The FTT exchange token played a key role in the downfall of the crypto exchange FTX and affiliated trading firm Alameda Research. It was the use of FTT to inflate both entities’ balance sheets, reported by CoinDesk’s Ian Allison on Nov. 2, that raised the first doubts that sparked the collapse.
FTT may have been core to another aspect of the FTX fraud, serving as notional (but actually worthless) “collateral” for loans of customer funds made by FTX to bail out Alameda.
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But what are exchange tokens? What role do they serve for the exchanges that issue them? How should they be treated under modern accounting standards? And how do they advance the crypto industry’s agenda of decentralization?
To answer the last question first: Exchange tokens are by and large not decentralized, and, if anything, their goal is the opposite of decentralization. They are, at bottom, an incentive to keep using the same centralized exchange. Holders can use them to get discounts on trading fees, rewards and early access to offerings. Despite chatter on Twitter, the FTT token did not distribute a share of FTX platform revenue or give holders any governance rights, and neither do most exchange tokens.
Technically, exchange tokens are nothing special. FTT was tracked as an ERC-20 token on Ethereum, a kind of token that pretty much anyone can create with limited technical skill. BNB, Binance’s exchange token, is tracked on its branded BNB Chain, a blockchain that began life as an Ethereum fork but has merged with a separate permissioned blockchain.
That’s in contrast to one of the concepts that may have inspired the creation of exchange tokens. Starting roughly in 2016-2017, there was a lot of discussion in crypto of “utility tokens” that would be used to incentivize and pay nodes for decentralized computing services. Though the term seems to have faded, current examples include the decentralized storage network Storj; the BitTorrent token now managed by Tron; and even Helium, the troubled Wi-Fi node project.
The appeal of utility tokens is you don’t need any legal regime to enforce property rights or claim a place in the “capital stack” – that is, the ordered list of obligations from an organization to counterparties including debtors and investors. That’s partly because there is no capital stack, but also because the value derives procedurally from demand for services that are, in effect, directly connected to the blockchain.
The value of exchange tokens, by contrast, is implied to rest on a regulatory or legal regime that in many cases doesn’t actually exist. Most if not all exchange tokens are issued by so-called “offshore” exchanges, like FTX and Binance, that are registered in light-touch regulatory havens such as, in FTX’s case, the Bahamas. U.S.-registered exchanges Kraken and Coinbase, by contrast, do not have their own tokens because they have access to standard equity markets (and the associated regulatory restraints). Exchange tokens represent a way for offshore exchanges to raise money without that access.
“Binance was the first to launch, and it was really successful. And when you’re successful, you get copycats,” Katie Talati, co-founder and director of research at the crypto asset manager Arca, said. “Huobi, OKX, they all launched their own token and, going forward, it has been standard. FTX didn’t launch until the second half of 2019, and at the same time they launched their token.”
But just because exchange tokens can raise money like equity doesn’t mean that’s what they are. “Currently, these aren’t part of the capital stack and you can’t claim anything in a bankruptcy, for instance,” Talati said. “There’s no governance, you can’t say you want the exchange to do X,Y and Z.”
But in a strange sort of ontological mystery that is fairly common in crypto, these tokens, issued by entities without strong regulators or even necessarily well-enforced property rights, trade a lot like equity. Talati said that a discounted cash flow model is one useful way to think about their value, “but there are a lot of inputs that we can’t model.”
This semi-fungibility with an equity model may have eased the way to Sam Bankman-Fried’s fraudulent finances. One element of the grift was that FTT was what’s known as a “low-flow, high-fully diluted value” token. Only a very small portion traded publicly, but the public price for that fraction was assumed to apply to hundreds of millions of dollars of the token owned by FTX itself. This makes a rough sort of sense if you think in terms of the “equity value” that a startup founder, for instance, hangs on to after venture capital investors get their slice.
But the handling of the FTT tokens on FTX and Alameda’s balance sheets didn’t track either to standard equity accounting practices or, more importantly, to reality. When accounting for its own equity, or handling stock it has bought back from public markets, companies do not add them to their valuation estimate or liquid assets, instead usually tallying them separately as “treasury stock.”
That’s because a company’s equity isn’t part of its total value, it is a reflection of that value. Adding your own stock to your bottom line would be a bit like a snake eating its own tail.
This basic accounting deception became a time bomb when Bankman-Fried seemingly began using FTT as collateral for loans between FTX and Alameda, as well as other related entities. As I wrote last week, these shenanigans resemble nothing so much as Enron’s use of related entities and paper shuffling to hide debt and pump its own valuation.
The centrality of FTT to the worst crypto blowup of all time has pushed crypto leaders to clarify their stance on accounting for exchange tokens and similar in-house assets. Changpeng Zhao, CEO of Binance, took pains last week to clarify that Binance has “never used BNB as collateral.” In a Twitter Space last week, Ripple CEO Brad Garlinghouse similarly clarified that his company does not count its vast trove of XRP on its balance sheet.
This relatively unspoken norm helps explain why CoinDesk’s reporting about flows of FTT was so explosive. It’s not the sort of asset that should be used in the way it seemingly was, and no truly independent entity would have accepted it as loan collateral, or even considered it an “asset.”
Experienced crypto investors are in a position to be the bulwark enforcing that norm – and to lose their shirts when they don’t. Talati is unambiguous on Arca’s stance.
“When we look at [projects], a lot of them will have their own token on their balance sheet,” she said. “And we just cross that out.”