Fall of the (crypto) titan

The last year has been rather tough for crypto. Over the summer we saw prices crash and several companies fail. If anyone thought the following months would bring a change to that trend, they were in for a rough ride. In November, the so-called “crypto winter” would take it biggest scalp yet, in the form of Chapter 11 bankruptcy of crypto-darling and one of the biggest exchanges of its kind – FTX, an implode that shook the whole environment and seriously impacted the faith in it. 

The company presented itself as willing to work with regulators, its founder, Sam Bankman-Fried, often found himself speaking with them on how crypto should be controlled. It also played a role of guardian angel, bailing out companies that struggled after the crashes. Simply put a role model for any crypto exchange and a leader in its field, what could possibly go wrong? Well, you could end up with $8bn in liabilities, both founders facing criminal charges (one already plead guilty) and become the best deterrent for crypto to date. But I’m getting ahead of myself. 

Sam Bankman-Fried

The saga is one of passion, ambition, and a whole lot of math (but only the cool kind; you’ll get that joke on your way out). It all started back in 2017, when Sam Bankman-Fried, or SBF as he’s commonly known, fresh off a stint at the elite trading firm Jane Street, decided to strike out on his own and start Alameda Research. Armed with a deep understanding of financial markets and a passion for cutting-edge technology, he set out to create a quantitative trading powerhouse. By this I of course mean, they mainly did arbitrage trading and sometimes invested in dogecoin hoping Elon would tweet about it.

Naturally that wasn’t enough. SBF wanted an exchange that would suit his needs and because it’s crypto, he could just make it. In 2019 he and Gary Wang founded FTX, a platform that combined the best of traditional finance with the wild west of crypto. The company quickly established itself as one of the most popular and widely used exchanges on the market. And it’s not hard to see why. The exchange offered a wide range of innovative financial products, leverage, a sleek and user-friendly interface and efficiency, everything a crypto investor might need.

The hype was further driven by the company’s extensive advertising. They had Tom Brady and Steph Curry in their ads and sponsored teams in all different sports, including F1, NHL, NBA and NFL. What also helped, was SBF’s appearance, a nice trustworthy looking guy, always in shorts, never saw a comb. An advocate for regulation, common guest in Congress using newly acquired billionaire status to become a significant political donor (partly as PR stunts, as he admitted during DealBook summit). If that wasn’t enough, he was a believer in effective altruism (you “earn the right to give”), promising to eventually give away most of his money. Oh, and he also made covers of few magazines (he says “every magazine”, but I wouldn’t trust his words). What a great guy. There were some reservations about his position in Alameda who was now trading on FTX’s platform (although he stepped down as CEO of Alameda), but no one’s perfect, so it was brushed over.

Everything seemed to get better and better for SBF, his empire and crypto in general up until 2022. The “crypto winter” saw prices crash, including bitcoin’s loss of almost 50% of its value from the March high. Multiple companies failed. The whole industry lost 2/3 of its value! And yet, the almighty FTX was going strong, both it and Alameda even bailed out some of the failing ones (e.g. BlockFi, Voyager), earning SBF comparisons to the legendary John Pierpont Morgan. 

Former FTX Arena in Miami

But a true hero story requires a major plot twist. Such came for SBF on November 2ndCoinDesk ran the story of how FTT, a crypto token made by FTX (it gave owners discounts on trading fees and increased commission, among else), was Alameda’s biggest asset. This was a big deal; when a trader, like Alameda, makes bets, it borrows, and to do so it must post collateral. Everyone knows the company trades on FTX, so they assumed it posts FTT to ensure it and started panicking. Why? The token works sort of like a stock, if FTX performs well, the price of it rises and the opposite. Taking a collateral in your own stock is like betting against yourself. If your performance worsens, you also lose assets, this might destabilise you and which in turn decreases value of assets and so forth. A death spiral. 

The story itself sent FTT down 30%, however the biggest hit came four days later when Changpeng Zhao (CZ in short), CEO of Binance, the biggest rival of FTX (and the biggest exchange), tweeted that “due to recent revelations” his exchange will be selling FTT it holds. Now, this caused panic and mass withdrawals. SBF came to twitter to ensure the company’s fine. It wasn’t. Less than 24 hours later, the world of crypto was rocked by the news that Binance would acquire FTX to prevent a further liquidity crisis. 

A few days that took everyone by surprise. Well, it wasn’t nearly the end. Another 24 hours passed, and CZ was back on twitter saying they are backing out of the deal after conducting their due diligence. At this point SBF was running with the spreadsheet trying to gather funds and stay afloat. Just four days after the “FTX is fine”, he announced the company and Alameda filed for bankruptcy. In less than two weeks they went from heroes hailed by all, to zeros that have SEC and CFTC breathing down their necks. 

