What is a cryptocurrency trading token and how did it help make FTX explode?

The FTT exchange token played a key role in the downfall of cryptocurrency exchange FTX and its affiliated trading company Alameda Research. It was the use of the FTT to inflate both entities’ balance sheets, reported by CoinDesk’s Ian Allison on Nov. 2, that raised the initial doubts that triggered the crash.

The FTT may have been the focus of another aspect of the FTX fraud, serving as a fictitious (but in fact worthless) “collateral” for loans of customer funds made by FTX to save Alameda.

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But what are exchange tokens? What role do they play for the exchanges that issue them? How should they be treated according to modern accounting principles? And how do they advance the cryptocurrency industry decentralization agenda?

To answer the last question first: Token exchanges are generally non-decentralized and, if anything, their goal is the opposite of decentralization. They are, basically, an incentive to keep using the same centralized exchange. Holders can use them to get discounts on trading fees, rewards and early access to offers. Despite the chatter on Twitter, the FTT token has not distributed a share of the FTX platform’s revenue or granted holders any governance rights, nor have most of the exchange tokens.

Technically, trading tokens are nothing special. FTT has been tracked as an ERC-20 token on Ethereum, a sort of token that virtually anyone with limited technical skills can create. BNB, Binance’s trading token, is tracked on its BNB Chain, a blockchain that began as a fork of Ethereum but has merged with a separate licensed blockchain.

See also: Binance looks to revive its BNB blockchain

This runs counter to one of the concepts that may have inspired the creation of trading tokens. Starting roughly 2016-2017, there was much discussion in crypto about “utility tokens” that would be used to incentivize and pay nodes for decentralized computing services. While the term appears 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 that you don’t need any legal regime for enforcing property rights or claiming a place in the “capital track”, i.e. the ordered list of obligations of an organization to counterparties, including debtors and investors. This is partly because there is no capital stack, but also because value is procedurally derived from the demand for services that are, in fact, directly connected to the blockchain.

Conversely, the value of trading tokens is implied to rest on a regulatory or legal regime that in many cases does not actually exist. Most, if not all, exchange tokens are issued by so-called “offshore” exchanges, such as FTX and Binance, which are registered in light regulatory havens such as, in FTX’s case, the Bahamas. US-registered exchanges Kraken and Coinbase, by contrast, do not have their own tokens because they have access to standard stock markets (and associated regulatory restrictions). Exchange Tokens are a way for offshore exchanges to raise funds without such access.

“Binance was the first to launch and it was a real success. And when you succeed, you get imitations,” said Katie Talati, co-founder and director of research at crypto asset manager Arca. “Huobi, OKX, they all launched their own token, and moving forward, it became standard. FTX it didn’t launch until the second half of 2019 and launched its token at the same time.”

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 equity pile and you can’t claim anything in case of bankruptcy, for example,” 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 quite common in cryptocurrencies, these tokens, issued by entities without strong regulators or even necessarily well-enforced property rights, trade much like equity. Talati said a discounted cash flow model is a useful way to think about their value, “but there are a lot of inputs we can’t model.”

This semi-fungibility with an equity model may have paved the way for Sam Bankman-Fried’s fraudulent finances. One element of the deception was that FTT was what is known as a “fully diluted low flow, high value” token. Only a very small fraction has been publicly traded, but the public price for that fraction was assumed to apply to hundreds of millions of dollars of the FTX-owned token itself. This makes rough sense when you think in terms of the “share value” that a startup founder, for example, holds on to after venture capital investors get their cut.

But the management of FTT tokens on the balance sheets of FTX and Alameda neither matched standard stock accounting practices nor, more importantly, reality. When accounting for its capital or managing the shares it has repurchased from the public markets, companies do not add them to their valuation estimate or liquid assets, but usually calculate them separately as “treasury shares”.

This is because a company’s equity is not part of its total value, it is a reflection of that value. Adding your shares to profits would be a bit like a snake eating its own tail.

This basic accounting deception became a time bomb when Bankman-Fried apparently began using FTT as collateral for loans between FTX and Alameda, as well as other related entities. As I wrote last week, these shenanigans don’t look much like Enron’s use of related entities and paper shuffling to hide debt and pump up its own valuation.

FTT’s centrality to the worst cryptocurrency blowout of all time prompted cryptocurrency leaders to clarify their stance on accounting for exchange tokens and similar internal assets. Binance CEO Changpeng Zhao took the trouble to clarify last week that Binance has “I have never used BNB as collateral.” In a space on Twitter last week, Ripple CEO Brad Garlinghouse similarly clarified that his company not counting his vast hoard of XRP on its budget.

See also: Binance launches Native Oracle Network, starting with BNB

This relatively unspoken rule helps explain why CoinDesk’s reporting on FTT flows was so explosive. It’s not the kind of asset that should be used the way it ostensibly was, and no truly independent entity would accept it as loan collateral, or even consider it an “asset.”

Savvy cryptocurrency investors are in a position to be the bulwark enforcing that rule and lose their shirts when they don’t. Talati is unequivocal about Arca’s position.

“When we look [projects]a lot of them will have their own token in their balance sheet,” he said. “And we just write it off.”

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