Presenting: FTX Exchange
***This article was written prior to FTX’s collapse***
Executive summary
This report introduces the cryptocurrency exchange FTX and its placement within the crypto industry. An extensive analysis of FTX’s business strategy and operations model has been conducted to evaluate their current level of success in the market. The report has also assessed the alignment between strategy and operations to discover their impact on the business’s success. In concluding remarks, some key recommendations and feedback received from FTX have been analyzed to gain insight into the company’s future direction.
FTX is a cryptocurrency exchange founded in April 2019 by CEO Sam-Fried. Amidst a sea of unfunctional exchanges, FTX has aimed to provide cryptocurrency users with a highly liquid and reliable exchange. They primarily market towards the rapidly growing segment of wealthy
funds and professional traders [exhibit 1]. Sam has leveraged services from his previous trading firm, the Alameda Research Group, to provide value to these customers. Beyond implementing some liquidity features, core Alameda team members have also transitioned into FTX to aid with R&D. Establishing a reputation in the industry is the most challenging piece of the puzzle, as many exchanges succumb to hacks [exhibit 2]. To overcome this hurdle, the team has marketed the exchange in a favorable light through critical partnerships, donations, and regulatory compliance.
After just two years of implementing its strategies, FTX has become an industry titan, largely attributed to the alignment between strategy and operations. Its operations model has established processes to provide its target market with value offerings. Such methods include talent acquisition, capital infusions, resource acquisition, and market-efficient technology. As the cryptocurrency markets continue to heat up, competing firms are at each other’s necks, and if FTX wants to remain at the top, development must continue.
Introduction & Background
Industry Background
FTX is currently operating within the financial industry. Their primary services, however, are catered towards the more niche cryptocurrency industry. Cryptocurrency, which gained traction with the birth of Bitcoin in 2009, is a grassroots ecosystem premised upon decentralization. Adoption rates, especially after near 0% interest rates introduced in 2020, have skyrocketed [exhibit 3]. While traders and investors continue to flood the space, the total size of the crypto industry remains extremely small compared to that of the global markets. Total assets held or traded in traditional markets, such as the stock market, amount to over $67T USD, while the cryptocurrency market is currently hovering around $1.5T USD. However, the relative market size is the most attractive part of the space, as it offers higher growth potential. This has put institutional investors on high alert. As respectable traders and investors continue supporting this market, global trade volumes and open interest have exploded [exhibit 4].
Rising volumes and user accrual, while highly beneficial to the space, have also exposed some infrastructure issues, which can largely be attributed to exchanges. Amidst these exchange issues, many new venues have sprung up. Currently, the largest and most trusted venues in the space include FTX, Coinbase, Binance, Bitfinex, and Bybit. It’s crucial, however, to understand the scope of these exchanges. All these exchanges are technically competitors to FTX. However, Coinbase, Bitfinex, and Bybit focus on spot trading as they’ve only listed a few prominent capitalization cryptocurrencies [exhibit 5]. Binance, on the other hand, offers derivative trading and prides itself on a massive altcoin (alternative cryptocurrencies) trading asset base and, therefore, must be recognized as the most direct competitor to FTX [exhibit 6]. Via spot trading markets, Coinbase maintains a 40% market share, Bitfinex has 20%, Binance has 20%, and the remaining is split between Bybit and FTX. In terms of derivates trading, Binance has maintained a 45% share, while FTX holds a 35% share, and Bybit has a 20% share.
Company Background
Since its inception in April 2019, FTX has quickly risen to the forefront as a crypto-native exchange. While an inexperienced market participant may see them as just one of a hundred competing exchanges, experienced traders have recognized FTX’s value proposition. Before
spearheading the creation of FTX, CEO Sam-Fried was the head of a market-making firm called the Alameda Research Group. Creating a grassroots financial exchange is a highly tall order, as user
attraction, and thereby liquidity levels, are difficult to attain. To overcome these issues, Sam leveraged Alameda’s power to ensure FTX would hit the ground running. Through the implementation of a deep-pocketed market-making firm, FTX could provide deep books, tight spreads, and liquid OTC services from the get-go [exhibit 7]. Beyond the provision of liquidity, Alameda also offered FTX with top-level talent acquisition. Alongside Sam-Fried, four other Alameda employees migrated over to build out the exchange. Their roles consist of operating and maintaining back-end systems, developing new products, establishing industry partnerships, and assisting in financing services.
