FTX in 8 questions: What happened to FTX? What should investors do?

– FTX, the darling of the crypto world, had an incredible rise in three years that turned one of its founders and former CEO, Sam Bankman-Fried, into a multi-billionaire. Early November, FTX suddenly crashed and burned wiping out not only the entire value of the firm but also Sam Bankman-Fried’s entire net worth. Multi-billion crypto exchange FTX and its sister firm Alameda Research blew up in a matter of days. It is still not clear where billions of dollars of customer assets have disappeared to.

– Not long after SBF started FTX, crypto began to boom. The price of bitcoin, which is considered an indicator for the crypto market and traded at around $4,000 in early 2019, shot up in 2021, peaking at more than $64,000 towards the end of that year. Venture capital investors flocked to blockchain and crypto markets which made crypto platforms extremely attractive. The customers they started to attract were beyond the original investors such as technologists and blockchain hardcore believers and expanded to broader public who normally invested into non-crypto assets. This fueled the rise of the crypto exchanges. Even those unfamiliar with the technology were lured to FTX with promises that they could park their money in accounts and earn much higher yields than at traditional banks. 

– FTX rose to international fame through a series of high-profile acquisitions, aggressive marketing strategies and low trading fees. As the company grew, so did SBF’s reputation and  net worth. He became the face of FTX and crypto in general while strengthening his ties in Washington DC with various politicians and donating visible sums of money.  Celebrity endorsements and major sports sponsorships made FTX hard to miss. By the end of 2021 FTX had annual revenue of $1 billion. At the start of 2022, the platform had more than a million registered users.

– The price of Bitcoin declined dramatically from its late 2021 heights. As of November 18^th it was trading around $16,000. Other crypto and token values followed suit. The crypto industry decline had already forced many major platforms to shut down, but FTX seemed immune, even buying up some of its struggling competitors. Hence SBF was considered the “savior” in the crypto world distributing his assets across the industry as well as politicians.

– But things began to change earlier in November, when the balance sheet of a crypto investing firm that was also owned by Bankman-Fried, Alameda Research, was published by CoinDesk a crypto-focused digital media website. It showed that Alameda held a large amount of a digital currency created by FTX called FTT. Even though FTT held a certain market value, if the price were to drop,  Alameda would be at risk of insolvency. This also highlighted the unusually close ties between two entities that looked like a conflict of interest.

– FTT is a digital token created by FTX that is similar to cryptocurrencies like Bitcoin. Many crypto platforms now create their own tokens as a way to encourage people to use their services by offering perks associated with their tokens. As such, tokens can act like a stock in the platform. These digital tokens use blockchain technology, in which computers contribute to a shared ledger that can be used to track digital assets.

– Both the US Securities and Exchange Commission and the Department of Justice are investigating FTX for possible violations, as reported by the Associated Press. Such risks are not small in the crypto industry as it remains unregulated in the U.S. and in many markets around the world. Regulators are trying to determine if employees at FTX’s trading arm, called Alameda Research, used customer funds to make risky trades. 

– FTX Trading which is the parent company of FTX and is based in the Bahamas has been ordered to transfer its assets to Bahamas Securities Commission for safekeeping. It is not clear where the liquidation of assets will take place and how different clients globally will receive their funds back. In short this will be a relatively lengthy process to recover the client assets.

– Crypto is one of the very few assets in the world that investors can custody themselves without the need of a financial entity or any exchange. To mitigate any risk of such loss of assets like in the case of FTX, investors could consider move towards that model until the industry gets more regulated that would create more protection and comfort for investors as the industry matures. Another option for crypto investors is considering to use the more regulated crypto exchanges such as Coinbase in the US and BitBuy as they may benefit from a greater focus on regulated  entities.

– While one of the largest financial failures in the US, FTX blow up is not the first and won’t be the last. There will always be growing pains in any industry as companies try to cut corners in financial matters consciously or unconsciously. Hence the onus is with the investors who should avoid herd mentality and focus on the underlying operational risks in detail in any investment they are making. FTX situation highlights once again how governance or lack thereof could make or break an entity even though the ideas behind the firm could be brilliant. Learning from these lessons is up to the investors.

Until recently FTX was a darling of the crypto world — a startup founded in 2019 by two Massachusetts Institute of Technology graduates who aimed to build an exchange that would let its users buy and sell bitcoin and other digital currencies. In its latest funding round FTX was valued at $32 billion dollars.

But what happened to FTX?

After an incredible rise in three years that turned one of its founders and former CEO, Sam Bankman-Fried, into a multi-billionaire, FTX suddenly crashed and burned wiping out not only the entire value of the firm but also Sam Bankman-Fried’s entire net worth.

The news of the spectacular blow up of the multi-billion crypto exchange FTX and its sister firm Alameda Research in a matter of days has flooded the media since early November.  While every day new details of the FTX fiasco surfaces in the media, it is still not clear where billions of dollars of customer assets have disappeared to.

In this issue we lift the veil on FTX and explain how FTX rose to such heights, how it fell and what could investors learn from one of the most spectacular disasters in financial history.

WHAT IS FTX?

