How FTX’s own token was the final nail in its coffin

Like many other centralized cryptocurrency exchanges, FTX issued FTT after launching in 2019. 

For a while, FTT was a massive source of growth and revenue for FTX. Investors bought into the idea of FTT, since FTX offered rewards in exchange for ownership of the token, including trading discounts and VIP status on its site. Investors also were promised “guaranteed liquidity” by disgraced FTX founder Sam Bankman-Fried, insinuating that the risk of buying in was pretty much nonexistent. But, as it turns out, the risk was actually super high—a fact now devastatingly clear.

FTT was apparently used by Bankman-Fried to prop up his cryptocurrency exchange and its sister trading firm, Alameda Research, which lead to the scheme’s demise.

So, how did this all happen?

The collapse

Though Bankman-Fried and Caroline Ellison, CEO of Alameda Research, swore up and down that their companies were very separate, both were very intertwined.

Reporting from CoinDesk first found this to be true, revealing that Alameda actually owned a hefty amount of FTT and listed $3.66 billion of “unlocked FTT” and $2.16 billion of “FTT collateral” as assets on its balance sheet as of June 30.

This is bad for a number of reasons—especially since Alameda used FTT as collateral for loans it took out.

“If the exchange issues a huge number of tokens and holds them on their balance sheet, only offers a small number of those tokens for trading—restricting the ‘free float,’ which can create an artificially high valuation—and uses the locked tokens on its balance sheet as collateral for loans, this creates a systemic risk because the collateral’s paper value isn’t real,” Matt Hougan, CIO at Bitwise Asset Management, told Fortune via email. “If the loans get called, the exchange may be insolvent.”

It’s essentially “using printed money to access hard money,” said Michael Safai, a founding partner at Dexterity Capital. “The fates of the token price, loans, and the financial health of the company become intertwined, which, in a downturn, will accelerate their decline. Even then, it’s just not a good idea, which is why investors were quick to turn on FTT once they realized the extent of it.”

Indeed, following the CoinDesk report, Binance CEO Changpeng “CZ” Zhao announced he would “liquidate any remaining holdings of FTT on our books” citing “recent revelations that have came to light.”

Fearful, investors then rushed to retrieve their money from FTX, sparking a $6 billion bank run. FTX could not sustain itself and halted withdrawals. Days later, FTX filed for bankruptcy. It turns out that when the price of FTT dropped, Alameda couldn’t repay lenders, and to do so, FTX used customer funds. 

Though its creator is out of commission, FTT is currently trading for about $1, down 98% from its 2021 all-time high.

‘Poor risk management and misconduct’

How FTX used FTT is obviously a case of “poor risk management and misconduct of customers’ funds,” said Youwei Yang, chief economist at BTCM.

For starters, said Aaron Jacob, head of accounting solutions at TaxBit: “FTX was recognizing created but non-issued FTT on its balance sheet as an asset, which is very questionable accounting given that FTX could create those tokens at will. It’s also tough to argue that the total value of those tokens on its balance sheet was appropriate, because if FTX would have tried to liquidate, then it would have collapsed the price.”

Additionally, because of the close, undisclosed relationship between FTX and Alameda and their related transactions, the two could “essentially manipulate both the supply and demand of the token and therefore the price,” Jacob added. 

Does that mean other exchanges with in-house tokens, like Binance and its BNB token, are similarly at risk of a collapse?

“The only way that the FTT situation could happen to BNB would be if Binance commits the same mistake of getting highly levered against it,” said Lucas Outumuro, head of research at IntoTheBlock. “It seems unlikely, especially given the current market conditions, and it would be an even bigger black swan event.”

Overall, exchange-issued tokens might not pose a systemic risk to an exchange or crypto in general, but that doesn’t necessarily mean they’re good investments or devoid of risk.

“Just because there isn’t an automatic risk from an exchange issuing a token, that doesn’t mean everything’s fine. There is a concern that an exchange issuing that token will do things with it that create systemic risk,” Bitwise’s Hougan told Fortune. “In the current crypto atmosphere, investors are right to ask questions of exchanges that have tokens, because they don’t know what the exchange is doing behind the scenes.”

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