FTX

SBF: Scam, Bankrupt, Fraud?

Nov 27, 2022

This post was originally published on November 27, 2022, but I have made a few edits since then to incorporate subsequently released news about FTX. Links to these stories are listed below the originals and marked as new.

You have to hand it to Sam Bankman-Fried. By the age of 30 he built a crypto-currency exchange reportedly valued at over $30 billion and then blew it up in dramatic fashion, generating shock waves that are still reverberating across the crypto world. FTX and over 130 affiliate companies have now filed for bankruptcy protection from creditors, billions of dollars of customer funds seem to have gone missing, and shareholders’ investments in FTX now appear to be worthless. And SBF himself has gone from being a rock star ‘tech god’ among the Silicon Valley VC crowd, widely admired for his promotion of ‘effective altruism’, to becoming today’s poster child for financial irresponsibility, appalling corporate governance and quite possibly criminal fraud.

There is still much that we do not know about what really happened at FTX, but we are currently experiencing a Buffalo Springfield moment and I don’t want to waste it. Yes, there is definitely something going on here, even if what it is ain’t exactly clear. But let’s explore a bit and see if we can’t figure it out.

Who is SBF? SBF is Sam Bankman-Fried, the founder, majority shareholder and former CEO of FTX. He is also the founder and majority shareholder of the crypto prop trading firm Alameda Research, which figures prominently in the FTX bankruptcy. At one time SBF was reported to have a personal net worth in excess of $20 billion, but with the bankruptcy of FTX and impending legal claims against the company and its principals it is quite likely that SBF will also soon be bankrupted personally. Wikipedia now refers to him as a “former” billionaire.

SBF is by all accounts a very smart young man, although perhaps not as smart as he and others once thought, a trait that he shares with many others in Silicon Valley. He is a graduate of MIT (physics and math) who went to work trading international ETFs at Jane Street Capital, a global quant trading firm, before founding Alameda Research and FTX. SBF is reportedly an avid player of the video game League of Legends, where he racked up ‘win ratios’ that the Financial Times described as “average-to-bad”.

For the past few years SBF lived and worked in the Bahamas, sharing a 5-bedroom penthouse (and apparently more) with ten roommates and reportedly sleeping only a few hours a night. The NY Post described the environment at SBF’s home as “polyamory and pills”. “Stimulants when you wake up, sleeping pills when you sleep”, tweeted SBF. “Nothing like regular amphetamine use to make you appreciate how dumb a lot of normal, non-medicated human experience is,” tweeted his 27-year old sometime girlfriend and Alameda Research CEO Caroline Ellison. Exactly the sort of behavior one would expect from the CEOs of VC-funded financial institutions managing large amounts of other people’s money, no?

For a now somewhat dated but nevertheless interesting profile of four major crypto founders, including SBF, read this December 2021 piece from The Economist, “The Most Powerful People in Crypto”.

What is (or was) FTX? There is a lot that we still do not know about FTX, but one thing does seem clear: FTX was more than just a crypto ‘exchange’. FTX conducted its operations through more than 130 subsidiaries and affiliates in various legal jurisdictions, which is not as unusual as it may seem for a complex financial institution. In addition to operating several crypto exchanges (including one in the US), FTX also conducted a variety of other activities normally associated with firms in the banking, brokerage, trading, money management and gambling industries, centered for the most part around digital currencies. FTX and its affiliates held customer assets (cash, securities and crypto), extended loans to third parties (apparently including insiders and affiliates) and engaged in brokerage and market making activities as well as prop trading, venture capital investing and various other forms of financial and speculative activity. In fact we should probably think of FTX more like a big opaque digital casino than like the NY Stock Exchange.

What is a financial ‘exchange’? In this context, a financial ‘exchange’ refers to a financial institution which hosts and facilitates customer trading in securities, commodities, derivatives and other financial instruments, in this case digital currencies. Traditional (non-crypto) examples would include the New York Stock Exchange, the Chicago Board of Trade and the London Metal Exchange, but of course there are many other traditional exchanges operating in pretty much every developed country across the globe. At its peak, FTX was one of the five largest crypto exchanges in the world—others include Binance, Coinbase and Kraken—but there are reportedly hundreds of crypto exchanges operating globally.

The core function of any financial exchange is to ensure fair and orderly customer trading and the efficient dissemination of price information for whatever trading takes place on the exchange. Exchanges are used both for secondary trading (trading in already outstanding financial instruments) as well as primary issuance (the sale of newly issued securities, eg IPOs), with secondary activity comprising the bulk of transaction volumes in most financial instruments. The vast majority of transactions conducted on (and off) financial exchanges are executed electronically, which was not the case when I started in business back in the dark ages.

