The collapse of FTX: A shockwave through crypto markets

Andrada Ilie and Sofia Bulycheva

Finance Division

Introduction

Once a large and trusted cryptocurrency exchange, FTX reached its peak valuation of $32 billion, before collapsing due to their misuse of consumer funds being revealed, sending shockwaves through the entire cryptocurrency ecosystem. Its founder, Sam Bankman-Fried, received one of the highest sentences for a white-collar crime in recent years, namely 25 years in prison, having generated billions in investor losses.

Misuse of customer deposits

The most central element of the scandal was the misallocation of consumer funds. Customers deposited assets with FTX assuming that they would be secure and available to them on demand. In spite of that, a significant portion of funds was diverted to Alameda

Research, a quantitative trading firm, the sister company of FTX, also controlled by Sam Bankman-Fried. Without customers’ consent, these funds were used in highly leveraged and speculative trading strategies. Once market conditions worsened and Alameda’s positions were down, the following losses impacted the availability of funds for withdrawal requests.

Liquidity crisis

The misuse of consumer funds through Alameda went on for a prolonged period, due to lack of transparency. Since FTX was not a traditional financial intermediary, it was able to operate while lacking regulatory oversight, capital requirements, and other typical risk management safeguards imposed on financial institutions. This increased its exposure to liquidity shocks and made it easier to conceal the misuse of customer assets. Ultimately, once the crypto news site CoinDesk revealed the mismanagement going on behind the scenes, customer trust was eroded and people started withdrawing funds, generating a classic liquidity crisis.

Contagion in crypto markets

The collapse of FTX was not limited to the exchange itself, but it instead triggered widespread instability across the broader cryptocurrency market. Because FTX was one of the largest and most influential platforms in the industry, its failure caused panic among investors, raising concerns about the financial health of other crypto companies. Usually, when one company suddenly refuses redemption requests, other companies may also face liquidity pressure as worried investors start rushing to withdraw their funds. Such news unnerve investors, prompting them to make further withdrawals, which worsen the panic. This development is especially common in digital-asset markets, as they’re not backed by a Federal Reserve or other central bank in the same way as traditional financial systems are, making it harder to contain a crisis once confidence collapses. This is indeed what happened within the cryptocurrency ecosystem once the FTX scandal became known.

Conclusion

The collapse of FTX became one of the most significant scandals in the history of cryptocurrency, exposing the dangers of poor governance, lack of transparency and misuse of customer funds. Starting off as a very successful and innovative financial platform, it was built on weak controls and risky practices that left it very vulnerable to collapse. So once the truth became public, it caused an almost instant collapse in confidence, leading to a liquidity crisis and contagion across crypto markets.