How Can Crypto Custodians Rebuild Trust Post-FTX?

Posted on nov. 28, 2022 | BLOG


The shocking collapse of Sam Bankman-Fried’s crypto exchange FTX and investment firm Alameda Research have dragged the digital assets industry into the mainstream media headlines once again, and the judgments are grim. One recent article in The Atlantic is headlined “You Can Forget About Crypto Now.”

Many crypto veterans fear this incident will have a longer and more damaging impact than previous ones, which in 2022 alone includes the collapse of the algorithmic stablecoin TerraUSD, and subsequently custodial lenders Celsius and Three Arrows Capital as well as the plethora of decentralized finance (DeFi) hacks we have seen over the last two years. However, the FTX story conjures up memories of the original crypto calamity, the 2014 Mt. Gox hack, which could well pale in comparison to the fallout generated by Bahamas-based exchange’s demise. 

With so many threads still to be unwound, it’s premature to do a full autopsy of the FTX debacle; however, a number of facts are already clear. Let’s dive into what happened and explore the immediate consequences in detail. 

FTX collapse: A brief history

The first signs of trouble at FTX began when a Nov. 2 CoinDesk report indicated the exchange’s sister firm, Alameda Research, held $5.85B of the $14.6B on its balance sheet in FTT tokens. These tokens were created by FTX itself for use on the platform. Meanwhile, much of the rest of the balance sheet was said to be illiquid. Alameda CEO Caroline Ellison later tweeted that another $10B in holdings were not reflected in the report.

Events began to accelerate on Nov. 6, when Binance CEO Changpeng Zhao (CZ) said that his exchange would be liquidating its substantial holdings of FTT due to the CoinDesk report. He also took a dig at FTX founder Sam Bankman-Fried (SBF) for his lobbying activities in Washington. Considered by many to be a calculated move to stem the momentum of a rival who was undermining Binance’s reputation in the US, it worked. It started a chain of events that ultimately resulted in likely the most devastating destruction that crypto retail users have faced. 

Ellison reached out to CZ via Twitter with an offer to buy up all of Binance’s FTT holdings at $22 each, inadvertently revealing the price at which the token would collapse, and setting off a wave of short selling. CZ declined the offer, publicly opting to let the “free market” handle it.

By Nov. 8, the price of FTT had crashed 30%. This was soon followed by SBF announcing Binance would acquire his exchange, ensuring all assets would be covered 1:1, he claimed. The following day, CZ backed out of the deal, citing the dismal state of the FTX balance sheet as well as reports of investigations and mishandled user funds. To save the exchange, SBF attempted to raise $8B in capital elsewhere but failed.

By Nov. 10, FTX had effectively shut down, with withdrawals halted on its international exchange and Bahamian regulators freezing the company’s assets in the country (where it is domiciled). By Nov. 11, the entire staff of Alameda had resigned, FTX had filed for bankruptcy, and a new CEO with experience winding down scandal-rocked companies had been appointed.

FTX hack

Within a day of the bankruptcy filing, a hacker siphoned around $600M from FTX. Blockchain security auditing firm Hacken discovered the cybercriminal had made the amateur mistake of involving their Kraken account to cover some gas fees, which led analysts to speculate it may have been a nervous FXT insider. Kraken investigated the matter and later revealed they know the identity of the hacker, though they have not made it public. On 20 November, industry panic spread after it was revealed that the hacker was dumping ETH for other crypto and using bridges in order to cash out anonymously. 

Alameda and FTX user funds

Despite SBF’s insistence that the funds of FTX users were never traded – which would be illegal without their consent – mounting evidence suggests that users’ funds were traded on an enormous scale. Alameda’s Ellison even admitted as much during a meeting with her employees, according to the WSJ. The need reportedly stemmed from the over-leveraged positions taken by the hedge fund.

In what may yet amount to a criminal confession, Ellison shared with her team that Alameda had used FTX user funds to cover payments on loans it was too illiquid to handle amid the bear market. FTX is said to have lent as much as $10B to its sister company, and the ties between the two entities are a cornerstone of the ongoing investigations.

To make matters even more complicated, two high-ranking FTX employees told Reuters that SBF had installed a “backdoor” he could use to move funds between Alameda and the exchange under the nose of both regulators and the internal compliance team. SBF has denied the allegations. 

What’s next for crypto after FTX?

Crypto is in a dark place, but it’s been here several times before, as the Bitcoin Obituaries site shows. There is a clear cycle that has repeated itself at least three times since the inception of Bitcoin in 2009. It’s during these bear markets, when the tide goes out, that the bad actors are exposed. As the cycle continues, new builders create a more solid foundation and runway for the next wave of innovation that inevitably results in the next bull run. Here’s some of what needs to be considered as we enter this next phase.

Final thoughts

It should almost go without saying, but the industry should brace itself for a newfound urgency on the part of regulators to get a firmer grip on crypto and the companies that offer services related to it. These agencies are now empowered like they never before and perhaps rightly so. 

With any luck, crypto will come out stronger after this intense evolutionary pressure. Like everyone else, we eagerly anticipate crypto’s transformation into a secure financial ecosystem, and we believe we are perfectly poised to contribute to the process of rebuilding crypto’s reputation.