We often take for granted that the huge volume of transactions conducted on financial exchanges will be processed in an orderly, efficient and transparent manner, without interruption and in compliance with accepted rules and regulations. Which is usually the case, outside of the crypto world at least. But this benign state of affairs depends critically on the consistent smooth operation of various complex ‘back office’ functions conducted by the exchanges and various financial counterparties, including transaction execution, clearing and settlement, customer financing, collateral management and the safeguarding of segregated customer funds. This last point, regarding the segregation of customer funds, is a core precept of financial regulation applicable to exchanges and most other types of non-depository financial institutions which appears to have been violated (in size) by FTX.

Given their central role in the “plumbing” of the financial system, exchanges are almost always highly regulated and closely supervised entities. If a major financial exchange like the NYSE were to fail in the way that FTX has, the global systemic financial impact would be considerable. And so financial regulators work very hard to make sure this does not happen, as do the owners, executives, directors and customers of the exchanges themselves.

This does not seem to have been the case at FTX or with its regulators in the Bahamas, however. In criticizing the Bahamas, which went all out in an effort to attract crypto firms like FTX, I am not suggesting that the rest of the world has its act together when it comes to regulating crypto—it doesn’t and neither does the US. (More on this below.) But the Bahamas is by reputation a very light touch regulatory jurisdiction, known for hosting shady ‘off-shore’ banks and now crypto firms, which makes it sort of the Wild West in contemporary financial market terms. Which is exactly where FTX wanted to be domiciled, for reasons that now seem apparent.

What made FTX so popular (for a time)? I am not entirely sure, but it seems that FTX did offer its customers a generally good trading experience, at least until it didn’t. FTX hosted a wide variety of digital ‘products’, substantial financing (leverage) and attractive pricing on trade execution. FTX also spent (and contracted to spend) an awful lot of money on media promotion, much of it targeted to sports fans (in the US at least). And what’s more popular with US sports fans than a closely contested Super Bowl or a killer UFC championship bout? Even more than beer and wings? Why gambling of course. And what better way to gamble than on crypto, with leverage in excess of 100x with some products?

To this end, FTX ran Super Bowl ads, the Miami Heat played in the FTX arena, MLB umpires wore FTX patches on their uniforms, Formula 1 race cars sported the FTX logo, and FTX products were promoted by the likes of Steph Curry and Tom Brady, who encouraged viewers to go “all in” on crypto and to execute their trades via FTX. Not surprisingly, these FTX promotions have mostly now come down and have done so even faster than the fall in advertising revenues and employee head count at Twitter 2.0. This won’t stop FTX’s celebrity promotors from being sued, of course, if only because their pockets are now a lot deeper than those of SBF and his former roommates.

But was FTX ever really a “safe and easy way to get into crypto”, as ad viewers were encouraged to believe before parting with their money? “Nah, I don’t think so”, said Larry David in this ad. And this statement may provide Mr. David not only with the personal satisfaction of having been right about FTX—he is never wrong about these things you know—but also with the best legal defense available to any of the FTX celebrity promotors. “You bought $100,000 of crypto on FTX after viewing my ad? And you lost it all? Tough luck, dummy, I told you not to do it! Go complain to Steph and the GOAT.”

Was FTX really worth over $30 billion just a few months ago? No, probably not, in which case SBF was never worth $20 billion either. But let’s talk about what we mean by ‘worth’ or ‘value’ in this context. FTX was (and is) a privately-owned company which never went public and whose shares did not trade on a stock exchange. Nor was FTX ever bought or sold in an M&A transaction of any sort. And so we don’t have reliable valuation metrics derived from either of these sources. But FTX did raise something like $2 billion in several equity private placements, some of it funded by well known VC firms and other institutional investors like Sequoia, BlackRock and Softbank. And it is the price paid by these firms for small minority stakes in the company which established the implied valuations of FTX picked up by the press.

But ‘price’ and ‘value’ are distinct (albeit related) concepts, and we should resist the urge to conflate the two. Warren Buffet likes to say that ‘price is what you pay and value is what you get’. The ‘price’ of a single lottery ticket may be $2, but with a 50% payout ratio the expected ‘value’ of that ticket is only $1. Which of course is a much better value than what the FTX investors apparently received.

So what happened at FTX and why did it fail? The true facts of what exactly transpired at FTX over the past few weeks and months are still unfolding and we simply do not yet understand all of what went wrong there. But the facts will eventually come out and when they do it is likely that they will not be pretty. What does seem clear at this time, however, is that the FTX collapse involved more than just a broad drop in the market price of various crypto assets and a resulting liquidity squeeze at FTX, as SBF and his supporters would like us all to believe. Based on press reports to date, the failure of FTX most likely involved the misuse of large amounts of customer funds which should have been segregated and safeguarded apart from FTX’s general operating funds, not lent to affiliates and insiders as appears to have happened.

