The Demise of FTX and Sam Bankman-Fried

Topic: Investments

Tom Wilson CFA, MFin

January 31, 2023

Image used with permission: iStock/bodym


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The Demise of FTX and Sam Bankman-Fried

At the beginning of November 2022, Sam Bankman-Fried was crypto-currency’s “White Knight”. The flip-flop and t-shirt-wearing 30-year-old was the founder of one of the largest crypto exchanges, FTX, valued at $32 billion at its peak.

FTX had become a household name, attracting celebrity endorsements from the likes of superstar quarterback Tom Brady, as well as high-profile naming rights to the Miami Heat’s NBA stadium.(1) Bankman-Fried was a billionaire and FTX, it seemed, could do no wrong. However, by the end of 2022, FTX had collapsed into bankruptcy, Bankman-Fried extradited to the U.S. to face criminal prosecution, and FTX’s clients’ and investors’ interests virtually wiped out. However, before we get into the demise of Sam Bankman-Fried and FTX, we’d like to outline what investors can learn from this catastrophe, and how, at Nexus, we put our clients’ wellbeing above all else.

What Can We Draw From This Debacle?

  • FTX withdrew and spent billions of dollars from client accounts without consent. There was no effort to keep client assets separate and protected. At Nexus, all client funds and investments are held by RBC Investor Services Trust, a federally-regulated custodian that is independent of our firm. Nexus’s authority is limited to directing the purchase and sale of the investments held in client accounts. We have no authority to withdraw any money or investments from client accounts and/or give such funds to anyone other than the account holder.
  • Whatever legal duties FTX and its management had to clients were not only ignored but breached. There were many undisclosed conflicts of interests between FTX and its affiliated entities. FTX executives personally benefited from unauthorized client transactions. And the firm failed to disclose to investors that their capital could be withdrawn and/or borrowed from their accounts without their consent. By contrast, as a discretionary asset manager and fiduciary, Nexus has a responsibility and obligation to act solely in our clients’ best interests and to place their needs ahead of our own. We understand that clients place the utmost trust and confidence in us and it’s a duty we do not take lightly.
  • FTX investors were investing in digital tokens that are essentially “made-up” instruments with value that is highly speculative and underpinned by little more than investor belief that the tokens might be worth something. At Nexus, we seek to protect and grow the real value of client capital over time by investing in well-run companies with strong profitability, visible cash flows, and solid balance sheets comprised of definable assets. Instruments without such “intrinsic value”, whose price is solely dependent on what the next buyer will pay, simply don’t qualify as “investable”.
  • Finally, it’s clear that the whole crypto “ecosystem” is riven with the same type of extraordinary leverage that made the Great Financial Crisis of 2008/2009 so bad. Leverage increases an investor’s upside potential, to be sure. But more ominously, it magnifies risk, increasing the extent of losses and limiting participants’ ability to “ride them out”.

What Happened?

So how did this crypto prodigy, who had amassed a fortune of over $25 billion, manage the twin miseries of leading the largest and most-trusted crypto platform into bankruptcy and being accused of orchestrating one of the largest cases of financial fraud in history?

Who is SBF and what was FTX?

Sam Bankman-Fried, otherwise known as “SBF”, was born in California to parents who are professors at Stanford Law School. He studied math and physics at MIT prior to a brief stint on Wall Street. In 2017, he founded his own crypto hedge fund named Alameda Research, and subsequently founded FTX in 2019.

FTX became one of the largest crypto exchanges in the world, where investors could buy and sell cryptocurrencies like Bitcoin, Ethereum, and Dogecoin. The exchange was advertised as a safe and easy way to invest in crypto, and soon gained international recognition through a series of large, aggressive acquisitions and splashy celebrity endorsements.

The Collapse

The cracks started to appear with the broader decline of the crypto industry last fall. The price of Bitcoin dropped drastically from its peak of $64,000 in 2021 to $16,000, forcing other major crypto platforms to shut down. FTX seemed immune, and even bought up some of its struggling competitors.(2)

However, on November 2nd, things changed abruptly. Questions about the financial stability of FTX started to emerge after a crypto news site, CoinDesk, suggested that most of the assets held by SBF’s crypto hedge fund, Alameda Research, were made up of a digital token created by FTX called FTT. A fall in the token’s value could cause real problems for both Alameda and FTX.

