DUBAI (S&P Global Ratings) Nov. 10, 2022--S&P Global Ratings believes that the collapse of crypto exchange FTX.com will ripple through the digital assets ecosystem and sharpen regulatory impetus. This week's events amplify an already significant fall in crypto prices that started earlier this year and will likely accelerate collateral calls and liquidations. This could lead to more crypto players defaulting.

Thankfully, contagion risks to traditional finance (TradFi) appear contained for now. The "crypto winter", which started in May this year with the sharp depreciation of many digital assets and the collapse of a few crypto players, has already materially diminished the volatile emerging ecosystem, and tested TradFi entities' (limited) exposure to it.

What Happened

The events revolve around FTX and Binance, which are two of the largest centralized digital asset exchanges, and Alameda Research (Alameda), a principal trading company focused on digital assets. Alameda and FTX were founded by the same person. None of these entities are rated by S&P Global Ratings. Publicly available information such as financial statements is limited for these privately-owned companies.

FTX this week suffered material redemption requests (reportedly in excess of $6 billion) and stopped being able to meet customers' requests due to liquidity issues. The events followed a series of public exchanges between FTX and Binance, after the latter publicly announced its intention to sell its holdings of FTX tokens (FTT).

What We've Learned So Far

The facts around the build-up to the events are still emerging, but some points are already clear:

Crypto entities are also subject to the traditional rules of financial risk management.  Following this summer's failures of Celsius, Voyager, and Three Arrows Capital, these developments again point to potentially material failings in risk management at centralized entities operating in this space, including in terms of liquidity and asset-liability management (ALM).

Whilst decentralized finance (DeFi) protocols promise improved transparency through the availability of real time data on a blockchain, this does not extend to all centralized players in that ecosystem, often referred to as CeFi (centralized finance).  For instance, many of the centralized exchanges, such as FTX, are private companies with limited public disclosure. Reportedly leaked financial statements revealed the magnitude of Alameda's FTT exposure. The impact of the disclosure of sensitive information via social media is magnified by some of the entities' lack of public disclosure. The magnitude of FTX's exposure to Alameda remains unclear. The industry may push for improved disclosure from centralized exchanges. At the same time, greater transparency regarding the reserves of decentralized exchanges is not a guarantee of sound risk management, and the nature of assets held in these reserves--in particular, where reserves include the exchange's native token--is an important risk consideration.

Potential contagion risks may materialize within the crypto world in coming days and weeks.  These events have already triggered significant falls in the values of key crypto assets, with possible effects on entities exposed to these assets. Retail investors will likely suffer most. Those using FTX as an exchange, and holding FTTs, have already seen a significant financial loss and those losses may increase following FTX's decision to halt client withdrawals. Recent press statements estimate a liquidity shortfall of up to $8 billion at the exchange.

Reports suggest that regulators are investigating misuse of customer funds at FTX.   Among other factors, the nature of customer accounts, and particularly whether they are custodial or non-custodial, will affect customers' ability to retrieve their assets, should FTX enter into bankruptcy proceedings.

Despite the decentralized nature of the underlying blockchain technology, new forms of concentration abound in the ecosystem, and can crystalize risks.   The collapse of FTX illustrates the potential risks inherent in vertical integration, especially if that is largely unregulated. Certain crypto exchanges assume, directly or indirectly, a broad range of roles (brokerage, trading, custody, etc.). These are activities that are typically heavily regulated in the TradFi world

What's Next?

We believe that applications and protocol leveraging the benefits, including transparency, of blockchain technology will continue to grow. But these developments are likely to have a durable effect on centralized actors in the ecosystem and the broader crypto industry.

We see this unfolding via four channels:

The importance of governance will once again come to the fore:  The events are a severe blow to the crypto industry's credibility. The demise of a company viewed as one of the industry's best-established players may solidify the perception of crypto industry as an immature and highly risky space. FTX was perceived as a robust player, and one capable of consolidating crypto firms experiencing financial woes due to the downturn in recent months. For instance, FTX had agreed to purchase the assets of bankrupt digital asset firm Voyager. Strong governance and greater transparency, including on centralized players' financial position and management's conflicts of interest, are critical to the stability of this emerging ecosystem.

