Why do crypto exchanges fail?
Ivan Mikhaylov
Recently the 3rd biggest crypto exchanged called ‘FTX’ Trading’ had called for bankruptcy and its owner Sam Bankman-Fried was arrested on the charges of defrauding investors. This has shaken up the crypto community by wiping off $150billion from crypto market cap and has raised question about the future of these decentralized exchanges.
Chain 1: Why did FTX fail?
On November 10th 2022 FTX balance sheet (record of company’s assets and liabilities) was leaked. It showed that FTX had loaned a lot of its customers’ money in the form of FTT crypto tokens to its sister company Alameda Research. Alameda was also owned by Sam Bankman-Fried and it was known to engage in risky trading strategies. In actual fact, this reckless trading was financed by FTX customers’ assets and FTX printing more FTT tokens. Another crypto exchange Binance was the first to express its concerns by selling off its large share of FTT. Although, Bankman-Fried had bought back Binance’s share, the damage was already done. The panic had spread causing investors to withdraw their money from FTX. As a result, the price of FTT plummeted to zero and Bankman-Fried was forced to ask Binance for a bail out. However, having been rejected FTX filed for bankruptcy.
Chain 2: What can we learn from this?
FTX was considered one of the leading firms with visionary management and so its collapse has severely dampened crypto’s reputation. However, the collapse of FTX had nothing to do with cryptocurrencies themselves. The problem was the fraud committed by the management. Granted this was only possible due to the lack of government regulation in the crypto industry. Surprisingly, this shows that FTX collapse is not the end for crypto but rather a valuable lesson. FTX was performing really well before the leak suggesting that cryptocurrencies are a viable financial instrument and that crypto exchanges can be good. We should instead by focusing on preventing the crimes and failure of managements in order to protect other exchanges.
Chain 3: Was Luna collapse similar to FTX?
Luna and Terra USD (UST) were the main cryptocurrencies of the Terra blockchain. UST was a stablecoin. Usually, a stablecoin is a cryptocurrency whose value is pegged to a more stable asset such as the US dollar and backed by USD reserves. However, UST was an algorithmic backed stablecoin meaning that its value was backed by Luna coins using a mathematical algorithm which either mined more Luna or destroyed Luna to keep the value of UST at $1 of Luna.
In May 2022, $2 billion worth of UST was unstacked and quickly liquidated. Stacking is when users pledge their coins to the blockchain which uses them to verify other blockchain transactions. In rewards for this, users receive rewards such as high interest rate on their stacked stable coins. This rapid sell off of UST sent its price down to $0.91. However, due to the algorithm, $0.91 of UST could still be exchanged for Luna. As a result, traders exploited this feature and tried to exchange all of their UST for Luna. As a result, UST was de-pegged of Luna and so quickly lost its value. In turn Luna supply was quickly flooded making it effectively worthless.
Luna crash has wiped off $60 billion off crypto market cap. This also tanked the bitcoin price increasing the investor losses to $300 billion. Major crypto exchanges including Voyager, Celcius and Three Arrow Capital (3AC) want bankrupt.
Luna problem was an unprecedented event rather than management fraud. It’s unknown why $2 billion UST was unstacked so suddenly. One guess is a coordinated cyber-attack at Terra blockchain core structure. This could have been prevented had there been limits on the number of coins you can unstack at once. Similar to FTX, Luna failure also shows the need for increased regulation. Although it does highlight crypto’s volatility, this volatility wasn’t without cause.
Chain 4: What does this mean for the future of crypto?
2022 has definitely been a disaster year for crypto as nearly $2 trillion was wiped off the crypto market and the two biggest crypto currencies Bitcoin and Ethereum are down by more than 65%. Even the largess exchange platform ‘Binance’ is having trouble with the regulators. It is being investigated for charges relating to money laundering and Iran sanctions violations. This year alone, its customers have cashed out $3.6 billion of cryptocurrencies causing it to stop withdrawals of USD Coins (Binance has cited technological problems).
However, 2022 has been a hard year in general. A cost-of-living crisis has caused a squeeze on consumer income resulting in a decrease in risky crypto investments. This is one of the reasons for the decrease in crypto market cap. Furthermore, most crypto troubles have been caused by unconnected factors such as irresponsible management or cyber-attacks. After the huge crypto growth in 2021, these troubles are normal. Collapses of FTX or Luna will definitely put off investors and slow down crypto growth but they won’t be able to destroy the whole crypto market. Government investigations are a good thing since they show increasing government interest which will likely bring more regulation and stability.