FTX’s failure appears to have been caused by a variety of corporate governance failures as well as managerial incompetence and likely malfeasance, including the misuse of customer funds. Press reports suggest that FTX not only employed high amounts of financial leverage (which is not unusual for financial institutions), it also capitalized a significant portion of its operations not with cash or liquid securities but with its own internally manufactured digital tokens (aka FTT’s or ‘shitcoins’). Press reports and statements from FTX’s new management team also suggest that some significant portion of the Company’s hard assets (fiat currency) has gone missing, perhaps through theft, and that customer funds were not segregated and may have been lent to affiliates including Alameda and possibly SBF. Key financial and accounting controls were either non-existent or not operating, and financial and legal record keeping was a mess.

John Ray, the new CEO of FTX appointed to supervise the liquidation of the Company, says that over the course of his 40-year restructuring career he has “never seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here." “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” This is quite a statement coming from the man who managed the liquidation of Enron, which for the past twenty years has been the poster child for failed and fraudulent corporate financial reporting, until FTX that is.

Suffice it to say that this is not how sound financial institutions (including exchanges) are supposed to be run, even in crypto world.

What does this story tell us about the so-called ‘smart money’ venture capital investors who bought shares in FTX? Nothing good, in my mind at least, although perhaps not for the reasons you might expect. I do not think it is entirely fair to criticize Sequoia and the other VC firms for so quickly losing all of their clients’ money invested in FTX. But I do think it is fair to question the way in which they went about making and monitoring this particular investment, which does not seem to have met even the much reduced fiduciary standards expected of VC firms these days.

The venture capital business is by its nature particularly risky. Even at the leading VC firms most portfolio investments do not generate big returns and many prove to be entirely worthless. The VC business model works (when it does) because investors expect that the total amount of money lost on bad investments will be more than compensated for by the huge returns generated from a relatively small number of highly successful investments. Aaron Judge may strike out much of the time (25% in 2021, down from 45% five years ago), but he gets paid tens of millions of dollars each year because he hits so many home runs (62 this past year, a new MLB record.) And it works the same way in the venture capital world, where the VCs strike out more often than they hit the ball out of the park but get rich nonetheless.

Even if we accept that many venture investments will turn out to be worthless, however, it is entirely appropriate to ask how well the professional venture capitalists manage their portfolio investments, which after all are made with OPM (Other People’s Money). Do the VCs conduct thorough due diligence? Do they structure their investment in a way to mitigate risk? Do they obtain information and corporate governance rights that will allow them not only to monitor and manage their investments but also to provide their portfolio companies with the benefits of the VCs’ considerable expertise and experience? In the case of FTX the answer would seem to be no, on pretty much all counts.

And what are we to make of press reports that Sequoia reportedly became enamored of TFX during an investor pitch in which SBF spent most of the time playing video games? “I LOVE THIS FOUNDER”, one Sequoia partner apparently texted his colleagues at the time. Sequoia wasn’t troubled by SBF’s arrogant, distracted and disrespectful behavior; they were impressed by it. And what does that tell us about the character and judgement not only of SBF, but of the partners at Sequoia itself? Is this how you expect them to manage your money?

What is the future of crypto? Despite all of the ‘man bites dog’ aspects of this story, it is likely that the failure of FTX will prove to be a consequential event in the development of the crypto industry and perhaps a turning point in private sector efforts to build a ‘decentralized’ financial system. And so this seems like as good a time as any to reflect briefly upon the future of crypto and DeFi.

Let me begin by asking the one question that should always be asked about newfangled financial products like crypto, which have the potential so quickly to separate gullible people from large amounts of their hard-earned money. This is the same question which the musician Edwin Starr so famously asked about war: “What is it good for?” If the answer to the question about crypto is in fact “absolutely nothing”, then it is quite possible that crypto will not be with us for much longer, at least not in the way we know it today.

But it seems that millions of people continue to believe fervently in crypto, despite all the evidence to the contrary, and there is still a lot of money promoting crypto in financial and political capitals across the globe. And so it may be that recent reports of the impending death of crypto prove to be overstated or premature, despite so many former emperors of crypto having now been shown to have no clothes.

Blockchain may or may not turn out to be a useful feature of future financial technology—I really have no idea—but it is quite possible that blockchain may prove to be important, even revolutionary, while much of the crypto world goes the way of the dodo. But why is this?

Digital coins, tokens and currencies have no intrinsic value, unlike stocks, bonds and commodities. And recent experience would suggest that crypto is not well suited to play the role of ‘money’, either as a store of value or as a medium of exchange (except for criminals). Perhaps crypto serves some interesting role as a new medium for financial speculation, an activity which may or may not have much social value, but in the wake of FTX and the many other scandals in the crypto industry we have to ask: At what cost?

