Crypto Catastrophe: After Exchange Giant FTX’s Collapse, What Comes Next?
February 2023 | Luke Perea (Staff Writer and Editor)
During Super Bowl 56, a commercial aired showing comedian Larry David traveling through time while criticizing inventions that would become successful—such as the wheel and the light bulb. The commercial ended in the present day with David responding, “eh, I don’t think so,” to the suggestion that one cryptocurrency exchange company, Futures Exchange (FTX), was a safe and easy way to get into cryptocurrency. Ironically, David’s prediction proved to be correct. FTX, one of the leading cryptocurrency exchanges, filed for bankruptcy in November 2022, a stunning downfall of what was once a shining star in the industry. A month later, its founder and CEO, Sam Bankman-Fried, was arrested under several fraud charges. Bankman-Fried is currently awaiting trial, and deliberation is underway in bankruptcy court to attempt to recover lost assets. Additionally, government agencies are debating the future of cryptocurrency regulation. The legal outcomes of FTX’s collapse may dictate the livelihood of many impacted customers, as well as the future of financial laws in the U.S.
Cryptocurrencies are a relatively new form of monetary units and their basic tenets are central to understanding why FTX failed. Despite the extensive cryptography used in its mining process, cryptocurrency—or crypto—in its simplest form is a digital currency with the intended purpose of acting as any currency does, representing monetary value and being a medium for transactions. [1] However, most crypto today resembles traditional assets such as stocks and commodities, as their value comes purely from supply and demand. Unlike fiat money—money that is managed by a central national bank—crypto is decentralized. [2] Instead of being managed by a third party, trading and purchasing of crypto are possible through a blockchain, a digital ledger that uses complex cryptography to record transactions. This process is intended to be both secure through its irreversible chaining of encrypted transactions, as well as transparent since all recorded transactions are available to the public. [3] In centralized exchanges such as FTX, individuals can make cash or crypto deposits in order to buy and trade other cryptocurrencies. [4] These exchanges generate revenue through deposit or transaction fees, but store customer funds in their own centralized wallet as opposed to each customer having an individual wallet. FTX’s collapse was a result of the mismanagement and theft of these funds and the manipulation of investors, who were unaware of the internal schemes and monetary crises occurring within the company.
On November 11th, 2022, FTX filed for bankruptcy, as $8 billion in customer funds went missing and FTX was unable to meet customer withdrawal requests. This happened because of the backdoor relationship between FTX and its sister company, Alameda Research. In 2017, Samuel Bankman-Fried, along with several of his acquaintances from college, founded Alameda Research, which operated as a crypto hedge fund and trading company. [5] Bankman-Fried initially used Alameda’s profits to fund FTX, which created its own token called FTT, allowing for discounts on exchange fees. [6] FTT was minted by FTX, meaning its value was intrinsically tied to the value of FTX itself. As FTX grew rapidly, prominent investors put new capital into the company. Behind the scenes, however, Bankman-Fried was using FTX customers’ funds to finance Alameda’s business, which was strictly against FTX’s own terms of service. By allowing an exception in FTX’s coding, Alameda could hold a negative account. With this account, Bankman-Fried could withdraw unlimited user funds from FTX to make risky bets that frequently turned into losses. [7] Additionally, Bankman-Fried and his associates used these withdrawal systems for their own agendas, such as investments into less popular—and as such, more unstable—cryptocurrencies, as well as exchanges, hedge funds, illegal political donations, and personal expenditures such as real estate. [8] In Spring 2022, Bankman-Fried diverted even more customer funds to pay off several loans due to the collapse of several cryptocurrencies, causing a minor crisis in the overall crypto market. [9]
This blatant theft of customer funds would be exposed on November 2nd, 2022, with the publication of a CoinDesk article [10] which showed that approximately half of Alameda’s assets on its balance sheet consisted of FTT tokens—meaning that Alameda largely depended on an illiquid currency that Bankman-Fried himself created. [11] Once this information became public, business rival and fellow exchange Binance liquidated their FTT tokens to create a withdrawal run, resulting in mass withdrawal requests from customers and the tanking of FTT’s price. [12] Due to Alameda having lost $8 billion worth of customer funds, as well as the inability of Alameda’s FTT to cover its losses as collateral, FTX was unable to accommodate withdrawal requests. [13] Ultimately, it was the theft of customer funds that caused FTX—and subsequently Alameda—to file for bankruptcy on November 11th, the same day that Bankman-Fried stepped down as its CEO. [14] On December 12th, because of the aforementioned schemes, Bankman-Fried was arrested by Bahamian officials and extradited to the United States. [15]
The first legal consequence of this debacle will likely come in the form of Sam Bankman-Fried’s trial, as well as the deliberation on how the lost funds will be recovered. Currently, Bankman-Fried is under house arrest at his parents' home, after posting a $250 million bail bond. [16] His arrest and extradition from his home in the Bahamas were followed by a criminal indictment in which the United States charged him with wire fraud, conspiracy to commit wire fraud, commodity fraud, securities fraud, conspiracy to commit money laundering, and defrauding the United States and its election laws. [17] Bankman-Fried pled not guilty to all charges. [18] If convicted of all these charges, Bankman-Fried could potentially face up to 115 years in prison. In addition to the criminal charges, he also faces civil suits from both the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission. [19] However, as of February 13th, 2023, these cases have been put on hold until the conclusion of the criminal trial. The U.S. attorney for the Southern District of New York, Damian Williams, cited in his February 7th appeal, “All the facts at issue in the civil cases are also at issue in the criminal case.” [20] At the time of publication, the criminal trial is scheduled for October 2nd, 2023.
