Why Did FTX Pause Withdrawals if It Wasn't Trading Customer Funds?

Yesterday was one of the most head-spinning days in the entire history of the cryptocurrency industry, with Changpeng Zhao’s Binance signing a letter of intent to acquire, and effectively bail out, Sam Bankman-Fried’s FTX exchange. FTX had been considered a huge success story since its founding in 2019, and founder Bankman-Fried had become a respected figurehead.

The issues at FTX have complex roots, but reached a head early Tuesday, Nov. 8, when a huge wave of withdrawals drained FTX of liquidity and effectively froze the platform – almost always a sign of serious issues for a centralized exchange.

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The problems at FTX were shocking for many reasons, but perhaps most frightening is the simple fact that customer funds seemingly weren’t where they were supposed to be. As many observers pointed out, the liquidity crunch implies FTX violated its own terms of service, which read:

“None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading.”

(This would not include customers who opted in to the FTX Earn product, which offered yield on deposits.)

The restrictive terms are a useful contrast with a platform like Celsius Network, whose entire premise was using customer funds to generate returns through speculative lending and trading. Celsius failed spectacularly at this task and melted down earlier this year, taking customer funds with it.

But deposits at FTX were not supposed to be subject to that kind of risk – while individual tokens might lose value, the expectation of a centralized exchange is that they won’t gamble with your money.

However, there are suddenly hints that something else may have been going on. Among those signs were dark intimations from Coinbase CEO Brian Armstrong in an interview with Bloomberg late Tuesday.

"I had a number of conversations with people over the last 24 hours,” Armstrong said, “And there's reasons why [Coinbase acquiring FTX] would not make sense, and we're not quite at liberty to share the details right now. I’m going to let other people share that if and when they’re ready ... it'll probably all come out eventually."

See also: The Story of Sam Bankman-Fried's Backroom Deal With | Opinion

At a moment of great uncertainty, it’s risky to read too much into those sorts of tea leaves. But Armstrong certainly seems to know something the rest of us don’t. Just before publication of this story, it also became apparent that Binance may pull its buyout offer off the table after less than 24 hours of reviewing FTX’s balance sheet.

The nightmare scenario would be that FTX has been using customer funds for trading or other speculative activities – possibly including loans to sister company Alameda Research – and lost funds in the process.

For now, it’s unclear whether FTX is facing Celsius-style insolvency – an uncoverable debt at the level of its entire balance sheet. But the swift movement to seek a bailout after just a few hours of liquidity crunch could be read as further evidence of deeper, and perhaps more insidious, problems.