Marketing, on the other hand, is mainly completed in-house by Sam himself [exhibit 8]. While the core team remains a five-person unit, they can all be considered superstars. As of April 2021, FTX has listed over 250 tradeable assets, with the list continuing to grow by the
day. These assets fall under various classes: spot, derivatives, volatility, and prediction markets. The most common trading market instrument among those listed are derivatives, which currently comprise over 70% of total trading volume. Regarding specific numbers, FTX has recently amassed over $12B USD worth of daily volume across all product offerings, compared to $1.2B USD per day in April 2020 [Exhibit 9]. Like many other cryptocurrency exchanges, FTX has released its own centralized exchange token (CEX)called FTT. As stated by the team, FTT is the backbone of the FTX ecosystem and offers numerous advantages to those who own it. Such advantages include OTC rebates, trading fee discounts, collateral utility, and socialized gains. Like Coinbase’s publicly listed stock, rising volumes, and user accrual positively impact the price of the FTT token. As of current writing, FTT has harvested a market capitalization of $4.2B USD, which ranks third amongst all crypto-native CEX tokens.
Business Strategy & Operations Model
Business Strategy Characterization
FTX has tailored its business towards experienced cryptocurrency traders by offering the most liquid tradeable assets and innovative products. Derived from a career in financial trading, Sam-Fried set out to provide solutions from a trader’s standpoint, with the FTX motto premised on being “built by traders, for traders”. Attracting new users, especially in an industry heavily driven by reputation, is a highly challenging feat. FTX’s strategy was to build upwards from the bottom to overcome this difficulty. The initialization of FTX’s strategy kicked off with immediate liquidity provisions. Like many other industries, newly established companies within the cryptocurrency industry face the central challenge of offering immediate benefits that will trump competitors. FTX leveraged Alameda’s services to supply the exchange with deep order books, tight spreads, and highly liquid OTC services to provide immediate benefits. These services attracted professional traders who were quickly converting into permanent customers. Many of these traders were also highly respected, which meant that their switch to FTX carried weight in the industry, giving instantaneous validity to the FTX exchange. Another benefit of attracting professional traders as early users is consistent liquidity, as many of these traders quickly transitioned into liquidity provider roles (LPs) via market-making actions.
Once a core customer base was established, FTX released its centralized exchange token FTT, allowing it to become a true competitor. Much like competitor models, holding the FTT token offered basic rewards such as reduced trading fees, listing fees, and socialized gains. However, the token’s real competitive advantage was its unique utility functions. FTX implemented fee tiers for the token, meaning that those holding a higher amount of FTT would receive additional fee reductions. Beyond the tiering system, the most valuable part of the token was its collateral functionality. Holding FTT on the exchange would allow customers to use it as collateral for derivatives trading, which made FTX the first crypto-native exchange to offer a multi-collateral trading suite.
Using the FTX token as collateral brings us to the strategy’s next stage: innovative product offerings. With an extensive background in the trading profession, the FTX team had established an edge in combining R&D with customer demands, which was accomplished via Twitter polls and personal consultations [exhibit 10]. Through this process, FTX was able to develop one of its most competitively advantageous offerings, the multi-collateral trading system. While this feature was first rolled out as FTT-exclusive, the exchange has expanded the system’s ability to include every listed asset. The benefits of this feature are endless; however, it best favors their target market. Family offices, proprietary funds, and even large-scale traders are typically required to maintain a specific asset allocation level. These customers can trade numerous derivative products through the multi-collateral system while satisfying asset allocation requirements.
An industry-exclusive multi-collateral system is not the only innovation FTX brought to the table, however. They also created live-time prediction markets. These markets consist of betting contracts, such as the US-ELECTION-2020, OLYMPIC-21, and SUPERBOWL-2021 contracts. While not originally intended as a marketing move, the US-ELECTION-2020 contract garnered attention from media outlets and resulted in the trading of over $15M USD worth of volume [exhibit 11].