A fair question would be one of what happened to that well managed platform, with the best safety algorithms. A glimpse at that was provided by the Financial Times, who published “balance sheet”, which SBF showed potential investors in the last days of the company. It was, let’s say… optimistic. And a complete mess. It revealed $9bn in liabilities against only $900mn of easily accessible assets. Yes, according to the spreadsheet the value of all assets was about $9.4bn, but it included FTT, Solana and Serum – tokens that FTX created itself – FTT was losing its value at a rapid pace and the other two didn’t have nearly enough turnover to be worth as much. These tokens might have had value, when everything was fine, but now it was next to nothing. Almost forgot, at the bottom of the sheet was a negative $8bn entry labelled “hidden, poorly internally labelled ‘fiat@’ account”. What. Even in this surreal reality where you can sell $2.2bn worth of crypto that has a market cap of only $65mn, there is still a case of almost the same amount missing.

So as established, no one (understandably) wanted to touch this mess with a ten-foot pole and FTX and Alameda were forced to file for bankruptcy. As a result, SBF stepped down as CEO and John Ray III took position at the helm to guide the company through the process and recover as much customer’s funds as possible. Now, John is your go to guy in case like this. He’s been the CEO or Chief Restructuring Officer in some of the biggest company failures in history. So, when he says “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” in his first day declaration, it is certain that the case is worse than just one “hidden, poorly labelled” account. 

One of those problems regarded the form of payment requests in the company. As one could expect, a company managed by a bunch of young finance whiz kids living in the Bahamas couldn’t have just a “normal” payment system. They needed something cool, and nothing can be even remotely as cool as approving Brady’s contract with the use of personalised emojis (I might have let my imagination go at this one, but at least ad campaigns etc. were approved this way). Keeping track of all the assets and any sort of records in general are boring as well, so they skipped that. Those included (or didn’t to be more precise) books on investments, which resulted in an unbelievable statement that they are recreating it from the “bottom up” and are looking at third-party sources to locate them. How is it possible to be that poor at bookkeeping and manage for so long? An interesting point raised in the declaration concerned the secret exemption from the auto-liquidation protocol (automatic sell if one’s account approached zero to protect him from owing more than he has) given to Alameda.

This proved that Alameda was treated differently and raised concerns about the integrity and separation between the companies. Fraud possibility slowly starts crawling into the picture. SBF advertised FTX’s protocol as one protecting customer funds but failed to mention his second company is exempted. At that time, the crypto founder himself was, despite advice from his lawyers or in fact everyone around, making media (virtual) tours trying to explain himself and talk to anyone who wanted to listen. “I’ve had a bad month” he said to Sorkin in an interview during the Dealbook Summit was a bit of an understatement. He tried to play it as incompetence (better than fraud but still not great) saying they overlooked a significant (and undercollateralized) bet Alameda made and when it crashed it just wiped out the assets. Well, it wouldn’t happen if you hadn’t excluded them from the system. Turns out US prosecutors had similar thoughts about it.

On December 12, after saying he doesn’t think he’ll be arrested less then 48 hours before (do you see the pattern?), SBF was detained in the Bahamas on US fraud charges and soon after extradited to the US. Turns out that while he was busy tweeting, co-founder of FTX, Gary Wang and Caroline Elisson, who replaced him as CEO of Alameda were cooperating with prosecution after pleading guilty to similar charges. Besides lying to the public about the safety algorithm it also turned out that Alameda had the ability to make bets while their account was in red. That’s bad, but you could argue that if it was a small limit and they weren’t able to withdraw that, it is still okay-ish. The limit given was $65 billion and yeah, they could withdraw even with -$4bn in the balance. Basically, unlimited money source if they ever needed it.

The story behind it is Alameda took out loans from different lenders, securing them with FTT. Lenders got spooked and wanted their money back, so Alameda made pretty eyes to SBF, he increased their negative limit, and they paid loans back with FTX’s money. Why didn’t they just returned what they borrowed? Some money was just lost, some spent on the heroic bailouts and some on even more important spendings, such as perks for employees (including $253mn on Bahamas real estate) or personal loans to FTX’s top execs. Not looking great.

So, what’s going on now? John Ray III is doing some magnificent work scrolling Google, as he managed to find around $5.5 billion of liquid assets. In his last interview since taking over, he told WSJ, he’s exploring the opportunity of reviving the exchange. A completely reasonable thought would be that people wouldn’t trust it, but apparently there is interest. It also makes sense, one of the biggest holdings of assets FTX has lies in FTT, which at the sole mention of revival jumped by 30% (although still 97% below it’s all-time high). With a competent record system and oversight, it might work. At least enough to recover what’s owed. 

As for SBF, after pleading not guilty, he’s now spending time on a $250 million bail and under house-arrest in his parent’s home in Palo Alto, playing games and writing a substack. He argues the US subsidiary of the group should still be solvable, which if true would really help him in avoiding hefty prison time. The trial is set to begin in October.

Crypto is a confidence business, it relies on trust and faith. SBF knew it, hence all the bailouts. Now it’s a role CZ took upon himself, trying to establish Binance fund that would help struggling companies. Despite those efforts those efforts, crypto is struggling. Yes, Bitcoin’s rising since the beginning of the year, but FTX’s collapse significantly impacted the industry. Multiple companies announced layoffs, BlockFi filed for bankruptcy and Genesis is contemplating the same. We just have to wait and see, whether the crisis is a short hiccup or a new norm.