How did FTX go bust – and what does it mean for crypto? – Sydney Morning Herald
Even during the flurry of apologising Sam Bankman-Fried was doing as his company FTX – one of the world's largest cryptocurrency exchanges – collapsed, he fired off a dig at a long-time rival. "Well played. You won," he tweeted in reference to his "sparring partner" Changpeng Zhao, head of the world's biggest cryto exchange Binance.
Just weeks earlier, Bankman-Fried was himself the white knight of a crypto world in crisis, the billionaire wunderkind bailing out other firms going under as prices plummeted. He was seen as a safe pair of hands pushing for "common sense" regulation to help legitimise the Wild West of crypto; the kind of boss who slept under his desk at times and stood onstage in boardshorts, alongside the likes of Bill Clinton and Tony Blair; who vowed to make dizzying amounts of money, only so he could give most of it away.
But by December, Bankman-Fried was being arrested in the Bahamas for what US prosecutors allege is one of the greatest financial crimes in history. FTX was dead, owing more than a million people money, including 30,000 Australians. And the fallout was spreading.
Cryptocurrency – the new digital money secured by computers, not banks – was meant to be above the corruption of the big institutions that had caused the devastating global financial crisis of 2008. But here was its "Lehman Brothers moment" already, comparisons coming in thick and fast to the major investment fund whose implosion helped ignite the GFC meltdown.
Bankman-Fried, or SBF as he's called, insists he didn't know the details of what was happening behind the scenes at FTX. Prosecutors argue he was masterminding a massive fraud all along.
So how did FTX go bust? And does it spell the end for crypto? And what do luxury penthouses, a bitter corporate rivalry and a trail of political donations have to do with it?
Credit:Sam Bankman-Fried.
What in the world is a crypto exchange?
In 2008, not long after Wall Street collapsed, a mysterious computer coder known as Satoshi Nakamoto laid out the blueprint for "cryptocurrency". Banks and governments had been ripping off people for decades, Nakamoto argued, because they control the money. But what if there was a digital coin secured by clever code, rather than a central bank, that put the power back in the people's hands? "People had lost their life savings [in the GFC]," says Dr Paul Mazzola at the University of Wollongong, a former international banking executive turned financial researcher. "There was a mistrust of centralised power. Then Bitcoin came along."
Instead of a traditional "trusted third party", to secure and set the value of a currency, Nakamoto devised a public ledger called a blockchain, in which every transaction ever is recorded in precise order. No one controls it – transactions are verified, encrypted and maintained by thousands of computers all over the world. In 2009, Nakamoto created the first cryptocurrency, Bitcoin, using this formula – and then vanished. "Still no one knows who that was," says Mazzola. "But blockchain is a wonderful piece of technology."
The problem is that as the crypto boom took off, and coins such as Bitcoin (and others created using separate blockchains and platforms) shot up in value, Wall Street took note. With money to be made from the "next big thing", the usual forces of power and greed began to warp the early idealism of this "democratised currency", says Mazzola. Soon, the crypto pioneers were following the same playbook as the old financial institutions behind the GFC. Only this time, there was even less regulation.
Nowhere is this more apparent than in the fall of FTX, founded in 2019 by Bankman-Fried and Gary Wang, a former Google software engineer. "It requires a bit of knowledge to set up a digital wallet and trade directly with other holders of [cryptocurrencies]," explains Mazzola. "So along came these exchanges, offering a one-stop shop."
Exchanges have touted themselves as safe and easy places to buy and sell cryptocurrency but many of them, including FTX, are centralised. FTX not only facilitated trades between those holding coins, the way a stock exchange does, it also held people's money like a bank. And what's more, FTX then used that money – customer deposits – to make trades and loans. People could even borrow from FTX to make riskier trades. It was exchange, bank and broker all in one, says Mazzola.
You need identification to set up a customer account on an exchange, converting your dollars into crypto purchases and vice versa. "But that's where the regulation stops," he says. Most people leave their money (in both dollar and crypto form) in those exchange accounts "just like you would leave your money with a bank".
