Ever since its initial promise to decentralise finance, the market for cryptocurrency has now grown to be a trillion-dollar industry. New ‘coins’ or currencies pop up everyday, as do new exchange platforms. The industry is yet to meet with significant regulation, which allows for this unchecked growth. Unfortunately, this also means that coupled with the amounts of funds being channelled into the space, the crypto space is also especially vulnerable to the malintentions of bad actors. The case of Sam Bankman-Fried, who stands accused of carrying out a crypto scam through FTX, the exchange platform he founded, is an example of one such bad actor in the space.
The stock exchange, but for crypto
Much like a traditional stock exchange platform, a cryptocurrency exchange allows investors to buy and sell cryptocurrencies such as Bitcoin or Ethereum. Traders access these through digital apps on their phone or through the desktop, which provides them with the tools to view and analyse what’s going on in the market. As of 2020, the largest cryptocurrency exchanges in operation were Cayman Islands-registered Binance and Bahamas-based FTX.
FTX, was the highly successful brain child of ‘effective altruist’ Sam Bankman-Fried, who propounded the value of earning vast amounts of money for the express purpose of dedicating wealth to the good of mankind. Fuelled by belief in its founders good intentions and credibility, the platform peaked in popularity shortly after being founded in 2019. By January of 2022, FTX was worth 32 billion USD and the company would file for bankruptcy only later that year. As of today, Bankman-Fried is incarcerated in Brooklyn’s Metropolitan Detention Center, awaiting trial on seven counts of fraud and money laundering. If found guilty, he could face up to 115 years in prison.
What happened to FTX?
Just two years after starting business, FTX was the second largest cryptocurrency exchange in the world, just after competitor Binance – that was until CoinDesk published an exposé describing the precarious situation of FTX’s finances. A news site specialising in bitcoin and digital currencies, CoinDesk revealed that the majority of the billions of dollars in assets that FTX held, were held in FTT, FTX’s own cryptocurrency project. Little financial knowledge is needed to understand why this is an unacceptable state of affairs. The financial assets held by FTX are funds owned by their customers/clients, which they received in dollars. These funds are only meant to be held in trust by the exchange platform. Converting them into FTT for which they did not obtain their client’s consent, effectively rendered the funds vulnerable to market forces – for which once again, clients had not given their consent. Additionally, FTT was FTX’s own cryptocurrency project, which meant that there was a serious conflict of interest between the management of client funds and the in-house cryptocurrency project on FTX’s part.
FTX’s slide into insolvency
Between CoinDesk’s exposition that the client funds held by FTX effectively had no monetary insurance and that FTX held close to 8 billion US dollars in liabilities, of which 7.4 billion dollars were in loans, rumours soon circulated that FTX was at risk of being insolvent. This was the cue for many who had chosen to invest in FTX and via FTX to quickly withdraw their money. In a traditional banking system, this would be counterintuitive, as the sudden withdrawal of funds by clients from the institution would make a bank insolvent in any case. Clients can afford to ‘bank’ on trust in a bank as there is a level of insurance in case of insolvency. Banks themselves are mandated to carry a level of funds to mitigate sudden crises, and governments are prepared to step in to ensure that the sudden collapse of a bank has limited impact on the ecosystem. The blockchain carries no such insurance, which is why FTX customers cannot be blamed for wanting to save what they could of their funds. Cryptocurrency platforms are also often unprepared for the level of liquidity they should maintain to mitigate unexpected situations such as these, which is why bankruptcies are so common among exchange companies.
Binance: a shark in the water
Interpretations of Binance’s actions that followed are mixed, with some alleging that the crypto exchange platform acted deliberately to sabotage their competitor’s chances of solving their insolvency crisis. What later investigations revealed however make it difficult to believe that Binance can be held responsible for what happened: FTX’s downfall was of its own, deliberate making. While the true facts of the matter were yet to be revealed, in 2022 however, it would appear that Binance was only too happy to make the situation a little more difficult for FTX.
As FTX’s liquidity gradually worsened, Binance CEO tweeted out that they would be liquidating their assets held in FTT. The Tweet, and the influx of FTT tokens into the market that followed, caused the market price of FTT to plummet, heightening the panic of FTT investors as to whether they would ever be able to recover their investments. Alameda Research, FTX’s sister company, offered to buy out Binance’s FTT stocks at the market price of $22 dollars per token to mitigate the issue, an offer that the CEO of Binance was quick to decline. It is clear that Binance too were not innocent of seeking to eliminate market competition when the opportunity was ripe.
FTX finally had to respond by freezing FTT transactions on their blockchain, solidifying the market’s belief that the company was truly insolvent. It is in this context that Binance stepped into the crisis, offering to buy out FTX in order to mitigate the liquidity crisis. The agreement that was struck between FTX and Binance however was non-binding, as Binance was yet to carry out their due diligence to assess the true value of their proposed acquisition.
In the days and media reports that followed, Binance was as quick to back out of their agreement: allegations of fraud, customer fund mismanagement, and missing funds that amounted to billions of US dollars meant that FTX was more of a liability than Binance could afford. In terms of the larger picture, it is possibly just as well: the purchase would have ultimately centralised the cryptocurrency space, the very issue in the traditional banking system that cryptocurrency promised to address. Needless to say, Binance’s very public declaration of their intentions was another nail in the coffin as far as public perception of the company went.
Alameda Research
Alameda Research was a trading firm co-founded in 2017 by Sam Bankman-Fried with business partner Tara Mac Aulay. The company acted as FTX’s own cryptocurrency arm, FTX’s own attempt to leverage its position in the market to promote its own cryptocurrency. As FTX’s situation worsened, the question that was at the forefront of everyone’s mind was: where had the money actually gone?