FTX Trading is the Bahamas-based company that runs cryptocurrency exchange FTX. Sam Bankman-Fried (called SBF) and Gary Wang founded the company in 2019 and over three years built it into the third-largest crypto platform by trade volume. In its early stages, FTX raised a total of nearly $2 billion in venture capital from a range of investors, including blue-chip venture capital firms such as Sequoia Capital, wealth management giant BlackRock and even the famous Canadian pension plan Ontario Teachers’ Pension Plan, according to Pitchbook.

Investors used FTX to purchase, store and trade hundreds of different cryptocurrencies, including Bitcoin, Ether, Solana, Litecoin, Ripple and Dogecoin. About $840 million worth of crypto assets were exchanged on its platform daily, according to CoinMarketCap. Competitor platforms included Kraken, Coinbase and Gemini.

HOW DID FTX BECOME SO BIG?

Not long after SBF started FTX, crypto began to boom. The price of bitcoin, which is considered an indicator for the crypto market and traded at around $4,000 in early 2019, shot up in 2021, peaking at more than $64,000 towards the end of that year. Venture capital investors flocked to blockchain and crypto markets which made crypto platforms extremely attractive. The customers they started to attract were beyond the original investors such as technologists and blockchain hardcore believers and expanded to broader public who normally invested into non-crypto assets. This fueled the rise of the crypto exchanges. Even those unfamiliar with the technology were lured to FTX with promises that they could park their money in accounts and earn much higher yields than at traditional banks.

FTX rose to international fame through a series of high-profile acquisitions, aggressive marketing strategies and low trading fees. As the company grew, so did SBF’s reputation and  net worth. He became the face of FTX and crypto in general while strengthening his ties in Washington DC with various politicians and donating visible sums of money.  Celebrity endorsements and major sports sponsorships made FTX hard to miss. By the end of 2021 FTX had annual revenue of $1 billion. At the start of 2022, the platform had more than a million registered users.

WHAT LED TO FTX DECLARING BANKRUPTCY?

The price of Bitcoin declined dramatically from its late 2021 heights. As of November 18^th it was trading around $16,000. Other crypto and token values followed suit.

The crypto industry decline had already forced many major platforms to shut down, but FTX seemed immune, even buying up some of its struggling competitors. Hence SBF was considered the “savior” in the crypto world distributing his assets across the industry as well as politicians.

But things began to change earlier in November, when the balance sheet of a crypto investing firm that was also owned by Bankman-Fried, Alameda Research, was published by CoinDesk a crypto-focused digital media website. It showed that Alameda held a large amount of a digital currency created by FTX called FTT. Even though FTT held a certain market value, if the price were to drop,  Alameda would be at risk of insolvency. This also highlighted the unusually close ties between two entities that looked like a conflict of interest.

WHAT IS FTT?

FTT is a digital token created by FTX that is similar to cryptocurrencies like Bitcoin. Many crypto platforms now create their own tokens as a way to encourage people to use their services by offering perks associated with their tokens. As such, tokens can act like a stock in the platform. These digital tokens use blockchain technology, in which computers contribute to a shared ledger that can be used to track digital assets. The first blockchain project, bitcoin, relies on many computers competing against one another to create a distributed system that no one computer can control. But not all blockchains, cryptocurrencies or tokens work the same way, and many are no longer distributed as bitcoin. The major difference between FTT and other tokens was that FTT was less transparent than other tokens, making it hard to track just how many tokens had been created. People could buy and sell FTT, but given it wasn’t as liquid as Bitcoin its trading was relatively limited. Other platforms also held the token.

After Alameda’s balance sheet was leaked, Changpeng “CZ’’ Zhao, CEO of the crypto platform Binance, a rival of FTX, announced on November 6^th that his company would sell off all its FTT tokens. Consequently, the price of FTT tanked sharply from $22 on November 7^th to $5 the next day. While at the time, the close ties between Alameda and FTX were not yet public, a series of other crypto platform collapses had already put the crypto community on edge. As a result many FTX customers moved to withdraw their assets from the platform.

And in a matter of weeks, FTX found itself over three billion dollars in debt after a series of miscalculations and investments that didn’t pan out!

WHAT EXACTLY WAS THE ISSUE WITH FTX BALANCE SHEET?

Bankman-Fried said in one of his tweets that he had “mistakenly believed the company had enough cash on hand to pay 24 times the amount of money users typically withdraw in a day”. It turned out that FTX only had enough cash to pay 0.8 times the amount — a critically thin capital cushion.

As customers rushed to the exits simultaneously, billions of dollars poured out of the platform turning an already a difficult situation into an impossible one. This resembled a classic bank run. When a bank’s depositors all worry about a bank’s solvency rush to get their money out before it runs out of cash, it could create the situation where the bank would indeed run out of cash and become insolvent. FTX was in the exact same situation.

On November 8^th, FTX stopped allowing customers to take money out of the platform. That was because it had run out of cash.

WHY ARE REGULATORS INVESTIGATING FTX?

