When Enron Meets Madoff: The Spectacular and Scandalous Fall of FTX
How the high-flying crypto exchange and its famous founder went bankrupt in just five days.
Sam Bankman-Fried, or just SBF. He was everywhere. He was friends with politicians, regulators, celebrities. He was bailing out failed crypto companies. He was called the new JP Morgan. He was worth $16 billion as of last week. He was also a fraud. The fall of the crypto exchange he founded, FTX, will cost its users the equivalent of more than $10 billion, and the ramifications of the fraud are still not fully known.
It all started with an article posted by Coindesk on November 2 that showed that a large chunk of Alameda Research’s $14.6 billion of assets was in the form of FTT tokens, $3.7 billion of it. Alameda Research is the crypto hedge fund that was also founded by SBF in 2017, before he founded FTX in 2019.
The issue with this asset allocation was that the FTT token was fairly illiquid, and that Alameda had used its stock of FTT tokens as collateral for borrowing. Who did it borrow from? FTX. How did Alameda acquire so many FTT tokens? It turns out that SBF himself transferred $4 billion worth of it to Alameda in the first half of 2022 to cover the losses of Alameda.
So, SBF sends FTT tokens to Alameda, a token he himself can print (it is FTX’s token), so that Alameda can borrow from FTX using the FTT tokens as collateral. Kind of circular, isn’t it? FTX accepted its own token that it could create in unlimited amounts to lend the funds of its unsuspecting customers. The issue was that the deposits on FTX were never supposed to be lent or invested. They were supposed to be held on a 1:1 basis to match exactly the balances of its customers.
The fraud had started at least five or six months ago, most likely as a result of the $50 billion collapse of LUNA (I had written a newsletter about it here), which led to a cascade of bankruptcies, including that of Alameda’s number 1 rival crypto hedge fund: Three Arrows Capital (3AC). It turns out that Alameda would have probably gone bankrupt at the same time as 3AC if it weren’t for FTX. Because SBF owned both FTX and Alameda, he decided to use the deposits on FTX to cover the losses of Alameda. There was no going back after crossing this line.
FTX has been engaging in illegal activities and had likely been insolvent for months. So, what triggered FTX’s downfall? Enter CZ, the founder and owner of FTX’s biggest competitor: Binance. On November 6, CZ announced that Binance was going to liquidate its $500 million position in FTT tokens it had received when it exited from FTX’s shareholding last year.
This was an unusual move. When you want to sell a large chunk of an illiquid asset, it’s better to do it quietly over time to avoid moving the market. You don’t announce it publicly. But CZ did the opposite, probably hoping it would tank the token. A few minutes later, the CEO of Alameda responded that Alameda would buy all the FTT tokens at the current market price: $22.
This was also an odd move given that Alameda was already overexposed to this illiquid token. The reality was that Alameda had to protect the value of this token at all costs since Alameda had used the FTT token as collateral for billions of dollars of loans. But it was too late. The market got spooked and heavy selling of the FTT token started immediately. The price of FTT broke under $22 the next day before falling to five dollars on November 8 (and less than two dollars now).
Seeing that Alameda was in trouble and suspecting that Alameda had borrowed from FTX, many FTX users started withdrawing their assets from FTX on November 6. By November 8, FTX users had withdrawn $6 billion of assets from FTX. The total assets of FTX before the withdrawals started were estimated at $16 billion.
The withdrawals shouldn’t have been a problem if FTX had kept the deposits as it was supposed to. But it hadn’t. CZ again, then offered to buy FTX three days after triggering its collapse. The offer, however, was non-binding and subject to due diligence. FTX had to open its books first.
Meanwhile, most of FTX’s legal department resigned.
The next day, Binance announced it wouldn’t acquire FTX. Binance didn’t like what it saw in FTX’s books.
The reason Binance walked out was simple: FTX had lent out $10 billion of its clients’ assets to Alameda, and Alameda was unable to repay the loans.
FTX only had $6 billion of assets when its customers started pulling their funds, which meant it was unable to honor withdrawals after three days once people had already withdrawn $6 billion.
What happened next was a death sentence for any crypto exchange: FTX suspended withdrawals. Not a single exchange has ever recovered from a suspension of withdrawals. Once trust is broken, customers will rush for the exit at the first opportunity they have, never to return.
On Friday November 11, FTX filed for bankruptcy.
A total of 134 companies of the FTX group filed for bankruptcy.
In its collapse, FTX is leaving behind thousands of customers who have little hope of recovering anything.
The last time FTX had raised capital was in early 2022. It was valued at $32 billion then. Its equity has now been wiped out.
