What You Need to Know About Exchange Tokens After FTX’s FTT Meltdown

04It was the shot heard ‘round the crypto world.

On November 6, 2022, Changpeng “CZ” Zhao, CEO of the world’s largest cryptocurrency exchange Binance, said his company would move to liquidate its holdings of FTT, the native token of rival exchange FTX.

His announcement triggered an FTT selloff, bringing a top-five crypto exchange to its knees. FTX experienced a bank-run moment, with $5 billion worth of customer funds withdrawn in one day and didn’t have the liquidity to cover.

In the aftermath of FTX’s meltdown, reporting has revealed just how much FTX and CEO Sam Bankman-Fried’s hedge fund Alameda were using FTT as collateral. Those revelations have put exchange tokens under the microscope.

This Learn article will look at exchange tokens like FTT, what they are for, and what risks they carry.

What is an exchange token?

An exchange token is one native to a cryptocurrency exchange and created by the company that runs the exchange, often framed as a “utility token” because it has use on the exchange.

The best-known examples of exchange tokens are Binance’s BNB (the largest exchange token by market cap) and FTX’s FTT. The other top centralized exchanges with their own tokens include KuCoin (KCS), Bitfinex (LEO), Crypto.com (CRO), OKX (OKB), and Huobi Global (HT).

How are exchange tokens used?

Crypto exchanges launch tokens for various reasons, including as customer incentives for staking the token, covering transaction costs, raising capital and liquidity, and in cases of exchanges that are governed by a DAO, serving as a governance token.

In the case of Binance, “Along with ‘fueling’ transactions on BNB Chain (similar to gas on Ethereum), BNB also acts as a governance token,” Binance says in a blog post explaining the token.

Binance says holding BNB gives investors the right to “make your voice heard” and is necessary to participate in BNB Chain’s decentralized on-chain governance.

Over at KuCoin, “KuCoin token holders get special discounts on trading fees and other associated costs within the KuCoin exchange,” KuCoin says in its explanation of the benefits of its KCS token.

As KuCoin explains, the percentage of discounts an investor may receive is calculated based on the number of KCS tokens held by them.

In addition, KuCoin says KCS holders can use the exchange’s token to pay transaction fees.

Crypto.com’s CRO “gives its users access to special rewards and discounts offered through its flagship credit card product,” Crypto.com writes.“As Crypto.com grew into an ecosystem of crypto solutions, CRO also added benefits such as lower trading fees, higher lending rewards, and more.”

How do you buy exchange tokens?

As their name suggests, investors can purchase these tokens through the token’s parent exchange. In some instances, as with FTX’s FTT token, they can also be bought on rival exchanges.

Unless the exchange has a fiat onramp, investors looking to load up on exchange tokens will need to swap their Bitcoin or Ethereum for the token. This process typically involves setting up an account and going through know-your-customer (KYC) verification.

Depending on the exchange, some tokens are only available in certain regions. For example, FTT is unavailable in the United States and other prohibited jurisdictions.

“If you are located in, incorporated or otherwise established in, or a resident of the United States of America, you are not permitted to transact in FTT,” the FTX.com website says.

What are the risks with exchange tokens?

The risk involved with cryptocurrency exchange tokens may be obscure at first.

In cases like FTX, which appeared to the industry to be a strong global impact player, investing in FTT may have looked like a good idea. That was until we consider how many of those tokens a rival cryptocurrency exchange held.

As noted above, Binance held a large number of FTT tokens: 23 million, worth around $529 million. Binance held all that FTT because it was an early investor in FTX in 2019, and when FTX cashed out Binance’s equity stake in July 2021, it paid out Binance in FTT.

When Binance announced it would liquidate its entire position and amid an ensuing liquidity crisis, FTT’s value sank 85.6%.

Another risk with investing in exchange tokens is what is known as counterparty risk. In crypto, counterparty risk is mostly associated with stablecoins and the issuer’s claim that a real-world asset backs the coin. Cryptocurrency exchange tokens carry a similar risk: What’s backing them?

This risk includes whether the exchange has the liquidity it needs to back its token, backed by a reserve of any sort that it can tap into if—as in the case of FTX—liquidity dries up suddenly.

Because investors may need to exchange BTC or ETH to receive these exchange tokens, if the value or price of that token drops, there is no recourse to get back the exchanged BTC or ETH. The same risk comes with staking tokens.

Staking tokens lock them into the network or exchange, and while staked, the investor cannot move or trade those tokens. If the exchange suffers a meltdown or cyber attack, the tokens will potentially go with it.

A common refrain in the Bitcoin and cryptocurrency space is “not your keys, not your crypto.” But in cases like FTX, and Terra’s LUNA, holding your coins in cold storage won’t help protect their value and will also remove any utility it would carry on the exchange.