In the short time between the indictment and the time of publication, there have been several complications and interesting turns in the proceedings of the criminal case. On January 27th, the Department of Justice requested District Court Judge Lewis Kaplan ban Bankman-Fried from communicating with former colleagues or employees of FTX, as he was found to have messaged former FTX general counsel Ryne Miller via Signal—an app that allows encrypted messaging. [21] The prosecutors claimed that Bankman-Fried was attempting to sway witnesses who would potentially aid or incriminate him in October’s trial. Additionally, on February 14th, Kaplan ordered a ban on the use of virtual private networks (VPNs), which could allow someone to have their information disguised when using the internet, as a new condition of Bankman-Fried’s bail. [22] While Bankman-Fried and his attorneys asserted that he was using it to watch NFL playoff games, prosecutors alleged that Bankman-Fried may have been using a VPN to help transfer assets from Alameda. The Department of Justice (DOJ) is currently suggesting that Bankman-Fried be banned from accessing the internet and utilizing any devices that can connect to the internet, except in special circumstances. [23]
Despite the overwhelming evidence presented against Bankman-Fried, it is still unclear whether he will be found guilty of some or all of these charges due to the current stage of the case. However, these post-bail actions taken by Bankman-Fried will not only tighten his bail conditions, but also likely will not do him or his defendants any favors when the trial commences. Additionally, some of Bankman Fried’s notable colleagues, including Alameda CEO Caroline Ellison and FTX cofounder Gary Wang, have pleaded guilty to their own charges and are reportedly working with prosecutors to potentially testify against Bankman-Fried. [24] The individuals formerly in control of FTX will have their lives burdened by this trial, although many more lives were ruined by their actions.
The ongoing bankruptcy case of FTX is extremely important to the creditors as well as customers who lost significant amounts of money from the fraudulent exchange. FTX filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court in the state of Delaware. [25] According to a presentation by FTX’s legal counsel, including Sullivan & Cromwell LLP, the debtors have identified around $5.5 billion in assets. [26] These assets include fiat money and crypto located in brokerage accounts, venture investments, and Bahamian property. These expenditures are all being traced in order to recover as much capital as possible. [27] For example, on February 15th, reports circulated about negotiations to recover a $400 million investment made into a Brazilian hedge fund called Modulo. [28] Additionally, politicians who received donations from Bankman-Fried have been contacted about returning some of the donated capital. [29] Presuming all of the identified $5.5 billion worth of assets are recovered, it would only be a portion of the $8 billion in reported liabilities. [30] Moreover, given the early stage of the bankruptcy process, it will be some time before those who lost money can potentially see its return. The next important step will take place on March 8th, when a scheduled omnibus hearing will gather further general information and evidence for this case. [31]
The final implication of FTX’s collapse will be the future of regulatory measures on the entire crypto market. The collapse of a crypto exchange giant the size of FTX has sent shockwaves through the country, with many congresspeople beginning to call for more complex and stricter regulation of the industry. The issue is so urgent that the Republican Chairman of the House Financial Services Committee, Patrick McHenry, is cited as being “very eager to engage” with Democrats on addressing the issue of regulation. [32] While some legislation has gained traction in recent months, including legislation promoting the oversight of stablecoins—which are cryptos tied to the United States dollar—nothing substantial or impactful has yet to pass. [33] In fact, the only “regulations” currently in place at the federal level are those given by different financial administrations, such as the aforementioned Commodities Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC). The pair have cracked down on several crypto exchanges, yet these agencies disagree on what crypto is. The SEC views crypto as a security, such as a stock or bond, and it has taken an aggressive approach to monitor exchanges; meanwhile, the CFTC identifies crypto as a commodity—as in a raw material worth value, such as livestock in the case of agriculture—which is not a security. [34] The federal government has not provided a concrete answer of whether crypto falls under the jurisdiction of either of these administrations, with the US Congressional Research Service stating,
“Currently, there is no comprehensive regulatory framework for cryptocurrencies or other digital assets. Instead, various state and federal financial industry regulators apply existing frameworks and regulations where exchanges or digital assets resemble traditional financial products. As such, regulators may treat digital assets as securities, commodities, or currencies depending on the circumstances.” [35]
A bill titled the “Digital Commodities Consumer Protection Act” was primed to give the CFTC jurisdiction over crypto, but it has fallen out of favor given FTX’s collapse. [36] While this debate continues without a clear resolution, there is confidence that FTX’s collapse will drive lawmakers to have more urgency in passing legislation.