Regulators are likely to take a tougher stance:  This week's news reinforces our view that regulation will be a defining feature of the crypto ecosystem over the next two years (see "Regulating Crypto: The Bid To Frame, Tame, Or Game The Ecosystem," published on July 13, 2022). The rapid deterioration of one of the largest crypto exchanges will likely sharpen policymakers' resolve to address investor protection, market conduct, and financial stability. Regulators' objective to also foster innovation may take a backseat to those other priorities.

Some contagion to DeFi protocols is likely to materialize at least in the short term, even if their business models differ and are not automatically questioned:  The events will have ripple effects for the valuation of other crypto assets, and therefore impact DeFi protocols. The links between FTX and Alameda—which is reportedly being wounded-down--and reported issues around the use of client funds, were enabled by the centralized and opaque nature of the privately-owned exchange. Conversely, decentralized protocols, including decentralized exchanges, are not owned, or operated by an entity, and have no central management. Smart contracts underpin their operations, with transactions typically visible on a public blockchain.

We expect the impact on TradFi will be limited:  FTX's issues and other potential weaknesses in the industry are unlikely to have a material impact on traditional financial markets or the global economy. We understand that the exposure of TradFi to crypto-focused entities remains limited. That said, knock-on effects to early investors and backers of FTX and Alameda could indirectly spillover to TradFi, if for example venture funds and other nonbanking financial organizations used loans and other leveraged products to fund or interact with these entities.

How The Events Unfolded

• On Nov. 2, 2022, a press report citing leaked financial statements suggested that Alameda holds a significant amount of FTT tokens--the native token of the FTX exchange. Owners of FTT were able to use the token as collateral for leveraged trades on the exchange and benefitted from certain incentive schemes on FTX, such as trading discounts.These holdings reportedly represented over half of Alameda's total assets (formerly estimated at about $15 billion). The FTT token is created by FTX and its value derives from the market's perception of FTX's business prospects. It gives no ownership rights, which differentiates it from traditional equity shares of companies. The leaked financial statements drew market attention to potential liquidity and solvency risks at Alameda if the value of the FTT token were to fall. Rumors, notably on Twitter, that Alameda was also using FTT tokens as collateral for part of its liabilities exacerbated solvency concerns of the trading company.
• On Nov. 6, Binance's CEO, Changpeng Zao (known as CZ), announced that Binance would sell its FTT holdings. This put further pressure on the market value of the FTT tokens, leading to concerns over FTX's exposure to Alameda. Shortly after the announcement, Binance prepared to unwind $580 million of its FTT tokens. The CEO of Binance declared "learnings from the Luna" turmoil in May 2022 (see "Stablecoins: Common Promises, Diverging Outcomes," published on June 15, 2022) as one of the reasons for Binance's decision to liquidate its FTT holdings. FTT's price tumbled and triggered material redemptions by FTX users. Significant overnight withdrawals from the exchange and evidence of on-chain based liquidity transactions from Alameda to FTX increased fear of a liquidity crunch at the crypto exchange.
• Subsequently, FTX entered discussions with Binance for a potential acquisition, culminating in the signing of a non-binding letter of intent on Nov, 8, pending due diligence. Within 24 hours, Binance announced it was abandoning the acquisition, listing the potential of "mishandled customer funds and alleged US agency investigations" as reasons. We note reports that the U.S. Securities and Exchange Commission had started an investigation into potential securities law violation by FTX.US before the current turmoil.

Related Research

• A Deep Dive Into Crypto Valuation, Nov. 10, 2022
• Regulating Crypto: The Bid To Frame, Tame Or Game The Ecosystem, July 13, 2022
• Exploring Crypto And DeFi Risks In Credit Ratings, June 30, 2022
• Stablecoins: Common Promises, Diverging Outcomes, June 15, 2022
• The Current Crypto Downturn Is A Timely Wake-Up Call, May 13, 2022