FTX — Opening the Crypt

By Reuvain Borchardt

Josh White, a finance professor at Vanderbilt University, spoke with Hamodia last week about the collapse of cryptocurrency exchange FTX.

White, who has a Ph.D. in finance, was a financial economist for the U.S. Securities and Exchange Commission (SEC) from 2012 to 2018.

Tell us about the collapse of FTX, how the company operated and what exactly happened here.

If I wanted to invest in crypto, for example, to use your dollars to purchase Bitcoin, you need to find an exchange — similar to if you’re traveling to Israel and want to convert your dollars to shekels, there’s a currency exchange at the airport.

FTX was an exchange. In the U.S., one of the best-known exchanges is Coinbase. They do very similar services. In Southeast Asia, Binance is a big one. And there are some others.

[Disclosure: I do know people at Coinbase, and one of my former supervisors is at Coinbase. I have a tiny investment in cryptocurrency — worth less than $100.]

Cryptocurrency itself is what we call decentralized finance: DeFi. It is based on blockchain technology. The exchanges, because you’re dealing with an actual entity, that’s what we would call centralized finance, or CeFi.

So what happened with FTX is this: Say I bought some Bitcoin with FTX, I sent them my dollars and they convert it using a conversion rate to Bitcoin, I would then have two options:

Under the first option, I can leave my Bitcoin with FTX, the exchange, kind of like the same way if I bought stocks through Charles Schwab and left my stocks there; it’s not like they send me the stocks I purchase and I would put the stock certificates in a vault. Or if I deposited money in the bank, I leave the money there.

So I now own whatever fraction of Bitcoin that my dollars were converted to, and I leave it with that exchange, who is the custodian. This was FTX’s primary business model, at least what we thought from the outside world.

Of course there are lots of cryptocurrencies in the world. And so what FTX was doing was they were exchanging money for cryptocurrencies, or exchanging one type of cryptocurrency for another and charging small fees or profit margins to earn income.

The true DeFi version of crypto is the second option. I could transact with FTX by giving them dollars, which they convert to Bitcoin, then I pay FTX to send the Bitcoin back to my digital wallet, which I store on a local hard drive. We call that self-custody. If you do that, then when FTX collapses, it does not affect you. The private keys that identify your cryptocurrency are stored on your hard drive — it’s kind of like if you withdrew your money and then the bank collapses, that does not affect you.

So the people who lost their money with FTX were leaving it in the exchange. Why would one do that rather than putting it into their digital wallet? 

Sometimes people are a little lazy and don’t want to self-custody; you hear the stories of people losing hard drives or keys to access their digital wallet. And you know, if you’ve ever stored anything on a USB flash drive, you know that they sometimes fail. There is also a transaction fee for moving the Bitcoin from FTX to your digital wallet.

This is why people don’t always want to self-custody their cryptocurrency.

It’s like stories of your Grandma storing cash in her couch and forgetting about it. Grandma passes away, you give away the couch and then somebody finds that Grandma also had $20,000 in cash under the cushions. So of course there is a risk to self-custody as well. That’s why a lot of people left their money in the exchange.

The exchange also offered you incentives to keep certain cryptocurrencies on the exchange rather than moving it to your digital wallet. It’s called staking. When you stake your cryptocurrency, you are locking it up for a period of time on the exchange and telling the exchange that it can go sell or loan your currency to other people that need cryptocurrency to verify transactions, and they pay you a yield. They’re essentially paying you interest or rewards so they can use your cryptocurrency to make the blockchain work. It’s kind of like buying a CD at a bank. You leave your money with the bank, tied up for a specific period of time. The bank might pay you 2% interest, then lend out that money to someone else at 5% interest.

FTX also had its own “token,” or cryptocurrency, known as FTT.

So maybe they would offer you incentives to convert your Bitcoin into FTT, which you could also stake.

So the business model of this exchange that, I wouldn’t say everything’s on the up and up, because we don’t have digital asset regulation in place yet; but it’s no different than what other exchanges like Coinbase or Binance and everybody else is doing. So that part of FTX wasn’t what they got in trouble for. What got SBF [FTX founder and CEO Sam Bankman-Fried] in trouble was that when he first got into cryptocurrency he started this Alameda Research.

