Prologue: A Symptom, Not the Disease
When veteran bankruptcy attorney John Ray III calls an insolvency unprecedented, it is essential to perk up our ears and listen. On the one hand, the man oversaw the liquidation of Enron. To date, the Enron bankruptcy ranks among the 10 largest corporate failures in American history—an infamous failure of oversight and the product of a faulty corporate culture propped up by corrupt advisors. On the other hand, his forty years of experience means such a judgment is unlikely to be impulsive. Rather, it accurately identifies the unique nature of FTX’s failures. Among them is the fact that it should have never happened and we ought to have seen it coming (and maybe, like Gillian Tett in the 2008 crisis, some of us did).
In November 2022, FTX, a Bahamas-based cryptocurrency exchange, filed for bankruptcy. Before its collapse, FTX was the third-largest cryptocurrency exchange by volume and had over one million users. The news sent shockwaves through the crypto community, raising questions about the future of the industry and FTX’s users.
Unpacking FTX’s bankruptcy is complex, but it’s essential for understanding the implications for the future. In short, the mayhem surrounding FTX’s cataclysmic fall highlights the risks of investing in cryptocurrencies and serves as a reminder of the need for greater regulatory oversight and consumer protection in the industry. It also points to a worrying culture of unchecked risk-taking, poor financial controls and misplaced priorities in a fast-growing industry with exposure to millions of retail investors.
Act I: The Collapse
Founded in 2019, the exchange allowed users to connect their wallets, make trades, exchange digital currencies, enter derivative contracts, and buy and sell NFTs while also promoting the liquidity and trading of coins and tokens. With a daily trading volume in the billions of dollars at its height, the exchange had about a million users. The exchange had its headquarters in the Bahamas, was registered in Antigua and Barbuda, and had a separate organization that catered to US residents.
Reports that FTX’s CEO Sam Bankman-Fried had used customer deposits on the platform for trading on his hedge fund, Alameda Research, led to the company’s demise. Concerns about the unusually close ties between the two businesses were raised when cryptocurrency outlet Coindesk revealed that a significant portion of Alameda’s assets were linked to FTX’s flagship coin, FTT. In response to the Coindesk article, Changpeng Zhao, CEO of Binance, declared on November 7, 2022, that he would sell all his company’s FTT tokens. This sparked a several-day bank run at the company, causing it to struggle to meet withdrawal demands. After seeking solutions, an agreement was reached with Binance to acquire FTX. However, Binance quickly withdrew from the agreement, which worsened the situation for the company. In a tweet, Binance noted that “In the beginning, our hope was to be able to support FTX’s customers to provide liquidity, but the issues are beyond our control or ability to help.” Bankman-Fried saw his net worth plummet due to the liquidity crisis from roughly $23 billion at one point to almost $100,000. Beyond SBF, several institutional investors in the firm had to write off their entire stakes after the collapse of the exchange.
Act II: The Aftermath
Bitcoin was at the heart of FTX. After FTX’s demise, the currency hit its lowest point in two years. However, the dent in investor confidence is unlikely to recover enough to send Bitcoin back on its initial trajectory. FTX had a growing presence in developing economies like those in Africa where the currency’s price instability further wiped out large sums of money from everyday investors around the world.
“an Excel file full of the howling of ghosts and the shrieking of tortured souls. If you look too long at that spreadsheet, you will go insane.”
Bloomberg’s Matt Levine on FTX’s balance sheet
Like the waves caused by Lehman Brothers in 2008, this instability rippled across the crypto markets, spurring a tsunami of losses in the crypto-verse. Genesis, a digital asset brokerage, and Gemini, a cryptocurrency exchange, were two institutional victims of FTX’s collapse that suffered the most. The former, founded by the famously unlucky Winklevoss twins, suffered a crisis in its lending operation which led to suspended redemptions and new loan originations and a revelation that the firm had $175 million locked in its FTX trading account. In November 2022, FTX, FTX US, Alameda Research, and more than 100 affiliates filed for bankruptcy in Delaware. Experts note that should the 600,000 bitcoins on its books get liquidated, it could lead to deeper issues for the industry. All of this emphasizes the obvious risks that (retail) investors rarely hear about; cryptocurrencies are still in their infancy and are risky investments that are subject to sharp price swings. Without exercising caution, investors run the risk of losing their money.
The collapse highlighted the acute lack of basic financial management and accounting practices among exchanges like FTX. The condition of FTX’s balance sheet was described by Bloomberg’s Matt Levine as “an Excel file full of the howling of ghosts and the shrieking of tortured souls. If you look too long at that spreadsheet, you will go insane.” A kind description considering the details of what was on paper.
