Guest Post: The collapse of FTX and the mechanisms of (dis)control
Would MiCA had been able to avoid it?
As I work towards truly reentering society after taking time off to be with my family following the arrival of my second son on February 28 (baby pictures available upon request), I have struggled to get my content creation to fit into the working day. Fortunately for me (and for you, dear reader), I have the good fortune of working with some brilliant people, who themselves work with equally brilliant people.
So, without further ado, I give you my colleague Ana Carolina Oliveira (PhD) and her colleague Luz Parrondo, PhD:
The collapse of FTX and the mechanisms of (dis)control. Would MiCA had been able to avoid it?
By: Ana Carolina Carlos de Oliveira and Luz Parrondo. University Pompeu Fabra, Spain.
Originally published at: Gestion Financiera, January 2023.
Last November 11, the FTX Crypto-Exchange filed for bankruptcy after its utility token (FTT) plummeted to almost zero. This fall has been considered the first major scandal of digital bonds, placing it on par with the famous Enron case. The Enron case led to a major change in accounting regulation, with the Sarbanes & Oxley Act being proposed as the main mechanism to prevent future fraudulent cases of such magnitude. Perhaps based on the FTX case, we can accelerate the regulation of the new digital market.
At their core, both situations (FTX and Enron) are similar regarding the complete failure of corporate controls and due diligence mechanisms of external auditors. As well as in their protagonists’ profit motives and risky or reckless decisions. But unlike Enron, which highlighted the failures in a regulated system, FTX is in a market that is still immature and lacking in regulation. This certainly increases the possibility of profits, but it also magnifies the associated risks and the magnitude of the damage done to investors and the ecosystem in general. On the other hand, since this is a high-risk scenario, recognized and alerted by regulatory bodies, one could also question the decisional autonomy of investors when choosing to invest their capital in this kind of business. They could a expect a lower degree of capital’s protection from supervisory and regulatory bodies [1].
Following this case, the question of the limits and legitimacy of issuing utility tokens for the evaluation of the financial wealth of the issuers companies arises. Considering the progress of the MiCAR[2] negotiations, it is worth questioning whether such a rule, if it were in force, could have prevented the financial damage of the dimensions observed with FTX. This case, in addition to serving as a lesson and warning for future “irregular” projects, highlights the pressing need to regulate the crypto-assets market and the new digital finances.
Before going into regulation, let's analyze the causes of this collapse and see what the control errors were.
FTX case
FTX is a crypto-Exchange founded in 2019 by MIT graduates Sam Bankman-Fried (SBF) and Gary Wang, who became the second largest Crypto-Exchange in the world, with a daily trading volume of up to $15 billion. On this platform, retail and institutional traders could buy and sell cryptocurrencies, futures, options, leveraged tokens, fiat currency, or non-fungible tokens (NFT). In other words, operations in the crypto ecosystem were similar to those of a traditional banking institution.
SBF decided to create such a “crypto bank” two years after founding a hedge fund called Alameda Research. Alameda has specialized in highly profitable crypto-arbitrage operations, offering its clients returns of over 10%. It accumulated high degrees of liquidity that allowed it to invest in FTX and in other investments in the crypto sphere. It is important to note that the headquarters of both companies, FTX and Alamenda Research, are “strategically” located in the Bahamas. The key to FTX's successful strategy was to offer low fees and implement aggressive marketing strategies by offering discounts to customers who stored in the FTT utility token.
These tokens were mostly used to build loyalty among FTX customers by offering discounts on trading fees and referral rewards. To understand the reasons that led to the downfall of FTX, we must first analyze the nature and risks of utility tokens, in this case the native FTT token.
Utility-token FTT
Most blockchain-native companies and projects have their own native token. This token is the mechanism through which advance collections from future customers of the project are channeled, as well as discount vouchers or other commercial relationships between the company and its users. These tokens do not represent a financial instrument but are closer to discount coupons or casino chips, to look for two traditional analogies.
The company issues an arbitrary amount of these tokens to sell to its customers, with which it acquires a future obligation (recorded in its liabilities) to be redeemed by delivering a good or a service or by repurchasing them in exchange for fiat money. Currently, no regulation limits the issuance of such utility tokens, nor is there any regulation that determines how they are to be treated for accounting purposes. Each company is responsible for deciding how many tokens it issues and how many it makes available to the market. In the near future, the MiCA regulatory framework will delimit the legal framework for these issuances, as we explain below.
In practice, crypto companies generate their utility tokens in the same way that casinos create their plastic tokens or restaurants their discount vouchers. That is, at cost - if we do not include the costs of advertising and launching the ICO - close to zero. But unlike casinos and restaurants, these companies use their own “tokens” to pay their suppliers and their employees or even to carry out investments or guarantee loans. This happens because the counterparty recognizes the token as a “bill of exchange payable” by the issuing company and accepts it as a medium of exchange.
