Collapse of FTX: what happened and what comes next

Here’s an introduction to what happened at FTX, a cryptocurrency exchange that imploded late last year

Lesson summary

Hi there, I’m Jeff and this is Plain English, where you can upgrade your English by listening to lessons about current events and trending topics. This is lesson number 542 on Monday, January 30, 2023. Two days left until February !

Last Monday, we talked about banking, and the ways banks can get in trouble . The lesson was an oversimplification. But the basic idea is still helpful. A financial institution can have a liquidity crisis or a solvency crisis. Both of them are bad, but a solvency crisis is really bad. We talked about that in Lesson 540, so if you haven’t heard it yet, go back and listen now .

You’re going to want to keep that vocabulary in mind as you listen to today’s lesson about FTX, the failed cryptocurrency exchange. The expression we’ll talk about today is “pay up” and I have a quote of the week. Let’s get going.

The collapse of FTX

FTX International was a cryptocurrency futures exchange; in fact , the name FTX stood for “futures exchange.” This is not a new thing; futures exchanges have been around for 300 years. There are futures exchanges for all kinds of things: oil, gold, soybeans, orange juice, coffee, even for financial things like interest rates, stocks, or, now, cryptocurrencies.

Here is what happens in a futures exchange. Customers bet on the value of assets without having to own the assets. Their bets are just contracts. You can bet on an asset’s value going up; you can bet on the value going down. The exchange doesn’t care one way or another . They sit in the middle and settle the bets. They make their own profit by taking a small fee off every bet.

Futures exchanges make sure that customers don’t make bets that they can’t afford to lose. This is important. If you win a bet on a futures exchange, the exchange needs to pay you what you won. But the exchange can only pay the winner if they take money from the loser.

This is why every customer needs to post collateral: the exchange doesn’t just trust you to pay up if you lose. “Posting collateral” means, you give the exchange something of value, and they can keep it if you lose your bet. Collateral can be money, stocks, bonds, other currencies, things like that.

The point is, you have to give them enough valuable assets before you start the betting. The exchange determines how much to take in advance, the exchange keeps track of this all, and if you start to lose too much, the exchange asks you for more collateral. If you can’t give more collateral, it shuts you down before you lose too much.

This is a complicated and risky business to say the least . The big futures exchanges like the Chicago Mercantile Exchange and the London Metal Exchange have lots of complicated rules and systems to protect themselves, and their customers.

FTX International was a futures exchange where people could bet on cryptocurrencies going up and going down. Like at other exchanges, customers deposited money and other cryptocurrencies as collateral. FTX promised to keep track of the bets, take from the losers, and give to the winners, just like other exchanges do.

Now is where I’m telling you what the U.S. government alleges FTX to have done. None of this has been proven in court yet, and the founder of FTX has pleaded not guilty to all of the charges against him. But here are the allegations.

FTX did have a complicated risk-management computer system that kept track of the bets, requested collateral, and settled bets, just like every other exchange—only theirs, they said, was better. If customers started losing too much, FTX asked for more collateral or shut them down. So far, so good.

Just one problem: one customer was exempt from the system. That one customer was called Alameda Research, 90 percent of which was owned by—just wait—the founder of FTX, Sam Bankman-Fried. Alameda Research made highly risky bets on cryptocurrencies and lost those bets; they lost big. Not only that, but the collateral that they gave FTX also fell in value. So they lost their bets, and their collateral was worth less.

But instead of being shut down, like any other customer would have been, instead of being shut down, Alameda kept making bets without having to post more valuable collateral. And they kept losing. For them, it was like going to a casino and getting free chips.

Another crypto company, a rival to FTX, noticed some of what was going on and suspected that Alameda might not be able to pay for all its losing bets. This other investor published a note, very publicly, saying they thought a big FTX customer had not posted good collateral.

So this made other FTX customers worry. Remember: if a loser can’t pay, then the winners won’t get what they rightfully won. And nobody wants to be on an exchange if they won’t be paid their winnings.

When FTX customers saw this research note, they (understandably) decided to close their accounts and try to get their money back. And a lot of them did that all at once . If this sounds familiar from last week, it should. All the customers wanted their deposits back at once; FTX couldn’t pay them out right away. Is it a liquidity problem or a solvency problem ?

The U.S. government says it’s a solvency problem; they say that Alameda lost big, big, big bets and didn’t post enough collateral, and they were exempt from all the controls that should have prevented this from happening . The result was that one customer, Alameda, was able to bet with other customers’ money, Alameda kept losing, and those other customers didn’t know about it. The charges allege that FTX committed fraud by doing this.

Sam Bankman-Fried resigned as CEO and was later arrested at FTX headquarters in the Bahamas. He says that this was a liquidity crisis; if he had been allowed to stay on as CEO just a little bit longer, he would have been able to find an outside investor to help him weather the storm . He says he would have been able to pay out all the winners, he just needed a little bit of liquidity in the short term. He says the assets were all there. And he says the outside investor who published that critical note was just looking to hurt FTX.

A few things are happening now. The U.S. subsidiary of FTX is in bankruptcy in an American court. Second, Sam Bankman-Fried will be on trial for fraud, lying to customers, and money laundering. He’s also facing lawsuits from several U.S. government agencies.

The bankruptcy and the trial and the lawsuits will take a long time, but I have a feeling that there won’t ever be a satisfactory explanation for what happened. It will be good for one person, though: the journalist Michael Lewis was, coincidentally, spending time at FTX during its fateful last days. He’s negotiating a combined book and movie deal with Apple now.

There’s more…

This was an oversimplification, and if you follow this, you know there’s a lot more to the story. But this was the basic outline of what happened, and the charges against FTX.

There are some jaw-dropping allegations in the bankruptcy case, too. FTX was so sloppy with its accounting and bank accounts; customers were depositing money to the wrong places; and FTX didn’t keep track of who had deposited what, and where. They didn’t know what money belonged to their customers and what money belonged to their company. These are things you have to get right if you’re an exchange! Like, the whole purpose of an exchange is to keep track of this stuff accurately!

So during all this time, their twenty-something CEO and top executives decided to act like twenty-somethings with a lot of money and no adults around: they bought a Superbowl commercial, they bought luxury cars, luxury real estate, they sponsored the Miami Heat basketball arena, they donated to politicians, made big gifts to charity, sponsored conferences, went on television, and acted like big business moguls. But they were doing it all with other people’s money, not their own, according to the charges.

And now there are about nine million people who aren’t getting their money back from this exchange. And if convicted, the now-30-year-old founder would face up to 115 years in jail.