The insider leaks and subsequent investigative media coverage quickly shed light on where the missing funds had gone: to FTX’s own pockets – or rather, to Alameda Research. It was in fact thought that Alameda Research’s investment activities were heavily funded by FTX assets. FTX assets that were in fact, customer funds that it had promised not to trade. Customer funds that in the conversion to FTT, FTX lost all ability to provide monetary insurance for, for their customers. It was later found that Bankman-Fried had actually had a ‘backdoor’ installed in FTX’s blockchain to facilitate the transfer of funds between the two companies without attracting attention.
Prior to the FTX crisis, Bitcoin had also been declining steadily in value since late 2021. Other cryptocurrencies would also soon follow the trend, resulting in many exchange platforms declaring insolvency. Alameda Research had taken this opportunity to acquire their failing competitors at the time. It is assumed that acquisitions such as these, coupled with FTX’s excessive celebrity marketing campaigns, were responsible for FTX’s dwindling funds. As FTT values fell due to the events that were to follow, FTX funds that had been tied up in the tokens vanished. Alameda Research and FTX were clearly tied too closely together with little delineation between the two companies, as could be seen from Alameda Research’s dependency on FTX for capital. FTX was also a private company, which meant that it was not required by law to make its balance sheets public – neither were its partner companies required to publicise their financial statements – including Alameda Research.
The collapse of a Titan – a timeline
The omission of dates so far in the narrative can seem surprising. The omission was deliberate, given the short time period between which FTX’s exposé and subsequent collapse occurred. CoinDesk published the disparity in FTX’s assets and liabilities on the 2nd of November – the company had frozen withdrawals by the 8th. On the 11th of November, FTX had filed for bankruptcy. Authorities intervened to arrest Sam Bankman-Fried on the 12th of December, 2022: He had been indicted by the US District Court on eight separate criminal charges, and was also under investigation by the Securities and Exchange Commission (SEC) as well as the Commodity Futures Trading Commission (CFTC). The charges levied against him by the District Court included money laundering, wire fraud, campaign finance violations, and securities fraud. On the 15th of the same month, investors of FTX filed a class action lawsuit against the company and the celebrities who endorsed the company for ‘false representation and deceptive conduct’.
FTX debtors released a debtor’s report in April of this year, detailing the internal failures that had led up to the organisation’s demise. Security failures such as private keys that moved crypto assets between accounts being left unencrypted, crypto assets that were left in unsecure wallets that were connected to the internet, failure to use multifactor authentication and access to large crypto assets being shared among several individuals were among some of the weaknesses highlighted. The lack of formalities for what should have been transactions between separate entities, the lack of financial control, lack of risk management were some of the most basic internal controls that FTX were also found to be lacking in.
The aftermath
Bankman-Fried was first placed under arrest in the Bahamas, and was subsequently extradited to the US to face trial. As the country in which the company is registered, the Bahamas will also continue its investigations against FTX, even as the US pursues their criminal charges against Bankman-Fried. He was placed under house arrest on a bond of 250 million US dollars shortly after his arrest, which is the largest bond to be set against an individual in a criminal proceeding in the US. His bail however has since been revoked due to allegations of witness tampering – he was once again detained at the Brooklyn Metropolitan Detention Center just earlier this month.
Of the 8 billion US dollars in total initially reported missing since FTX’s collapse, 5 billion US dollars worth of assets had been recovered as of January this year. However, the collapse of such a giant in the cryptocurrency space has left many loath to trust their futures with cryptocurrency. In addition to the revelation of the presence and the magnitude of the bad actors in the space, the instability of the value of cryptocurrency and the lack of monetary insurance are all reasons enough to give many pause. FTX’s collapse alone for example had adverse effects on the value of other crypto exchanges and their native cryptocurrencies, especially on those whose values were tied to that of FTX’s, such as Solana, another crypto exchange platform. According to Bloomberg reports, FTX’s collapse had led to an institutional scepticism of cryptocurrencies as an asset class.
May this year also saw the US Securities and Exchange Commission doubling its crypto enforcement unit in size, a clear reflection of the Commission’s acknowledgement of the increasing significance of the space in finance going forward. As of now, the SEC has even filed charges against Binance, the world’s largest crypto exchange, as well as Coinbase, which is the US’ largest crypto exchange, for mismanagement. Future SEC actions will likely involve sustained efforts to define cryptocurrency, with the possible exception of Bitcoin, as securities, which are financial instruments whose regulations are already very thoroughly provided for by existing legislation. This will effectively render all cryptocurrency exchange platforms and broker-dealers illegal within US jurisdiction.
Regulation of cryptocurrency in the US is still up in the air and it will remain that way until it is decided whether crypto should be treated as a commodity or a financial security. The commodity market, which includes commodities such as crude oil and gold, is regulated chiefly by the Commodity Futures Trading Commission or the CFTC. Securities such as publicly traded stocks and bonds on the other hand fall under the jurisdiction of the SEC. Those who believe that most cryptocurrency should be defined as a security do so because of the speculative element surrounding them: they are instead largely used as a vehicle for investment. Bitcoin is often exempted from this generalisation because it is widely accepted as a currency already, and is classified as a commodity instead.
Debate between proponents and opponents for cryptocurrency however still rages fiercely on as ever. The fact remains that crypto will struggle to succeed as a currency until it is adopted in the mainstream as such, and will likely struggle to reach an equilibrium as an investment until the largest players in the market buy into it. Either seems an impossibility until the space is bought under financial regulation. Unfortunately, this will also leave the anti-authoritarian philosophy of cryptocurrency a moot point, the process for which it would appear that Sam Bankman-Fried has already initiated.
(Theruni Liyanage)