In 2009, a shadowy figure named “Satoshi Nakamoto” invented a decentralized Internet-based currency called Bitcoin. Since then, cryptocurrency has grown exponentially, and the cryptocurrency exchange now rivals hard currency markets like the NYSE and Dow Jones in trades, volume, and their impact on the financial world.
In November of 2022, cryptocurrency billionaire and investor Sam Bankman-Fried caused a crypto-collapse reminiscent of the 1929 stock market crash or the junk-bond debacle of the 1980s, when his company, FTX, went from $32 billion to bankruptcy in less than 10 days. The ripple effects are still being felt in the crypto market, and possibly in the financial world at large.
But what happened to FTX and Bankman-Fried?
What is Cryptocurrency?
Cryptocurrency is virtual currency with no physical existence. Unlike fiat currency, which is issued by a government and theoretically is backed by the government’s treasury or monetary reserves, cryptocurrency, or crypto, is secured by nothing but the existence of the crypto network. Crypto remains stable only as long as the network that supports it is stable.
Crypto is attractive to Internet investors because it is secured online by cryptography, making it impossible to counterfeit. Crypto uses blockchain technology, meaning the transactions are spread over a network of connected computers, preventing any single source from having all the data. The goal of the blockchain was to create a trustworthy system among mutually suspicious partners, a condition that describes both crypto and the fall of FTX.
The Rise of Cryptocurrency
Crypto has been around for a long time. The concept of non-traceable electronic money was first conceived in 1983 by cryptographer David Chaum, who later invented Digicash. However, Digicash, like other early electronic money systems, required users to print out their “electronic money” and enter the code back into a computer to use it.
The first true cryptocurrency was Bitcoin in 2009. Bitcoin used open-source software, allowing access to anyone who wished to use it, and it relied on blockchain technology for distribution.
Bitcoin was rapidly followed by other open-source blockchain cryptocurrencies, including Ethereum, Tether, and Dogecoin. Various countries have accepted, rejected, or even (in the case of China) attempted to make cryptocurrency illegal, but the decentralized nature of the currency, and the sometimes shadowy nature of the users, makes it useful for online transactions and attractive for entrepreneurs.
Next Steps: Crypto Exchanges and Crypto Brokers
Once crypto became established as a viable money substitute, the next thing people needed was a way to convert crypto into conventional currency and back again, or to convert one form of cryptocurrency into another. Enter cryptocurrency exchanges. A crypto exchange was simply a business that allowed users to transfer various types of crypto, such as Bitcoin, into US dollars or other crytocurrencies for trading purposes or purchases.
Other exchanges and brokerages emerged, such as Robinhood, which allowed users to use cryptocurrency to buy stocks. Robinhood has been plagued by its own scandals, as well as hit with the fallout from the FTX debacle.
Enter Sam Bankman-Fried and FTX
In 2017, two young entrepreneurs, Sam Bankman-Fried and Tara MacAulay, started Alameda Research, a cryptocurrency trading and arbitrage firm. Alameda was successful in brokering deals between crypto traders, similar to foreign exchange (forex) brokers.
By 2019, Bankman-Fried started FTX (for “Futures Exchange”) as his own foray into the cryptocurrency exchange industry.
Bankman-Fried spent the next several years acquiring cryptocurrencies and expanding his market. Rival exchange Binance initially held a 20% stake in FTX but was later bought out by Bankman-Fried. FTX then acquired Blockfolio, a system for tracking cryptocurrency portfolios.
In 2022, FTX announced it would be making an IPO later that year, declared it was entering the gaming world with the NFT market, and finalized an option to buy digital asset lender BlockFi. As of September 2022, it seemed things were going well for FTX and its CEO.
Cracks in the Crypto
On November 2, 2022, the news site CoinDesk released an article revealing some undisclosed facts about Alameda Research and FTX. It turned out that, contrary to the regulations that would have prohibited such activities in a traditional brokerage, Alameda had been trading on FTX as though it was an ordinary investor. Alameda had been using their position within FTX to gather crypto tokens ahead of FTX’s decision to list them for trading.
The CoinDesk article further showed that more than half of FTX’s assets had been “loaned” to Alameda, a direct violation of FTX’s own policies. The majority of Alameda’s assets, some $5.1 billion, were held in FTT tokens, FTX’s “native token,” not any other fiat currency or cryptocurrency on the market. This immediately raised red flags about the solvency of FTX and the degree of leverage and insider trading going on between FTX and Alameda.
On November 6, less than a week after the CoinDesk article, Binance, the world’s largest crypto exchange and former minority shareholder of FTX, announced it was dumping its entire holding of FTT tokens, a value of about $529 million. Within two days, despite Bankman-Fried’s assurance that FTX was stable, and amidst his frantic search for additional capital to shore up the reserves, additional customers cashed in their tokens, draining more than $6 billion from FTX.
On November 11, 2022, FTX filed for bankruptcy.
Things Get Worse for FTX
On November 8, prior to the bankruptcy filing, rival Binance said it would make a total buyout of FTX and all its non-US holdings. The deal fell through the following day after Binance conducted its due diligence. Binance may have been told what was coming: An asset freeze and indictment from the Bahamas for criminal activity related to banking transactions in the islands. The Bahamian government took control of all FTX assets held there.