Innovative products have been a key part of the FTX business plan; however, their branding and marketing efforts may be the most impactful. Upon entering the ecosystem, FTX has formed numerous partnerships with crucial industry titans, the most impressive being stable coin partnerships.
Stablecoins fuel cryptocurrency markets simply by placing coins pegged to the US dollar. Through select partnerships with USDC and DAI stablecoins, FTX users can efficiently deposit, swap, and withdraw large amounts of capital. In addition to key partnerships, the team has strived to increase branding through crypto-native acquisitions. One of their most significant and most recent acquisitions was Blockfolio, an iPhone portfolio application that is currently in the top 10 for global downloads. While this acquisition won’t provide much value to large-scale customers, Blockfolio will help to expand their target market, which will ultimately increase the exchange’s liquidity levels.
Regarding marketing efforts, FTX has seized opportunities to advance regulatory friendliness. Cryptocurrency is alreadyin a “grey area” for government regulations, and as crypto scams have continued to exploit retail traders, SEC regulatory talks have heated up. The resulting impact of SEC attention has exchanges scrambling to meet requirements, as failing to do so could result in a permanent shutdown. Sam-Fried pledged $5M USD to avoid such a catastrophe to Biden’s presidential campaign and conducted numerous meetings with the SEC chairman. FTX has also created a charity campaign to further its marketing efforts, to which it plans to donate a percentage of fee revenues. Both actions have achieved press attention, and Sam’s recent placement in the Forbes 30-under-30 list, the FTX exchange appears to have created a perfect strategy [exhibit 12].
Operations Model Characterization
Liquidity and collateral have been discussed at length throughout this report. These market features seem relatively straightforward, but once implemented into an exchange, their importance and complexity are magnified. To better understand how FTX implements these features to gain an edge over competitors, we can analyze a crucial component in their operational model, the liquidation engine.
In cryptocurrency markets, most trading orders are executed through anonymous accounts. Unlike traditional markets, where brokerages can hold customers to negative account balances, crypto exchanges do not have this luxury. To overcome this, liquidation engines were created, which allow an exchange to utilize a user’s entire collateral base to service a loss. Essentially, a liquidation acts as a permeant margin call.
Liquidation engines are what truly separate the good, the bad, and the ugly of cryptocurrency exchanges. This was demonstrated during the March 2020 black swan event, where the leading derivatives exchange, BitMex, encountered severe issues with their liquation engine. The
the resulting impact led to Bitcoin nearly going to zero, as the exchange was overcome with cascading liquidations [exhibit 13]. This event perfectly demonstrates how significant operational efficiencies are, which is why FTX has significantly emphasized these processes.
To avoid a similar event, FTX designed a two-pronged liquation approach. The first system, operated during lower volatility, is the volume-limited liquidation process. This system, which primarily revolves around balancing process flows, is designed to shorten the flow time of liquidation orders. This is achieved via maintenance margin alerts, which trigger when a user’s collateral
base drops below a certain threshold. When this occurs, the FTX order system gradually processes the liquidation orders based on inflow/outflow buildups. However, with these periods of lower volatility, market-making firms and large-scale traders will typically reduce delta exposure, which reduces market liquidity. As a result, deviations outside of realized volatility can negatively impact the exchange’s functionality. To avoid functionality failures, FTX utilizes control limits to reduce process variability, and take actions when the limits are breached. Algorithms have been implemented to monitor the trading environment and act when deemed appropriate frequently.
FTX’s second liquidation system is primarily utilized during extreme volatility and volume periods, such as the March 2020 crash [exhibit 14]. During such an event, normal liquidation orders in the order book are unlikely to be closed before a large-scale liquidation account goes bankrupt. To avoid cascading liquidations like those encountered by BitMex, FTX created a “backstop liquidity provider” system.
When volatility rapidly increases, order size and frequency variability disrupts exchange systems. Due to these variations in order sizes, finding a counterparty with enough firepower to backstop liquidations is daunting. This is where the backstop liquidity provider system is utilized. Rather than hoping to find a counterparty in times of extreme market movements, FTX leveraged Alameda’s deep pockets alongside other partners to provide large liquidity blocks. Onboarding liquidity
However, providers (LPs) are just the tip of the iceberg.
