The FTX fraud and first principles

FTX, which was valued at $32 billion a few months ago and funded by the finest names of the global financial markets, suddenly declared bankruptcy on November 11

Since the middle of last week, the spectacular bonfire of FTX, a crypto exchange, has kept us enthralled. FTX, which was valued at $32 billion a few months ago and funded by the finest names of the global financial markets such as Sequoia, Temasek, Ontario Teachers’ Pension Plan, SoftBank Group Corp, and hedge funds Third Point and Tiger Global, suddenly declared bankruptcy on November 11. Since then, bizarre stories of worthless tokens shown as assets, the sudden withdrawal of billions of dollars of cash before bankruptcy, the fake altruistic halo of the frizzy-haired boy-wonder founder Sam Bankman-Fried, known as SBF, and complete lack of controls, checks, and balances at FTX have stunned the world. What are the lessons from this saga of gigantic fraud? FTX could not have grown to this size and flamed out had two of the most important players in the system — institutional investors and regulators — not drifted from first principles. What are these first principles?

First principles of investing: As Wall Street Journal columnist Jason Zweig writes: “SBF may be at the center of what went wrong, but he didn’t act alone. Behind him lies a vast ecosystem of fantasy and fakery. It’s called the investing business.” In the case of FTX, the finest investors failed to do due diligence on the operation that FTX was running. John Ray III, who has been appointed chief executive officer (CEO) of FTX by the debtors after it filed for bankruptcy, scathingly says: “I have over 40 years of legal and restructuring experience. I have been the chief restructuring officer or CEO in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance … 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. 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 ought to have been obvious to investors. There were plenty of red flags.

* FTX’s board had only three directors earlier this year: SBF, an FTX employee, and an Antigua lawyer who specialises in gaming.
 

* During a Zoom interview to raise money from Sequoia Capital, SBF was surreptitiously playing a videogame, which was a bragging point in profile on him, commissioned by Sequoia.

* The audit firm of FTX.com and similar exchanges in non-US jurisdictions was Prager Metis, whose website claims it is the “first-ever CPA (certified public accountant) firm to officially open its Metaverse headquarters in the metaverse platform Decentraland”.

* SBF controlled Alameda Research LLC, which was a “crypto hedge fund” applying strategies such as arbitrage, market making, yield farming, and trading volatility. It also offered over-the-counter trading services, and made other debt and equity investments. SBF owned 90 per cent and Gary Wang (10 per cent) in the company. Alameda prepared consolidated financial statements on a quarterly basis but it appears that none of these financial statements has been audited. The September 30, 2022, balance sheet shows $13.46 billion in total assets, which were mostly in useless tokens issued by FTX.
 

Indeed, it seems insane that any seasoned investor would bother to take a second look at the crypto or crypto-related business in any form. Cryptos are speculative products that cannot be valued because these are not backed by anything. Successful investors like Warren Buffett and Charlie Munger of Berkshire Hathaway have consistently warned of the dangers of cryptos. Mr Munger has likened cryptos to “venereal disease” and said anyone who sells them is either “delusional or evil”. Perhaps SBF knew this. In several interviews, he did not even bother to counter suggestions that the whole crypto business was a giant Ponzi scheme and that many crypto currencies would eventually be worthless. Clearly many first principles of investing were violated here.

First principles of regulations: Providing an effective regulatory environment for exchanges is not hard if the first principles are followed. These involve segregating or preventing comingling of customer assets; a fail-safe clearing and settlement system, and a trade guarantee fund. Regulators also subject exchanges to regular inspection. It is inconceivable that exchanges would be allowed to issue their own securities that are backed by nothing and also invest in other worthless cryptos. This is exactly what crypto exchanges like FTX and Binance are allowed to do. On top of this, the Commodity Futures Trading Commission licensed FTX to launch a crypto exchange and all related speculative products like futures, options, and swap contracts on digital assets and other commodities to both US and non-US persons. Strangely, US laws allow this kind of shaky business to accept money from customers and permits lenders to loan them money. US regulatory gaps also allowed FTX to grow enormously in the US as an offshore exchange (a large part of FTX is regulated in the Bahamas).
 

While it is true that every new development cannot be anticipated by regulatory foresight, damage from new shenanigans can be contained if regulators follow the first principles of moving quickly when something does not smell right and are made accountable when they ignore the red flag in plain sight. FTX is part of a long line of crypto bankruptcies such as Celsius, Three Arrows (a hedge fund), and Luna, but regulators refused to be alerted. Even the Bernie Madoff Ponzi scheme would have been detected far earlier if the Securities and Exchange Commission had acted on letters from a whistle-blower. In short, both investors are regulators are guilty of deviating from first principles and that allowed such a gigantic fraud to be perpetrated.
 

The writer is the editor of www.moneylife.in

Twitter: @Moneylifers