The Crypto B/S
In the last few days, a deluge of details have emerged regarding FTX’s collapse and its CEO, Sam Bankman-Fried (SBF). The prevailing understanding of what led to FTX’s collapse is as follows:
FTX, a trading platform, trafficked in buying and selling crypto. It also developed its own made up coin, FTT, as a byproduct of and tool for the platform that effectively acted as FTX’s stock.
SBF previously founded a crypto hedge fund, Alameda Research, that is now run by his ex-girlfriend, Caroline Ellison. Combined, these sister companies had access to customer funds that they could essentially bet with.
Earlier this year, crypto prices collapsed. Alameda Research bet poorly, and lost a lot of money. SBF, the white knight of crypto, the savior of failing exchanges, the delight of the Bahamas, titles titles titles, stepped in and funneled nearly $10 billion (!) from FTX to prop up Alameda.
He then tried to cover his tracks with questionable accounting that sorta kinda replaced the value of the missing balances with the perceived value of FTT and other made up coins.
Zhao, CEO of Binance, figured this out and alerted the market to this house of cards. People got worried and withdrew their money. FTX couldn’t come up with liquid assets fast enough to pay customers, forcing them to file for bankruptcy.
To be clear, this is still at least in part, conjecture. But that doesn’t mean it’s wrong.
Matt Levine recently dissected FTX’s terrible, horrible, no good, very bad balance sheet. As its name implies, the balance sheet discloses the current balances of assets, liabilities, and equity of a company. All the numbers must um, balance, implying that all transactions are accounted for somewhere in the books. Among FTX’s many, many question marks, this stood out:
Last week I was shocked that one of the main assets of FTX — one of the main assets it relied on to be able to pay out customer balances — was a token it had just made up. But I was wrong! It was two tokens that it had just made up! FTX’s two largest asset balances … were $5.9 billion of FTT … and $5.4 billion of SRM … Something like two-thirds of the money that FTX owed to customers was backed by its own tokens that it had made up.
This is some Greg level gibberish.
The crux of FTX’s bonkers balance sheet is that after you sift through the actual cash and equity and investments, you’re left with a financial statement that is basically held together with bubble gum and popsicle sticks. There are huge holes in the accounting that basically boil down to FTX scribbling numbers on Post-Its and claiming they’re worth billions. That’s not how accounting works!
But perhaps this is kind of how crypto works, right? Isn’t that why we’ve assigned Dogecoin, ostensibly a parody, an actual value in USD that isn’t like, zero? Value is in the eye of the beholder. FTX perceived the value of many, many coins - some of which they made up themselves! - to be in the billions; and so they recorded those assets as such on their balance sheet. The only issue is nobody else perceived those the same way. And when shit hits the fan, people want cold hard cash in their hands, not Post-Its.
Triangle of Success
In accounting 101, there’s a neat little thing called the fraud triangle:
The thinking is that financial fraud is highly probable to occur when all three phases of the triangle exist. Let’s review FTX again:
Opportunity: Among his many companies, SBF owned both a crypto exchange and a hedge fund. He had access to customer cash and an avenue through which to place bets. This is clear.
Pressure: Alameda Research lost a ton of money. As the savior of the crypto world, SBF took it upon himself to prove the validity of the ecosystem and convince skeptics of crypto’s soundness. He could not let it fail; and as the CEO of multiple crypto companies, he had every financial incentive tied to crypto succeeding.
Rationalization: This is where we get a bit personal, as explaining why someone would do something that is intentionally wrong requires some level of armchair psychology. SBF subscribed to a philosophy known as effective altruism, which essentially functions as a utilitarian mindset that prioritizes the most good for the most people. In an interview with Bloomberg from earlier this year, SBF stated that “the explicit working principle we had [in the crypto bailouts was that] we are incinerating a relatively small-ish amount of money doing this [in exchange for keeping the crypto ecosystem healthy.]” Huh. Did SBF knowingly misuse people’s money to save his own company and believe he could make it all back before anyone noticed? Probably. Did he perceive that Alameda’s losses were more pressing, greater in number, or of more ethical importance than those of FTX? Maybe. Did he convince himself that his grand plan of popularizing the entire crypto ecosystem - a crypto messiah - would ultimately do more good for more people than “incinerating a relatively small-ish amount of money?” Seems so. Did he use one party’s funds (FTX) to cover another party’s losses (Alameda), and continue bringing in new customers to replenish the coffers? SBF may believe that to be a practical application of effective altruism. I believe that to be a Ponzi scheme.
Follow The Money
So, customers who transacted on FTX actually sent real money, just like you or I may connect a bank account to Coinbase or Robinhood or E-Trade and transfer money into the platforms. FTX now owes customers somewhere around $8 billion. Its balance sheet mostly consists of imaginary coins and duct tape. This all begs the question: where did the customers’ money actually go?
There may be many explanations, but the prevailing theories seem to be one, or some combination, of the following:
Alameda Research lost a lot of money betting on crypto, so FTX bailed it out with customer funds. But then crypto kept collapsing, so Alameda kept losing money. So it couldn’t pay FTX back, even though it wanted to. This is not necessarily fraud so much as gross negligence - an investment in the hands of inept people that went down the drain. Being stupid is not illegal, but it’s still not great.