The difference is banks are heavily regulated, he says. So while they also use your deposits for lending (that's where your interest comes from), they must report what they are doing, and the risks, to the regulator (under even stricter rules in the wake of the GFC and other banking scandals). Crucially, banks have to prove they have enough capital to cover a sudden rush of withdrawals (known as a bank run). "Can you imagine if everyone in Australia decided to withdraw cash on the same day? Banks have to deal with that," says Mazzola.
When the equivalent of a bank run came to FTX's door, the veil lifted on how the company was really using customer money. Because most of it was gone.
Before his empire fell, FTX founder and CEO Sam Bankman-Fried was celebrated as the "boy genius" of crypto. Credit:Bloomberg
Let's return to Bankman-Fried in board shorts in the Bahamas. The shaggy-haired 30-year-old was a maths and physics graduate who had done a stint on Wall Street back when he broke into crypto. The son of two Stanford law professors, SBF made a name for himself (and millions of dollars) through a clever trade taking advantage of a higher price for Bitcoin in Japan. He and Wang set up their crypto hedge fund, Alameda Research, in 2017. Two years later, they created the exchange FTX, aimed at newbie crypto investors.
They took out flashy ads featuring celebrity endorsements, including during the Superbowl. They bought naming rights to the Miami Heat stadium and attracted big investors such as BlackRock. They wanted to make crypto mainstream. "And to mum-and-dad investors, they looked legitimate, safe," says Mazzola. SBF himself quickly became a media darling, a new breed of billionaire playing video games during business calls and running his empire from a penthouse with 10 roommates in the Bahamas, all while touting his brand of "effective altruism", making money to give to charity (and to some degree he did, donating mostly to AI research, pandemic prevention and the US Democrats).
In a sea of cowboys, SBF became the responsible face of crypto, with comparisons to the likes of finance titans Warren Buffett and John Pierpont Morgan. He was even lobbying Washington for regulation. That went against the wishes of much of the sector, including Binance's Changpeng Zhao, known as CZ, who argued it would stifle innovation mostly to the benefit of FTX, not competitors. Even those in favour of regulation pointed out that SBF's "suggestions" seemed designed to legitimise rather than police.
SBF backed a proposed US bill to give more control over crypto to the Commodity Futures Trading Commission (CFTC), for example, but at the expense of better-resourced (and toothier) agencies such as the Security Exchange Commission (SEC). And then there was the fact that FTX (and Binance and other crypto exchanges) were headquartered in tax havens outside US jurisdiction.
Still, FTX was booming. In early November, it was valued at about $US30 billion ($45 billion). But, within days, that number (and SBF's personal net worth) plunged to virtually zero.
The penthouse in the Bahamas where Sam Bankman-Fried and his inner circle previously lived.
How did FTX collapse?
Strap in. It's a wild ride. Over 72 hours, the FTX crash wiped out $US150 billion in market value across the world's top 10 cryptocurrencies. It started on November 6 when Binance's CZ announced he was selling off hundreds of millions of dollars worth of the digital coin FTT – that's the cryptocurrency minted by FTX itself. Binance, as a former investor in FTX, still had a large store of the tokens. But a leaked balance sheet published by CoinDesk had just suggested something alarming.
Though Alameda – FTX's sister company and also SBF and Wang's original hedge fund – claimed to have $US14.6 billion dollars in assets, this report said nearly half of that was in FTT. There were already concerns over SBF owning both one of the biggest crypto exchanges facilitating trades and a hedge fund making them on the same platform. Now this suggested that Alameda might not only be artificially raising the price of FTT by holding so much, Mazzola explains, but that it was built on a house of cards, a currency FTX could make itself rather than real assets. And that meant both companies – the exchange and the hedge fund – might be unstable, hollowed out of capital.
When Binance started to offload FTT ("due to recent revelations," CZ said), much of the world followed, sending the price into freefall. FTT lost more than 80 per cent of its value in just 72 hours.
People also rushed to withdraw funds stored with the FTX exchange. More than $US6 billion was taken out in three days. Although FTX had claimed to have enough capital to cover each customer's funds (known as "on a one-to-one basis"), its coffers quickly started to empty. This was a bank run and FTX shut down withdrawals.
