The Fall of FTX – A Case Study
In the second half of 2022, the crypto market was rocked by one shock after another. First, Bitcoin suffered one of its most dramatic drops, plummeting from $35,000 in April to $17,000 by June, with altcoins following the same pattern. That was largely attributed to the TerraUSD Classic (USTC) losing its peg against the USD and sending the market into an existential panic.
That was only a foreshock of the financial tsunami that was approaching, however, as over ten chaotic days in November, one of the largest and apparently healthiest crypto exchanges went into a fatal nosedive for all the world to see. Now, the dust has had six months to settle and we can take an educated view on what happened, what didn’t, and what the industry can and must do to stop it from happening again.
What happened? The fall of a giant
Bitcoin wasn’t going through its first winter in 2022 and the bear market was no worse than what has come before in 2021 and 2017. However, the root causes were different and had a direct bearing on the gathering storm.
The collapse of the Terra stablecoin prompted a risk management review of Binance’s holdings. This review led to the decision on 06 November to liquidate its entire FTT position – about 23 million tokens worth more than $0.5 billion.
Binance to liquidate its positions in FTX token
Sam Bankman-Fried, the founder and CEO of FTX attempted to calm investors with reassurances that the exchange could absorb the shock and its assets were stable, but to no avail. Customers started to demand withdrawals in their droves, to a total value of about $6 billion and the value of FTT fell by 80 percent in the space of about 48 hours.
Bankman-Fried needed extra capital and quickly, but appeals to venture capitalists went unanswered. His only option was to turn to Binance, who, on 08 November, announced what was essentially a bail out. Binance CEO CZ Zhao announced that his exchange had reached a non-binding agreement to buy out its biggest rivals, or at least its non-US subsidiaries, for a non-disclosed sum.
It would have made Binance even more influential withing the crypto space, and other than agreeing to the deal, Bankman-Fried remained an elusive figure, declining all media contact. Within hours of the announcement, however, the deal was off. Even such hurried due diligence that Binance was able to rush through raised more red flags than the last Labour Party Conference and on 09 November, Binance said the issues were beyond its control or ability to help.
Binance made vague allusions to “mishandling of customer funds among other issues,” which was, of course, enough to ensure that any investors who had hung on in that far now resolved to cash in their chips and run.
The next day, 10 November, the market was buzzing with the news that Bankman-Fried was desperately seeking an $8 billion injection to keep the exchange afloat. Within hours, the Bahamas’ securities regulator froze FTX Digital Markets’ assets, and minutes later, there was an announcement from the California Department of Financial Protection and Innovation (DFPI) that it was launching an investigation into the “apparent failure” of FTX.
Just when it seemed the day could not get any crazier, Bankman-Fried emerged from his bunker and chose Twitter to make an extraordinary succession of statements in which, among other things, he apologised for what he called his “fuck up,” accepted responsibility, admitted that the non-US exchange had insufficient funds to meet customer demands, and referred to himself as CEO in the past tense. He blamed the collapse on “poor internal labeling” that led to leverage and liquidity being fatally miscalculated. He added that Alameda Research, the FTT-based quantitative trading firm that he ran, would be winding down.
The 15-part Tweet attracted more cynicism than sympathy, with the majority of responses suggesting that he was only sorry he got caught.
On November 11, Bankman-Fried’s removal as CEO was confirmed, and he was replaced under court order by attorney and professional troubleshooter John J Ray III. This was the man who was appointed to lead Enron through bankruptcy proceedings 20 years ago.
The same day, FTX filed for Chapter 11 bankruptcy protection and hours later, it claimed its systems had been hacked and almost $0.5 billion had been removed in unauthorised transactions. Given the timing and some basic slip-ups that the hacker made, there was immediate suspicion that the hack was an inside job.
On November 16, a class action federal lawsuit was filed in Florida by Edwin Garrison, charging a group of individuals with “creating a fraudulent cryptocurrency scheme designed to take advantage of unsophisticated investors from across the US.” The co-defendants included Bankman-Fried, plus various celebrity backers including Tom Brady, Kevin O’Leary, Shaquille O’Neal and many others.
On November 18, the Securities Commission of The Bahamas (SCB) took control of cryptocurrency assets held by FTX and instructed Bankman-Fried to move crypto assets to the regulator’s wallet in a move to protect creditors.
| Timeline of events 06 Nov: Binance sells all FTT tokens. 07 Nov: Bankman-Fried seeks bailout for FTX from venture capitalists, then appeals to Binance. 08 Nov: Binance agrees to buy FTX’s non-US business. 09 Nov: Binance pulls out of FTX acquisition due to concerns raised in due diligence. 10 Nov: SCB freezes FTX assets. Bankman-Fried admits liquidity crisis and apologises. California DFPI launches its own investigation. 11 Nov: Bankman-Fried officially steps down as FTX CEO, court appoints John Ray to replace him. FTX files for Chapter 11 bankruptcy protection. 12 Nov: FTX reports alleged hack, in which around $500 million assets have been transferred. 18 Nov: SCB takes control of FTX assets held in Bahamas. |
On 12 December, Bankman-Fried was arrested and imprisoned by Bahamas police. He was extradited to the US and attended the Federal Court in Manhatten on 22 December, where he was indicted on eight counts. The 30-year old was released to home detention at his parents’ house in California, having paid a $250 million bond. He agreed to wear a monitoring bracelet and restrict his movements within and between the Northern District of California and the Southern and Eastern Districts of New York.
