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FTX Collapse


CONTEXT: Exchange goes from hero to zero

WHY IT MATTERS: Investors lost millions - Lessons are important


A large amount of news coverage of late has focused on the collapse of FTX. For the ill-informed, FTX was one of the most prominent crypto exchanges until its collapse. At its peak, it ranked 3rd globally in trading volumes. So successful was the exchange that it was generating >$1B in revenue per annum. Not chump change. With a diverse offering of spot and derivative products, it was a favourite for many in the investment and trading community. FTX and its disgraced founder Sam Bankman Fried (or ‘SBF’ as he is known) were a big deal. SBF’s media profile was so big that he was compared to the renowned JP Morgan, the famous US banker that dominated corporate finance during the 1800s and early 1900s. Buying and bailing out failed crypto outfits, in a very saviour-like fashion, generates such an image.

It was also just a few months back that FTX commercials were front and centre in the media. Famous athletes and other well-known personalities appeared, highlighting the benefits of the exchange. Celebrities weren’t alone. Well-known investors and fund managers were also involved via direct or indirect investments. But perhaps the most notable links to FTX and SBF were the political ones. SBF and associated entities were heavy donors to US political parties. He was also a regular face in and around Washington. To influence legislation and regulation, SBF was a regular on the political circuit and heavily involved in public narratives regarding the Digital Commodities Consumer Protection Act. So involved was he, that the bill was dubbed the ‘SBF Bill’. Despite this impressive highlight reel, FTX filed for chapter 11 bankruptcy on 11 November 2022 due to its inability to process mass cash withdrawals from customer accounts. A run on the bank as it’s known. So how does the ‘JP Morgan of our day’ and his multi-billion-dollar vehicle, go from hero to zero overnight?

For some, the word Ponzi comes to mind, but no doubt the courts and history will determine what occurred. At the heart of the matter seems to be its close relationship with Alameda Research. An entity also owned and founded by SBF. While the details are yet to be confirmed, it seems Alameda’s unique access to the exchange and its capital, played some role in the exchange's demise.

Very early in the bankruptcy process, it was revealed that FTX’s balance sheet was highly illiquid. Included on the asset side was its token, FTT. Which was created out of thin air by non-other than…. FTX. Based on SBF’s efforts to raise capital in its final days, it became evident there was a large hole in the balance sheet - to the tune of $8B. Eight Billion United States Dollars. Think about how much that is. Using a median annual US salary of c. $55,000, it would take the average worker approximately 145,000 YEARS to earn such a figure. That’s a lot of cash. It definitely wouldn’t fit under the mattress. So how does $8B go missing?

Everyone wants answers. And rightly so. When one deposits funds with a custodian, they expect it to be kept safe. But perhaps more importantly, they expect it to be redeemable at any time. For countless customers, this tragically was not the case. Investors all over the world, uncomfortably found out that FTX was insolvent. Unable to redeem the deposits that belonged to them. The investigation will take time to unearth the inner workings of the exchange and its closely related sibling Alameda. Until it’s resolved, what lessons can be drawn from one of the largest failures in corporate history? It seems there are several important ones.

The first is due diligence. When it came to the fiscal strength of the entity, only inside investors had access to its books. So how could countless sophisticated investors including large public asset managers, Hedge funds and other high-net-worth individuals have glossed over a seemingly illiquid balance sheet? The term ‘Herd Mentality’ comes to mind. Whatever the reason, the importance of a robust balance sheet seems like an elementary aspect to consider. This entire situation is evidence that basic accounting and its review of a business should not be overlooked – but prioritized.

For customers who didn’t have access to the books, it was a little harder. All they had to rely on are the viewpoints and perspectives of the big outfits that invested. In this example, those viewpoints were less than accurate, to say the least. With no inside access to the health of the business, customers don’t have a lot to base an opinion on. If the product works well, and others are using it in droves, one will assume the business is operating similarly. Only it wasn’t.

Unfortunately, if the whole world distrusted every business model based on events like this, business and the investment needed for its growth would collapse. Learning the best ways to mitigate risk seems to be the only solution to the erosion of trust that these situations create. So how does an individual or organisation mitigate risk when they still need exposure to potential growth with new businesses, products & services?

In the case of exchanges, specifically crypto ones, the key lesson is self-custody. When a participant in the spot markets utilises self-custody, it ensures that assets are out of the hands of an intermediary and only accessible via private keys. Of course, risk is present when utilising an exchange to execute a trade. But if material positions are moved to and from self-custody, the risk lowers substantially.

This risk increases when trading derivatives. But exposure can be somewhat mitigated by spreading and diversifying across multiple reputable exchanges.

For those positioning long in the spot market, however, self-custody is the wisest solution. Various hot wallets are certainly better than leaving assets with an exchange. But the best protection comes from utilising cold wallets which are not connected to the internet. A robust risk strategy combined with utilising hot and cold wallets helps to significantly mitigate risk and exposure to events like this. For an individual, this seems like a reasonably simple fix to implement. When it comes to an organisation that holds or manages digital assets, this can be more challenging. So how does an organisation implement a risk strategy/ process to protect them from future events like the FTX one?

Organisations should ask the following questions:

⁃ Have we defined our risk and exposure in a worst-case scenario?
⁃ Have we developed a strategy to mitigate losses?
⁃ Are our assets secured with a non-custodial solution?
⁃ If wallets are being utilised, are they enterprise solutions with multi-sig functionality?
⁃ Is our solution compliant, incorporating basic segregation of duties principles?

Navigating the risks associated with digital assets can be challenging but not impossible. Reach out to us to see how we can help with strategies that mitigate risk for your organisation. Wunderkind or not, the learnings from SBFs leadership or lack thereof, highlight the importance of taking control of said risk. Managing the risks your company is exposed to, seems like a taxing exercise but it will reap material benefits in the future - regardless of whatever FTX-style event occurs.

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