Then came a possible lifeline – from Binance itself. SBF asked CZ to bail out his empire, for the industry and customers' sakes. "I don't know how things got so bad between us," he reportedly texted him, according to The New York Times. CZ agreed to buy FTX but, after looking at the books, changed his mind. With the deal dead, SBF resigned as chief executive and FTX filed for bankruptcy. There was an $US8 billion dollar hole in its accounts it couldn't pay back.
And the final twist? A few days later, as US administrators stepped in to carve up what was left of the company, hundreds of millions of dollars mysteriously vanished. But what was first thought to be a computer "hack" turned out to be the Bahamas government ordering SBF and Wang to siphon off funds on the country's behalf. (Those now in charge at FTX have accused SBF of working with the Bahamas liquidators to "undermine" the US bankruptcy case and hide assets overseas.)
Meanwhile, some customers in Australia say they have lost hundreds of thousands of dollars on the platform – life savings wiped out in hours. "They'll be lucky to get any of that back," says Mazzola. "Administrators are still trying to work out where the money's gone." Other crypto firms and exchanges have also been forced to close their doors as the already turbulent market shudders in the wake of the crash, including the Brisbane exchange Digital Surge.
Sam Bankman-Fried escorted by authorities to court in the Bahamas. Credit:AP
What is SBF charged with?
On December 13, SBF was due to testify before US Congress – called in to explain the spectacular crash of his exchange. But the night before, as he put the finishing touches on his speech (which began with "I f—ed up", according to a leaked draft), he was arrested by local Bahamas police.
It was at the request of US authorities, who had been circling ever since FTX crashed. They allege that far from getting in over his head and taking his eye off the ball, as SBF's public apologies suggest, the 30-year-old ran FTX like a "personal fiefdom" from the beginning, diverting billions of dollars of customer funds to luxury real estate for FTX executives and risky bets through Alameda.
Millions of dollars also went into US political donations on both sides of the aisle, including to individual politicians investigating FTX and other exchanges. While SBF was a large Democrat donor, he admitted in November that he also donated about the same amount secretly to the Republicans as he lobbied in Washington – through "dark", undisclosed money. FTX administrators are now trying to claw back payments made to politicians and celebrities.
And SBF has been hit with charges from three US agencies, including criminal counts of fraud, money laundering and conspiracy, and civil charges of fraud by the SEC and CFTC.
As he was extradited from the Bahamas to the US, where he could face years in prison, prosecutors had an announcement: two of his former colleagues were co-operating with authorities and had now pleaded guilty to charges "related to their roles in the fraud that contributed to FTX's collapse". They were Caroline Ellison, the former CEO of Alameda Research, and his FTX co-founder Gary Wang. In agreements signed with prosecutors on December 19, Ellison and Wang agreed to plead guilty to charges including wire fraud, securities fraud and commodities fraud in return for leniency at sentencing if they co-operate fully.
SEC chair Gary Gensler says SBF built "a house of cards on a foundation of deception, while telling investors that it was one of the safest buildings in crypto". The Justice Department has called the FTX scandal "one of the biggest financial frauds in American history".
Meanwhile, instead of SBF, it was John Ray III, the chief executive now handling FTX's restructuring, who ended up testifying before that US hearing into the company's crash. Ray has overseen some of the world's biggest bankruptcies, including at the disgraced energy firm Enron, but said his investigation at FTX had so far revealed a company in even worse shape, with "a complete absence of trustworthy financial information". He had "never seen such an utter lack of record keeping". There was no independent board overseeing things. There were "absolutely no internal controls whatsoever". Where Enron's criminals were "highly sophisticated", Ray said FTX looked like "old-fashioned embezzlement".
SBF has been far from silent, though, speaking out repeatedly since the fall of FTX. While he has apologised for mistakes and vowed to make it right for customers, he insists he did not knowingly defraud anyone. He says he was "hands-off" at his fund Alameda and has denied any knowledge of FTX funds being used to pay off Alameda's debts after it lost capital on risky investments. But regulators say he still owned 90 per cent of the fund and "remained [its] ultimate decision-maker".