SBF and Alameda CEO Caroline Ellison, who’s another one of the key players here, had worked together at Jane Street, which is a Wall Street quantitative trading fund. The way that these funds and some hedge funds make money is by looking for what we call arbitrage opportunities: they go out and try to find assets that are, for whatever reasons, undervalued, buy them, sell them quickly and make money. So they’re just looking for ways to use computers and algorithms to make some money, take a lot of risk. Think of it like an investment.

That’s what Alameda Research was supposed to do. But here’s where things get blurry: Exchanges shouldn’t necessarily also be doing investing, because if I have an investment firm and let’s say a huge order comes in to FTX to buy Bitcoin — an order that’s big enough to move its price — if Alameda had that information, they could “front-run” that trade, meaning they could go buy Bitcoin real quick, knowing the price is going to move for the order, and then sell it to them.

So they were potentially mixing trading and exchanging. In traditional finance, we have laws against that: You shouldn’t be trading against your clients. You have to act in their best interest.

Of course, I’ll state here that everything we are saying are just allegations; nothing has been proven yet in court.

What appears to be the case, based on the testimony of John Ray, who has now been appointed FTX CEO, is that there were essentially no corporate controls. So SBF could take money and tokens that belonged to customers, that they were supposed to just be holding on that exchange, and send it to Alameda Research to fund really high-risk investments.

So if I wanted to make a huge investment as Alameda — let’s say I think the cryptocurrency Etherium is going to go way up, I could take that collateral out of Bitcoin owned by FTX customers, and use that to fund some big investment in Etherium as Alameda research. Well that all works good when prices go up. But when prices drop … that’s when it all goes wrong.

Everything we discuss is of course based only on allegations. With that said, the money that he allegedly used, had it been staked? If so, would it have been legal for him to use it to invest?

My understanding is that if the money is staked — so the client is paid for use of their money and knows the money is being used in other investments or to verify transactions— that’s okay.

But it may not be okay if you’re sending it to Alameda and sharing information. I think the allegations are not only that he used those staked tokens, but he used other money that was stored on the exchange, and sent that to Alameda, which is commingling of assets. He basically had a back channel where he could send money to Alameda and fund these really risky investments, with money that was not staked and which he was not allowed to use.

So once it got out that maybe FTX was having financial troubles, people tried to start withdrawing those assets. Well, those assets weren’t there, because he had sent them to Alameda, and he had lost a lot of it. So a bank run happened, and they essentially collapsed. They ran into liquidity issues. If my account shows I have 20 Bitcoins, and I tried to withdraw it in dollars or Bitcoin, they weren’t able to meet those withdrawal requests. They didn’t have the 20 Bitcoins. Right. So that’s where the house of cards failed.

So how exactly did the business with Alameda Research operate?

Alameda Research was a crypto hedge fund, and was supposed to be operating separately, but they’re both located sort of in the same geographic location, SBF and Ellison lived in the same area and had dated at one point. They were taking these really risky moves, and they were trying to arbitrage cryptocurrencies or just make large bets on behalf of Alameda, using money customers had stored on the FTX exchange.

How much money was lost by investors?

When FTX customers requested to withdraw their money, I think there was a shortfall of $8 billion.

The number that has been publicly reported is $37 billion or more. I’m not certain what the exact number is; it may perhaps include investments in FTX lost by venture capitalists, and what Alameda lost on these bets.

We won’t know what FTX and Alameda’s true losses are until all the documents come out during the investigation and litigation.

Is this story about a failure of crypto, or is it a plain and simple story of fraud by a company whose business happened to be cryptocurrencies?

I think it’s the latter. But it took the crypto collapse to expose the fraud. If crypto had kept going up, we wouldn’t have known about this fraud.

The most surprising part to me is that you had all of these what we call sophisticated investors like the Sequoia Capital and Softbank investing hundreds of millions of dollars in FTX with minimal due diligence. Perhaps conducting due diligence would have uncovered the lack of internal controls and the commingling of FTX’s customer assets with Alameda.

