How Stable Is Binance?

Barely last month, Changpeng Zhao seemed like the undisputed king of crypto. The upstart exchange FTX had abruptly imploded in early November, and Zhao, the CEO of the exchange giant Binance, had executed the kill shot by dumping FTX’s native crypto token and triggering a liquidity crisis that eventually sank FTX and its founder and CEO, Sam Bankman-Fried. For several days, it even seemed like Binance would acquire FTX.

In the weeks that followed, FTX’s disordered collapse has risked pushing a highly-stressed crypto sector over the brink. The prosecutors and regulators have alleged that the FTX exchange was not only a firm in distress, but a huge fund, and Bankman-Fried was arrested in the Bahamas. The FTX saga has also triggered massive mistrust among the crypto survivors, who are watching for what dominoes may fall next – and whether one of them could be Binance.

Binance is the world’s biggest crypto exchange by volume. However, it has been plagued by trouble with regulators and facing possible criminal charges related to sanctions violations and money laundering. Misgivings about the firm accelerated this week after clients pulled billions worth of assets from its platform and Binance temporarily stopped withdrawals of a major asset.

Other crypto firms held crisis meetings to plan how they will respond in case Binance’s situation worsened. So, how much trouble is Binance in? It is not as bad as FTX, insiders say, but it is still not good.

The senior executives at many other well-known crypto companies, including Binance’s largest rivals, told Fortune they do not think Binance is on the cusp of insolvency – a conclusion supported by blockchain data that shows the firm holds ample stores of Bitcoin and liquid assets. While some of the casual observers have drawn some comparisons between Binance and FTX, those within the sector are not going there.

Zhao acknowledged this week that the firm and crypto more widely are enduring a tough stretch. In a memo to staff, he wrote that the sector is undergoing a “historic moment” and that the next several months would be “bumpy,” but guaranteed them that Binance “will survive any crypto winter.”

Nevertheless, the firm and its CEO are under scrutiny like never before – and the next several months will determine whether Binance has any long-term future.

Binance’s Very Bad Week

While this week’s news cycle has been consumed by Bankman-Fried, and crypto-related testimony in Washington, D.C., a new drama about Binance came up quietly in the background. It started when the analytics company Nansen published data to show clients cashed out nearly $3.6 billion worth of assets within seven days from Binance, including nearly $2 billion in one day.

The spur of these withdrawals was possibly a report published Monday that alleged that factions in the Justice Department are pushing aggressively aiming to file multiple criminal charges related to sanctions violations and money laundering against Binance and its CEO. The full extent of the outflows might have been significantly higher than reported because the Nansen data includes withdrawals of Ethereum and stablecoins but not Bitcoin (BTC).

An executive at a Binance rival, who requested anonymity since he was not allowed to speak publicly, told Fortune that his firm’s internal estimates indicate that total outflows may have been as high as $6 billion to $8 billion, including cash-outs of Bitcoin and other currencies like Tron.

The alarm over Binance surged amid growing reports that the firm was failing to process withdrawals of USDC, one of the widely used stablecoins pegged to the US dollar. This made it feel urgent to map out the worst-case scenarios involving Binance, the executive at the rival firm stated.

In that context, the worst-case scenario may sound familiar: it speculates that Binance exchange could be using a token known as BNB, native to Binance’s blockchain, as collateral for loans. Binance has vehemently denied that practice, but if it was true, it could leave the firm vulnerable similar to FTX’s FTT token.

The value of BNB might crater in case the market was to become uneasy about the health of Binance, which would leave the exchange unable to pay back loans, making it sell its holdings of the wildcat stablecoin Tether. Such a scenario would lead to Tether – whose reserve structure has always been murky – failing to maintain its $1 peg, which would eventually set off a massive conflagration across the entire crypto market.

One spokesperson for Binance told Fortune that the crypto exchange has never used BNB as collateral. However, speculation about such a disastrous scenario is now making some in the Sector uneasy about Binance’s huge holdings of assets like Tether and BNB, which offer little transparency.

Another executive, who also insisted on anonymity, said their company convened a special meeting in the wake of this week’s Binance headlines to explore how it would react in case the giant exchange collapses abruptly over the holidays.

Binance itself has responded forcefully to all of the severe prognosticating (which might be highly reassuring had we not all seen the same behavior from other troubled top crypto executives).

On December 13, amid increased rumors about the situation at Binance, CEO Zhao went on Twitter to downplay the recent outflows, noting that the firm has experienced bigger ones in the past and said that these events amount to healthy “stress tests.”

