Learning From the Downfall of Sam Bankman-Fried
Sam Bankman-Fried (“SBF”), the now former CEO of Alameda Research and FTX, was clearly facing a solvency crisis, not a liquidity one. Yet for the past week many in the industry and media characterized his troubles as a liquidity crisis. If that were actually the case, however, someone would have bailed out SBF.
How do I know this?
Whenever a company’s assets are greater than its liabilities, but it cannot meet immediate customer demands for liquidity, then the company is solvent, but it may take some time to honor what’s owed to customers (e.g., due to outstanding loans to other customers).
Whenever a company’s liabilities are greater than its assets, and it cannot meet immediate customer demands for liquidity, now or in the future, the company is insolvent. Sure, they may have a short term liquidity crunch, but they will also have a long term liquidity crisis as well.
Binance, the largest crypto exchange and the party that pulled back the curtain on FTX’s woes (more on that below), had an opportunity to buy FTX. SBF was trying to sell it to Binance after the FTX troubles were publicized, but its CEO, Changpeng Zhao (“CZ”), said no. That was after conducting due diligence on FTX’s books and records.
Rich companies like Binance don’t just pass on acquiring competitors like FTX just to watch them go bankrupt and send the industry into free fall. It was in Binance’s best interests to make a deal. Provided FTX was solvent, of course.
Other companies and ultra-rich people that SBF said he was talking to don’t simply pass on an opportunity to buy a company only facing a liquidity crisis that could be resolved with inflows of fresh capital.
Warren Buffett made billions bailing out multiple companies facing death. It’s good business. So long as the company’s balance sheet is sound (e.g., more assets than liabilities), the bargain price for a distressed company ultimately pays for itself exponentially.
The fact nobody stepped in, forcing SBF and his companies, Alameda Research and FTX, to file for bankruptcy, makes it clear that what SBF faced was not simply a liquidity crisis. He was insolvent.
Crypto’s Lehman moment
This is crypto’s Lehman moment. And it’s still not over. As of this writing, there appear to have been unauthorized transactions and/or hacks made on FTX. They’ve moved any remaining funds to cold wallets to mitigate the damage.
Hacks aside, there are potentially billions of dollars in customer funds missing. Billions!
As with Lehman’s collapse, the downfall of SBF and his companies are likely only the beginning. FTX’s sudden collapse – in less than a week! – has destabilized an industry still reeling from a market that has lost some $1 trillion since spring. Crypto prices across the board, from Bitcoin to Ethereum, have all nosedived.
It was only a week ago that FTX was valued at $32 billion by some of the most sophisticated investors in Silicon Valley. Now many of them are left with nothing.
Crypto was supposed to prevent these types of economic collapses. It was created in response to the Lehman, Bear Stearns, and traditional finance meltdowns of 2008.
FTX’s bankruptcy in under a week shows that crypto is not immune from its own Lehman moment. It turns out that risk and capital controls, sound lending practices, and good corporate governance are important even in the decentralized crypto world.
FTX has shown us that crypto suffers from similar “traditional finance” risks
It turns out that if investors are uneasy about a crypto exchange’s health, they might want to remove their funds. En masse. It’s basically the equivalent of a bank run, which any financial historian will tell you, instigated the Great Depression.
Like traditional finance, crypto’s stability is built on investor confidence. When investors lose confidence in a large company like FTX, they start to question the entire system, as evidenced by the mass selloff of crypto assets this past week.
Also like traditional finance, risk management and capital controls are important.
Any trader – whether crypto or otherwise – must understand their position, leverage ratio, and liquidity. Any crypto lender, which FTX was in part, must maintain sufficient capital reserves in the event that dreaded bank run actually happens. Or in the event loans sour and customers cannot answer margin calls.
There is nothing magical about crypto that immunizes it from traditional finance risks. For as much as crypto enthusiasts preach decentralization and power to the people, crypto suffers from many of the same problems as Wall Street with powerful intermediaries like Binance and FTX controlling large shares of the market.
Now with FTX’s demise, the market has consolidated even further, just like Wall Street did after Lehman and Bear Stearns collapsed.
Fraud, misappropriating customer funds (which appears to have happened with FTX), and bankruptcy can happen in any market. For most of its existence, crypto has been allowed to flourish and evolve without much oversight or control because the industry argued it was different.