Soon after the report, FTX’s main competitor, crypto exchange Binance, announced that it would be selling all its holdings in FTT, FTX’s internally created crypto currency, causing its value to fall over 80% in the span of 72 hours. As the price of FTT plummeted, many FTX customers rushed to withdraw their assets from the exchange. On November 8th, FTX froze all customer withdrawals from the platform. After one last failed opportunity to be acquired by Binance, FTX filed for bankruptcy on November 11th.(3)

What was not made public at the time was the extent of the connections between Alameda Research (SBF’s hedge fund) and FTX. The Wall Street Journal reported that, according to a Securities and Exchange Commission lawsuit, SBF and certain FTX executives had transferred over $8 billion in FTX customer deposits to Alameda. It then came to light that the transferred funds were used for questionable business practices, including funding venture capital investments, buying real estate, and propping up losses on existing investments. Furthermore, it was also reported that FTX went on a $5 billion spending spree in late 2021, and that $1 billion in loans and other payments were made to company insiders.(4) Some of this spending and lending included lavish real estate for friends and family, Super Bowl commercials, private jets, and political contributions. John Ray, the CEO brought on to oversee FTX’s bankruptcy restructuring, said his initial investigation showed “gross mismanagement, excessive leverage” and “failures of internal controls”.(5)

The Consequences

FTX’s implosion has been nothing short of a spectacle and vividly highlights that crypto investing is still very much the “Wild West”. Many view the collapse as a failure of regulatory oversight in an industry that operates outside of traditional banking rules. The crisis has sent shockwaves throughout the crypto world, with the price of major crypto currencies plummeting. However, the broader implications and consequences of the FTX collapse for crypto will take time to play out. Financial regulators across the globe may see the collapse of FTX as justification for tightening regulatory scrutiny of cryptocurrencies, and politicians will likely step in and create new laws governing digital exchanges.

The most devastating impact of FTX’s bankruptcy, however, lies with investors. FTX had an estimated 1.2 million users, many of whom were retail investors. The stories of investing losses have trickled out in the press and stand as testament to the very real risks of speculative crypto investing. One high-flying tech entrepreneur lost almost $2 million on the collapse of FTX.(6) A Pakistani actor living in California lost the $20,000 savings he planned to use to pay his lawyer to work on his citizenship application. A 43-year old father of two stands to lose almost all of his life savings after investing $600,000 in BlockFi, a now-bankrupt cryptocurrency trading firm that had close ties to FTX.(7) Closer to home, Ontario Teachers Pension Plan recently wrote down its US$95 million investment in FTX.(8)

Unfortunately, it seems unlikely that investors will be able to recover any of their losses.

So, what will happen to SBF? After being arrested in the Bahamas, he’s been extradited to the U.S. and is facing eight criminal charges, including conspiracy to commit wire fraud and money laundering. He has pled not guilty to all charges. Time will tell regarding SBF’s future and the regulation of the crypto market more generally, but the tale of FTX is sure to have ripple effects throughout the market for years to come. In the meantime, Nexus clients can continue to rely on our disciplined and principled approach to investing.

(1) In 2021, FTX paid $135 million for the naming rights to the Miami-Dade Arena, which was previously named American Airlines Arena from 1999 to mid-2021.

(2)The FTX collapse, explained,” NBC News, NBC, November 18, 2022.

(3)The fall of the FTX ‘King of Crypto’ Sam Bankman-Fried,” BBC, December 13, 2022.

(4)FTX’s implosion and SBF’s arrest, explained,” Vox, December 13, 2022.

(5)What to know about Sam Bankman-Fried and the FTX crypto exchange collapse,” The Washington Post, December 14, 2022.

(6)‘Call him Sam Bankman Fraud’: FTX investors who lost up to $2M lash out,” The New York Post, December 6, 2022.

(7)Ordinary Investors Who Jumped Into Crypto Are Saying: Now What?” The New York Times, December 5, 2022.

(8)Ontario Teachers writes off FTX stake, taking $95-million loss,” The Financial Post, November 18, 2022.

 

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