This is really about what the Sarbanes-Oxley financial regulation law of 2002 was meant to address: a lack of proper accounting and corporate controls. You had SBF running FTX with no board of directors, he sort of oversaw everything, he had access to send money to Alameda Research. If you were running a legitimate enterprise, these are internal controls you would have in place. And if you had your business audited, auditors would come in and say you shouldn’t be sending client money over to Alameda Research to make bets.

The fact that FTX had no oversight, was it because they were a crypto company, or because they weren’t U.S.-based?

It’s the latter. They were operating outside of the U.S. regulatory system because they’re in the Bahamas. They have a U.S. subsidiary, which does have to follow U.S. laws, regardless of whether they’re operating crypto or if you’re selling widgets. And I think that’s why the case is being brought in the Southern District of New York and SBF is agreeing to come back to the U.S. and face the fraud charges there. Even though the legal system in the Bahamas might be more relaxed and the punishment could be less severe, which is one of the reasons that he operated FTX and Alameda there, what he did is illegal, taking client’s money that he was supposed to be holding, and investing in something risky on the side. It’s plain old vanilla fraud.

Just today, SBF said he will go to the U.S. and face charges, and not fight extradition. Why did he do this willingly?

My conjecture is that he knew he was going to spend a lot of time in prison somewhere, and that the prisons in the U.S. are probably a much nicer location, and closer to his family, than the prisons in the Bahamas.

But it’s pure conjecture.

A lot of the things that he’s done have not been what I think traditional lawyers would advise. Like he has given all these self-incriminating interviews.

How do regulations of foreign companies work? You said FTX’s U.S. subsidiary is subject to U.S. regulations. FTX was not publicly traded, but what about any company that wants to be on a stock exchange here; are they subject to U.S. regulatory laws?

Here’s the kicker — and I have a paper on this. Let’s say you’re headquartered in China, you incorporate in the Bahamas or the Cayman Islands, and you list on the New York Stock Exchange or NASDAQ. The way the SEC has set up the reporting system, you’re called a foreign private issuer, or FPI. When the rule system was set up, most companies that did this had their primary listing on like the London Stock Exchange. So it was like BP Oil, and they want to list in the U.S. they can get access to U.S. investors. And so the SEC said, on everything besides your annual report, we’ll just defer your reporting regulations to your home market, because we don’t want to put extra costs on you. That worked well when it first came out, but eventually people start to see regulatory loopholes. Some companies have no other listing — they don’t list in London, but they incorporate in the Cayman Islands or the Bahamas and list in the U.S., and they still get these relaxed rules of the Cayman Islands or Bahamas. I have a research paper trying to say, hey, this is problematic.

So it’s a red flag if a company incorporates in the Bahamas, or the Cayman Islands. Some of it may just be that it is a tax haven, they’re trying to avoid taxes. But in our paper we call it a “disclosure haven” because you get these relaxed disclosure rules that you really shouldn’t get.

You mentioned that SBF was giving interviews. The interviews essentially admitting what he was doing. Did he not have lawyers? Did he not listen to them? What is with this guy?

Both of his parents are Stanford law professors. And he hired a law firm. I think that he was going against what his lawyers were telling him. The lawyers had advised him to hunker down and not say anything and let the attorneys argue for you in court. It’s hard to explain why he got out there and started talking. This is irrational behavior.

He was arrested the day before he was supposed to testify in Congress. Is this coincidental? Or are there some members of Congress who did not want him to talk, because it’s known that he had connections with Democrats in Congress?

I try not to drift too much into the political realm. One could conjecture that people on Capitol Hill would not have wanted him testifying. But I think his donations were already public.

I think it was more that the prosecutors bringing the case in the Southern District of New York said, let this guy go do all these interviews, because we can use this against him in court. And the day before he’s scheduled to testify, let’s not let him go try to convince anybody else in Congress, to influence the perception of him or the perception of him on Capitol Hill.

Let’s just go ahead and bring the legal case now.

Were there any red flags with FTX? Had anyone publicly warned that this company might be engaged in improprieties?