In the case of a well-designed project token-economy, i.e. a correct issuance, allocation, exchange, and burning of tokens, the sale of the utility token allows the viability of incipient projects by giving them access to direct and cheaper financing in their user base. Conversely, the absence of proper design of this token economy, with or without malicious intent, can wreak real havoc.
On November 2, 2022, Coindesk reported from a leaked document that Alameda Research had an abnormally high amount of FTT tokens on its balance sheet. In practice, FTX and Alameda were acting as a single company, i.e. for consolidation purposes, the company has on its balance sheet two-thirds of an asset that it itself generated at no cost and valued at market price. A price determined in the market with only one-third of the existing tokens. Let us understand that if all the tokens issued were put into circulation, the break-even price would be much lower.
Following this report, Binance, the world’s highest-volume crypto-asset exchange platform, announced that it was divesting all of its units of FTTs. This sparked panic among token holders, and the value of FTT began to plummet[3] . In a desperate attempt to keep the value of its balance sheet afloat, FTX used (allegedly) assets held in custody of its customers to defend the price of FTT. This attempt proved unsuccessful as following Binance’s refusal to bail out the Crypto-Exchange, the value of FTT continued to free fall, leading Alameda, and consequently FTX, into technical insolvency.
First warning signs (ignored by the market and investors)
According to the information so far shared by the press, losses of more than one billion dollars[4] in client funds are estimated for clients who had their securities improperly transferred from FTX to Alameda Research. From the main features of FTX's and Alameda's operations disclosed, some of the characteristics of the business that indicate the potential for fraud on clients and investors, which has also been overlooked by the auditing firms, become apparent.
The signs were many, and all ignored by investors. First of all, the lack of experience of the director of Alameda Research in managing funds of the magnitude of those she operated[5]. Other than the principal, no other member of the team had, on the face of it, the necessary experience to manage the high-risk transactions being conducted at Alameda, which could characterize a pattern of reckless management of the firm’s assets and its clients or investors. According to Coindesk, current and former FTX employees, there were many conflicts of interest between FTX and Alameda with management marked by nepotism and lack of oversight.
Risky capital management was manifest in the behavior of the FTX director, with offensively unserious approaches to clients. For example, there are reports that in one of the cases, SBF was playing League of Legends during the negotiation of a $210 million deal. Interestingly, the investor took that as an act of genius and invested that amount.
Existing irregularities
Although they were separate companies, FTX (the Exchange) allegedly diverted customer assets as loans to Alameda (the trading company), which in turn covered those loans with tokens that FTX minted at will. Moreover, such unlimited issuance was not based on any real value reservation, nor was there any control over the minimum liquidity or solvency required to guarantee such token issuances.
In short, FTX was issuing its FTT utility tokens on an unlimited basis, the value of which was kept high based on market confidence in the companies, which began to erode after the aforementioned Coinbase news (a leak that showed accounting documents from Alameda Research and FTX questioning the solvency of both [6]). Most of the assets were supported by the proprietary token, whose potential devaluation would place Alameda at risk of insolvency.
The questions that remain open are the following:
Does MiCA set limits or conditions on the amount of tokens issued and held?
How should Alameda have accounted for the tokens on its balance sheet?
Control mechanisms
Control mechanisms at issuance
According to MiCAR (recital 44 and arts. 4 ff.), the requirements for issuing cryptoassets on the market are quite simple: a White Paper (WP) with information on the issued cryptoasset and on its admission to a trading platform is required (art. 8) [7] . This WP must be shared with the authorities (at least 20 days before its publication) and subsequently made public, at the latest on the ICO’s start date. MiCA also defines (recital 24 and art. 14) the existence of civil liability of cryptoasset issuers on the information contained in such WP.
It is important to underline that MiCA requires the crypto-asset issuer to “notify” (art. 4) the national supervisory bodies about the WP of its token but does not mention the need for approval or review by them. Interestingly, MiCA provisions (recital 36, for example) only require reserve funds, or capital requirements, in the case of stablecoin issuance projects. The capital requirements are to be calculated as a percentage of the reserve assets backing the value of these tokens. These observations do not extend to crypto-asset issuers or cryptocurrency trading service providers, so the way the FTT token is issued and managed would not have been more secure for investors in the event that MiCA was already in place.
Of all that has been raised so far, perhaps the only element of MiCA that would have been relevant to the FTT-holding public is the requirement to take out insurance policies to guarantee a portion of the clients' capital (art. 60) [8] . This is a requirement that should have been applied by Alameda Research, as a cryptocurrency trading company, under the MiCA regulation.
In this regard, the prudential requirements mandated by the MiCA may have provided some indication of the irregularity of capital management by Alameda Research. In addition to taking out insurance, crypto-asset service providers will have the duty to adopt prudential safeguards; and to assign custodians that meet the diligent administrator criteria[9] (i.e., have sufficient training to manage cryptocurrency exchange services: “skills, knowledge and experience necessary for the performance of the responsibilities assigned to them”, art. 61).