Things seem to have stabilized. Yesterday was not the highest withdrawals we processed, not even top 5. We processed more during LUNA or FTX crashes. Now deposits are coming back in. 🤷‍♂️💪 https://t.co/WLK2KyCym0

— CZ 🔶 Binance (@cz_binance) December 14, 2022

By the end of the week, outflows from the platform had started tapering and fears about its financial health quieted down some of them.

Just A ‘Stress Test’?

Other crypto sector figures agreed with Changpeng Zhao’s assertion that worries about the outflows were overblown. They included the venture capitalist Nic Carter, who rejected the claims of a “bank run” at Binance as hyperbolic. He also noted that total assets on its platforms dropped by 15% at most and that much of the money had already flowed back to the exchange.

Reposting charts (just 2022 data) bc the ones above were lacking december data. Note the Y axis does NOT go to 0 (so exaggerates scale of the move)

we are talking peak to trough withdrawals of 10-15% for BTC & stables, ~unchanged for ETH pic.twitter.com/UDUbrg7wA7

— GPT-nic (@nic__carter) December 14, 2022

As for Binance suspending withdrawals of USDC, the firm said that happened for technical reasons rather than because of any existential threat to Binance’s financial health. The backstory is quite complicated but it features a recent decision by Binance to change its holdings of USDC – which is controlled by rivals Coinbase and Circle – to its own stablecoin called BUSD.

Binance possibly made that decision to favor its coin, as other exchanges have recently done, since stablecoins have now become a majorly crucial source of revenue for their issuers as the interest rates surge. Issuers normally invest the dollars backing the stablecoins into T-bills and pocket the realized interest.

Binance does, nonetheless, let clients change any USDCs that were forcibly changed to BUSD back to USDC for the purpose of withdrawals. The upshot is that, when the fearful and nervous investors sought to redeem their USDC from Binance this week, the firm did not have adequate on hand to instantly honor the withdrawals.

It meant that Binance had to wait for its American banking partner – a New York firm known as Paxos that tokenizes assets and issues white-labeled stablecoins for Binance and others – to acquire more USDC on its behalf. In a recent interview, Paxos confirmed all that, explaining that most of the withdrawal requests happened outside of banking hours, which eventually slowed down its ability to deliver USDC to Binance.

In that context, a huge number of Binance’s clients seemed to have dropped Binance’s stablecoin in favor of the one that was issued by Circle and Coinbase. Circle’s CEO, Jeremy Allaire, said:

“We saw record-making history yesterday with more than $2.5B USDC issuance in a 24-hour period.”

While Binance seems to have survived the events of the past week relatively uninjured, its biggest battles seem to lie ahead.

Binance’s Fight For Legitimacy

Binance appeared on the scene during the crypto boom of 2017 and gained massive popularity by offering a cornucopia of digital assets and innovations, which included its in-house blockchain. Soon, it became the largest crypto exchange in the world by trading volume, partially thanks to Zhao’s relentless growth-at-all-cost strategies that featured hopscotching the world seeking favorable regulatory environments and – during its early days – lax application of know-your-customer laws.

But even as Binance evolved into the dominant operator in the crypto space, Changpeng Zhao has maintained the status of an outsider. This might be because he is not among the entrepreneurs who are believed to have brought Bitcoin into the mainstream during crypto’s early days, and who still command massive influence at conferences and on social media.

It might also be because the crypto establishment is uneasy with Binance’s original cowboy approach to regulation – although almost all popular crypto firms also played it fast-and-loose in their early days. Whatever the case, Binance has few friends in Washington D.C., which has already become the de facto center of global crypto regulation – a situation that might spell lots of trouble for the firm as US legislators move to impose some new laws on the controversial sector.

In recent weeks, Binance has aimed to portray worries about the firm as a xenophobic response to Zhao’s Chinese heritage. In a September blog post, Changpeng Zhao – whose parents moved the family to Vancouver when he was 12 – said that competitors were striving to undermine him by playing up his ethnicity. He wrote:

“I am a Canadian citizen, Period.”

He has reiterated these sentiments on Twitter in recent weeks.

However, despite Binance’s disavowal of links to China, rumors persist. One credible report, for example, indicates that the firm maintained an office in Shanghai that was closed down in late 2019, although Binance has already denied its existence.

The firm has moved headquarters between different jurisdictions renowned for light regulation, including Malta, and does not offer any clear information about where its headquarters are located currently. One spokesperson stated that Binance has “regional hubs” in Paris and Dubai.

Then there is the issue of Binance’s finances. Changpeng Zhao has repeatedly claimed on Twitter that all assets that users place on the Binance platform are backed 1:1 by assets held by Binance. Earlier in the week, the firm published an audit, an apparent attempt to assure users that their funds were safe.

