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analysis

The near-collapse of FTX, a dominant cryptocurrency exchange once seen as a trustworthy oasis in a sketchy industry, is ricocheting through the crypto sector at alarming speed, sending the prices of multiple cryptocurrencies plummeting and raising serious doubts about the business model for all crypto assets.

The potential for contagion is only growing following the news late Wednesday that Binance, a rival exchange, is walking away from its potential takeover of FTX, citing concerns about FTX’s finances and a new regulatory probe of the exchange.

Because there is so much uncertainty, FTX’s halo has disappeared. That’s not only trouble for FTX founder and chief executive Sam Bankman-Fried, who has now likely lost billions of dollars, it’s also perilous for the entire industry.

Until Tuesday, when FTX announced the shocking news it had signed a letter of intent with Binance for a potential takeover, Mr. Bankman-Fried was often hailed as the industry’s golden boy – someone who got extraordinarily rich off crypto and was willing to play nice with lawmakers in Washington.

Walking that fine line made Mr. Bankman-Fried an industry unicorn. Many crypto bros, as they are known, voice blatant distrust for anyone in authority, and want to build a parallel financial system, one where computer code – which underpins crypto assets – is the law, not regulators or elected officials.

By contrast, Mr. Bankman-Fried seemed much more trustworthy, so he was able to court premier celebrities to market his exchange, including Tom Brady, Steph Curry and Larry David. He also won over sophisticated institutional investment managers, including Ontario Teachers’ Pension Plan and Tiger Global, which invested directly in FTX.

And in Washington, he showered U.S. lawmakers with campaign donations at a time when industry regulation is a pressing topic. Mr. Bankman-Fried reportedly spent US$40-million during the U.S. midterm elections, often giving to Democrats.

“Sam Bankman-Fried is the sun in the solar system,” said Steve Diamond, a securities lawyer and professor at Santa Clara University in California.

The problem now is that it’s much harder to know who can be trusted. The whole crypto sector was already wobbling, with two-thirds of its value, or US$2-trillion, evaporating in six months earlier this year. Now with the latest liquidity crunch – something that was never supposed to happen to FTX – the fallout is worsening by the hour.

As of late Tuesday, the prices of bitcoin and ether, the two most popular cryptocurrencies, have dropped 24 per cent and 28 per cent, respectively, since the start of the week. They are now both down 76 per cent over the past year.

Things could easily keep getting worse. Financial markets go haywire when there is uncertainty, and investors often cut and run.

Some of the industry’s biggest supporters are trying to shore up confidence. Late Monday, Som Seif, the founder of Purpose Investments, which launched Canada’s first Bitcoin ETF, tried to spin this as a positive for the crypto sector in the long run.

“Although today’s events will cause anxiety for many, it’s important to recognize that there will be a great deal of learnings from it. This should pave the way for a stronger and better future for crypto and digital assets,” he wrote in a statement. The price of bitcoin is down 65 per cent since Purpose launched its ETF.

But little is known about FTX’s financial woes, and an information vacuum is the worst thing for financial markets in times of stress. The crypto sector is particularly vulnerable because it is so lightly regulated, and many of its major operators are private companies.

“Because the crypto industry is so non-transparent,” said Dennis Kelleher, CEO at Better Markets, a lobby group in Washington, “it’s harder to know how deep the crypto collapse will be.”

Details of what caused the liquidity crunch at FTX is still hazy, but early indications suggest the exchange’s currency might play a prominent role. Many crypto trading platforms create their own currencies, known as exchange tokens, and FTX’s is called FTT.

But most crypto companies aren’t regulated, so there are no formal rules about how much capital a trading hub or exchange must hold as a buffer against market crashes. It’s possible FTX took money invested in FTT and invested it in other cryptocurrencies, or even lent it out to other crypto companies.

Mr. Bankman-Fried also runs a separate crypto company, Alameda Research. No one seems to know if there was co-mingling of funds between FTX and Alameda, but the value of FTT plummeted over the weekend and it might have wiped out FTX’s safety buffer – similar to how a housing crash can wipe out the collateral on a home-equity loan.

With so much uncertainty, a downward spiral can form. If, for instance, FTX, invested its users’ money in bitcoin, the value of its capital safety buffer will have suffered has bitcoin crashed over the past year. Now, nervous investors may sell more bitcoin, and shrink the buffer even more.

Banks, by contrast, are required to hold their capital in highly liquid securities, such as U.S. Treasuries.

A death spiral of this sort already played out earlier this year with the cryptocurrencies luna and terraUSD. Galaxy Digital Holdings, a TSX-listed crypto fund, lost hundreds of millions of dollars.

But with FTX the spillover is much larger. Mr. Bankman-Fried, for example, recently invested in Robinhood, the retail trading app that was wildly popular during COVID-19 lockdowns in early 2021. Robinhood’s shares are down 30 per cent since Monday.

The saving grace, however, is that nothing so far has spread to core financial markets, and that’s largely because regulators applied quiet pressure. “The banks were salivating to get into the crypto business,” Mr. Kelleher said of U.S. lenders. “They put enormous pressure on elected officials and regulators.”

“The untold story so far is the regulators kept it out of the banking system,” he added.

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