The hits kept coming throughout December and January 2023. Bankman-Fried was arrested in the Bahamas and held on securities and bank fraud, extradited to the US, and eventually released on a $250 million dollar bond. He has been charged in the US with eight counts, including securities fraud and money laundering. Class action suits have been filed in California and Florida, alleging the site targeted “unsophisticated investors.”
The bankruptcy court appointed experienced restructuring CEO John J. Ray III to handle FTX’s recovery. Ray, who handled the Enron bankruptcy recovery, stated, “Never in my career have I seen such a complete failure of corporate controls… this situation is unprecedented." Ray has recovered about $5 billion in lost funds for FTX, but doubts investors will ever see most of their money again.
Bankman-Fried apologized, blaming “poor internal labeling” for the lack of liquidity.
The Hack that Wasn’t
On November 12, FTX claimed it was hit by a hacker, further draining its accounts of remaining cryptocurrencies. Up to $477 million was believed to be missing, and all remaining funds were moved to “cold storage” (an isolated server) for safekeeping.
Some believe that this “hack” was not a hack at all. The total amount of money removed was actually closer to $663 million. Blockchain analyst group Elliptic attributes the additional $186 million to FTX staffers attempting to secure some of the compromised funds. Of the $477 million, about half—$220 million—was converted to stablecoin and ether.
Other observers wonder if the "hacker" had been the Bahamian government since the Securities Commission of the Bahamas announced it had seized control of FTX’s Bahamian assets. Bankman-Fried and associate Gary Wang were already in Bahamian custody at the time and could have been instructed to make the transfer.
Other analysts believe that, given FTX’s complete absence of corporate governance, virtually anyone could have inserted malware into the system, and removed the assets at their leisure. It is possible, according to some, that a hacker had been waiting for months or years to drain FTX’s wallets, and just picked the wrong time to do it.
However, despite the numerous theories, there is no way to tell for sure if there was a hacker and who it might have been.
The Dominoes Begin To Fall
The fallout from the FTX collapse has just started to spread. To begin, a number of celebrities were caught in the initial collapse, including Larry David, Tom Brady, Shaquille O’Neal, and Steph Curry, all of whom are facing allegations of participating in the scheme to defraud investors.
As many as 130 other companies were named in the bankruptcy filing, and Rep. Maxine Waters of the House Committee on Financial Services has spoken with Bankman-Fried about the matter. It seems likely that the extent of the damage won’t be known for quite some time. For example, cryptocurrency stock broker Robinhood Markets, itself no stranger to crypto scandals, had Alameda Research as a minority shareholder. Alameda used its Robinhood stocks as collateral during the November 2022 effort to salvage FTX.
Killing the Cryptocurrency Market
“Satoshi Nakamoto” created Bitcoin to be free of regulation because of the lack of trust among competing entities. Now the process has come full circle. Because of the lack of regulation among entities, nobody can trust them. Since nobody was watching Bankman-Fried during his tenure at FTX, he was free to do as he pleased and take all the money he wanted.
It seems likely that the SEC will use this and similar fiascos as justification for developing and increasing regulation on cryptocurrencies. Congress and overseas markets will be more inclined to follow the Bahamas' lead and create laws regarding digital tokens, exchanges, and brokerages.
Investors will be less likely to fund crypto startups, and users will be less likely to entrust their money to crypto platforms like FTX for routine purchases. Cryptolender BlockFi, which had been up for purchase by FTX, has paused client withdrawals. Genesis Global Trading has suspended withdrawals from its crypto lending unit. In all, things are not looking good for cryptocurrency.
End of the Crypto Chain
On January 3, 2023, Sam Bankman-Fried pleaded not guilty to all criminal charges in a federal court in New York. He will face trial on eight charges, including money laundering and securities fraud, on October 2, 2023. There are still Congressional investigations and civil class action suits pending against him.
Today he is wearing an ankle monitor in his parents’ home in Palo Alto. Hopefully, he is not listening to the news, because CoinDesk just reported that on March 1, 2023, FTX’s Engineering Head, Nishad Singh, pleaded guilty to six federal charges and is fully cooperating with the Feds in their case against Bankman-Fried.
Among other things, Singh has confirmed that client funds were funneled directly into Alameda, and Alameda was listed under a false client name with a negative balance to allow Alameda to utilize funds for its own purposes.
Company owners can avoid the scrutiny of regulators and courts by hiding behind the protections of incorporation. This is known in legalese as “the corporate veil.” Getting through the corporate veil can be tricky because protecting the shareholders and officers of the corporation has long been a hallmark of American jurisprudence.
However, one way to “pierce the corporate veil” is to show that the officers or board members were using the company as their personal piggy bank. When Bankman-Fried began using FTX to transfer money into Alameda, he provided investigators with the means they needed to pierce that veil and open all his transactions to their gaze.
The only takeaway from this sorry state of affairs is that investments are risky even when they involve known products and known risks. When they involve the creation of a new type of money without the support of any government or tangible source, then caveat emptor.
For entrepreneurs who find themselves on the leading edge of the charge, the risk is believing your own press. Bankman-Fried was briefly the darling of the cryptocurrency set. He had the support of sports stars and Forbes. Now, however, even his former friends are abandoning him. When you start a new business, your safest course is to play it straight, follow the rules, and do the right thing for your customers and investors. Ultimately, it is less painful than spending a few years in a 6x9-foot cell in Illinois.