This article appears as the "Discussion of the month" topic in AML News and Updates Newsletter - November 2022 edition which can be found here.
The week from 7th to 11th November 2022 ended with the announcement of the bankruptcy of FTX, one of the major crypto exchanges, blowing away the crypto industry globally.
FTX was considered one of the most stable and responsible companies in the regulated crypto industry. Sam Bankman-Fried, the founder and CEO, was one of the most influential and respected leaders in the crypto industry.
However, bad risk management practices, poor governance and other actions led to the downfall of FTX within a few days.
The Collapse of FTX Empire
The downfall of FTX started on 6th November, when the CEO of Binance announced publicly that would liquidate the positions in the token of FTX - the FTT token. This announcement created a crypto "bank run" where investors started withdrawing their crypto holdings from FTX.
Unable to meet the demand, on the 8th of November, Binance CEO Changpeng Zhao announced that has reached a non-binding deal to buy FTX and help cover the "liquidity crunch".
On the 9th of November, Binance backed out of the deal, leaving FTX with no option other than filing for bankruptcy.
According to a CNN article, at least $1 billion of customer funds have disappeared from FTX. According to the same article, Sam Bankman-Fried "secretly transferred $10 billion of customer funds from FTX to Bankman-Fried's trading company Alameda Research". Since then, a large portion of those funds has disappeared.
The liquidity problem was huge. According to investment materials seen by the Financial Times, "FTX exchange held just $900 mn in easily sellable assets against $9 bn of liabilities the day before it collapsed into bankruptcy".
The domino effect of the bankruptcy of FTX is now a reality. Genesis Global Capital has suspended withdrawals and new loans for its customers. Gemini exchange has also paused withdrawals on its interest-earning accounts. BlockFi, an all-in-one cryptocurrency platform offering loans is preparing a potential bankruptcy filing due to its significant exposure to FTX according to The Wall Street Journal.
Flashback to 2008: Similarities with the Collapose of Lehman Brothers
This case reminded me of the 2008 days when Lehman Brothers, a global, well-respected financial services firm collapsed and filed for bankruptcy within only a few days.
Although there were some discussions about selling Lehman Brothers to Bank of America, the sale was never completed because the US regulators refused to provide a federal guarantee or any other form of bailout. Some discussions were also made with Barclays but again, the sale was not completed.
The Lehman Brothers collapse had a domino effect on the financial industry back in 2008 that led to what we call "the global financial crisis". Companies, banks, money market funds and individuals worldwide lost vast amounts of funds due to their investments in Lehman Brothers. Some of these entities were forced to shut down.
Similarities between Lehmans Brothers and FTX
By examining the collapse of the two firms, there are some similarities since both companies:
assumed that the markets will always work to their benefit
there was a public belief that both companies were trustworthy and "too big to fail"
used very bad risk management practices
went from top to bottom within a few days
were to be sold but the sale was not completed
the regulators were not willing to bail out either of them.
their failure had a domino effect on the industry.
Can regulation indeed help?
There were several discussions in the past regarding the need of regulating the crypto industry and the need for investor protection.
The truth is that regulations will not protect customers from losses when investing in high-risk products and products that they do not understand. However, regulations impose requirements on regulated entities to prevent bad practices that could harm or mislead investors when making investment decisions.
In the case of FTX where we have seen the following bad practices:
❌ Bad governance
❌ Inappropriate safeguarding of clients' funds
❌ No disclosures as to the way funds were used
❌ Fraud
❌ Market manipulation
These bad practices could have been prevented if FTX had appropriate procedures in place regarding governance, safeguarding, disclosure arrangements, fraud prevention and market abuse policies.
On the other side, the crypto industry is very different to the traditional financial industry and any regulations must be designed carefully, taking into consideration the specific nature of crypto, and in a way that will not "kill" the market.
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