For much of the past year or two, FTX, the new cryptocurrency exchange birthed by Samuel Bankman-Fried, existed on the periphery of crypto mania. Word seeped around quickly about the enormous value of the new company and the billions amassed by Bankman-Fried (who was widely known as "SBF"). Whispers and estimates of his net worth suggested he had over $5 billion. Or $10 billion? Or 15 billion?
How was this "worth" culled or computed? What was it based on? As it turns out, his worth was based scraps of paper, elaborate Excel spreadsheets, and far-flung estimates of values of tokens and currencies. The organization, presenting itself as a financial exchange, was eventually funded by investments from venture funds, pension funds, and other private equity funds. It now appears they flocked to the enterprise without bothering to engage in conventional due diligence. They trusted SBF, bought into the storyline, and would wait patiently to reap vast returns.
SBF had aspired to be crypto-world's statesman, a leader who would perfect the business model of cryptocurrencies and continue as an ambassador a world not yet completely convinced of the purpose and raison d'etre of crypto.
The new billionaire spread the word, name and brand of crypto investing and trading. In a short period, "FTX," the name and brand, was implanted and spotted around the country--on the floor of an NBA arena (in Miami), on the field at a college stadium (UC-Berkeley), and on the front jackets of baseball umpires. Many of us knew what FTX was engaged in (crypto-something), and many knew it all might have involved speculative investing, although most didn't know exactly what FTX was up to.
By late November, almost everybody following financial markets knew FTX blew up and disappeared in a matter of days. The scrutiny the now-bankrupt company and its confusing web of affiliates are receiving in the financial media is exponentially greater than what it received throughout its existence. Mainstream news organizations are combing through 2022's version of "house of cards" to piece together the financial story.
Meanwhile, the legal system and bankruptcy court will figure out how to resolve billions in losses, billions in liabilities and claims and how billions in firm value disappeared overnight. There have been several comparisons to Lehman, Enron, and Madoff.
Stay In Your Lane
If FTX had stayed in its lane or remained as a functioning exchange, it may have survived. But it drifted from what it publicly said it would be. Examiners are trying to determine what propelled it to go beyond its purpose. Was FTX taking advantage of the inability of regulators to bring the group of companies into their domains and corral activities? Did FTX observe a gold-mine opportunity and try to exploit crypto markets to its advantage? Was it desperate to recoup losses in its affiliates, including the hedge fund Alameda?
As a proper exchange, it would not be taking market positions of any kind and be subject to asset (cryptocurrency) volatility. Exchanges provide access to markets or sometimes make markets, but essentially insulate themselves from market and credit risk--market risks arising from the assets traded, credit risks from from participants. Exchanges have defined roles: price discovery, price disclosure, access to markets, trade confirmation, and clearance and settlement (associated with after-the-trade activities).
More often, exchanges and their related "clearing houses" are typically more concerned about credit risk--the risk that participants and members will not make payments on what is due or will not deliver assets (securities, e.g.) when they are due. They manage the credit risk accordingly. Sometimes that might involve participants themselves contributing to a "default fund" to absorb worst-case credit risks
Exchanges and clearinghouses project conservatively what customer/participant losses could be and require participants to post "up front" margin (cash or government securities) in anticipation of worst-case scenarios. Markets can be wildly volatile (as they have been in 2022), and customers and broker/dealers may be subject to unusual gains and losses. But a proper exchange manages this risk without subjecting itself to the same unusual gains and losses.
FTX billed itself as a futures exchange for cryptocurrencies (Bitcoin, e.g.). It, too, could require participants to contribute a "margin" or up-front cash. In this case, participants are not buying or selling Microsoft stock or pork-belly futures. They are getting into a position tied to cryptocurrency values. An exchange such as FTX would earn a transaction or brokerage fee. The sum of such fees should be the primary source of revenue for the exchange. (It can earn additional fees from selling data, prices and other services.)
How It Presented Itself
As a futures exchange, participants would buy into a position by placing a margin amount, a fraction of the total price of the position. Participants sell a position and also place margin to cover potential losses. Gains and losses related to the trading positions are added or subtracted to the deposits participants initially put up.)
As a securities exchange, participants buy a position by purchasing the entire amount (or at broker/dealer, participants can borrow from the broker/dealer to purchase the entire amount)).
Outside of crypto trading and investing, exchanges fall somewhere within the grasps of securities, derivatives and banking regulation--no matter where around the globe. In the U.S., that would be the SEC, the CFTC, or even in 2022, the Federal Reserve, which seeks to rationalize getting involved to manage "systemic risk" in the financial system.
