An acquisition of FTX would likely weaken Binance’s reserves-to-deposits ratio and put them in a risky position that is vulnerable to the very same bank run that FTX suffered from today. The only way for this acquisition to happen is if 1) FTX and Alameda have liquid assets lying around somewhere that can satisfy a large portion of withdrawals, or 2) Binance can raise billions in capital from investors to fund this acquisition within a short amount of time.

What happens if Binance’s acquisition doesn’t go through? Well, FTX’s remaining depositors end up with cents on the dollar, Alameda defaults on all its loans (which were collateralized with now-worthless FTT), and this leaves a bunch of cefi lenders and hedge funds with huge holes in their balance sheet. This would be a deleveraging event as big, if not bigger, than the collapse of Three Arrows Capital, and trigger a 20-30% drop in the crypto market cap as there is a scramble to raise stablecoin and USD fiat liquidity. Hence, I am currently short ETH/USD (which can be done via the CME futures contract).

A further fall in crypto prices could topple more dominoes in the cefi space. Some bitcoin miners, already under pressure, would go under and be forced to sell what few BTC reserves they have left. Microstrategy, at a certain price in BTC (probably somewhere in the low teen’s) will be theoretically insolvent. Tether, crypto’s largest stablecoin, has constantly been questioned about its transparency and whether it holds enough assets to back every dollar of USDT it has issued. A $20-30B run on Tether would likely trigger a rush to redeem USDT and expose the hole in their balance sheet. In a bear market as brutal as this, any company with a single nexus of vulnerability will get targeted.

It is ironic that SBF was only recently labeled “The JP Morgan of crypto” due to Alameda coming in as the white knight to rescue the companies that were swept up by the Three Arrows implosion. The community elevated SBF to God status, and he used this credibility to lobby US politicians on shaping crypto regulation - regulation that was supposed to protect retail crypto customers from this exact occurrence. These crypto-friendly politicians, having been misled by a deeply hypocritical figure, have lost credibility and will likely cede power to the crypto-unfriendly voices in the US House and Senate. Between the shattered confidence of crypto investors and the tough regulation coming down the pipe that will possibly suppress the growth and adoption of crypto, this crypto winter may be extended by another 2-3 years.

CZ and Binance being the dominant entities in crypto does not inspire confidence for the future. Transparency, strong governance, and openness to regulation are not the hallmarks of Binance. The cefi ecosystem and infrastructure that was built and then torn down needs to be rebuilt on defi, with regulations that allow institutions to participate and contribute to liquidity and transaction volume. After this week, the only path to a crypto bull market that I can see would be an environment where inflation has run out of control and the public no longer trusts fiat and the institutions that back it. In this version of the future, crypto would be a ray of hope.

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