Alameda Research intentionally lost a lot of money betting on crypto, so FTX bailed it out with customer funds. This is similar to the first possibility, except that SBF knowingly bet against the market and tried to paper over the losses with other people’s money. Why would he do that? To provide a good customer experience to its traders. To convince skeptics of crypto’s value and win new customers on his exchange. To to be a modern-day Robin Hood, funneling funds from some customers and returning them to other customers in the form of trading gains. Altruistic, right? This is convoluted and misleading. It’s also fraudulent.1
SBF tricked us all with his aw-shucks boyish innocence and deft virtue signaling. He actually lives an extravagant lifestyle and blows millions of dollars on private jets (true), houses, hookers, and cocaine. FTX is headquartered in the Bahamas, long considered to be a tax haven due to its lax financial regulations. SBF has built a vast crypto empire and could have been funneling customer funds through various offshore shell companies, cleaning the money, and using it for his own personal gains. To be clear, I’m trying to give SBF the benefit of the doubt here as this seems highly unlikely. But it’s not impossible.
Counterweights
When SBF was raising money from Sequoia Capital, he supposedly played video games while on the call. The VC partners took this behavior from a twenty-something year old with no prior experience running a financial institution to be some signal of genius, as in “Look at his multi-tasking skills! He’s pitching us on an asset class nobody understands, and he’s doing it while shooting zombies! We must invest.” But now in retrospect, maybe SBF wasn’t some kind of prophet that operates on a higher plane than us common folk. Maybe he’s just an asshole who can only think of himself:
If there’s a silver lining to all this, it’s that the counterweights we have in place seem to have worked. Just as the Delaware Chancery Court forced Elon Musk to honor his original price to purchase Twitter, just as our legal system held Elizabeth Holmes accountable to her lies, institutions matter. Systems matter. Market dynamics forced FTX into bankruptcy, same as any other over-leveraged institution. And now the adults are taking over - John J. Ray III, who previously oversaw the Enron liquidation, has been appointed the new FTX CEO and charged with cleaning up this mess. On November 17, he filed a declaration in FTX’s bankruptcy case, stating:
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.
Oof. Ray’s basic job is to parcel out who owes what to whom; but he just repeatedly runs into roadblocks. He states such gems as this:
Because of historical cash management failures, the Debtors do not yet know the exact amount of cash that the FTX Group held as of the Petition Date.
And this:
The FTX Group received audit opinions on consolidated financial statements for two of the Silos … The Debtors have not yet been able to locate any audited financial statements…
And this:
The Debtors did not have the type of disbursement controls that I believe are appropriate for a business enterprise. For example, employees of the FTX Group submitted payment requests through an online ‘chat’ platform where a disparate group of supervisors approved disbursements by responding with personalized emojis.
And finally, this shocker:
In the Bahamas, I understand that corporate funds of the FTX Group were used to purchase homes and other personal items for employees and advisors. I understand that there does not appear to be documentation for certain of these transactions as loans, and that certain real estate was recorded in the personal name of these employees and advisors on the records of the Bahamas.
Last week, SBF himself starting DM’ing Kelsey Piper at Vox to kinda sorta explain himself. Among his many admissions - “messy accounting … I didn’t realize full size of it until a few weeks ago” - his rationalization of doing unethical things for the greater good is startling:
Remember earlier when I tried to give SBF the benefit of the doubt by saying he’s probably a good guy and probably didn’t steal people’s money to buy himself planes and houses? I was wrong.
Optimism
Let’s end on a high note. Given all that’s been going on lately - war, layoffs, the midterms, the potential collapse of the entire crypto market - it’s probably fair to feel a bit down on the world. Many many people have lost their money - real money - in this bankruptcy. This is not good news. But nevertheless, it’s helpful to remember that business, at its core, is an optimistic endeavor.
At a fundamental level, I see SBF as an optimist. He saw opportunity in a fledgling asset class that few understood. He recognized a flailing market and thought he could scoop up some cheap assets and make lots of people lots of money. This is not meant to condone his actions; to be clear, I fully believe SBF intentionally engaged in fraudulent activities and will be charged accordingly. It’s merely to note that the line between ambition and a courtroom is vanishingly thin.
FTX had a pretty powerful list of venture capital investors: Sequoia, NEA, Altimeter Capital, Softbank, Blackrock, just to name a few. That means that FTX must have done something right to convince these institutions to part with millions of dollars. One could attempt to attribute some fault to FTX’s VCs as enablers of this behavior. But that would be mistaking an anomaly for the norm. The very essence of venture capitalists is to tread in overt optimism. They seek out the next generation of innovators. They invest in potentially world-changing technology. They trade millions for a chance to make billions behind unproven leaders. There’s a dash of foolishness in that logic, sure. And some greed and hubris and virtue signaling. But there’s also a fundamental belief that things work out for the better.
That’s why we all do what we all do. We engage in business for advancement, for improvement, to make things just slightly less bad than it was before - financially, socially, ethically. No entrepreneur starts a company, works 80 hours a week, travels 3 weeks a month, and cuts their salary by 50% just to fail at their job. We are capitalists. We believe. We venture. And despite the faults of some, I still think that’s a good thing.
Looking into Bahamian real estate,
A