This week, FTX founder Sam Bankman-Fried is on trial for committing or conspiring to commit wire fraud, securities fraud and money laundering. The media is focused on the topics readers can all relate to— his immorality, or that of crypto; the sums of money involved; or the nature of the charges, which are not everyday words.
The last point—charges—is closest to what this trial is really about. They are: wire fraud, a scam that reaps wrongful or criminal financial gain via the internet or old-fashioned telephone. Money laundering: disguising financial assets generated from criminal activity so they look legitimate. Securities fraud: the go-to theory for litigating financial misconduct, being easy to bring to court with big payoff potential, as Bloomberg’s Matt Levine has famously argued.
But, dig deeper. Not one of these charges touches on the essential violation underlying all mega-crises of our day, from LTCM to the 2008 GFC, to now, FTX.
Giving an illusion of solvency from a position of insolvency—
FTX was first incubated in the crypto trading firm Berkeley-based Alameda Research, which Bankman-Fried set up in 2017 with Jane Street Capital colleagues. Alameda found early success buying low bitcoin prices and selling them high. When the bitcoin arbitrage strategy dried up (as all arbitrage does, at scale) Bankman-Fried and Zixiao Gary Wang established FTX in May 2019 as an offshore exchange for traders to buy, sell or take synthetic positions in a wide range of fiat and crypto currencies and nonfungible tokens (NFTs). Its revenue model was supposedly that of an exchange: FTX would generate earnings from trading, lending and interchange fees through the use of branded debit cards and making markets in NFTs.
In July 2021, FTX raised USD 900 MM (later claimed USD 1.0 BN) from over 60 investors at an $18 BN valuation. Their pitch deck supported the narrative:
“After years of using other exchanges, team realizes they could build a better exchange. FTX is launched.”
In October 2021, an FTX press release announced a Series B-1 round of USD 420 MM, and in January 2022, a Series C USD 400 MM round, at respective valuations of USD 25 and 32 BN. Claims of dramatic growth in the user base and trade volume boosted the valuations. Trading levels were now said to average USD 14 BN daily. Believers (participants in one or more rounds) in the narrative were Softbank, Sequoia Capital, Paradigm, Temasek, Tiger Global Management, Lightspeed Venture Partners, Ontario Teachers’ Pension Plan, Patriots owner Robert Kraft, hedge fund legend Paul Tudor Jones, and Coinbase Ventures, investment arm of the competitor crypto exchange founded in 2012. FTX also opened a USD 2 BN venture fund in early 2022. Within the year, FTX filed for bankruptcy in early November 2022.
John J. Ray III, CEO appointed to the FTX bankrupt estate and former chair of Enron Creditors Recovery Corp., would go on to say how FTX suffered “a complete failure of corporate controls,” and that he had never seen anything as bad as FTX. Details of the balance sheet links between of Alameda Research and FTX are still coming to light, including a secret “backdoor” to withdraw FTX customer funds to fund Alameda’s USD 65 BN balance sheet hole.
What is so interesting about fraud is always the surface narrative—
Fraud can be arcane, dazzling, beguiling. This is the money-laundering part where criminality is repackaged into complex financial assets (CDOs or cryptocurrencies) designed to intimidate and confuse. Going viral is the wire-fraud part. Using your savings and mine is the securities fraud part.
But the essential fraud is none of these.
The essential fraud can be sussed out by asking two simple credit questions: Does the financial value proposition make sense? Are the enterprise operations sustainable?
If the answers are “yes,” then the work gets much harder. Expertise in valuing FTX’s investments in gamification, visualization, databases and other investee firms; valuing exotic currencies held in custody for FTX customers; and assigning a credible present value to the future stream of bread-and-butter exchange revenues are all needed. But first, the answers to the simple financial and operational questions must both be “yes.”
If the answer to either question is “no,” suspect fraud.
Start with the financial valuation. A claim of USD 14 BN in daily trading supporting the high valuations is dubious. The New York Stock Exchange (NYSE) closing auction averages under USD 20 BN in trading volume. For FTX to approach 75% of the NYSE’s largest daily liquidity event is impressive. Is it believable? Reality check: the NYSE is 231 years old, has 2400 listings and its market cap is about USD 23 TN.