Even with the backing of Alameda and other partners, there is an inherent risk associated with backstopping liquidations. A common occurrence in the cryptocurrency markets is “impermanent losses,” which describes a loss of funds experienced by liquidity providers due to volatility in a trading market. FTX enabled a buffer system to allow LPs to hedge their books across trading venues to reduce the risk of an impermanent loss. This act of hedging across venues requires the usage of an insurance fund. While not exclusive to FTX, an insurance fund is integral to the backstopping solution. With the implementation of an insurance fund, their system has all the pieces to both service liquidations and counter impermanent losses. The system is derived from a variability utilization formula (VUT). For example, liquidity providers would consider A’s position if account A were to be liquated. At the same time, the insurance fund would credit account A to allow LPs to hedge their delta exposure on another trading venue. In this process, account A’s liquation acts as the inflow, the insurance fund as the buffer, the LPs as servers, and the hedged value represents the outflow [exhibit 15]. By introducing and integrating multiple actors into the liquidation engine process, FTX can handle periods of extreme variability caused by volatility [exhibit 16].
Analyses & Recommendations
Operational Model Analysis
Creating a business strategy is integral to a company’s success, but how it will be executed is solemnly discussed. So far, we have analyzed FTX’s liquidation engine and core value creation processes. However, a holistic view of their operational processes will show the true extent of their creative excellence. As evident through the exchange’s rapid rise to power, its operational model has been tailored to fit strategic goals. The alignmentof these models can be recognized through four core operational processes.
In many ways, creating a successful financial exchange is like venturing into the restaurant industry. Competition is extremely high, and the ability to differentiate from competitors is no easy task. Often,
startup exchanges aim to compete purely off pricing. FTX, however, took a much more innovative approach. They have utilized human resources to separate themselves from the highly competitive market. Derived from Alameda, the FTX team created some truly unique operational processes. While the liquidation engine has been discussed, additional processes like the insurance fund demonstrate alignment with their strategy. The insurance fund, which automatically dispenses refunds to backstop liquidity providers in case of an emergency, maintains the exchange’s ability to always be in operation. Through a stable process, utilization remains sustainable, providing institutional traders with a reliable venue where milliseconds can be the difference between millions in profit and losses.
While the back-end processes allow the exchange to maintain competitive advantages via speed, the FTX team has also been able to align customer experience processes to their business strategy. An underrated aspect that many exchanges tend to overlook is the quality of customer service. Like order submissions, customer service timing is paramount, especially for FTX’s professional trading target market.
FTX has established personalized digital relationships through online chat rooms and a direct phone line. Often, the CEO, Sam-Fried, will be in direct contact if a customer requests assistance. In addition to personalized relationship services, loyalty programs can also deliver value. Many of FTX’s loyalty programs are established through FTT fee rebates, as those who hold higher amounts are entitled to more significantfee reductions. Recently, however, FTX has increased its customer loyalty programs. Many exchanges have begun conducting IEOs (Initial exchange offerings), which are very much like IPOs (Initial public offerings). During periods of market expansion, allocation positions are heavily oversubscribed. To provide value to loyal customers, FTX now offers traders who hold high amounts of
FTT tokens provide an opportunity to secure an allocation in an IEO.
Another integral part of the operations model is funding abilities. Before launching FTX, SBF had spent over five years as a trader on Wall Street, which resulted in the birth of the Alameda Research Group. As his trading firm excelled, he was able to establish connections with large financial
firms and wealthy venture capitalists. To assist in the funding of FTX, Sam leveraged those connections to create a financing pipeline. While only collecting $8M USD in their first funding round, the exchange
has now conducted three more financial rounds. Additionally, an emergency reserve has been established through Alameda to serve in the rare occurrence of an operational failure. Consistent financing rounds and an emergency fund have permitted FTX to acquire one of the most valuable pieces of its operational model: exchange resources.
