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Understanding the Fall of FTX — the False Reality of Market Caps

Let’s have a look at the critical question that was never asked in the first place…

In finance, the “market capitalization” or “market cap” of a security or currency is a simple way to evaluate the overall “value” of the total entity (this is also called “network value” in terms of a cryptocurrency).

It is easiest to think about market caps in terms of stocks instead of currencies. In the stock market, if ABC Company is broken up into 100,000 shares, and the going market price is $3 per share, then the market cap of ABC is $300,000. Likewise for coins, if there are 100,000 coins available, and the current market price of the coin is $7, then the market cap of the coin will be $700,000. The idea behind the market cap is that, if every coin were sold at the current market price, this would be the amount of money it would require to buy them all.

However, hidden within this simplicity are many intricacies and complexities. The FTX cryptocurrency exchange collapsed recently for a variety of reasons. But one of them is that everyone took the coin market caps way too seriously, when they are at best a grossly simplified first-pass measurement. To explain, I will use stocks to illustrate the point for non-crypto audiences, but the point carries over perfectly to crypto as well.

Why are market caps often a false reality?

Let’s say that ABC Company has 100,000 shares, and the current market price is $3. However, you cannot buy or sell the entire company for that $3 per share price. Why not? Because, when stocks are heavily bought, the price goes up. Therefore, after you buy 100 shares at $3, everyone in the market sees that someone is buying at $3, so they raise their price. The price is now $3.15. Therefore, the rest of the shares are more expensive. As you buy, the price will simply continue to rise. Therefore, at best, the market cap tells you that, if you wanted to buy the whole company (or buy all the cryptocurrency), this is the minimum price you would pay.

However, this doesn’t mean that market caps are too low. Consider the other side of the transaction. Let’s say that I own 50,000 out of the 100,000 shares of ABC, and I want to sell. If the current market price is $3, you might think that I could get $150,000 for my shares, right? Probably not even close to that. As you sell, there are fewer and fewer people available to buy your shares at $3, so you have to entice new buyers. How would I do that? Buy lowering the price. Therefore, after selling 100 shares at $3, I might have to lower the price to $2.90 to sell more. This means that, in order to sell the company, the market cap represents that maximum amount that someone could possibly receive if they owned all the shares and sold them all at the market price.

So, as you can see, in basic terms, the market capitalization represents both a minimum and a maximum value for the company, depending on if you are looking to buy or sell shares in it on the open market. In neither case does it represent an actual realistic buying or selling price.

The critical question that is rarely asked

However, there is another question that is rarely asked, but needs to be put front and center in our current environment of unicorn valuations — where did the market cap come from in the first place?

Let’s take valuations of startups. Let’s say that ABC company is just starting up and is raising money. It owns all of its 100,000 shares. Now, let’s say that 10% of the company gets sold at a share price of $73 per share. That puts $730,000 cash into the company. However, because only 10% of the company was sold, ABC company can claim that it is valued at $7,300,000. Please note that it does not have assets or sales or contracts or anything else that justifies this value. It merely sold 10% of its company for $73,000.

Now, selling 10% of your company is a big deal. Perhaps one can justify saying that the company is “worth” that much money if investors can be convinced to invest that large a percentage in the company. However, what if the share price is kept at $73 but only 0.1% of the company is sold. This means that the company receives $7,300, but can still say that it is “worth” $7,300,000.

And this is how “unicorn valuations” are born. In fact, one can sell 0.1% of the company for $73 a share, and sell the next 0.1% of the company for $83 per share two months later, and then claim that the value of the company has risen by $1 million dollars despite only having received a total of $15,600 in investment. This can generate a lot of hype which is used to catalyze more investment at higher and higher prices.

All of this matters mainly to the investors as long as we are simply discussing the stock itself. The contagion starts to spread when the market cap is leveraged for other purposes. For instance, lets say that either an investor or the company itself takes out a bank loan using the stock as collateral. Is the stock actually worth anything? Is anything actually backing that loan? Let’s say that the stock is used as compensation for employees. They are receiving what they think is valuable pay — company stock that keeps on rising in value. But its actual value is highly questionable.

