Brief background: From hero to zero in seven days

Sam Bankman Fried (or “SBF” as he has become known in mainstream media) started FTX in 2019, after having successfully founded a quantitative crypto trading firm, Alameda Research (Alameda), a few years prior. Although FTX started off slowly, the crypto market began booming in around 2020, and by 2021 FTX was averaging around $10 billion per day in trading volume. SBF appeared on the cover of Forbes magazine and his net worth was estimated to be around $26,5 billion at one point.

After FTX started becoming successful, in part as a result of funds received from Alameda, SBF stepped down as CEO of Alameda and appointed his reported girlfriend, Caroline Ellison, as CEO in his place. It is this close relationship between FTX and Alameda that appears to have started the domino effect which resulted in the ultimate collapse of both these companies, as well as their 134 subsidiaries.

On 2 November 2022, Coindesk released a report in which they revealed that the majority of the Alameda balance sheet consisted of FTT, a crypto token created by FTX, and that many of Alameda’s assets were intertwined with those of FTX. FTT, although at some point valued at over $85 dollars, had no intrinsic value other than that attributed to it by the market. Holders of FTT received certain benefits and rewards while trading on FTX (such as lower trading fees), and could trade FTT on the open market. FTT was essentially FTX’s own currency, which they could mint (print) and circulate into the market as they wished.

Shortly after the publication, Changpeng Zhao (known as “CZ”) the CEO of Binance (one of FTX’s biggest competitors) announced on Twitter that Binance had “decided to liquidate any remaining FTT on our books”. Binance held a significant amount of FTT at the time, and the announcement that millions of dollars’ worth of FTT would be flooding the market sent the price plummeting and investors scrambling to get rid of their own FTT. Essentially, FTX faced a bank run and withdrawals had to be paused.

It became clear that FTX was in serious financial trouble when SBF reached out to CZ asking him to buy out FTX in a last-minute attempt to save the company from bankruptcy. While CZ initially agreed to sign a non-binding offer, less than 24 hours into the due diligence process, CZ announced that Binance was going to walk away as it was clear to Binance that FTX’s books were in shambles and billions of dollars were simply missing. Shortly thereafter, a mere seven days after the initial Coindesk report, FTX filed for bankruptcy.

So what went wrong?

In a nutshell, the collapse of FTX appears to be attributable to a complete lack of regulatory oversight and a total disregard for corporate governance. John Ray III, the insolvency professional who has been tasked with overseeing the liquidation of FTX, has been quoted by Time as saying that “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”. This is particularly ironic, as FTX was in the process of establishing its headquarters in the Bahamas, one of the first countries in the world to have enacted a comprehensive legal framework for dealing with crypto assets. The Bahamas, which less than two years ago was still on the Financial Action Task Force’s grey list, had recently enacted the Digital Assets and Registered Exchanges Act (DARE Act), which provided clear rules for crypto exchanges to adhere to. Essentially, the aim was for the Bahamas to become a “crypto hub”, the idea being that crypto companies would prefer to establish themselves in a country where they had certainty around how crypto assets would be classified from a legal perspective. FTX was also one of the crypto companies that specifically called for greater regulation in the market, and the move to the Bahamas not only gave creditability to the DARE Act, but also to FTX as an accountable and transparent corporate crypto entity.

However, despite the enactment of the DARE Act, it appears that the implementation thereof, at least insofar as FTX is concerned, was non-existent. From a legal perspective, there are three main issues that stand out.

Firstly, the relationship between FTX and Alameda was a lot closer than any two separate juristic entities ought to be. Evidence has come to light showing millions of dollars’ worth of funds being transferred between FTX and Alameda on a regular basis, with FTX essentially bailing out Alameda on more than one occasion. Furthermore, so it has been reported, the funds that flowed from FTX to Alameda appear to have been customer funds – i.e. money that investors thought was sitting safely in their wallets on FTX, was in fact being funnelled out of FTX to Alameda. Additionally, it has now come to light that none of what essentially constituted “financial assistance” by FTX was accurately reported in the books of either FTX or Alameda, the result being that vast amounts of customer funds have simply gone missing. When investors started withdrawing their assets from FTX, withdrawals on FTX had to be paused, as the investors’ money had in reality been loaned to Alameda, which at that point had become insolvent due to the plummeting price of FTT.

Secondly, there appears to have been a total misuse of FTT, FTX’s own token. While FTT could be openly traded on the market, it had no intrinsic value, other than the benefits that holders receive from having it, such as discounts and rewards while trading on FTX. FTX also had the ability to artificially inflate the price of FTT, by controlling the circulation of FTT in the market. However, as revealed in the Coindesk report, Alameda was holding FTT as the largest asset on its balance sheet, and FTX was loaning money against it. Due to the large amount of FTT held by Alameda and the illiquid nature of the token, Alameda was unable to sell FTT in the market and pay back the “loans” given to it by FTX, resulting in the bankruptcy of both companies.

Thirdly, and perhaps most remarkably, is the fact that neither FTX, nor Alameda, appeared to have any accountability or corporate governance mechanisms in place. FTX, despite handling billions of dollars of customer money on a daily basis, has no record of a single board meeting ever taking place, and in fact, appeared to have no board of directors at all. It is also yet unclear whether FTX even had an official CFO, which perhaps explains the lack of reporting on the cashflows between FTX and Alameda, as well as the flagrant misuse of customer funds.

Now what?

The crypto industry has faced its fair share of financial disasters this past year, and the result is that governments are now forced to enact accountability frameworks much faster than they were perhaps previously willing to do.

In response to the collapse, the US has been pushing for the enactment of its new Digital Commodities Consumer Protection Act (DCCPA), which aims to “regulate the trading of cryptocurrencies and related digital assets”. According to the chairperson of the Commodity Futures Trading Commission, the DCCPA would have prevented the mix of customer and company funds, and would have required proper bookkeeping and corporate governance by FTX.

South Arica has also been taking further regulatory steps, with the Minister of Finance announcing, through publication in the Government Gazette on Tuesday last week, that crypto exchanges will be listed under Schedule 1 of the Financial Intelligence Centre Act 38 of 2001 (FIC Act) from 19 December 2022. This means that crypto exchanges will now be included in the list of “accountable institutions” under the FIC Act and will be subject to the same reporting requirements as banks and other companies dealing in foreign currency.

Apart from the steps already being taken by governments, there are also potential areas of self-regulation that could be implemented by the crypto industry itself. Firstly, developing a set of rules around what companies can and cannot do with their own tokens could prevent abuses in the market such as those that has been reported to have transpired in relation to FTT (and LUNA earlier this year). These sets of rules, if agreed upon by a majority of players in the crypto industry, could potentially be built into the blockchain. Another step, one which has already been taken by some crypto companies, is to publish a “proof of reserves” on their website, so that the public has insight into the assets on the company’s balance sheet. However, without transparency into the liabilities of a company, proof of reserves will never tell the full story and crypto companies should be encouraged to be more open and transparent about both sides of their balance sheet.

Conclusion

Unfortunately, the development of regulation in the crypto industry has constantly been reactive, instead of proactive. It has been an expensive lesson that has resulted in people losing large amounts of money and an increasing loss of trust in the crypto industry. It remains to be seen whether the enactment of further regulation, whether by government entities or by the crypto industry itself, will prevent similar collapses from happening in future.