The collapse of FTX has undoubtedly left a sizable mark, not only on the crypto industry but also on the legal environment surrounding it. While Bankman-Fried’s actions have not yet been determined to have malicious intent or the result of poor organizational structure, the consequences of his actions have changed the lives of many people across the globe. When Bankman-Fried’s trial concludes, the bankruptcy case will re-appropriate as many lost assets as it can, and hopefully, the U.S. will pass legislation for a more organized approach to regulating the crypto industry. Ultimately, the crypto landscape in America will be unequivocally changed by these distinctive events.
Sources
Patel, Dee. n.d. “A Beginner’s Guide to Cryptocurrency.” Penn Today. Accessed February 12, 2023.
Ibid.
SoFi’s Crypto Guide For Beginners. Social Finance. 2023.
Ibid.
Goswami, Rohan, and Mackenzie Sigalos. “How Sam Bankman-Fried Swindled $8 Billion in Customer Money, According to Federal Prosecutors.” CNBC. December 18, 2022.
Ibid.
Goldstein, Matthew, Alexandra Stevenson, Maureen Farrell, and David Yaffe-Bellany. “How FTX’s Sister Firm Brought the Crypto Exchange down.” The New York Times, November 18, 2022.
Goswami, Rohan, and Mackenzie Sigalos. “How Sam Bankman-Fried Swindled $8 Billion in Customer Money, According to Federal Prosecutors.” CNBC. December 18, 2022.
Ibid.
Allison, Ian. “Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet.” CoinDesk. November 2, 2022.
Goswami, Rohan, and Mackenzie Sigalos. “How Sam Bankman-Fried Swindled $8 Billion in Customer Money, According to Federal Prosecutors.” CNBC. December 18, 2022.
Goldstein, Matthew, Alexandra Stevenson, Maureen Farrell, and David Yaffe-Bellany. “How FTX’s Sister Firm Brought the Crypto Exchange down.” The New York Times, November 18, 2022.
Goswami, Rohan, and Mackenzie Sigalos. “How Sam Bankman-Fried Swindled $8 Billion in Customer Money, According to Federal Prosecutors.” CNBC. December 18, 2022.
Ibid.
Yaffe-Bellany, David, William K. Rashbaum, and Matthew Goldstein. 2022. “FTX’s Sam Bankman-Fried Is Arrested in the Bahamas.” The New York Times, December 12, 2022.
Helmore, Edward. “Sam Bankman-Fried Pleads Not Guilty in FTX Case.” The Guardian, January 3, 2023.
“United States v. Samuel Bankman-Fried, a/k/a ‘SBF,’ 22 Cr. 673 (LAK).” Justice.gov. January 6, 2023.
Ibid.
Helmore, Edward. “Sam Bankman-Fried Pleads Not Guilty in FTX Case.” The Guardian, January 3, 2023.
Wright, Turner. “US Attorney Requests SEC and CFTC Civil Cases against SBF Wait until after Criminal Trial.” Cointelegraph. February 7, 2023.
Lyons, Ciaran. “US Prosecutors Seek to Ban SBF from Signal after Alleged Witness Contact.” Cointelegraph. January 28, 2023.
Kaplan, Lewis A., Daniel Patrick Moynihan, and The, Silvio J. 2023. “Case 1:22-Cr-00673-LAK
Document 50 Filed 01/27/23.” Courtlistener.com. 2023.
Ibid.
Goldstein, Matthew, and David Yaffe-Bellany. “FTX Inquiry Expands as Prosecutors Reach out to Former Executives.” The New York Times, February 4, 2023.
“Chapter 11 - Bankruptcy Basics.” n.d. United States Courts. Accessed February 19, 2023.
“FTX Trading Ltd. Case No. 22-11068.” n.d. Kroll Restructuring Administration. Accessed February 19, 2023.
Ibid.
Chang, Ellen. “FTX Collapse: Creditors Could See Return of Huge Hedge Fund Investment.” Thestreet.com. February 18, 2023.
Ibid.
Ibid.
“FTX Trading Ltd. Case No. 22-11068.” n.d. Kroll Restructuring Administration. Accessed February 19, 2023.
Hamilton, Jesse. “After FTX: How Congress Is Gearing up to Regulate Crypto.”
CoinDesk. January 23, 2023.
Ibid.
“How Are Cryptocurrencies Regulated in the U.S. and the EU?” Dow Jones Professional. Dow Jones. August 28, 2020.
Zelkowitz, Jeff. “2023 CMC Crypto Playbook: US Crypto Regulation Outlook by APCO.” CoinMarketCap. January, 2023.
Ibid.