The prudential safeguards provided by MiCA consist of the higher amount between:
the minimum ongoing minimum capital requirements of up to €150 thousand, depending on the nature of the crypto asset services provided;
or one-quarter of the fixed overheads of the previous year, reviewed annually (art. 60).
Accounting
The MiCA regulation is silent regarding the accounting treatment of cryptocurrencies. One of the main factors in the bankruptcy of Alameda Research is the artificial value of its balance sheet, as a large part of its capital consisted of FTT tokens, issued by FTX and traded by Alameda, which were accounted for as a financial asset and valued at market price, without having been effectively exchanged for legal tender or settled on a real project. Thus, the accounting adopted between the FTX companies and Alameda (loans and guarantees based on the issuance of FTX’s own tokens) was artificially inflated based on the market prices at which the FTTs were traded on the trading platforms.
In previous publications we have analyzed the accounting nature of utility tokens. These tokens refer to rights of access to goods and/or services of the issuer, and in no case can they be considered financial instruments; they are intangible assets. The debate that arises from this point is whether these intangible assets should be valued at fair value or at acquisition cost
A conservative approach to the debate would be for Alameda to value the FTTs at cost, especially as it is an associated company. On the other hand, this generalized approach makes it impossible for companies holding utility tokens from other projects to give a true and fair view of the value of their assets.
Conclusion
After this collapse, investors will likely demand greater transparency from crypto platforms, and regulators will eventually accelerate the process of creating a legal framework to protect us from these practices.
The debate on the need for regulation in the crypto universe seems increasingly obvious. It is clear that in the face of the proliferation of centralized and arbitrary crypto models of governance we need regulation in the style of the traditional market. The hope that blockchain is inspired by enabling decentralized models and, therefore less exposed to manipulation and malicious activities seems to have less and less space because of irresponsible actions such as those of Sam Bankman-Fried and all those who, out of greed, have trusted him.
[1] Por ejemplo, en 9 de febrero de 2021 la CNMV y el Banco de España ya habían publicado un comunicado conjunto en el que alertaban sobre los riesgos del mercado cripto por su complejidad, volatilidad y la potencial falta de liquidez. Posteriormente, la CNMV ha editado la Circular Circular 1/22 de 10 de enero, que indicaba los requisitos para la publicidad sobre criptoactivos presentados como objeto de inversión.
[2] Proposal for Regulation of the European Parliamient and of the Council on Markets in Crypto-assets, and amending Directive (EU) 2019/1937, conocido como Markets in in Crypto-assets Regulation - MiCA/MiCAR. Disponible en: https://eur-lex.europa.eu/legal-content/ES/TXT/?uri=CELEX:52020PC0593.
[3]https://hub.elliptic.co/analysis/477-million-in-unauthorized-transfers-from-ftx/?utm_campaign=Elliptic%20Essentials%20%7C%20Crypto%20Regulatory%20Affairs&utm_medium=email&_hsmi=234934093&_hsenc=p2ANqtz-83paToad5CL4O9pk0ZdCevPrT37l2uVyQJHrJ7i8FPlhbzv6TXcHdE6zvWgv3YqdPCMGKRGMxwP1lzGMqRJGF7W2VVdw&utm_content=234934093&utm_source=hs_email
[4]Losses of customer funds are estimated between one and two trillion dollars identified by the end of November 2022. See: https://www.reuters.com/markets/currencies/exclusive-least-1-billion-client-funds-missing-failed-crypto-firm-ftx-sources-2022-11-12/
[5] Alameda Research CEO Caroline Ellison, a 2016 Stanford graduate, prior to being appointed CEO, has only 19 months of experience at Jane Street, a “quantitative trading” company.
[6] https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/?outputType=amp
[7] The white paper does not need to be published if the offering targets only qualified investors or fewer than 150 investors per Member State; does not exceed €1 million ($1.17 million) in 12 months; offers free cryptoassets, i.e. “airdrops”; issues mining rewards; or issues cryptoassets already previously available in the EU (excluding stablecoins).
[8] The characteristics of the insurance shall be as follows: The insurance policy referred to in paragraph 2(b) shall include coverage against the risk of: a) loss of documents; b) false or misleading statements; c) acts, errors or omissions involving a breach of: i) legal and regulatory obligations; ii) the duty to act honestly, impartially and professionally towards clients; iii) confidentiality obligations; d) failure to establish, implement and maintain adequate procedures to prevent conflicts of interest; e) losses arising from business interruptions or system failures; f) where applicable to the business model, gross negligence in the protection of crypto-assets and client funds.
[9] They should be managers of good reputation, proven experience and expertise of the members of the management of the cryptocurrency service provider, including the absence of convictions for financial crimes and money laundering.