Is FTX’s collapse another chapter in the golden age of fraud?
In the past week, much ink has been spilled on the multi-billion-dollar collapse of FTX, the crypto exchange started by one-time tech ‘wunderkind’, Sam Bankman-Fried. And no one, I believe, has summed up the situation better than Pete Drewienkiewicz, from UK broker Redington. It’s so spot-on, I’m just going to copy-paste it below.
“If there’s one thing I’ve got wrong over the past few years, I’ve been too positive on the various frauds that have come to light – initially surmising that the actors involved have been involved in a legitimate business with an Achilles heel that they just missed. Unfortunately, that’s consistently been an unrealistically positive stance, for Greensill, for Wirecard, and now for FTX, where it appears that customer “deposits” were routinely transferred to the business’s trading arm, Alameda Research, and quite possibly used to prop up the various crypto holdings there. Over the weekend the tale continued to rapidly unravel, showering further embarrassment on the various institutional investors in FTX. There are probably another 3 lessons to add to the ones I posited on Friday:
- If you can’t figure it out, it might well just be a fraud, sadly. Jim Chanos, the legendary short-seller, called it “the golden age of fraud” in summer 2020 – maybe we should stop being mean to short-sellers too?
- Laughing at Warren Buffett doesn’t age well. Far from being “over the hill” and “not understanding tech”, I think WB and Charlie Munger had it pegged – the unregulated nature of crypto was attracting bad actors and bad behaviour from all over the world.
- There is way too much “due diligence by reference” going on; by which I mean investors taking the view that somebody else credible had done the work, so they didn’t need to go deep. This one illustrates this.
So, since Friday, courtesy of FT Unhedged’s excellent summary, we’ve had:
- FTX was hacked for as much as $477 million.
- Why Binance didn’t buy [FTX] became clear. The FT got hold of FTX’s balance sheet as of November 10, showing an $8 billion gap between liquid assets and liabilities. (ed: more on this below)
- Legal trouble is brewing. The crypto exchange Kraken froze accounts associated with FTX execs after conversations with “law enforcement”. FTX said it would resume withdrawals for customers in the Bahamas, where it is based, suggesting this was at regulators’ request. The Bahamian financial regulator’s reply: we didn’t tell them to do anything. Later on Sunday, Bahamian authorities launched a probe to find “if any criminal misconduct occurred”.
- Everyone is scared of contagion. Binance’s CEO warned of “cascading effects”. Crypto traders like Genesis and Galois Capital disclosed hundreds of millions in funds trapped on FTX. The exchange Crypto.com saw a rush of customer withdrawals on fears it could be next (20 per cent of its assets are reportedly in shiba inu coin.)
Unhedged’s Robert Armstrong linked the collapse to higher interest rates, and there must be something here. If you can make 7 per cent in UK investment grade credit, it seems unlikely that you’d be interested in reverse repo-ing a dog-themed virtual currency to make 8 per cent. Anyway, about that balance sheet. As ever, Matt Levine is on it faster than a speeding bullet to report on the horror: “the balance sheet that Sam Bankman-Fried’s failed crypto exchange FTX.com sent to potential investors last week before filing for bankruptcy on Friday is very bad. It’s an Excel file full of the howling of ghosts and the shrieking of tortured souls. If you look too long at that spreadsheet, you will go insane.”
This is not your regular, everyday balance sheet:
“For a minute, ignore this nightmare balance sheet, and think about what FTX’s balance sheet should be. Conceptually, customers give you money — apparently about $16 billion in dollars, crypto, etc. — and then you hang on to the money and owe it back to them. In the simplest world, you keep the customers’ money in exactly the form they give it to you: Someone deposits $100, you keep $100 for him; someone deposits one Bitcoin, you keep one Bitcoin for her. For reasons we have discussed — some legitimate! — FTX doesn’t quite work that way, and you could imagine some more complicated balance sheet where a lot of the money and crypto that came in from some customers was loaned to others. But broadly speaking your balance sheet is still going to look roughly like:
Liabilities: Money customers gave you, which you owe to them;
Assets: Stuff you bought with that money.
And then the basic question is, how bad is the mismatch. Like, $16 billion of dollar liabilities and $16 billion of liquid dollar-denominated assets? Sure, great. $16 billion of dollar liabilities and $16 billion worth of Bitcoin assets? Not ideal, incredibly risky, but in some broad sense understandable. $16 billion of dollar liabilities and assets consisting entirely of some magic beans that you bought in the market for $16 billion? Very bad. $16 billion of dollar liabilities and assets consisting mostly of some magic beans that you invented yourself and acquired for zero dollars? WHAT? Never mind the valuation of the beans; where did the money go? What happened to the $16 billion?”
Because, yes, it does appear that a sizeable portion, perhaps as much as $6 billion, of the FTX “balance sheet” was holdings in related tokens, which are largely worthless if FTX fails to survive. I think at this point this has gone from “bad financial engineering” to “jail time” for those involved.”