The Cryptic story of Cryptocurrency

 

Cryptocurrency - Many of you might have heard this word in the news or some other financial articles. But, you might recognize it if I say the word BITCOIN, and do you know that a billion-dollar fraud is happening around it? Well, before entering into the details of the fraud, let's look at a brief introduction about it. 

So, what is cryptocurrency? In layman's terms, cryptocurrency is an unregulated digital currency. Unregulated because it is not regulated by any central bank. Digital currency because these cryptocurrencies are not available in physical form. 

If it is unregulated by any central bank or not available in physical form, the question that comes to mind is, who created them, and who is operating and controlling them?

Your guess is right. The cryptocurrencies (there are around 9000 of them globally) are created, operated, and controlled by private individuals and companies. The first cryptocurrency was BITCOIN introduced in 2009. Though it was introduced in 2009, the concept and currencies were not so famous till 2017.

So, how are these operated? These are managed digitally. People who want to transact in cryptocurrency buy them with actual currency. Once purchased, they can save the crypto in a digital wallet allocated by the respective cryptocurrency manager.  Based on the demand for the cryptocurrency, the currency's value either increases or decreases. This is where the speculation comes into action in crypto trading. So, anyone trading with multiple currencies will have one digital wallet for each currency.

Having multiple digital wallets means, the person has to remember multiple user names and passwords associated with each digital wallet. 

Since there are 1000s of cryptocurrencies available in the market, it becomes cumbersome for people trading in 100s of currencies at a time. This gave scope for the emergence of crypto exchanges.

So, what do these crypto exchanges do?

Crypto exchange creates a platform for trading in multiple currencies with a single wallet. This wallet can be organized by a "token" issued in the exchange for the currencies purchased through that exchange. 

The token will have a certain value that increases or decrease based on the demand for multiple basket currencies in that token. (The original process is a bit complicated, but simplified for the convenience of the readers).

The cryptic story of the cryptocurrency started in one such crypto exchange called FTX operated from the Bahamas.

FTX Trading Ltd is a short form for Futures Exchange founded in 2019 by Sam Bankman Fried and Zixiao Gary Wang. Its headquarters are located in the Bahamas. Since its inception, its operations are shoddy. Within six months of its inception, Changpeng Zhao, the owner of another crypto exchange called Binance purchased a 20% stake in FTX  for $100 million.

Before dwelling into the details of fraud by FTX, we have to get acquainted with another firm, Alameda Research founded in 2017 as a crypto hedge fund. This was also found by the same person Sam Bankman Fried. Caroline Ellison, an ex-colleague of SBF (Sam Bankman Fried) became co-CEO of Alameda in October 2021 and sole CEO in August 2022. 

Now coming back to FTX. FTX issued tokens called FTT for all the traders on FTX. Initially, 5 million FTT was issued to Alameda in 2019. This allotment came with an exception for one important clause, auto-liquidation protocol. 

So, what is this auto-liquidation protocol? 

In stocks or cryptocurrency, exchanges keep control over the volume of stocks or currency that is sold on the platform by a single entity or individual. This helps in controlling unwanted losses or pejorative gains by the traders. (You can learn about this concept through a simple Google search. As of now, this is enough).

So, in the absence of auto-liquidation protocol, Alameda got a free hand with the volumes of trading they can do on FTX. In the absence of regulation from the government or from FTX, Alameda went on trading at riskier market positions. 

In 3 years, Alameda accumulated around 280-350 million FTTs. This was around 90% of the FTTs traded on FTX. This means Alameda and FTX colluded to increase the value of assets in their balance sheets by not having any control over the volume and value of FTTs traded by Alameda.

This cryptic trading was exposed by The Wall Street Journal in early 2022. On November 2nd, 2022, Coindesk, a news portal specializing in reporting cryptocurrencies pointed out the inaccuracies in the balance sheets of Alameda and FTX. 

The meltdown of Alameda and FTX started 4 days after the report by Coindesk. Binance CEO Zhao who was holding a 20% stake in FTX expressed his intentions to sell his entire stake on Twitter on November 6th. This declaration on Twitter led to aggressive reactions from several FTX traders including Bankman Fried and Caroline. This in turn led to a sell-off of FTTs by several traders in a span of two days leading to a withdrawal of approx $6 billion from FTX. The value of FTTs dropped by 80% in two days.

This has drawn the attention of regulatory bodies like the Securities and Exchange Commission and the Commodities Futures Trading Commission. They started investigating the transactions of FTX and Alameda from their inception. 

Vowing to all these crises, the Securities Commission of Bahamas froze all the accounts of FTX and related subsidiaries on November 10th leading to the filing of bankruptcy by Alameda and FTX on November 11th, 2022.

This led to a crisis in the entire cryptocurrency market as investors realized the risk in an unregulated market. The story didn't end here. The investors in FTX are still waiting to withdraw their investments. 

So, what happens to the investors holding FTTs now?

Since the exchange is not functioning, investors cannot withdraw their monies from the exchange. However, the regulatory bodies investigating the case and the courts may come up with a fund to cover a part of the investments. But the investors will lose at least half of their investments and with the returns of the remaining funds hanging until the court cases are cleared for an indefinite period. The list of investors is ranging from big fund houses to individuals in foreign lands.

Why is this important for normal people?

We invest in mutual funds, shares, and other market instruments either on our own or through an advisor. This chain of events and fraud by FTX highlights the risks involved with unregulated markets.

If you have investments in mutual funds or ULIPs (Unit Linked Insurance Plans which invest in markets), it is important to keep a track of where the investments are going. 

After reading all this, you may get doubt on the part of regulatory bodies in these transactions. 

Until 2021, regulatory bodies didn't recognize crypto. However, with an increase in the volumes, from 2021, many regulators started taxing the gains encashed in the respective country's currency arising from trading in cryptocurrencies (For example, India started taxing at the rate of 30% on the capital gains substantiated in INR from crypto trading from April 1st, 2022). This step was taken to avoid crypto trading as a means of money laundering and to track the gains from crypto trading.

In 2022, many countries central banks started testing state-backed digital currencies. 

Learn more about digital-rupee (e-rupee), an initiative by RBI that is in testing here.

Update: The key accused in FTX fraud, Mr Sam Bankman Fried was sentenced to 25 years jail term by the US Supreme Court. 

The fact that crypto currency market is still unregulated makes it a risky business.