Late last week, one of the largest cryptocurrency exchanges, FTX, filed for bankruptcy. From the sound of it, defrauding investors occurred and jailtime should happen for some of the firm’s leadership. I have seen a lot of different use of the terms (1) illiquidity and (2) insolvency online the last few days to describe the situation, in some cases using the wrong one. Buckle up – lets define the two and apply to what supposedly FTX has done
First up, illiquidity. Before we can define illiquidity, we must describe what liquid means in a financial concept. In short, a company being liquid means it can pay its current liabilities using its current assets. Current liabilities include obligations such as accounts payable, taxes, loan payments, and payroll that are intended to be payable with current assets such as cash, securities, and accounts receivable. When a company can pay its current liabilities using its current assets that can easily be converted to cash, the company is considered liquid. When a company is illiquid, there are not enough current assets to satisfy current liabilities, though the entity may have the assets that are long-term and the issue is considered fixable. The company can borrow against property, get a line of credit, or raise cash from investors. In conclusion, liquidity issues are solvable, but stressful.
Insolvency is a much worse situation than illiquidity. An insolvent company can not cover total liabilities with total assets. In this FTX example, FTX could not repay its liabilities to customers and debtors with the assets they had (current and non-current assets). Insolvency usually results in a declaration of bankruptcy.
How did insolvency happen at FTX? Based on my understanding of the events, FTX was intended to hold digital assets for its customers. Instead, the assets were transferred over to a related trading company called Alameda Research and mismanaged via poor trading and converting those assets to a digital asset called FTT. They should not have done this, and this is where the fraud lies. I do not know this for certain, but I believe there is nothing in a client agreement that allows FTX to trade or convert client assets to FTT token via an outside party. What happened next is what caused all this to come crashing down. A competitor exchange, Binance, tweeted that it was selling all of its holdings of FTT token causing the FTT token to drop significantly in value. Customers of FTX started to demand their assets back, but FTX could not pay as the customer assets were parked in FTT tokens that became worthless. The customer assets should have been parked in the asset like Ethereum, Bitcoin, XRP, etc. that the customers believed they had. As this bank-run happened, FTX tried to raise cash from other investors but failed. FTX became insolvent and declared bankruptcy late last week.
If what all I have read is true, the actions of FTX management are eerily similar to Ponzi schemes and money laundering which are criminal offenses. FTX engaged in incredibly poor risk management by not hedging risk on price moves of assets and liabilities of customers.
On last reminder, FTX is different than cryptocurrency and Bitcoin itself. It is a cryptocurrency exchange, and exchanges are run by corruptible people. Conversely, Bitcoin is run by math and code. If you buy digital assets and custody yourself or use qualified custodians that do not have ability to trade your assets, your funds are secure. I am still very high on the asset class in the future and believe that it is an intriguing hedge on bonds and fiat currencies.
As always, please do not hesitate to reach out with any questions.