Starting, running, and maintaining a financial exchange can easily bankrupt a company if finances are improperly allocated. FTX was able to avoid this issue by utilizing its financials to obtain key resources
in an appropriate manner. As stated earlier in the report, SEC regulations have been responsible for many exchange failures. However, the root cause of these failures is that head offices of exchanges are established in restrictive regulatory areas, such as the United States. To counter this problem, FTX planted its head office in Hong Kong and created a subdivision in Silicon Valley. While Sam spends much of his time in Hong Kong, the exchange’s core resources have been placed in the Silicon Valley office. These resources, which play an integral role in the exchange’s efficiency, include data centers and servers. Exchanges that are targeting retail traders will typically rent these resources from another financial venue, as they require less technical order submissions. In FTX’s case, renting data centers and servers is not a possibility, as they are targeting large-scale traders. With larger flows comes higher complexity, as many of the FTX-native traders will exploit technological order submissions to gain an edge over competing market participants. Such order submissions are executed through high-frequency trading software, meaning that hundreds of thousands of orders are being sent to the exchange simultaneously.
To serve these types of orders, FTX had to build its own data center and server network. While extremely costly, the ends justify the means, as the increased speed and efficiency of FTX orders provide great value to their target market. In addition to a more efficient order submission model, the funding and creation of a personalized data center enhance the security of the exchange. The cryptocurrency markets are like none other in that massive hacks and scams occur frequently. Once data feeds are breached and exchange participants lose funds, it’s nearly impossible to restore a reputation. Through the usage of a self-owned data and server center, FTX traders can be assured that the highest level of security measures are put in place, which ultimately increases the quality of the exchange.
Recommendations
The cryptocurrency ecosystem is arguably one of the fastest-growing industries on planet Earth. While crypto first began with Bitcoin, today’s cryptocurrencies are much more advanced. Over the
past year, we have seen decentralized finance solutions rise to the forefront of crypto innovation. Mark Cuban, Elon Musk, and other noteworthy technological legends have voiced their support for decentralized financial products (DeFi). The range of these products is extensive; however, one solution has threatened the exchange ecosystem. This solution entails a decentralized cryptocurrency exchange (DEX). Such exchanges offer completely anonymous trading and an endless amount of listed assets, as
there are no requirements to list a coin on a DEX. As a result of these benefits, centralized crypto exchanges have begun to feel the heat, as the leading DEX, Uniswap, is currently trading over $1B USD per day.
Considering that one of FTX’s greatest advantages is associated with innovative offerings, I recommended they create their own DEX. While the majority of DEX’s target retail traders, it’s only a matter of time before large-scale traders make the switch, especially if liquidity increases. Creating a DEX would require extensive work; however, I believe that FTX is more than capable of doing so. Not only can Sam leverage the team’s ingenuity, but he can also utilize FTX’s data centers and servers required to create a brand-new DEX. In their current state, decentralized exchanges can handle retail flows. However, once larger traders try to flex their power, issues will arise. The leading DEXs also do not have order books, as all order processes are done via market orders, which can result in massive slippage fees. It would be monumental if FTX could develop a decentralized exchange that can integrate the FTT token while offering limit orders, tight spreads, and high levels of security. Not only would the creation allow FTX to compete in the DEX space, but they would also be thrust ahead of CEX competitors, as the FTT token would easily become the most valuable exchange token on the market.
Beyond creating a decentralized exchange, I would also encourage FTX to upgrade its back-end processes to offer more options trading. While they offer various trading instruments, the market demand for option products is picking up steam. Currently, only two exchanges have available option contracts for trading, both of which are not core competitors to FTX. This is quite interesting, as option demand amongst professional traders is exceptionally high. The reason is that they offer dynamic abilities to take advantage of market movements. Options contracts allow traders to bet on volatility rather than simply profiting off the price moving up or down. Additionally, they offer a wide variety of hedging solutions, which, if implemented on FTX, would be of high value, as liquidity providers of the liquidation engine would more easily be able to hedge across venues. Considering that demand for options amongst professional traders is high, offering them would greatly benefit both the
FTX traders
Exhibits
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This article was commissioned for Queen’s University.
Disclaimer: A vast majority of the research provided in the paper is derived from personal knowledge.
Additionally, research included from institutional research firms such as Messari.io, Skew.com, and Theblockcrypto.com, cannot be cited as they are a paid service.
