FTX is in the news for both the enormity of its bankruptcy and the moral bankruptcy of its founder, Sam Bankman-Fried. Before even reading the news I knew in general how FTX went bankrupt, because it’s the same way every crypto ponzi scheme, sorry crypto “exchange” goes bankrupt. Here’s how it always happens.

Someone creates a whole bunch of magic beans, a billion in fact, then sells one of the beans to a sucker for a dollar. Their billion beans are now worth 1 billion dollars, because the most recent sale multiplied by the total number of items must be the fair value of them all, right? With net assets of 1 billion dollars, you can start doing some real financial malfeasance. You can take out big loans (using beans as collateral) or trade your beans for someone else’s beans, since you’re both playing a game where you pretend these beans have value. This gives you cashflow (although most of your “cash” is just other people’s beans) and the ability to pretend you’re running a business.

Once you’re trading beans, you tell suckers (retail investors) that your business is profitable and they should invest. Not by buying stocks in your company on the stock market, that’s a mug’s game. Stocks actually have value and are regulated by the government, no we’re in the business of beans. You tell people that to invest in your beans they just have to hand you over some of their dollars and in exchange you’ll give them beans. You tell them that the beans are interest payments on the dollars they’ve deposited with you, and since you’re still claiming the beans have value these suckers can then trade the beans amongst themselves. You then take those dollars they deposited and gamble them away on over-leveraged stock and crypto bets, all while pretending you’re the Wolf of Wall Street.

As long as people keep giving you dollars in exchange for beans, the scheme is solvent. The beans cost you nothing and you can print as many as you like. If a few people want to exchange their beans for dollars again, well that’s OK too because you’ve still got a big pot of dollars that you haven’t lost yet, so you can give them back their dollars and take back your beans to maintain the illusion of solvency. Your beans are your main asset remember, they’re what you are selling to raise money, they’re what is underwriting all your loans, so people need to believe that the beans have value and the best way to maintain that lie is to always be willing to buy back beans at the current market price.

It seems like the magic of a flywheel, once you spin it up it keeps going and going forever. As more and more people see your company as being profitable, more and more will want to buy your beans to “invest” in you. And when they invest, you give them all the beans they could ever ask for. As long as you keep buying back beans, fear of missing out (FOMO) will drive many investors to throw more and more money at you, driving up the price of your beans and making your company seem like a can’t lose bet. But nothing lasts forever, entropy will eventually slow down a flywheel and risky bets will eventually end a crypto exchange. There’s always some trigger, whether it be too many bad bets, a collapse in the price of bitcoin (which is probably one of your main “assets” after your magic beans) or you or an employee just steals everything and runs. But eventually people will start to catch on that you’re probably insolvent, and they’ll want their money back.

The reason FTX was insolvent is the same reason every crypto “exchange” is insolvent, there is absolutely no profit to be made in doing what they claim to do which is hold people’s money and always be willing to give it back. There is zero profit in doing this, banks write loans using depositor’s funds because that’s the only way to make a profit, and for the same reason exchanges gamble with depositor’s money because that’s the only way they make a profit. But banks are highly regulated to prevent insolvency and stupid bets, whereas crypto exchanges just aren’t. So eventually all exchanges make stupid bets and go insolvent, while most banks don’t.

So insolvency, it’s just a fancy word meaning people want their money back and you don’t have it. You gambled it all away and now all you have are magic beans, magic beans which only have value because you’ve been claiming you’d always buy them back at the market price. So the price of your beans collapse once people learn what’s up and that you no longer have the money to support your beans. Everyone tries to get their money out but you’re broke and can’t give it to them, then the people you took loans from realize you can’t pay them back either. As long as the numbers were going up, people kept buying beans from you and you could use more and more deposits to pay back your loans and keep up the fascade, now you can’t so you’ve got no choice but to default on those loans. And those loans and other obligations were underwritten with beans, which are now worthless as you won’t buy them back from anybody.

This above scenario is more or less how every crypto collapse has operated, plus or minus a few cases of an insider just taking all the money and leaving. They always issue their own coin because it’s an easy way to create the illusion of assets, they always take deposits and gamble them because it’s the only way to make money, and their balance sheet is always nothing but crypto so when the price of crypto goes down, they collapse under the weight of their own coins. Sam Bankman-Fried isn’t the first crypto scammer (although he does have the most appropriate name for one), he’s just the biggest one so far.