Both the US Securities and Exchange Commission and the Department of Justice are investigating FTX for possible violations, as reported by the Associated Press. Such risks are not small in the crypto industry as it remains unregulated in the U.S. and in many markets around the world.

Regulators are trying to determine if employees at FTX’s trading arm, called Alameda Research, used customer funds to make risky trades. There have also been unauthorized transfers out of FTX which are suspected to be triggered internally by FTX employees. Some of the assets at Alameda are suspected to be coming from FTX which potentially be the client assets. Yet all of this is to be determined and addressed through the investigations. And this could naturally take some time.

Securities regulators in Australia, Japan and the Bahamas have also launched inquiries into FTX. The Securities Commission of The Bahamas, where FTX is based, froze the company’s assets and appointed a firm to liquidate its holdings there.

“The Commission is aware of public statements suggesting that clients’ assets were mishandled, mismanaged or transferred to Alameda Research. Based on the Commission’s information, any such actions would have been contrary to normal governance, without client consent and potentially unlawful.” the agency said in a statement on November 10^th.

NOW WHAT?

In the aftermath of the failure, John J. Ray  III was appointed as CEO to take over the bankrupt FTX to see it through its liquidation. He wrote “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information!”

“From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

This says a lot coming from the man who also oversaw the liquidation of Enron back in early 2000s, one of the largest blow ups in US history.

These events brought up the details and the quality of the audits done on FTX. Because FTX is a private company, audits weren’t required unless an investor or a bank asked for them or if FTX was considering an IPO but FTX does have some audit reports. In 2021 audits were done by two smaller accounting firms, Armanino and Prager Metis. However, strangely neither firm highlighted any of the issues that have recently come to light. It is also not clear at this stage why FTX used two accounting firms instead of one and why they didn’t use any of the big four.

There is also the problem of SBF filing for bankruptcy in the US for the US arm of FTX Trading. This requires the liquidation and distribution of the assets in the US. However, FTX Trading which is the parent company of FTX and is based in the Bahamas has been ordered to transfer its assets to Bahamas Securities Commission for safekeeping. It is not clear where the liquidation of assets will take place and how different clients globally will receive their funds back.

In short this will be a relatively lengthy process to recover the client assets. For Enron, it lasted almost ten years before some of the assets could be recovered and the one for Madoff that happened in 2008 is still ongoing. Time will show how long it will take for FTX.

WHAT SHOULD CRYPTO INVESTORS DO GOING FORWARD ?

The crypto exchanges that managed to survive the debacle raced to prove who had better reserves while noting that the FTX failure would only strengthen and legitimize the crypto landscape. Blockchain.com CEO and co-founder Peter Smith in a recent interview said that FTX collapse is a “a tragedy and total failure of governance,” but it’s not going to sink the crypto economy by any stretch. In fact, he argued, this would accelerate a trend back towards regulated crypto institutions as well as a shift back towards individuals holding crypto assets on their own private keys.

Crypto is one of the very few assets in the world that investors can custody themselves without the need of a financial entity or any exchange. To mitigate any risk of such loss of assets like in the case of FTX, investors could consider move towards that model until the industry gets more regulated that would create more protection and comfort for investors as the industry matures.

Another option for crypto investors is considering to use the more regulated crypto exchanges such as Coinbase in the US and BitBuy as they may benefit from a greater focus on regulated  entities.

While one of the largest financial failures in the US, FTX blow up is not the first and won’t be the last. There will always be growing pains in any industry as companies try to cut corners in financial matters consciously or unconsciously. Hence the onus is with the investors who should avoid herd mentality and focus on the underlying operational risks in detail in any investment they are making. FTX situation highlights once again how governance or lack thereof could make or break an entity even though the ideas behind the firm could be brilliant. Learning from these lessons is up to the investors.

 ELA KARAHASANOGLU, MBA, CFA, CAIA

International Finance Expert

karahasanoglu@turcomoney.com

ela.karahasanoglu@ekrtotalportfolioadvisory.com

https://www.linkedin.com/in/elakarahasanoglu/

 Who is Ela Karahasanoglu?

Ela Karahasanoglu is the CEO of EKR Total Portfolio Advisory based in Toronto, Canada. EKR advises global institutional investors and asset managers on alternative investment and portfolio construction from a total portfolio perspective. Previously, Ela was the Head of Total Fund Management team at BCI, one of the largest asset managers in US and Canada with assets over $200 billion.

Ela has over 25 years of international investments and executive leadership experience. She has worked with global asset management, consulting and pension fund companies in London, New York and Toronto including UBS, Merrill Lynch, Mercer, CIBC Asset Management and BCI. Ela is a frequent speaker and a globally published investment thought leader in institutional asset management. Amongst the awards she has received includes the “Global Leading Innovator” in 2020 and “Hedge Fund Rising Star” in 2018 by The Institutional Investor, one of the leading publications in the institutional investment field.

Ela is a graduate of Uskudar American Academy in Turkey and has earned her MBA from Georgetown University in 2000. She has been a CFA Charterholder since 2002 and a CAIA Charterholder since 2010. Ela serves as the Co-Head for CAIA’s Toronto Chapter since 2018. Ela is married and lives in Toronto.