Binance to acquire FTX.com in a shock-inducing move after a $6 billion liquidity crisis

Binance, the world’s largest cryptocurrency exchange by volume, has signed “a non-binding [letter of intent] LOI” to acquire FTX.com, the third largest exchange by volume, in a move that would send shockwaves through the entire crypto industry. The deal is intended to help FTX cover a reported liquidity shortfall. The acquisition is dependent on the completion of due diligence.

Binance CEO Changpeng Zhao (CZ) and FTX CEO Sam Bankman-Fried (SBF) revealed the deal on the social networking site Twitter — here and here. With the agreement classified as “non-binding,” Binance can pull out of the deal at will.

This comes just days after Zhao disclosed that his company would liquidate its FTX token (FTT) holding, citing unspecified “recent revelations” about FTX. The plan was to exit FTT in a way that minimizes market impact, CZ wrote.

FTT is FTX’s native utility token that offers its holders benefits such as tiered trading fee discounts.

Before CZ’s tweet, crypto publication Coindesk reported on Nov. 2 that there were irregularities in the balance sheet of Alameda Research, a trading firm owned by Bankman-Fried. Much of Alameda’s equity was in FTT — the token created out of nothing by its sister company FTX.

Binance’s decision to dump the FTX token triggered a classic bank-like run, with users looking to withdraw their assets in droves. FTT token now trades around the $4 mark, down about 84% from the pre-saga levels of around $25. The Block reported on Nov. 8 that FTX had stopped processing withdrawals on the Ethereum, Solana and Tron networks, citing on-chain data. All withdrawals (crypto and fiat) have now been halted, according to an announcement in the FTX Support Telegram group.

Liquidity crunch

News outlet Semafor reported that FTX combed Wall Street and Silicon Valley for a bailout of more than $1 billion before the embattled crypto exchange agreed to sell itself to Binance. A source told Semafor that the hole in FTX’s books was much more significant — between $5 billion and $6 billion.

Liquidity shortfalls of this nature generally happen when a financial institution cannot sell assets rapidly enough to meet withdrawal requests.

But how did a hole appear in FTX’s books?

There are a few plausible causes, including:

• A security breach, which typically sees hackers steal users’ funds.
• Irresponsible business practices, where an exchange uses customer funds to do business.

In the FTX case, it wasn’t a security breach; otherwise, the story would be public.

Evidence points toward irresponsible business practices. In its simplest form, a crypto exchange primarily offers trading services for a fee. Unless the exchange does more than facilitate trades for a fee, every asset should be available for withdrawal regardless of its underlying value. So the fact that withdrawals had to be halted suggests that FTX has been engaging in rehypothecation, a practice in traditional finance where brokers use customer assets for their own benefit.

There may now be some clue as to where the liquidity issue arose.

Lucas Nuzzi, the head of research and development at crypto analytics firm Coinmetrics, published a Twitter thread on Nov. 9 that showed that “FTX might have provided a massive bailout for Alameda in [the second quarter], which now came back to haunt them.”

Nuzzi’s suggested that Alameda imploded in the second quarter with other trading giants like Three Arrows Capital (3AC) but only survived because it was able to secure funding from FTX.

“The Alameda bailout likely put a dent on FTXs balance sheet to the point where it was no longer solvent,” Nuzzi wrote.

The backstory

Binance had strategically invested in FTX in 2019, taking on equity and a long-term position in FTT as part of its investment. The more prominent exchange divested its equity interest last year when FTX raised $900 million in venture funding. Binance received the equivalent of $2.1 billion in stablecoin (BUSD) and FTT.

Little was known of the story behind Binance’s decision to offload its FTX equity just two years after entering making the “strategic investment,” which was supposed to see the two companies “work together to further develop the cryptocurrency ecosystem.” At the time, CZ said Binance’s sale of its FTX equity was just part of “a normal investment cycle,” adding that the deal was completed on good terms.

It’s worth noting that strategic investments typically happen because the investing company believes the target company can bring some business value over the long term — of course, in addition to the appreciation of the invested capital. This is different from when career investors — say, venture capitalists — buy shares in a company for returns alone.

According to a 2019 announcement post about Binance’s investment, FTX was, among other things, supposed to “help build out the liquidity and institutional product offerings across the Binance ecosystem, including its exchange (Binance.com) and over-the-counter (OTC) trading desk.”

The events of the last past couple of days would raise questions if there was always more to Binance’s exit from FTX.

Had CZ not publicly disclosed Binance’s intentions to sell its FTT holdings, it’s unlikely that FTX’s troubles would have been fast-tracked. FTX customers and FTT holders wouldn’t have any concerns. FTX is, after all, one of the world’s largest and most trusted exchanges.

“We’re still friends, but we no longer have any equity relationship,” Zhao told Forbes last year when Binance divested its interest in FTX.

The way Binance has handled the situation is anything but friendly. FTX had set an example in friendliness earlier in the year when the crash of Luna triggered an industry-wide liquidity crunch. The company famously bailed out companies like BlockFi. Although crypto publication Protos later reported that those deals were not so friendly, FTX handled the bailouts in ways that helped those companies stay alive.

It’s unclear where things went wrong between FTX and Binance. Still, these events cast further shadows over the credentials of the centralized crypto entities to spearhead the crypto revolution without regulatory oversight.