The author of this article argues that the failures with FTX are little to do with regulation or lack of it. Without proper controls, management integrity and attention to detail, most businesses will fail eventually.

As more information emerges on the FTX collapse, so do financial services figures seek to learn lessons from the saga. In the following article, Stephen Ashworth, who is investment director for WELREX, a digital investment management platform, considers the wreckage. The editors are pleased to share these views and invite replies. The usual disclaimers apply. Email tom.burroughes@wealthbriefing.com

Back in June we wrote about the increasing uncertainty in the crypto space off the back of the stable coin, Luna, and lending business, and Celsius, collapsing with significant losses to their creditors. We wrote of possible future carnage as the ripples fed through the crypto ecosystem. This month saw the collapse into bankruptcy of FTX, one of the industry’s largest and highest profile crypto exchange platforms.
 
As events have unfolded, we now have a glimpse of the shocking workings of the FTX business, set up and managed by the youthful and well-known crypto personality Sam Bankman-Fried. Crucially, its connected companies, in particular Alameda Research. Alameda began life in 2017 as an algo-based trading firm (SB-F was originally a mathematician and arbitrage trader). The FTX exchange came later off the back of Alameda’s trading successes. The amounts involved in the FTX failure are huge. [There was] an apparent $8 billion gap between assets and liabilities. 

A pure exchange business really should have very little risk 
It is worth reflecting that an exchange business is really just a matching platform between buyers and sellers. There may be some settlement risk but overall, the risk should be low. Indeed, crypto exchanges typically ask clients to pre-fund settlement amounts thereby reducing settlement risk. However, this is where the problems began. If you want to trade actively on an exchange you need to keep a balance of assets in hot wallets connected to the exchange, so in effect FTX was acting as a custodian too. As FTX activity grew, so did the balances of client money being held at the exchange. 

Further, FTX allowed clients to trade on margin and, as is now becoming clear and as announced by SB-F himself in a letter to employees this week, the true extent of margin ended up very high and was not known or tracked precisely by the management. 

So, not just an exchange after all
In reality, FTX seems to have had more in common with a shadow bank than an exchange, lending capital to Alameda. And worse, it would appear that some loans were made using client money! Alameda then made loans to other crypto businesses and provided leverage to FTX trading clients. 

Another interesting and less known activity is the way liquidity is provided to centralized crypto exchanges such as FTX. In traditional markets, market makers act as principal with their own capital at risk. Much of crypto market-making liquidity is provided via algo-based trading technologies. The firms offering this technology often partner with the exchanges under arrangements whereby the exchanges provide the risk capital.  Alameda was just such an algo-based trading firm providing market making for many underlying coins including FTX’s own token FTT (remember this point as you read on). So not only do we have client funds used for loans, but that same client capital may have been used to provide liquidity on FTX.

At one point it seemed that SB-F was the industry’s lender of last resort to collapsing crypto business. Several articles compared SB-F to Pierpont Morgan, the eponymous founder of JP Morgan, who rescued other failing banks in 1907. 

It was the Alameda business with the leverage problem that drove the FTX failure. Alameda suffered losses as crypto sold off this year. Alameda did provide collateral to support the loans from FTX but this collateral was in fact FTX issued tokens, FTT. Oh dear. The value of collateral was directly related to the success or failure of the FTX operating business not to mention that Alameda was also market-making prices for the collateral. Once FTT began to collapse it was always going to be game over.

Segregation is the single most critical control
After FTX filed for bankruptcy, a professional administrator, John Ray III (renowned for the same role post Enron), was appointed. His first report, released last week, makes damning reading.

Critically, there was no segregation of client monies, nor it seems any serious control over that money within the business. This is appalling – especially as we also now know that industry groups which pitched to help FTX deliver such a segregation with formal custodian services, were rebuffed by SBF despite apparently having the support of other personnel within the business.

The report makes for further depressing reading. No centralized cash reconciliation or control over cash. Massive holes in books and records such that a reconstruction process is underway from FTX’s creditors’ bank records. Overall, an interconnected web of incompetence and possibly, fraud.

Where do we go from here?
It is clear that this mess is going to take some time to unravel and resolve. SB-F was feted as being very clever. Too clever to be bothered with details or so clever we will never find out? Time will tell, or perhaps not.

More immediately, the debate about regulation gathers momentum. This too will take time to resolve but from our perspective the failures with FTX are little to do with regulation or lack of it. Without proper controls, management integrity and attention to detail, most businesses will fail eventually. This is not complex – it’s common business sense and good practice. It can and should be done regardless of regulation.

One further interesting observation: for all the centralized (Cefi) failures we have seen recently, the world of Defi – direct wallet-to-wallet connectivity with full control retained by the wallet owner and powered wholly by smart contracts – goes on untouched by events and with no points of failure for clients so far. Many crypto purists cite this as the end game for the blockchain technology. Right now, they seem to have the upper hand.