But even as FTX was filing for bankruptcy, the story was not over. On Friday night (November 11), whatever was left of FTX’s assets started being stolen. A hacker was draining the wallets of FTX and FTX US. More than $600 million was stolen as the company was filing for bankruptcy and as a liquidator had just been appointed (the same that was appointed to liquidate Enron). The way the hack was perpetrated points to an inside job. We’ll know more in the coming days.
This was just an overview of what unfolded over the past week. There are more details available online, but I tried to keep it short. Keep an eye out for new developments and what will happen to SBF. This is just the beginning.
The Infuriating Part
In hindsight, frauds are always obvious. But while the fraud is ongoing, everyone, or almost everyone, fell for it.
The Ponzi scheme was already obvious back in 2018. Look at how Alameda marketed itself.
Caroline Ellison took over from SBF as CEO of Alameda. She is the one who was heading the firm that borrowed and lost $10 billion worth of FTX’s deposits. Watch and decide for yourself if this is someone that you would trust with $10 billion.
The kids running Alameda:
The most prestigious VCs and investors invested in FTX. None of them seem to have done any proper due diligence. None of them demanded a board seat. The Board of Directors of FTX consisted of SBF and two other employees. A joke.
The regulators loved SBF. He was spending a lot of time in DC, where he was supporting a bill on crypto regulation.
Watch what SBF himself was telling lawmakers a few months ago while he knew he was running on Ponzi scheme and he was doing the exact opposite of what he was stating. He most likely perjured himself during this testimony.
Famous investor and Shark Tank celebrity Kevin O’Leary couldn’t say enough good things about SBF.
It turns out that SBF had backdoor access to FTX’s accounting system, which was used to hide the $10 billion of loans to Alameda. You can’t make this up. In this day and age, it’s unbelievable that a $10 billion hole in a balance sheet could be hidden.
SBF was the second largest donor to the Democratic party in the US midterm elections. Was he buying political protection?
The links between SBF, Gary Gensler (Chairman of the SEC), the CEO of Alameda, and Gensler’s former boss are unsettling.
A few months ago, nobody understood why SBF was bailing out failed crypto companies. Now we do. Even though these companies had liabilities that exceeded their assets, they had assets, which FTX needed to plug the shortfall left by the loans made to Alameda. Because these companies had to move their assets to FTX as part of the bailouts, they are unlikely to recover their assets now that FTX has gone bankrupt. If the companies “saved” by FTX had gone bankrupt, they could have distributed these assets to their depositors and creditors. Now they are left with nothing.
What is Next for Crypto
The crypto bull market that started in October 2020 brought many new investors to this space. These new investors thought they could trust an exchange like they could trust their bank. They were wrong. The reason Satoshi Nakamoto created Bitcoin was precisely so people could take custody of their own money and not have to trust any third party. By leaving crypto on an exchange, crypto investors forgot this foundational principle.
Other exchanges are now suspected of having insufficient reserves to back their customers’ deposits.
There is only one way to protect yourself against exchanges engaging in illegal activities or mismanagement: You should never leave any crypto on any exchange. Ever. The whole point of crypto is that once you acquire some on an exchange, you can withdraw it and take custody of it. I wrote many times about this, in this newsletter and previously. In November 2017, I wrote an article for the CoinTelegraph in which I explained why it was important to take custody of your crypto (link here).
The beauty of controlling your own private keys is that while exchanges can be hacked or shut down by governments and your assets and bank accounts seized or frozen, nobody can touch your coins.
Vincent Launay in Your wallet, your freedom article for the CoinTelegraph
Each generation of crypto investors learns the same lesson: Not your key, not your coins. If you own crypto on an exchange, learn about cold storage, and buy an $80 hardware wallet like a Ledger Nano S or X. Those who had crypto on FTX could have avoided billions of dollars of losses with this simple device. If you are in crypto and have no idea what I’m talking about, stop what you are doing and learn about it. There is a lot of free content available to educate yourself. The time you will invest learning about this space will be worth it.
There is likely going to be more collapses in the coming weeks. But this isn’t the first crisis in the crypto ecosystem, and it won’t be the last. Every time there is a crisis, the industry learns, and the market comes back stronger. There is no reason to think this time is any different. This fraud was a financial fraud that happened to be related to the crypto industry. But just like the Enron fraud didn’t kill the energy trading business, and the Madoff fraud didn’t kill the money management industry, this one won’t kill the crypto industry.
Despite crisis after crisis happening in crypto in 2022, the market capitalization of Bitcoin is still above $300 billion. This is larger than companies like Meta (Facebook), Bank of America, or Samsung. As usual with crypto, however, you can expect a bumpy ride in the next few years! Stay safe and get your coins off exchanges!