The main international exchange at FTX held just $900 million in easy-to-sell assets which could be used to pay off liabilities in the event of bankruptcy. However, the liabilities were over $8 billion on the day the bankruptcy was declared. A separate vehicle owned by SBF that was not initially listed in the bankruptcy filing by their lawyers contained $470 million of the liquid assets listed on the balance sheet that belonged to him. The inept and unchecked management of FTX allowed for this glaring financial gap, which in some ways may be indicative of the rest of the industry. For instance, BlockFi Inc., another exchange, also declared bankruptcy, stating that its primary goal is to “recover all obligations owed to BlockFi by its counterparties, including FTX and associated corporate entities,” adding that FTX’s bankruptcy is likely to cause a delay in those recoveries. FTT, the token at the heart of FTX’s demise, was used to pay employees, causing many of them to accumulate “wealth” in the token, which of course was destroyed along with the company they worked for. You’d expect that some of these brilliant minds, formerly working at leading tech companies and quant funds, would be able to see through this mess but the loyalty to Sam was almost cultish and symbolic of others like Changpeng at Binance.
Both BlockFi and FTX situations point to the fact that these are hardly liquidity crises. They are most likely solvency crises. Matt Levine summarises it sufficiently, “the problem is not a timing mismatch, in which FTX’s customers asked for their cash back but FTX did not have enough ready cash because it had long-term but money-good loans out. The problem is that FTX took its customers’ money and traded it for a pile of magic beans, and now the beans are worthless and there’s a huge hole in the balance sheet.”
Act III: The Bigger Question
Larry Summers, the former US treasury secretary really gets to the core of what we ought to be asking ourselves. How did we not see the signs? Once upon a time, Enron was known as one of America’s most innovative and entrepreneurial companies and for having “the smartest guys in the room.” Then, almost overnight, the company became known for its illegal accounting, the imploding stock price, and record-breaking bankruptcy. The unexplained implosions of wealth no one could explain. And of course, the firm also signed a 30-year multimillion-dollar deal to rename the Houston Astros’ stadium – the Enron Field. When you look at the 6 months to the fall of FTX, it almost feels set up to look like Enron and screams in our faces to notice it. The renaming of the Miami Heat home ground to the FTX Arena, Sam Bankman Fried on the cover of the Forbes 400 and of course, the hailing of the entire FTX team as disruptive geniuses in the crypto world. It is hard to ignore the fact that Bankman-Fried went from obscurity to a peak net worth of $26 billion.
Following the 2008 crisis, there was widespread distrust, and detachment from the legacy banking system, big government and big anything. While regulators made considerable efforts to improve regulation and implement reforms, there is still a continuous failure of corporate controls within large institutions. Either the regulations post-2008 failed in their role or they did not go far enough. Whilst the collapse of FTX did not affect the legacy banking system, there are relevant lessons one can draw from those mistakes and apply to the new area of loose, failed corporate management. A continued failure by regulators to view the internal operation of companies in this historical light to spot the dangers of failing systems risks destabilising the economic order of the world and having major political repercussions.
Consider, the case of the International Holding company in Abu Dhabi. Without conducting a substantial analysis of the business, for that is not the focus of this piece, this was a little-known company that ran fish farms, food and real estate businesses and employed just 40 people three years ago. Today, this Abu Dhabi-listed group has a market capitalisation of $240bn. This is more than double that of global giants Siemens and GE. It has a headcount of 150,000. When asked to explain the dramatic growth of this company, one UAE-based banker replied, “[n]obody knows,”. As for the CEO, when questioned, he uses all the buzzwords of acquisition, synergy and diversification to explain the rapid growth of his company. Sound familiar? If so, where are the regulators you might ask? To quote that banker above, “[n]obody knows”.
Yet, it is not simply that we failed to learn from history. And learn we should. We continue to be plagued with an endemic failure of corporate controls in the areas of risk management and due diligence. On risk, there is a lot of it floating around the crypto verse without justification. Consider that FTX lent $10 billion from customers’ accounts to fund Alameda research which went directly against the terms of service signed by customers. To call it a miscalculated risk is short of what it really was: illegal. Observe the use of FTT, created by FTX, as collateral for the fund to take on debt while aware of the insolvent position. Some may call this greed but it is simply an unnecessary risk taken without due regard for its impact. That needs to change. On due diligence, we live in the era of Elizabeth Holme’s Theranos, Elon Musk’s Twitter acquisition, JP Morgan’s acquisition of Frank and, of course, FTX. These days, it is hard to know what due diligence means when Ontario Teachers’ Pension Plan puts $95mn into FTX and insists that its professionals “conduct robust due diligence on all private investments”. There is a clear erosion of standards, possibly driven by a decade of cheap money and sky-high valuations. But it’s time it ended. Starting with financials and personalities, investors need to start knowing who they hand their money before it’s too late.