And what about the broader crypto DeFi economy? We should now understand, if we didn’t before, that even a so-called ‘decentralized’ financial system depends critically on trust. Trust in the products, the counterparties, the terms of trade and the dispute resolution mechanisms. And trust above all in the safeguarding of customer assets. But ‘trust’ is not the first word that comes to anyone’s mind when we are talking about crypto, certainly not in the wake of FTX.

There are many unanswered questions about the future of crypto. But one thing does seem increasingly clear: If crypto is to have any significant role in our global financial system going forward, it must be better regulated than it is today.

How should crypto be regulated? Should crypto be regulated like securities, like commodities, like gambling, like narcotics or like something else? Here in the US, there is a brewing battle over the scope and locus of crypto regulation which is being fought primarily by the SEC (securities), the CFTC (commodities) and Congress (legislation). And the states may want a regulatory role too, as they do with other forms of gambling. To my knowledge, the FDA has not yet thrown its hat in the ring.

This regulatory battle is one in which FTX and SBF were heavily invested, with over $100 million spent on political donations, lobbyists and the hiring of politically connected employees. During the 2022 US election cycle alone, FTX reportedly made $70 million in campaign contributions to politicians on both sides of the aisle, concentrated on those most closely involved in determining the future regulatory status of crypto.

Prior to the failure of FTX, it looked like Congress was lining up behind a ‘light touch’ regulatory approach to be housed in the thinly-staffed CFTC, which was the outcome favored by FTX and other crypto firms. With the collapse of FTX, however, the political winds may well shift in favor of the more stringent SEC, although the mid-term election results may complicate the passage of any legislation near term.

This ongoing regulatory battle seems to assume that crypto should or will have some continuing role to play in our financial system, an assumption that I believe needs to be challenged more forcefully than it has been to date. There is a lot I still do not understand about crypto—including what it is good for—but one thing does seem clear even to me: A lot of customer money ‘invested’ in crypto seems to have gone missing and on more than just a few occasions. And so fraud and customer abuse needs to be a major focus of regulation and regulators, more so than it has been to date.

This may come as a big surprise to those readers who work on Wall Street, but let me state for the record that the purpose of any financial system is not to make financial intermediaries rich. And this is a statement which SBF and most of the other crypto kings would probably agree with, in congressional testimony at least. It is after all a foundational premise behind the creation of crypto and the DeFi economy, one objective of which is to displace money-grubbing banks and financial institutions from the businesses of processing payments, lending money and managing investments. In practice, however, these same crypto kings have ironically pursued their own goals by creating ever more new, complex and corrupt forms of profit-hungry (and less regulated) financial intermediaries like FTX. And if the need to regulate traditional established financial services firms remains compelling, why isn’t the case for regulating crypto and crypto firms at least as strong?

As we consider the alternative ways in which crypto might be better regulated in the future, however, let’s also remember the truism that ‘regulation doesn’t always remove risk; it often just moves risk’. In the wake of the last financial crisis the US government increased the regulation of banks, which did in fact reduce certain risks substantially within the regulated banking sector. But it also moved much of that risk to the less regulated ‘shadow’ banking sector, which as a result attracted large volumes of business (and profits) away from the more heavily regulated banks. And we should expect the same thing to happen with crypto if and when it becomes more effectively regulated here in the US and in other countries. Which risks will be moved? To where and to whom? At what cost? And with what intended and unintended consequences?

Stay tuned. The crypto story is far from over, and it is likely that FTX will not be the last casualty. So watch the news and stay tuned. It will almost certainly be wild, if you like that sort of thing. And much more fun than betting on the stock market or the Super Bowl. Or playing the lottery for that matter.

Post-script. As noted above, the FTX story is far from over and so I am keeping this post ‘open’ to incorporate the latest developments, including today’s bankruptcy filing by crypto lender BlockFi, which did business with FTX as both a lender and as a borrower (see story below). Links to the latest stories are shown as New Links below.

Links

FTX Files for Bankruptcy, WSJ November 11, 2022

Understanding the FTX Bankruptcy, WSJ, November 22, 2022

The Failure of FTX and SBF Will Leave Big Scars, The Economist, November 17, 2022

New Restructuring CEO Calls FTX an Unprecedented Mess, WSJ, November 17, 2022

FTX Says It Owes Creditors More than $3 Billion, Washington Post, November 20, 2022

FTX Lawyer Says ‘Substantial’ Amount of Crypto May Be Missing, WSJ, November 22, 2022

Inside SBF’s Crypto Empire, WSJ November 19, 2022

SBF Cashed Our $300 Million During FTX Funding Round, WSJ, November 18, 2022

FTX Bet Big on Sports; What Happens Now? NY Times, November 10, 2022

Silicon Valley Poured Money into FTX with Few Strings Attached, WSJ, November 10, 2022

FTX Implodes and Top VC Backer Falls on its Face, Bloomberg, November 14, 2022