Alternatively, one could back into the enterprise valuations by bootstrapping the trade fee data. Given 260 working days in a year, an average trading fee of 3.5 BP, an average trade size of $10 MM, and an estimated one trade a day, the earnout would be approximately 2 million years.
Given an average trade size of $500 MM at the rate of one trade a minute, it would still take 27 years. Unfortunately, FTX did not live so long.
An even simpler question is—with USD 14 BN in daily trading volumes, assuming an average 3.5 BP fee again, FTX should be throwing off about USD 50 MM a day in fees. Why raise more equity rounds at all when, in theory, funding equal to the Series B-1 and C amounts could be internally generated in under a month.
To appraise operational sustainability, start with the business definition.
What kind of exchange is FTX?
I have a bit of an expert edge here having worked in and for exchanges, and having taught exchange mechanics to Chinese delegations in the ‘90s, but here is a shortcut. Ask, what kind of a research institute was Alameda? In the words of Bankman-Fried in 2021: “If you named your company ‘We Do Cryptocurrency Bitcoin
BTC
Given that Alameda is not a research institute, why would anyone believe FTX is an exchange?
Exchange viability comes down to its credit and liquidity position—
Exchanges are the quintessential structured finance vehicle, built to mitigate counterparty credit risk and give market participants liquid access to assets at transparent prices and low to negligible exposure to operating risk. All well-functioning exchanges have balance sheets with the following line items—
· Assets: cash and equivalents (the largest bucket), financial assets, accounts receivable, investments in other enterprises, fixed assets and goodwill.
· Liabilities: customer funds on deposit (the largest bucket), accounts payable, clearing member funds on account, leases, loans, share capital and equity attributable to shareholders.
Viable exchanges are solvent with multiple levels of risk protection. Customer and shareholder money are the biggest liabilities, and they are protected by robust trust and custody arrangements. Exchanges require customers to cash-collateralize their accounts based on current levels of market and asset volatility, and to settle their accounts daily, to ensure that the exchange, clearinghouse, members and customers, always know the end-of-day net risk and value positions, and manage accordingly.
FTX didn’t even have an accounting department or audited financial statements. Its assets and liabilities published on unofficial balance sheets were blatantly atypical. They showed an excess of self-generated cryptocurrencies (FTTs), which masked unauthorized loans from customers to the exchange.
FTX did not provide legitimate custody services at all but engaged in self-dealing. There was no margining system: FTX simply closed out customer accounts when the value dried up and probably pirated the difference.
Some of these details may have been nonpublic until before the bankruptcy filing, but a simple due diligence check before any of the financing rounds would have revealed that this “Exchange” was not only insolvent but operationally unsustainable.
Time to rethink criminalizing insolvency?
Juxtapose the FTX story with how “everyone knows” the world is drowning in debt. Global public debt was USD 92 Trillion in 2022. Few believe it can all be repaid because the money required to repay it lies outside the economics of the loans. We cannot call this securities fraud. Yet lending money without a visible means of repayment is clearly an abuse of the credit function.
It’s as if we didn’t recognize credit risk when we see it. Which is probably true.
Since the 1600s, natural persons have gone to jail for insolvency. Today we have serial organized criminal credit activity perpetrated by seemingly legitimate institutions that manufacture gains by masquerading as solvent operations to siphon off funds from unsuspecting clients—as much as possible for as long as possible. Charges like wire fraud, securities fraud and money laundering fail to address the criminal essence—the construction of vehicles that mimic financial and operational viability but lack essential safeguards.
If we want the law to become more effective, it is essential to be able to prosecute credit fraud. From years of plaintiff-side expertise in structured finance litigations, I know intentionality in credit frauds is hard to prove—much harder than negligence. This is, I believe, not because they are in fact difficult to prove. Demonstrating insolvency is actually relatively easy. It is because the criminal intent behind false representations of credit strength has not been taken seriously.
It should be. Maybe putting Sam Bankman-Fried on trial is a beginning.
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