What happens next?
That brings us up to date as far as the facts of the case are concerned. Bankman-Fried continues to abide by his bail conditions and is preparing for his trial, which is due to commence on 03 October 2023.
Meanwhile, two of Bankman-Fried’s top executives, Caroline Ellison and Gary Wang, pleaded guilty to four charges and are assisting federal authorities with their ongoing investigations.
It all suggests that there is plenty more dirty linen to be aired before this matter reaches its conclusions. But already, there are lessons to be learned. Despite the innovative fintech instruments that are in play here, the failings are of a type that predate the internet era, never mind blockchain and crypto.
The more things change, the more they stay the same
The collapse of FTX and the fallout that has ensued serves as a cautionary tale for businesses across every industry. The frustrating thing is that the failings that led to the downfall were largely avoidable and constituted the kind of basic internal controls that risk management consultants have been talking about for decades.
Attendees at risk seminars might sit listening to tales about Barings Bank, Arthur Andersen and Enron and wonder what relevance this ancient history can possibly have in the 2020s. Yet with the failure of FTX, we are seeing exactly the same failures leading to the same disastrous results.
It is never possible to eliminate all risks, but the actions and inactions at FTX genuinely constitute falling at the first, second and third hurdle of Risk Management 101. Here are some of the key takeaways:
1. Absence of proper internal governance
Poor governance can throw any company into chaos, and size is no defence. In fact, we saw with Enron that the bigger they are, the harder they fall. 20 years later, the court even appointed the same individual who was sent in to deal with the Enron scandal as acting CEO at FTX.
He was horrified by what he found. The Board of Directors, such as it was, consisted of the controlling shareholder, Mr. Bankman-Fried, and two others with whom he shared a home.
The whole point of a board is to ensure accountability and to challenge management by asking the awkward questions. This whole concept was entirely absent at FTX. With no real oversight, there was no accountability for the actions or inactions of the management team.
2. Inadequate financial controls
Financial controls are as fundamental a risk management process as you can get, and are essential for every businesses, large or small. Clearly, they are even more important for businesses whose entire purpose involves handling large financial transactions and holding substantial sums of other people’s money.
Financial controls take various forms, and we won’t go in-depth here, but some basics include the following:
- Segregation of duties
- Dual signatories for large transactions
- Regular reconcilliations
- Internal and external audits
There were shortcomings with even the most basic financial controls at FTX. For example, the bankruptcy report noted that an unsecured group email account was used to access confidential private keys and critically sensitive data.
FTX managers were also unable to provide any audited financial statements whatsoever.
| “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here” – John Ray, court-appointed CEO for FTX |
3. Lack of experience in the executive management team
The crypto market is young and vibrant, and many of the top companies have leaders who are similarly youthful. There is nothing wrong with that as such, but it can expose a business to risk, especially when other internal controls are so woefully lacking.
In the case of FTX, there can be little doubt that lack of business experience played a role in the general mismanagement and lack of oversight that has already been observed.
To be effective, risk management has to come from the top-down. A business’s appetite for risk and effectiveness at managing risks is ultimately a reflection of the CEO’s approach and for this reason, CEOs must come under close scrutiny. This is especially the case in the finance and tech industries, and FTX straddled both. The FTX collapse is a starrk reminder that placing blind trust in an inexperienced CEO, however brilliant and charismatic he might be, can be lead to disaster.
| “You must make sure that a young management team has access to experienced strategic advisors and professionals who can guide them and ensure there are proper controls in place” – Michael Crolla, Partner at law firm BDO Canada. |
4. Absence of effective due diligence
It is easy to stand on the sidelines after the event and criticise the lack of controls, financial mismanagement, inadequate corporate governance and out-and-out fraud that underpinned the FTX collapse. But all that cannot happen on such a grand scale overnight, and those who invested should take a long look in the mirror before they start casting stones.
The whole mess could not have continued and escalated as it did if investors had not continued to throw money at FTX. And why did they do so? Because they got caught up in the hype and put trust in Sam Bankman-Fried and his “x-factor” instead of in their own due diligence.
If something seems too good to be true, it probably is. Like the Enron scandal or the Barings Bank collapse, that’s a quote from ancient history. But it seems that even in these enlightened times of the 2020s, we still need to be reminded. If a company claims it will deliver huge profits, do your due diligence and pay particular attention to its governance systems to save yourself a world of hurt further down the line.
This content is brought to you by the secured loan team at ABC Finance.
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