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 charges are closest to the substance of the crime: 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. No charge touches on the essential violation underlying all mega-crises from LTCM to the 2008 GFC, to now, FTX, namely—
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 fiat and crypto currencies and nonfungible tokens (NFTs). The supposed revenue model was 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.
“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. Headline investors included 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 the venture arm of the established competitor crypto exchange, Coinbase. FTX also opened a USD 2 BN venture fund in early 2022.
When 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 FTX suffered “a complete failure’ of corporate controls—that he had never seen anything as bad as FTX. Today, details of the links between Alameda Research and FTX are still unfolding, 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 crypto) 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 was 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 is then needed to value the gamification, visualization, database and other IT of its investee firms, and to value exotic currencies held in custody for FTX customers. Assigning a credible present value to the future stream of bread-and-butter exchange revenues is essential.
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 a market cap of about USD 23 TN.
Alternatively, 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 one trade a day, the earnout would take about 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 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 Arbitrage Multinational Stuff,’ no one’s going to give you a bank account.[…] But everyone wants a Research Institute.’’
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. They are 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 exchange balance sheets have the following line items
Viable exchanges are solvent. They have multiple levels of risk protection. Customer and shareholder money, their biggest liabilities, 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 financials. 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. It 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 already insolvent and 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. The money required to repay it is outside the economic analysis 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 in preventing financial crises, we must be able to prosecute credit fraud.
From years of plaintiff-side expertise in structured finance litigations, I know the intentionality behind credit failure is hard to prove, much harder than negligence. This is, I believe, not because the fraud is hard to prove—but because the criminal intent behind false representations of credit strength is not taken seriously.
It should be. The trial of Sam Bankman-Fried could be the beginning of real change.