However, that did little to quiet fears and bad rumors. This audit was prepared by the South African branch of Mazars global company, instead of one of the Big Four accounting companies, and critics said that the document was mostly incomplete. One accounting professor went as far as to call it ‘worthless.’

While responding to an inquiry about the audit report, a renowned crypto founder – whose firm competes with Binance – also blasted the report as insufficient. The founder who asked to remain anonymous wrote:

“It really comes off as if they’re covering up something. … [They’re] trying to show collateral value rather than 1:1 assets vs liabilities. The collateral trick is exactly the game FTX was playing, borrowing good money from users with bad money for collateral. It’s very suspicious.”

On the other hand, while responding to an inquiry about why Binance did not use a Big Four firm, a spokesperson stated that the firm asked the companies to do a so-called proof-of-reserve audit but:

“They are currently unwilling to conduct a PoR for a private crypto company.”

They also said that Binance in the meantime wants to use technological solutions called zk-SNARKs and Merkle Trees to offer undisputable evidence to investors and traders that their funds are safe.

As for BNB, the Binance-created token was introduced in 2020 and is today the fifth-most-valuable crypto, with a market cap of nearly $43 billion. While responding to an inquiry from reporters, a Binance spokesperson mostly insisted that BNB is not analogous to FTT – the illiquid token that FTX exchange’s disgraced founder Sam Bankman-Fried developed and then used as collateral.

The spokesperson wrote:

“Binance has never used BNB for collateral, and we have never taken on debt as an organization. BNB is a blockchain token, which means it is the official currency of BNB Chain, the largest chain by active users on the globe—even larger than ethereum.”

“This is the utility that BNB provides to millions of users across the globe each day and why it is highly liquid and has organic demand. Furthermore, BNB is a finite asset that is algorithmically burned periodically and is managed by a voting protocol within the BNB Chain community. FTT on the other hand was an ‘exchange token’ which provided little to no utility to the marketplace and was entirely illiquid.”

Binance has strived to portray BNB and its associated blockchain as majorly decentralized, and akin to Ethereum or Bitcoin. These allegations have been received with doubts, nonetheless, within the larger crypto community, mainly after a revealing incident where the Binance chain was hacked for $570 million in early October.

In response to that hack, Binance speedily “paused” the chain’s activities – an exercise that could not be easily undertaken on a decentralized blockchain. The incident provoked some mocking responses about who really controlled the chain:

Need a chain halt? Okey dokey!https://t.co/HPN7OJKIEw pic.twitter.com/tylPhR8kVQ

— Jameson Lopp (@lopp) October 6, 2022

‘No Option But To Go Legal’

For now, the opinions of the crypto space are possibly going to have less of a say in shaping Binance’s future than the opinions of another influential body: the US government.

While Binance has been under massive scrutiny for years by different governments – as have many other crypto companies – the company currently seems to be facing an unexpected level of legal trouble. Recent Reuters reports, based partially on leaks from the US Justice Department, have highlighted a series of strategic actions by Binance that have put the firm and Zhao in the crosshairs of federal prosecutors.

These actions include Binance allowing actors in heavily-sanctioned Iran to execute millions of dollars of transactions on its platform, and a 2018 plan – first reported by Forbes – to use a United States subsidiary as a Potemkin Village to help distract regulators while the firm continued to let American users use its unregulated international exchange.

Binance insists it never put that plan into place, and says that it is unfair to crucify the firm for an aborted plan hatched more than four years ago.

In a recent report published on December 12, Reuters cites Justice Department official sources who say that prosecutors within the agency want to file criminal charges against Binance and Changpeng Zhao soon – although the agency is allegedly divided over whether to do that. Reuters also cites some discussions between the Justice Department and Binance lawyers about a possible plea deal.

All of that coincides with a major push by Binance in the last 18 months to repair its earlier outlaw reputation. The push has also featured hiring figures who occupied senior positions at enforcement agencies like the IRS and Interpol, and setting up a United States entity managed and operated by experienced American executives.

Finding means to walk the straight and narrow path has become essential, one person who has reported closely on Binance told reporters, since the firm’s offshore operations and huge volumes of cash floating across its platform have become considerably big for regulators to ignore. The person said:

“They got so big they had no choice but to go legal.”

Whether Binance exchange succeeds in the gambit is another issue on its own. For everything to work out, the firm needs to avoid the full wrath of the Justice Department and reassure investors and the rest of the crypto sector that it will always be transparent about the real nature of everything in its books – including its hoards of Tether, BNB, and other coins.

Up to today, it remains unclear what, exactly, is on Binance’s balance sheet.