One would assume that lessons will be learnt from this episode. Yet it is prudent to note from the outset that this will possibly not happen. A lot of ‘lessons’ are confirmation bias for what should have been done a long time ago. The signs were there and anyone who lived through the 2008 crisis should be able to distil them. Regulators continue to ignore the wreckless failures of corporate controls, advisors and governance which often involve defying the regulations they put in place. Financial institutions that are heavily regulated externally but poorly managed internally will always be vulnerable to a collapse through bank runs or other systemic risks. In the case of FTX and others similar to it, the bigger challenge is that the crypto industry rose in response to these issues after 2008, leading to the recurring assertion that it is safe from such catastrophes. Some will take FTX as a sign to the contrary but crypto puritans are unlikely to do so and therefore risk history repeating itself.
Act IV: What Now?
Where do we go from here? As expounded above, we go to history and apply it to the Enrons and Lehmans of today. We come to the present and vigorously advocate for the corporate controls necessary to run a modern business.
Beyond that, we need a legal framework for the industry that will offer necessary protections to consumers and ensure sufficient controls on finances and liquidity without stifling innovation.
To preface this, first, any regulation will concentrate on setting higher requirements for corporate governance and auditing of these businesses, in addition to the consumer protection that already exists in traditional financial institutions. Second, ongoing consultations and action being taken by regulators like the FCA and SEC indicate a consensus that their regulatory ambit extends to the crypto universe.
That the traditional finance industry is connected to the crypto world can be argued by focusing on relevant actors in both areas. Financial regulators have a mandate to broadly protect consumers and regulate institutions. Considering both parties are present in the conventional finance and crypto worlds, while it is a simplistic argument, this ought to motivate action by the agencies. Much like internet companies, any new regulation ought to focus on the platforms as much as the underlying technologies they run. The SEC and other regulatory bodies need to force their way in, if they must, to ensure that the financial health of platforms is monitored and stress tested endlessly. As noted earlier, the current consultations and ongoing action (such as this wonderful video from SEC Chair Gary Gensler) indicate that there is a recognition of overlap but this requires more than just guidelines. Going beyond simply stating what ought to be the status quo, my suggestion below aims to offer a policy consideration for further and more elaborate regulation.
Beyond this external regulation, there should be a more concerted effort on getting corporate controls and governance right. When he saw the list of investors backing FTX, Su Zhu, co-founder of Three Arrows Capital, a hedge fund that also failed, remarked, “I believed someone there conducted DD [due diligence].” This focus on the internals of startups is important because it would be a terrible shame if one of the effects of FTX was the end of our fascination with brilliant businesspeople. Iconoclasts have a rich history, especially in the field of technology. Without Steve Jobs, Jeff Bezos, and Bill Gates, there would be no Apple, Amazon, or Microsoft. Innovation necessitates audacity.
To address these failing corporate controls and issues of governance, a number of issues may be considered.
First, lessons can be taken from the EU’s remarkable Markets in Crypto Assets Regulation. Under the legislation, strong corporate governance and controls, an EU legal entity, and, most importantly, a corporate structure with jurisdictions that do not obstruct effective supervision are requirements for service providers. The collapse of FTX emphasises how crucial these criteria are. It is challenging to give the other exchanges high grades, though. For instance, Binance, the largest, still won’t disclose its headquarters.
Second, with respect to governance, there needs to be less reliance on personalities. Crypto was designed to do away with the requirement for interpersonal trust. Nonetheless, the entire system seems to increasingly rely on a small number of well-known figures. One was Bankman-Fried. He quickly amassed a sizable empire and generously donated money to worthy causes. They trusted him with their money as a result. Particularly investors demonstrated a surprising willingness to support his endeavours without the customary financial due investigation. If we are to do away with issues of governance, actors in the crypto industry need to revert to the adage, “Don’t trust, Verify!”
Finally, it is necessary to have greater accountability. The goal of cryptocurrencies was to increase the transparency of financial transactions. Yet unlike a traditional bank, FTX disclosed significantly less information about its financial situation. A convoluted organisational structure, intercompany transfers, and the rumoured use of FTT to bolster the balance sheet all contributed to the opaqueness of SBF’s businesses FTX and Alameda. As such, any actions towards internal reform will require stronger systems of accountability even where external regulation exists.