According to the SEC and CFTC, SBF and his executives used Alameda as a "personal piggy bank," dipping in for luxury houses, private jets and personal loans or investments. Alameda, in turn, had a virtually unlimited "line of credit" funded by FTX customers. What's more, SBF knowingly tried to conceal this, the SEC alleges, by setting up bank accounts controlled by an undisclosed Alameda subsidiary named North Dimension to move the money from FTX. It all came unstuck, authorities say, when the 2022 "crypto winter" downturn saw Alameda's debts come due. And the hole of missing money became harder to hide.
The collapse of FTX has rattled the crypto industry. Credit:Bloomberg
So, is the end nigh for crypto?
Not quite. FTX is not the first crypto exchange to collapse and far from the sector's first scandal. The multi-billion dollar scam OneCoin, for example, sucked in thousands of investors worldwide before it was revealed there was no cryptocurrency behind it at all. (Its founder, the glamorous Oxford graduate Dr Ruja Ignatova, had taken the money and vanished.)
But the collapse of a major player such as FTX has shaken confidence in a volatile market already in trouble, as high interest rates and other cost-of-living pressures bite. In May, the price of so-called "stable coins" terra and LUNA fell, in a $US40 billion dollar crash. Other firms that have gone bankrupt in 2022, such as the lender Voyager, have already attracted lawsuits from customers unable to reclaim funds.
In the weeks since FTX went under, its great rival Binance has also faced heavy customer withdrawals (and is still under investigation itself as part of a wider US probe into anti-money laundering compliance in the crypto world). CZ has denounced SBF and "dared" his own customers to withdraw, promising Binance could cover every account one-to-one. It's brought in auditors to look at its books (as did some other exchanges) but, although the accounting firm Mazars produced a limited "proof of reserves report" for Binance, the document soon disappeared online and the accounting firm has stopped its work for crypto exchanges. (Some Australian crypto firms, meanwhile, have also vowed to keep customer balances in 100 per cent full reserve, and to offer ongoing proof.)
While Mazzola says CZ's dare has quieted investor jitters somewhat, crypto is far from stable. (CZ is now positioning himself as the new saviour for the sector, setting up a fund to bail out firms as SBF once did as well as a new US political lobbying arm.)
Still, so far "contagion" has been quarantined to the crypto world. As digital currency integrates more into the regular financial system, Mazzola says, the risk of spillover from its wild market swings goes up. "But once it's properly in, crypto will stablise."
As the two markets come closer together, many experts say the FTX scandal proves the case for regulation. Centralised exchanges, for example, often escape licensing requirements that bind traditional platforms such as the ASX because they don't meet out-of-date definitions, says Mazzola. Others think it's a sign that customers should stick to decentralised platforms, where trades are made directly and assets held in personal digital wallets, even if it means schooling up on the wild trade winds of crypto. As researcher Daniel Schlagwein points out, cryptocurrency was created to cut out the powerful middleman (banks), but some exchanges have taken on the same role. And "if we trust the middlemen, then we do not need crypto to begin with," he says.
Australia is now considering its own crypto regulation. But just the threat of a crackdown has already been partially blamed for killing off a $1.5 billion merger between major Australian crypto exchange Swyftx and the online shares platform Superhero. In August, the corporate regulator, which has previously been hands-off on crypto, warned traditional online share trading platforms against incorporating cryptocurrency.
"The danger now [in all jurisdictions] is to go for soft quasi-regulation, just to legitimise," says Mazzola. The same lessons from banking scandals need to be learned with cryptocurrencies. Reporting and governance requirements and conflict of interest rules should all be priorities, he says.
But he adds that regulation must be brought in carefully too, without swamping the market. "You really don't want to stifle innovation."
And, while Bankman-Fried may have ushered in a criminal crackdown on the industry he sought to legitimise, Mazzola thinks the future of money is still written in code. "Crypto won't go away because so many people want a global currency" – one open to all, as Nakamoto intended.
This explainer has been updated since it was first published on December 22 to reflect Bankman-Fried's extradition and Ellison and Wang's guilty pleas.
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