But just as I say that crypto suffers from many traditional finance risks, FTX’s collapse is not a crypto-specific problem. It’s something we’ve witnessed time and again across industries, whether from Elizabeth Holmes or Sam Bankman-Fried.
We need to lose our hero complex with star founders
I’ll preface and disclaim all of this by saying we still don’t know the full story about what happened at FTX and Alameda Research. We still don’t know SBF’s culpability. Although it doesn’t look good.
What we do know is that just a week ago he was a shining star in the crypto industry. He was visiting Capitol Hill in Washington, D.C. FTX was everywhere, from commercials with celebrities to NBA stadiums.
When a founder reaches that level of stardom, it’s easy to think they can do no wrong. What could be bad about a champion of a burgeoning industry who graduated from MIT?
We naturally develop a hero complex with star founders like SBF. It makes everyone from the media to industry insiders less critical of their actions.
For example, nobody should have ever been comfortable with the fact Alameda Research traded on the FTX exchange, all the while being owned and operated by the SAME person, SBF.
That type of structure would be a BIG no-no in traditional finance where futures and equities exchanges have specific rules prohibiting conflicts between exchanges and market participants who trade on them.
And it should be easy to see why. If information barriers are not in place, Alameda could potentially have been privy to other customer orders. There’s also a major incentive for FTX to provide Alameda with better execution than the rest of the market. And if Alameda wanted to trade on margin? Well, FTX could give it VERY favorable terms, including allowing it to collateralize margin loans with FTX’s native coin, FTT.
If an investment bank in traditional finance allowed customers to collateralize debt with the bank’s own stock, it would not only be potentially illegal, the risks would significantly amplify. A bank’s liquidity problems could morph into solvency problems very quickly.
Although we don’t know all the facts still with FTX, it appears that’s exactly what happened.
FTX was able to operate with these inherent conflicts, however, because everyone largely trusted and admired SBF. Many thought crypto was different from traditional finance. Immune. Safe from those Wall Street structural defects.
Until we can effectively separate the actions from the actor, founders from Adam Neumann to Elizabeth Holmes to SBF, will continue to pull the wool over the eyes of investors and the public.
Crypto’s problems are not unique, and therefore it needs appropriate regulation
That doesn’t mean stunting innovation or preventing growth. Even Brian Armstrong, CEO of Coinbase, has noted that U.S. regulators in particular have been too adversarial from the start with crypto. Had regulators operated in conjunction with the industry’s growth in a coordinated manner, these types of cataclysmic events may not have happened. Or they’d be significantly smaller in scale.
Instead, exchanges like FTX were forced to operate largely outside of U.S. regulatory oversight in non-U.S. jurisdictions (like the Bahamas).
It’s time for regulators globally to apply a basic and consistent regulatory framework for the crypto world, similar to what exists in traditional finance. Basic risk management, capital, and oversight controls are imperative. Random users on subreddits and Twitter cannot effectively police the blockchain.
Regulators need clear mandates as to who regulates what. In the U.S. it’s currently a complete mess, with the SEC, CFTC, and local state regulators all vying for jurisdiction and control. As we’ve seen with the internet, you cannot always neatly apply regulations from almost 100 years ago to the new age of doing things. The risks may be similar, but the technology has evolved.
We also need regulatory resources to investigate how FTX and other crypto debacles even start. The origins of the FTX and SBF downfall are shady at best.
CZ clearly wanted to go for FTX’s jugular by announcing it was liquidating its entire FTT position (FTT is the native token for FTX). What CZ knew and why he wanted to do this is unclear. He vaguely stated: “Due to recent revelations that have came to light….”
Now that FTX is bankrupt and SBF has lost everything, we know there was far more to this story when CZ tweeted on November 6th. CZ then refused to sell Binance’s entire FTT holding to Alameda, opting to offload it to the broader market, despite knowing it would create chaos.
These are precisely the type of market safety and soundness issues that traditional finance regulators oversee and question. In crypto, that type of oversight is almost nonexistent even though the market is arguably even more transparent on the blockchain.
Until regulators get serious about oversight and global consistency, these types of cataclysmic crypto events are likely to repeat themselves.
We should be using this as an opportunity to learn from the downfall of Sam Bankman-Fried, not as fodder to lambast and dismiss a burgeoning industry with great potential.
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