The cryptocurrency world is still reeling from the spectacular, rapid collapse of FTX. Sam Bankman-Fried’s crypto exchange is now in Chapter 11 bankruptcy, as is his associated hedge fund, after the exchange—apparently—secretly took customers’ money and threw it into speculative bets that didn’t pay off at his fund, Alameda Research. This crash and burn has intensified doubts about crypto’s viability as a widely adopted financial system. And while all of FTX’s problems have some connection to crypto problems more generally, some of them appear to be extra bad because of decisions Bankman-Fried made that were unique to his businesses. Some details have come freshly to light in the last 48 hours through the revelation of FTX’s balance sheet, the bankruptcy of another crypto firm associated with FTX, and an interview that Bankman-Fried’s lawyers somehow did not prevent him from giving to the New York Times. He is also still tweeting.
Even for crypto skeptics who believe the entire ecosystem is flimsy, the speed and mechanics of FTX’s collapse have been mind-boggling. I have a lot of questions myself, so I called up Michael Dambra, an associate professor of accounting and law at the University at Buffalo School of Management whose research and teaching areas include accounting disclosures and business valuations. Where did Bankman-Fried start to go wrong? What can the Securities and Exchange Commission, or other U.S. authorities, do about it? Will the investors who stored $9 billion with FTX get any of their money back? Is this entire story as cartoonishly absurd as it looks on first glance? Spoiler on that last one: It’s worse.
Alex Kirshner: What do you think was Sam Bankman-Fried’s gravest sin that sealed the fate for him and his companies?
Michael Dambra: From all I’ve read, I think the No. 1 problem was the relationship that FTX had with Alameda. There’s a gaping hole on that balance sheet (which the Financial Times obtained and made public) that’s scared other crypto companies from bailing FTX out, and there’s just missing money.
And so I think that the biggest problem, or the cardinal sin we’ve seen here, is that you’ve taken customers’ investments in speculative but liquid assets that easily trade—so things like owning Bitcoin, things like owning Ethereum—and transferred these out of the FTX system. Those currencies are speculative, but at least there’s market prices and they’re easily tradable. And what we see from the liability side is a lot of customers have accounts similar to a bank deposit, but on the asset side of FTX, there’s these speculative currencies that are very illiquid: positions in Serum, a coin that FTX created; positions in FTT, which FTX also created.
“Where’s the money?” is what people don’t really know. And the assumption that’s going on right now in the markets is that Alameda ran into some problems, and they transferred some of the customer money in these liquid assets like Bitcoins into Alameda to cover some of the bets that Alameda made.
A problem with this relationship with Alameda is that these cryptocurrencies that FTX created are like pixie dust. FTX invented and minted them, and they didn’t actually have that much value. They go down, so the balance sheet gets worse, and it gets even worse because they’re holding these coins as collateral for those customer deposits that they’d lent out to the hedge fund. That just seems, as I say it aloud, completely insane. But I’m not a crypto trader or an accountant or a finance professor. Is there any more charitable way of viewing this other than as completely and utterly insane?
I think one of the issues is a lack of regulation, and maybe the SEC is going to respond because of this. Think about how a traditional bank works: You put money into your bank account, and you get paid a nominal rate of return. What the bank does is try to take that money and invest it in something that gets a higher rate of return, so they make interest on the yield on that return. And so a bank could take something and take out commercial loans that are generally safe, or they’ll invest in a diversified portfolio of equities.
What’s different about what banks are regulated against is they have to have a certain amount of assets on the books. And so you’re going to have Tier 1, highly liquid assets. You need a certain ratio of Tier 1 assets, a certain ratio of Tier 2 assets, and to protect the individuals that are giving their accounts to a bank, there’s some guaranteed protections against the bank using those funds in riskier, highly speculative ways.
That world doesn’t exist yet in crypto. You could have your coins held at FTX, and there’s no particular regulation that exists that restricts what FTX can do with that money. And so the insanity is the sort of cowboy society we have right now in the crypto world.
Spiritually, this feels like fraud. Given this lack of a regulatory scheme for crypto in the US and elsewhere, is there anything that jumps to your mind that could potentially be the regulatory kind of fraud or the legal kind of fraud? Or is this just people getting bilked because there are no rules to prevent it?
I’m not a regulatory expert. This isn’t investment advice. I don’t know offhand how FTX deals with their customers and what the guarantee is. Litigation risk could come from FTX having very stringent rules on saying what they’re going to do with the customer accounts. Coinbase is a lot more stable, and they’re going to have specific information in the information they provide with their investors or information they’re going to provide with individuals placing coins, on where the assets are going to be held. And so the real litigation risk, if you’re not going to get into the SEC sort of regulatory enforcement and whether this is fraud, we’d have to know exactly what FTX rules are in terms of how they convinced borrowers or loaners of coins, what the actual transaction or agreement was between those two stakeholders.
Could this story become the domain of American authorities, given that FTX is based in the Bahamas? It seems that there’s great uncertainty about whose job it is to make sure that something like this doesn’t happen, or to punish it if it does.
At this point, the SEC doesn’t have strict authority on this, but we could certainly see those regulations change. You’re certainly getting domestic individuals hurt by this, so the presumption is that regulators would act. But I agree with your point that because it’s the wild, wild west, we don’t have a lot of legal precedent on how fraud would be prosecuted in this particular case.