Now, with shares of a public or private company, there is a limit to how long this can go on. Ultimately, the number of shares is somewhat fixed, so there is some tethering to reality. Companies can increase the number of shares available, but only by a vote of the current stockholders. With cryptocurrencies, this is no longer the case.

Let’s say that, instead of ABC being a company, ABC is a cryptocurrency that is operated by some guy named Frank. In this cryptocurrency, Frank is the sole arbiter of how many tokens get generated. Let’s also say that Frank has a personal friendship with Bill and Steve.

Frank generates 1,000 tokens. He then sells half of them to Bill for $10 each. Then, Bill sells 10 of them to Steve for $1,000 each, now raising the total value of everyone’s coins. For $15,000, ABC’s total market cap becomes $1,000,000, with Frank owning $500,000 of it, and Bill owning $490,000.

Because Bill’s coins are now worth so much, he uses them as collateral on a loan. The bank views this value as legitimate because it was set by Steve, who is neither the issuer of the token nor the one asking for the loan. Now, with the loan, Bill can purchase other assets with real money. His portfolio looks diversified, despite the fact that its value ultimately only comes from the value of the tokens.

Additionally, since Frank controls token generation, Frank can generate new tokens at any time and apply them to any of their balances, if needed, to make it look like their balance sheets are better than they really are. All they need to do is avoid selling their own stock of tokens in order to keep the price of the tokens high.

In the case of FTX, the coin issued was FTT. FTX was able to set a price for the tokens by allowing users to pay their fees at a discount when using their own token. That is, FTX was a trading platform. If you paid FTX using FTT tokens, you got a discount on fees. That set a price for the tokens that FTX could claim was a “market price”. However, FTX could issue however many of these tokens as it wanted. Additionally, Alameda Research, which is FTX’s sister company, had billions of FTT tokens on the balance sheet which was used as collateral for trading.

What triggered FTX’s collapse?

The trigger to FTX’s collapse was that crypto exchange Binance decided to sell its FTT stash. Binance had acquired a large number of FTT tokens due to an ownership stake in FTX, but FTX had repurchased itself largely using its own FTT tokens. FTT is just printed at will by FTX, and its main use was to pay trading fees on the FTX platform. So when Binance decided to dump all of their FTT tokens on public exchanges the price went down dramatically. This also meant that all of the loans that FTX and Alameda had secured using FTT tokens were then called, because the value of the collateral had collapsed.

Note that these were not the only factors in play. It looks as if FTX was an entire mess of fraud and deceit. In fact, John Ray, who has been appointed as CEO of FTX post-collapse — to clean up the mess — said this: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” That’s saying something, considering that Ray also was the one appointed to clean up the Enron mess.

The point I’m making, however, is that, unfortunately, market cap (or network value) has been used uncritically by investors, the media, financial advisors, and pretty much everyone else as the primary means of assessing the “value” of something, whether stocks or cryptocurrencies. However, this number is inherently problematic as a value. It is open to extremely easy manipulation. I think everyone should look to find new ways to measure the “value” of a company that are more linked to its intrinsic value to the economy as a whole

You may also wish to read: Has the Bitcoin supply of “Greater Fools” finally been exhausted? It’s a bubble fueled by babble. At some point, the supply of greater fools will dry up, the manipulators will dump their bitcoin, and the bitcoin bubble will end the way all bubbles end. (Gary Smith)


Jonathan Bartlett

Senior Fellow, Walter Bradley Center for Natural & Artificial Intelligence
Jonathan Bartlett is a senior software R&D engineer at Specialized Bicycle Components, where he focuses on solving problems that span multiple software teams. Previously he was a senior developer at ITX, where he developed applications for companies across the US. He also offers his time as the Director of The Blyth Institute, focusing on the interplay between mathematics, philosophy, engineering, and science. Jonathan is the author of several textbooks and edited volumes which have been used by universities as diverse as Princeton and DeVry.

Understanding the Fall of FTX — the False Reality of Market Caps