1. Crypto

Explaining the FTX Crash and What’s Next for Crypto

The Economics of The November 2022 Crypto Fallout

Disclaimer: Solana Foundation and Solana Labs are customers of Dakai, Binance is a past customer

FTX, the second biggest cryptocurrency exchange ran out of money this week. Binance, the #1 exchange tried to help it but when they looked closer they found an 8 billion accounting hole.

Why was there such a crisis? At this point, we can say that FTX was a malicious actor funneling user funds into risky loans through Alameda, a sister company. Margin trading in general – buying assets for less than their value – is a risky proposition for the institution that backs it. FTX collapsed when it ran into a liquidity crunch as a result of its margin trading operation. 

How A Company like FTX Can Run out of Money

We’ll quickly delve into a hypothetical scenario that shows why backing margin trading can quickly break down. 

  • FTX lets a customer like Madison do a margin trade: they buy $10 worth of Bitcoin (BTC) for $5 
  • FTX also lets Taylor do the inverse: they buy $10 worth of USD for $5 worth of BTC
  • If the price of BTC falls, Madison likely tries to get their USD back by returning their BTC
  • However, BTC is locked up with Taylor and is now worth less than $5, so FTX doesn’t have the money to perform the transaction
  • In this case, FTX has to use their own or outside capital to fill orders – but that capital is not unlimited, comes at a cost, and the problems worsen if many customers try to do trades. 
  • Even worse, FTX used customer money to lend out billions of their own tokens and used it as collateral to get their own loans

When customers went to FTX to get the case seems to be that a lot of FTX’s money was in FTT (a token issued by FTX) and loaned improperly to the CEO’s own hedge fund, Alameda research (as well as other loans to the company).

Based on Tweets by Binance it seems customer funds were in Alameda’s hands without that communicated to the customer.

An Industry Influencer Triggers a Selloff at FTX

Binance’s CEO, Changpeng “CZ” Zhao, held $2 billion of FTX’s FTT token and noticed the entire operation was beginning to look like a house of cards. FTX was also a competitor of Binance and trying to use regulations in their company against them, so CZ decided to push back. 

Being a first investor and early equity holder of FTX, CZ’s opinions hold weight in the industry.

So when CZ tweeted that he sold all assets related to FTX and warned everyone else not to touch them, his followers all decided to do the same.

A Last Ditch Attempt to Save FTX Falls Through and Binance Drops FTX Deal

As an exchange, if all of your users want to withdraw money that’s not there, then you’re in deep trouble. 

The best case scenario is you lose money on every deal, but if you can’t find someone who lends you the money to make up the difference, you go bankrupt. 

So FTX decided to turn to its bigger brother, Binance, for help. 

However, Binance was able to walk back the deal anytime since there was no binding agreement without due diligence. 

Since FTX had been trading with customers’ money in risky assets and did other shady things, no one else was willing to touch it. Binance ended up walking back on the deal since they were also preparing a big sell frenzy from customers holding one of their coins (Solana).

Why Solana is Crashing

So that’s the story with FTX and FTT… but why is Solana crashing after announcing partnerships with Google Cloud, Instagram, showcasing their new mobile phone to thousands of people, and recreating the way physical stores work in crypto?

Here’s the story: Solana gives yields if coins are kept for the full amount, called staking. The next period when customers can unstake their coins without penalty is roughly the 10th of November. This means anyone who wanted to exit the market will have to do it at the same time on the 10th. Originally, Solana Foundation wanted to unstake and move coins as well ($500M of it) which caused panic as they effectively doubled the pool, so they rescheduled this. Roughly $500M (half the original amount) of Solana was unstaked in the end. Two big holders were FTX and Binance who are speculated to sell it soon due to demand for liquidity.

FTX was also the issuer of soBTC and similar assets that were used to trade other cryptocurrencies on Solana’s DeFi network. There is currently no information on whether these tokens have any backing or if they can be withdrawn, so many DeFi protocols on the network relying on these tokens might stop working in the coming days.

With the low confidence in FTX, industry people will likely want to sit out the market a bit with a secure USD account in their traditional bank. All traffic leaving the market selling their coins will go through one of the exchanges out there – it’s reasonable to assume most of them through Binance now that FTX has frozen withdrawals.

So What’s Next? When Will the Crypto Bear Market End?

At Dakai, with our network and technical knowledge in the industry, we think that general market growth is tied to technical innovation in this space even more so than others. DeFi/NFTs were the last such innovation. It’s difficult to estimate where new technical innovation that’s able to capture the trust of the mainstream and burned investors will come from. Since most people that can be reached by now have at least dipped their toes in crypto, it will be difficult for a startup or small company to reach everyone and build immediate trust.

On the other hand, most large companies have blockchain departments working on products. Most of these studios have been established in 2021 or early 2022. Based on our experience, it takes roughly 1-2 years for a department like that to bear fruit. Cryptocurrency conferences are increasingly filled with people from medium to large sized companies and we think that a lot of what happens in the industry will soon be directed by these incumbents enjoying the backing of capital-heavy enterprises.

Salesforce launched NFT cloud and many fashion brands lightly launched NFTs this year. These are small waves though as a lot of the regulation and laws around crypto are not yet formed. Currently, the digital assets departments of these companies are formed as separate smaller entities as to not surface on regulators’ radars. In 2022, holding crypto on your balance sheet or trading it is hellish for enterprises.

At Dakai we are keeping an eye out for regulatory changes in the United States as well as trying to monitor (or working on) the products these incubments are creating to assess where the next big push in the market will happen. We are also curious to see how “suits” mixing with the crypto bro culture will play out. 

We might see one of the biggest wave of leadership changes at these companies as the now-30s managers emerge during the next crypto wave who pushed this program through while crypto is still desperately looking for its real use case.

The current best use of the mixing of traditional industries and crypto is Solana Spaces which has just been introduced. It allows anyone to be a store owner of their favorite brands by purchasing an area on the map where they open a store of that brand seamlessly. 

Of course, a lot has to be figured out around this but we suspect that more similar use cases will emerge and shorten things like mergers and acquisitions, transactions of physical property between people etc. Things that took anywhere from a month to a year can now take a lot less time. There are some small companies focusing on these new sparks that enterprise can pick up in the coming months and year.

Let us know if you want to work together on the next big thing in crypto. Our team has created innovative software for Binance, Solana, Google, Spotify, and many others across industries