I assume SBF did not put his exchange in the Bahamas just because he liked the weather. Does it seem plausible that this is the kind of thing that can be gotten away with because a company is not headquartered on U.S. soil?
I think that’s a component of it. I think FTX would say they moved there for tax purposes, and there probably is some tax benefit of listing in a foreign location with a low tax rate.
But certainly, things are murkier when they’re abroad. You’re farther away from our traditional locations of SEC or other governmental transaction regulation. And so I would think that’s one component of the strategy to relocate headquarters.
One thing that FTX is doing in the U.S. is going through Chapter 11 bankruptcy. In bankruptcy, people who are owed money fight over who gets it. I know it depends on how much money has not just disappeared, but is there any way that retail investors who deposited with FTX could possibly find anything out of this pile of rubble?
That’s a great question. If we compare it to a traditional bank, something that we have in the regulations in the U.S. is that your bank deposits are guaranteed up to a certain dollar amount. So even if a bank run happens and the bank implodes, you can at least get some of that capital back. The number has changed over time. (It’s $250,000 now.) But in the crypto world, that doesn’t exist. FTX is not a bank, and you don’t have the same protections for these investors. And so I think you’ll see a lot of retail investors holding the bag. If you look through what’s left in the bank account, we have what they say are $14.4 billion of assets in these various cryptocurrencies. Once you take those off, there’s not a lot left.
A lot of it is these sort of handmade assets from Serum, the FTT currency, the MAPS currency, so a lot of cryptos where they’re highly illiquid. FTX has this high proportion of holdings of these cryptocurrencies. But the tradable, the sort of market value of the liquid assets out there, is different. Let’s say for instance for Serum: Oftentimes, if you’re creating a crypto, you’re not releasing all that into the market. If FTX actually released all the Serum they have, the market would implode. It’s already poorly priced. It’s already down to something around 29 cents as of this morning. But it’s going to be worth much less as the asset becomes more common. It’s like any kind of equity: If you flood the number of shares outstanding, the stock price drops.
Is there a fair analog here? I create a crypto token called AlexCoin, and I have a friend of mine buy it for 10 bucks, and then I make a million of those, and suddenly I have a $10 million market cap token, but we all know I really don’t.
Yeah, that’s a decent characterization of this, absolutely. If you tried to sell those AlexCoins on the open market for $10 a share, I think you’d have a hard time.
And that seems to be more or less what FTX’s balance sheet was made of.
Absolutely. I mean the Serum token, the FTT token, the MAPS crypto, they’re all self-made or promoted by FTX. And so there’s huge conflicts of interest here. I mean, if you really drill down to the assets, from what I’ve read, they have some Robinhood stock, which is valuable, and they have some cash. But the real liquid cryptos were probably already used to settle withdrawal accounts at FTX or settle debts at Alameda. You don’t see any Bitcoin, for instance, on the balance sheet. They probably already used it all up, because it was easily a liquid asset.
[A note: If these FTX-backed crytpos are the bulk of what’s left on FTX’s balance sheet, and they’re poised to lose value as they go to market to be sold, that makes it even harder to imagine a circumstance where FTX returns its money to people who left crypto on the exchange.]
Bitcoin would’ve been the relatively stable thing to have, then?
Yes. Well, I’m sure they had it, but it either vaporized settling customer withdrawals or is somehow transferred over to Alameda.
A big theme that permeates this discussion is that crypto is not well regulated. I wonder about an outcome where everyone just throws their hands up and says, “Wow, this was really bad, but it’s not our problem.” It feels like there’s a vacuum here.
If you read some of the speeches from SEC chairman Gary Gensler, I think you will see some changes to regulations such that cryptocurrencies can fall under the regime of a government regulation. One of the selling points of crypto during the market boom was, “Oh, it’s independent from government. It’s not a governmental currency. It’s going to be less volatile. It’s going to be more secure in the future. It’s going to lower transaction costs.”
But when we see this sort of damage, oftentimes we see lots of regulations. We’ve seen this throughout any sort of financial crisis. Sarbanes-Oxley in 2002, a couple of frauds happened, and there’s huge change in regulation. We saw this in the financial crisis in 2009. And so the amount of that capital that banks have to hold changed, to protect these retail, uninformed investors.
History does repeat itself, and we can see this happening again. With investors holding the bag on some nefarious activity, oftentimes regulation changes. And that’s what I would expect going forward.
Let’s say that takes some time. For now, most of these big exchanges are not based in the U.S. Most of them are private companies. Coinbase is a notable exception to both of those. But for now, if I don’t want something like this to happen to my crypto deposits at Crypto.com or Binance or anywhere else, do I just have to take their word for it that they’re not going to structure their business this way and then lose my money?
Yeah, I suppose that’s the hope.
What we’ve seen recently is more traditional institutions getting into allowing investors to purchase cryptocurrency. Coinbase is SEC-regulated because it’s publicly listed. Robinhood, very similar. And so if it’s going to be a flight to safety, I think it’s going to be companies that are more under the purview of government regulation. So there is some safety in that. If it’s publicly traded, there’s a lot more monitoring, a lot more control. We’ve also seen Binance coming out and saying, “We would never do this with your money.” I guess you sort of have to take it at their face value, unless they’re providing their financial statements for everyone to see.