FTX – setting a new benchmark for bad practice in crypto

WELREX Investment Director Stephen Ashworth offers his perspective on the FTX saga.

This article was featured on WealthBriefing and in their principal subscriber email on December 1st.

Back in June, we wrote about the increasing uncertainty in the crypto space off the back of the stable coin, Luna, and lending business, Celsius, collapsing with significant losses to their creditors. We wrote of possible future carnage as the ripples fed through the crypto ecosystem.  This month saw the collapse into bankruptcy of FTX, one of the industry’s largest and highest-profile crypto exchange platforms. 

As events have unfolded, we now have a glimpse of the shocking workings of the FTX business, set up and managed by the youthful and well-known crypto personality Sam Bankman Fried (“SBF”), and crucially its connected companies, in particular Alameda Research. Alameda began life in 2017 as an algo-based trading firm (SBF was originally a mathematician and arbitrage trader). The FTX exchange came later off the back of Alameda’s trading successes. The amounts involved in the FTX failure are huge. An apparent $8bn gap between assets and liabilities.

A pure exchange business really should have very little risk

It is worth reflecting that an exchange business is really just a matching platform between buyers and sellers. There may be some settlement risk but overall, the risk should be low. Indeed, crypto exchanges typically ask clients to pre-fund settlement amounts thereby reducing settlement risk. However, this is where the problems began. If you want to trade actively on an exchange you need to keep a balance of assets in hot wallets connected to the exchange, so in effect, FTX was acting as a custodian too. As FTX activity grew, so did the balances of client money being held at the exchange.

Further, FTX allowed clients to trade on margin and as is now becoming clear and as announced by SBF himself in a letter to employees this week, the true extent of the margin ended up very high and was not known or tracked precisely by the management.

So, not just an exchange after all

In reality, FTX seems to have had more in common with a shadow bank than an exchange, lending capital to Alameda. And worse, it would appear that some loans were made using client money! Alameda then made loans to other crypto businesses and provided leverage to FTX trading clients.

Another interesting and less-known activity is the way liquidity is provided to centralized crypto exchanges like FTX. In traditional markets, market makers act as principals with their own capital at risk. Much of crypto market-making liquidity is provided via algo-based trading technologies. The firms offering this technology often partner with the exchanges under arrangements where the exchanges provide the risk capital.  Alameda was just such an algo-based trading firm providing market-making for many underlying coins including FTX’s own token FTT (remember this point as you read on). So not only do we have client funds used for loans, but that same client capital may have been used to provide liquidity on FTX.

At one point it seemed SBF was the industry’s lender of last resort to collapsing crypto business. Several articles compared SBF to Pierpont Morgan, the eponymous founder of JP Morgan, who rescued other failing banks in 1907.

It was the Alameda business with the leverage problem that drove the FTX failure.  Alameda suffered losses as crypto sold off this year. Alameda did provide collateral to support the loans from FTX but this collateral was in fact FTX issued tokens, FTT. Oh, dear. The value of the collateral was directly related to the success or failure of the FTX operating business not to mention that Alameda was also market-making prices for the collateral. Once FTT began to collapse it was always going to be game over.

Segregation is the single most critical control

After FTX filed for bankruptcy, a professional administrator, John Ray III (renowned for the same role post-Enron), was appointed. His first report, released last week, makes damning reading.

Critically, there was no segregation of client monies, nor it seems any serious control over that money within the business. This is appalling – especially as we also now know that industry groups that pitched to help FTX deliver such segregation with formal custodian services, were rebuffed by SBF despite apparently having the support of other personnel within the business.

The report makes for further depressing reading. No centralised cash reconciliation or control over cash. Massive holes in books and records such that a reconstruction process is underway from FTX’s creditors’ bank records. Overall, an interconnected web of incompetence and possibly, fraud.

Where do we go from here?

It is clear this mess is going to take some time to unravel and resolve. SBF was feted as being very clever. Too clever to be bothered with details or so clever we will never find out? Time will tell, or perhaps not.

More immediately the debate about regulation gains momentum. This too will take time to resolve but from our perspective, the failures with FTX are little to do with regulation or lack of it. Without proper controls, management integrity, and attention to detail, most businesses will fail eventually. This is not complex – it’s common business sense and good practice. It can and should be done regardless of regulation.

One further interesting observation: for all the centralised (Cefi) failures we have seen recently, the world of Defi – direct wallet-to-wallet connectivity with full control retained by the wallet owner and powered wholly by smart contracts, goes on untouched by events and with no points of failure for clients so far. Many crypto purists cite this as the end game for blockchain technology. Right now, they seem to have the upper hand.

Stephen Ashworth

Investment Director

WELREX®