Regulators want to see the exchange runs a fair market with fair access to participants (brokers, market-makers, and moms and pops), and updated prices. Regulators will also want to ensure the exchange or trading platform has minimum amounts of capital--"operating capital" and "loss-absorption capital." Just as important, regulators seek to protect deposits from participants, members and customers (sometimes called 'initial margin" or "customer payables" or "customer credits").
Regulators don't want exchanges and clearinghouses to use customer funds for no other reason than to manage customer-related risks. Hence, the deposits should be funneled into low-risks investments or activities (cash, government securities, investment-grade securities, e.g.).
Even if it operated beyond the purview of financial regulation, FTX would have still wanted to ensure participants their idle deposits were protected. Participants can take risks and be subject to losses. But participants' funds (if not being used to support trading activity) would be safe.
What the world of investigators are now unraveling is a story of improper use of customer funds. Participants deposited funds to engage in trading. FTX used idle customer funds to fund activity that we now see was extraordinarily risky.
If FTX had been regulated (and that presumes the current crop of regulators would have gotten around to approving and permitting a crypto-exchange to exist in the first place), the customer funds deposited at FTX would have:
a) Been required to be invested in cash, cash reserves/bank deposits, or liquid securities rated investment grade (typically, U.S. Government securities),
b) Not been permitted to be used to fund proprietary trading elsewhere within the exchange or trading platform,
c) Not been permitted to be used to make loans to other unaffiliated third parties or counterparties, and
d) Not been permitted to be used to fund furniture, fixtures, and equipment (or luxury penthouses in the Bahamas, as it now appears FTX might have done).
Because it wasn't a regulated exchange (and because venture investors seemed careless or indifferent in bothering to probe), customer deposits could be used for whatever purpose FTX and SBF it chose. In this case, customer deposits had grown beyond $8 billion.
What It Really Wanted to Be
Now we know, FTX used such customer funds to venture into areas it had no business stepping into or connect with affiliates and activities that had to do with acting as an exchange. The exchange, it now appears, ran a hedge fund, lending business and private-equity investment fund on the side.
(Sounds familiar. Bernard Madoff, well known from the mid-2000s scandal, ran a prestigious, legitimate broker/dealer, but presided over a Ponzi-scheme hedge fund on the side. Customers of the regulated Madoff broker/dealer wouldn't lose money, because of strict broker/dealer rules. Customers of the hedge fund. Well, the tale is now a prominent chapter in financial history books.)
As a pure exchange and with an avalanche of volume (for which it could charge transaction fees), the FTX business model alone could likely be profitable or could get to profitability over a defined, projected timeframe. The market value of the entity (based on future flows of earnings), however, likely may not yet have eclipsed $1 billion. SBF, the billionaire, might have been SBF, the multi-millionaire. (Today's market value of the CME Group, parent company of the Chicago Mercantile Exchange, totals about $62 billion.)
As investigators and journalists unravel a messy pile-up of spreadsheets and SBF's tendency to create dozens (or hundreds?) of subsidiaries, affiliates, and entities on a whim, it turns out customer funds turned out to be FTX's bank to fund and support risk ventures beyond a basic exchange.
Customer funds funded loans to Alameda, the affiliate hedge fund. Customer funds funded investments in other vehicles, other ventures, and any purpose SBF had in mind at the moment.
The "exchange" also created, we know now, its own cryptocurrency ("coin" or "token") and manipulated its value by playing supply-demand games. And it used the same tokens to lend to Alameda, and Alameda used the same to pledge as collateral to get more funding. Examiners now reason that Alameda, the crypto hedge fund, had amassed debt and trading losses and likely tapped FTX for support. In effect, the SBF's trading venture desperately required support from SBF's exchange. The left hand seeks aid from the right hand. The right hand snatches funds belonging to customers to do so.
Unraveling, investigations, legal recourse, and bankruptcy proceedings could take years. In the end, all involved may conclude FTX wasn't the core operation. The hedge fund might have been the core entity, and the exchange was the funding vehicle.
Many will likely wait for the book and movie to understand what happened. Media outlets report Michael Lewis, arguably the finance industry's best storyteller of trends, scandal, characters, and unexplainable financial products, has already begun to prepare of draft of this story.
Tracy Williams
See also:
CFN: Bitcoin Mania Again, 2018
CFN: Bitcoins--Embrace or Beware? 2014
CFN: Wall Street's Flash Boys, 2014
CFN: High-Frequency Trading, 2014
CFN: Dark Days at Knight Capital, 2012
CFN: JPMorgan and Its $6 Billion Trading Loss, 2012
CFN: What is Really a Derivative? 2012
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