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Latest crypto crash a result of deadly mix of malpractice at FTX exchange & lack of regulation

How the crisis unfolded at FTX, the crypto exchange that recently declared bankruptcy, which led to a meltdown in the industry as a whole.

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New Delhi: The ongoing crash in cryptocurrency prices is largely due to malpractice by particular key players in the crypto market, coupled with a lack of regulation that has allowed such activities to take place. Macroeconomic conditions haven’t helped either.

Bitcoin, which makes up about 41 per cent of the crypto market, has seen a precipitous fall in its price over the last year. From $64,400 per Bitcoin on 12 November, 2021, the price is now hovering around the $16,500 range. Other, smaller cryptocurrencies have seen similar falls in price. From being the darling of new-age investors and those looking to make money quick, how has the crypto market been devastated in this manner?

“Think of it as a range of factors, such as the Fed rate hikes, the fall in the stock markets, etc, and incidents such as what happened at FTX,” said Sharan Nair, co-founder of PYOR — a company that deals in blockchain services — and also part of the founding teams of Unocoin & CoinSwitch.

“However, there are some factors that have a very large impact, such as the 3AC case, and very recently, FTX,” Nair explained. “The FTX crash is humongous. I would say FTX has contributed to about 70 per cent of the crash today.”

FTX is a Bahamas-based cryptocurrency exchange that was founded in 2019. Since then, the company gained a reputation for being one of the most stable and respected firms in the crypto industry. This reputation was also largely built on the back of its founder’s respect within and outside the industry.

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‘Poster-child of the crypto industry’

A crypto industry insider who declined to be named, told thePrint that the FTX founder — Sam Bankman-Fried — was a “poster-child” of the crypto industry, a position that played a large role in why his malpractice has had such devastating consequences.

“Everybody in the industry knew him and looked up to him. He was considered the leader the industry needed. Even for regulators and senators in the US, he was one of the people from within the industry that the lawmakers trusted,” the insider said.

In fact, such was the respect for Bankman-Fried that he was even compared to the likes of J.P. Morgan, the founder of the investment bank that carries his name, who came to the rescue of several companies in the US during the financial turmoil there in the early 1900s.

“This is why what he has done has done so much damage,” the insider added. “Apart from the financial aspect, the fact that he was so trusted has now meant that there is huge disappointment in the industry, as well as a real hit to investor confidence.”

What happened at FTX

On 2 November, crypto news portal coindesk.com published a report, after having analysed FTX’s balance sheets, that showed that the exchange’s assets under management (AUM) were largely held in the form of FTX’s own crypto token called FTT.

Now, as any investor worth their salt will say, diversification is one of the safest practices while handling investments and, conversely, concentrating funds in a single instrument is extremely risky. But this is what FTX and its founder were doing, much to their eventual detriment.

At around the same time, it also came to light that Bankman-Fried had been channeling FTX’s customers’ funds to Alameda Research, a trading firm founded by him. Alameda Research, for its part, was using these funds to take on more debt and raise more funds.

Now, this is where the regulators would have stepped in, had there been any regulation in place. In India, for example, the Securities and Exchange Board of India (SEBI) has specific rules that brokers cannot touch the customers’ funds in such a way. No such regulation exists for the cryptocurrency space, either in India or abroad.

It was when these two pieces of news — that most of the assets were in the form of a single cryptocurrency, and that users’ funds were being channeled out of the company — became public that the problems really started.

Binance’s move spooked the market

Binance, another cryptocurrency exchange and an early investor in FTX, held a large number of FTT tokens. On hearing the news about FTX, Binance announced last week that it would sell its entire holdings of FTT, saying it was safeguarding its interests and reducing its exposure to a risky asset. This sale amounted to about $2 billion worth of FTT tokens being sold in one shot.

This, naturally, spooked the market and precipitated a broader selloff where other holders of FTT also began selling their tokens. As was expected in such a scenario where there is a supply glut, the price of FTX plummeted by more than 30 per cent following Binance’s announcement and kept on falling.

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Contagion effect

The crash in the price of FTT had a huge contagion effect. Remember how Bankman-Fried was using the FTT token as collateral for loans? Well, those chickens came home to roost. With the value of that collateral in freefall, the creditors asked Bankman-Fried to add more collateral to secure the loans. Now, Bankman-Fried couldn’t do this. He tried to raise funds from private sources and failed. Further, a deal for Binance to purchase FTX also fell through, further hitting the value of the FTT token.

It was at this point that Bankman-Fried resigned as CEO of FTX and the company filed for bankruptcy, leaving disaster in its wake, and crypto prices around the world at record lows.

The contagion didn’t end there, though. Bankman-Fried was a big investor in Solana — another blockchain platform — and owned a large number of that platform’s token, Solana BTC. As events around FTX unfolded, people’s confidence in Solana BTC also fell quickly, leading to a significant fall in its price.

The incident also left the crypto market participants very jittery, and so their reactions to other pieces of bad news have been disproportionate.

Following the news that Crypto.com had mishandled a $400 million transaction, depositing the amount in the wrong type of account, the exchange’s customers rushed to withdraw their funds from the exchange. The value of Crypto.com’s own cryptocurrency fell by about 20 per cent in a single day.

Other factors at play

According to industry players, the FTX saga has been unfolding at a time when investor confidence within and outside the crypto industry has been at a low. On the inside, FTX comes on the back of another — albeit smaller — crisis in the industry this year, where Three Arrows Capital (3AC) saw $10 billion worth of wealth falling to zero.

While this is still much smaller than the $16 billion-to-zero fall in Bankman-Fried’s wealth, it was still a crisis big enough to shake the crypto industry.

The difference was that the Bankman-Fried’s reputation was such that his fall came as a devastating blow to investor confidence.

Other factors that have dampened the mood in the crypto market are more general, affecting other industries as well. The rate hikes by the US Federal Reserve, the tepid activity in stock markets around the world, and the increasing layoffs among Big Tech companies are all factors that have significantly eroded investor confidence in quick returns from the crypto market.

The FTX implosion was a sledgehammer to a weakening foundation. Whether it is the final blow remains to be seen.

(Edited by Geethalakshmi Ramanathan)

Also Read: Why cryptocurrencies became an investor favourite in 2020 & how their value is determined

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