The biggest warning, if there was one, was with this rivalry he had with Binance, which is run by this guy who goes by the name of CZ. He had an investment as well in FTX. And at some point, he decided he no longer wanted that investment and was going to sell it. Alameda said, “We’ll buy that from you,” because they don’t want the FTT token which it was held in going down. They bought it out and sent it to him in FTT. Well, they had this very public argument, where each of them was questioning the other one’s potential solvency or liquidity. That was probably the first red flag.

But you could argue that’s just a competitor trying to knock the competition.

Exactly.

To me, the big red flag was that he was in the Bahamas, had no board of directors and no auditors. But hindsight is 20/20. Nobody questioned it when it was going up.

I don’t know that this is necessarily an episode that says that crypto is bad. If anything, this says that centralized finance — CeFi, which is the opposite of crypto — still relies on people, and exchanges and trust, and people commit fraud.

Had people just exchanged their money with FTX, gotten their cryptocurrency and brought it back to self-custody, they would have been in the DeFi and they would still have every bit of the cryptocurrency that they had invested in.

So what do you think is the lesson from this episode?

I think the lesson is that if you’re going to be involved in cryptocurrency, don’t trust people, especially since we have very little regulation in this space. Some of the main people are incorporated overseas or outside the local legal system, and you can’t trust the other party. So you need to self-custody, or you need to deal with an organization where there are auditors and checks and balances in place.

Coinbase is a publicly traded company; they have an auditor. I would trust Coinbase over an entity like FTX. If Coinbase fails, there is risk, they have it in their annual disclosure that, hey, you might not get all your crypto back, it might be part of the bankruptcy proceedings. But their auditors periodically attest to their financial statements, including balance sheets, and Coinbase makes public disclosures on its internal control systems. 

Was SBF able to get away with running pretty much a one-man show because it was a crypto company, or could any company in the Bahamas do that, regardless of the industry?

I think it’s the latter. If you have a company with no board of directors, no control, one could have committed fraud with any sort of company.

So the fact that crypto markets are new and therefore not really regulated didn’t contribute to this?

I think that crypto contributed to it to the extent that there were such high returns and so many opportunities, and it’s such a new technology, that it generated the excitement that got the capital sent to FTX, but the fact that this was a crypto company did not contribute to the fraud itself. This is plain vanilla fraud.

I do think if we had regulation in place in the U.S. that said you can’t have a subsidiary here unless you have an auditor, you keep your clients’ money separate, etc., then regulations would have at least helped prevent some of the investor losses for the U.S. subsidiary. The same would apply to other jurisdictions if they create similar digital asset regulations.

Was SBF using the money just to make investments? Or is there any evidence he was pocketing it or using it to buy personal items?

The thing that’s been discussed is what they call Effective Altruism: He wanted to become extremely wealthy so that he could support causes that he thought made the world a better place. I do think that he used some of that money, and some of that client money to do things like make political contributions or contribute to causes that align with whatever his personal beliefs are, like funding a lot of campaigns against Donald Trump’s proposed candidates. But he also wanted to use it to obtain celebrity status. He got naming rights to a sports arena in Miami. He enjoyed things like sports. So he was absolutely using some of this to fund sort of his self interest.

Do you think this incident will scare people off of investing in crypto?

Yes, I think it will scare some, but not all, crypto investors away until better regulations or guardrails are in place. Many crypto investors will not understand the nuances of the fraud (CeFi vs. DeFi) and will just associate it purely with crypto. I also believe it will be the impetus for crypto regulation in the U.S., which has mostly been a turf war between the SEC and Commodity Futures Trading Commission (CFTC) and arguments over whether the cryptocurrencies represent securities (which the SEC regulates) versus commodities (which the CFTC regulates). It could also lead to more enforcement actions by the SEC against the exchanges. Once those actions are complete and safeguards are in place, we could see more investors return to the crypto space.

The extreme crypto enthusiasts, which were likely self-custodying their assets, will probably not be frightened by this outcome. Some others will simply take their assets off the exchange and self-custody rather than sell. I suspect both Coinbase and Binance have experienced large withdrawals of cryptocurrencies for self-custody in a digital wallet since the news of FTX first became public.

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This interview originally appeared in Hamodia’s Prime magazine.

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rborchardt@hamodia.com