I’ve done a lot of research on FTX and I have…opinions. If you haven’t paid attention, FTX was a crypto futures exchange. It had a related/sister crypto hedge fund known as Alameda Research. All of it melted down in late 2022. There are significant fraud allegations and guilty pleas so far. There are also a lot of lurid allegations. Matt Levine’s column, How to Do Fraud at a Futures Exchange is the clearest explanation of FTX. We’re going to try to go there, but first I have to get a few things off my chest.
- Sam Bankman-Fried’s “Balance Sheet” that he passed around trying to raise last-minute funds is offensive to me as an accountant. Maybe some investors don’t care, but I’d get fired for showing anything like that to anyone at any job I’ve ever held. A copy of that balance sheet is the image for this post.
- Quickbooks is not an appropriate accounting system for a company the size of FTX mostly because of its inability to scale to that size. I suspect Quickbooks would be happy to have no association with FTX given what SBF’s balance sheet looked like.
- If our Craigslist Accountant from a few weeks back worked at FTX (and actually did the work) she could steal $15k/day, every working day for a year, and FTX would only be out $4 million instead of billions.
Whew! Ok, where do we start?
FTX was a futures exchange. In a futures exchange, people bet on some proposition, say Bitcoin will go up or down. Some people bet up (long) and some down (short) but they place that bet with the exchange, not with each other. To guarantee these bets, customers deposit cash. On some defined time frame, the exchange checks the results and if Bitcoin went up the exchange takes some money from the short bettors and gives some to the long bettors. If it goes down, the reverse happens.
If an account goes too low, the exchange asks the bettor to put in more money. This is a margin call. If the bettor doesn’t cover, the exchange automatically closes out the position at a loss. If an account gets high enough, the bettor can take some money out. Ideally, the exchange is smart about this and limits the amount to reasonably match the volatility.
If an account goes below zero, that is if a bet on our Bitcoin example falls fast enough that there isn’t time to get more money or close out the position, the bettor owes more than what’s in the account. Collection from the debtor will be problematic at best and the exchange will have to pay out of their own money.
This is straightforward futures stuff. It’s very common and well-understood in traditional financial circles. That doesn’t make it easy or safe, but everyone knows that’s how this works. Notice that there are no actual Bitcoins in here, just bets on whether Bitcoin will go up or down. Much like betting on a football game, you don’t own the team, play for the team, or even get to see a game, you’re betting on the performance of something you don’t own.
Finally, we’re talking about leveraged futures trading here. Something like deposit $2k and the exchange lends you another $15k to bet on Bitcoin. Alternatively, deposit $2k and the exchange lends you $15k in Bitcoin to bet on. The exchange may hold a little of a given asset like Bitcoin, but it doesn’t really have to because it has customers on both sides of the trade so they more or less offset.
Leverage like this is really, really, one more really, risky. That’s a big loan on a small deposit. If prices move in the wrong direction quickly, positions get wiped out leaving the exchange holding the bag. Crypto often moves quickly in the wrong direction for someone.
Future Exchanges control risk by:
- Charging high margins.
- Tailoring the margin to the riskiness and size of the bets.
- Monitoring and closing out losing positions quickly.
- Limiting withdrawals. If a position grows and too much is removed, there isn’t enough to cover a reversal in fortune.
At least well-managed ones do. FTX on the other hand:
- Setup a futures exchange.
- Advertised their impressive risk engine with customized margin factors designed to carefully take into account volatility, liquidity, account position size, and unusual market moves to quickly close out losing positions and limit withdrawals as appropriate.
- Did a lot of trades with their own money.
- Without telling anyone, exempted themselves and related entities from all the risk management stuff they advertised.
- When bets moved in their favor, they withdrew funds for condos, political contributions, whatever.
- When bets moved against them, they didn’t put money back in, didn’t close out their bets, just let everything go negative and ignored it.
This is fraud because FTX advertised it had good risk management when it actually had bad risk management. Additionally, taking money out when FTX wins and not putting it back when FTX loses predictably moves money from customers to FTX. Third, FTX might be tempted to speed up this process with its own token. Say, create a bajillion magic beans out of thin air, trade a few magic beans with yourself and some friends to establish a price, then borrow against the remaining bajillion beans at the artificial price.
This is the crux of the SEC complaint against FTX. The infamous “back door” from early news reports was really exempting related firm Alameda from all the risk management constraints.
Also, there was additional comingling going on. FTX’s bank account couldn’t accept some foreign deposits so they went to Alameda who just kept them…apparently. There was some sort of loan(ish) disclosure, but the funds appeared as internal funds, not customer funds.
Eventually, if you take money out when you win and don’t put it back when you lose, you run out of money to play with. And when you borrow based on artificially inflated valuations, there is nothing left when the valuations pop.
Sam Bankman-Fried is going around apologizing, but this was not a mistake. Like Celsius from a few weeks ago, this was a failure to act as a fiduciary of the customer’s money. Being this reckless is not a mistake, it’s fraud.
I’ll try not to do too many of these giant frauds because the lessons are macro lessons. They aren’t actionable for average folks. But, fraud at the top is the most expensive kind of fraud. If you work for a company and see that, run. The tone at the top still matters and people have subsequently shown behaviors by FTX and Sam Bankman-Fried that should have raised red flags. As an FTX user, there doesn’t seem to be much that could have been done, other than quickly withdrawing funds at the first sign of trouble.
FTX appears to have melted down into a giant fraud. I don’t think it started that way. I’m not convinced that was the intent, but whether through hubris, a lack of maturity, or missing respect for the customer, it has ended up there.
As a footnote, FTX was a mess internally. We’ve previously seen that Celsius was a different kind of internal mess. However, both failures were precipitated by credit bubbles and crazy leverage. Richard Rumelt covers this well near the end of Good Strategy. Covering the 2008 housing crisis Rumelt notes that Bear Steans was leveraged by at least 32 to 1. Lehman Brothers were similarly leveraged and it didn’t take much to tip everything over the edge. Before that Worldcom was an earlier example. The crypto winter of 2022 was ultimately a cascading failure of easy credit, probably triggered by the failure of Three Arrows Capital.
It is not unusual for leverage-based failures to devolve into financial statement fraud as management tries to keep the company afloat. FTX and Celsius both also suffered from a lack of internal control that made fraud possible.