Regulatory clarity, on-chain transparency, and better accounting can help prevent the next crypto crisis
Many questions remain unanswered, and facts are still emerging, but the recent downfall of FTX will likely go down in history as Crypto’s Great Financial Crisis. While the industry continues to reel from the unfolding event, the overwhelming need to prevent future crises has become top-of-mind for regulators and investors alike. Regulatory clarity, on-chain transparency, and better accounting can provide a path forward.
On Friday, November 11, 2022, Sam Bankman-Fried – the previous CEO of the firm – filed for the bankruptcies of FTX, FTX US, and 134 other affiliated companies, including his investment company, Alameda Research. FTX had grown to become the second largest crypto exchange in the world – valued at $32 billion – and had raised nearly $2 billion from blue-chip investors including Sequoia Capital, Blackrock, Ribbit Capital, Insight Partners, Tiger Global, and more.
FTX investments throughout the digital-asset ecosystem were vast, and the complexity of its structure was highly convoluted. Most ominously, FTX had attracted consumer funds of approximately $16 billion to its platform. The magnitude of the role that FTX played in the crypto markets makes its downfall equally surprising and impactful. In a handful of days, FTX went from one of the kingpins in the market to becoming completely insolvent, resulting in billions of dollars worth of lost value for consumers and investors alike.
The quick demise of FTX at first appeared to mirror a classic bank run. As facts unfolded, however, it quickly became apparent that much more was going on, most notably indications of blatant fraud. On November 2, CoinDesk reported a leak of FTX financial statements, which raised serious doubts about the stability of FTX. Specifically, CoinDesk reported that the leaked statements showed that the quantity and quality of the assets on FTX’s books were not aligned with its liabilities, leaving FTX exposed to substantial risk, most notably because of an overreliance on its own crypto token, FTT.
As word of this exposure spread throughout the crypto market, investors began dumping the FTT token, collapsing its value, and ultimately exposing a hole in FTX’s balance sheet leading to its insolvency. While it is true that FTX experienced a market-driven run, it is also becoming increasingly clear that a much larger problem existed at FTX, including the misappropriation of customer assets and apparently fraudulent business practices.
The following sections outline several key areas that appear to have enabled FTX to perpetuate this fraud-like activity for as long as it did:
Alameda Research was the crypto trading company founded by SBF prior to FTX. The two companies were joined at the hip and each played a critical – and apparently fraudulent – role in the success of the other. While all the facts are still being pieced together, it is increasingly clear that the two companies were operating in sync in order to leverage the assets of the other.
For example, FTX could freely create its own token (FTT) in whatever quantity it wanted. Those tokens could then be transferred to Alameda, and Alameda – posing as a separate, independent entity owning the assets outright – could use them as collateral to borrow against, thereby leveraging the assets that FTX created. Alameda could then transfer the borrowed assets back to FTX to use however it wanted.
This created a flywheel effect where FTX could create and monetize FTT without diluting its market value. Essentially FTX created the appearance of Alameda’s financial strength by manufacturing digital assets for it, thus giving it the appearance of an entity worth investing in. This also created extreme exposure to FTT pricing for Alameda, such that as the price of FTT declined, Alameda became insolvent almost instantaneously.
As FTX took on customer deposits, those funds were misappropriated contrary to what was outlined in FTX’s terms and conditions. The terms of service clearly stated, “You control the Digital Assets held in your Account,” “Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX Trading,” and “None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading.”
SBF appears to have blatantly violated these terms of service, transferring customer assets to Alameda and likely creating the same flywheel effect described above. Customer assets may have also been used in other ways to fund risky investments as well as Alameda’s own trading operations.
One of the ways FTX (and indirectly Alameda) made it look like they had more assets than they actually did was via the creation of FTT and other incubated tokens. In short, FTX created its own token and then grossed up its balance sheet to the value of the tokens it created but had not circulated.
As a simple illustration, if a company creates one million of its own tokens and sells 100,000 of them in the market, the company should not recognize an asset on its balance sheet equal to the price of the tokens in circulation multiplied by the 900,000 still-uncirculated tokens.
This accounting treatment created the mirage that FTX had substantial holdings value in FTT (and other tokens). In reality, however, if FTX would have tried to liquidate its FTT position during this time, it would have flooded the market and collapsed FTT’s price. Without these FTT “assets” on its balance sheet, FTX would have had a very large negative equity balance because its liabilities outweighed its assets by a significant margin.
While facts are still coming to light, in the subsequent days since FTX filed for bankruptcy there have been numerous verified reports that showcase a broken internal control environment at the company. For example, SBF had the unilateral ability to transfer funds between FTX and Alameda without triggering compliance flags for investigation. He also had “backdoor” access to FTX’s bookkeeping system, which let him alter the company’s financial statements without notifying internal-compliance accounting teams or external auditors (SBF denies this and claims he didn’t make any secret transfers; he simply “had confusing internal labeling and misread it.”).
Finally, FTX lacked a standard governance structure and did not have a formal board of directors made up of investors that could conduct oversight of SBF and to whom he would be held accountable. In recent coverage by the Washington Post, FTX’s newly appointed CEO, John J. Ray III (who previously supervised the dissolution of Enron), “told a federal court Thursday that he had never seen in his career ‘such an absence of trustworthy financial information as occurred here.’ He couldn’t figure out what assets the company owned; he struggled to calculate what the firm owed, and to whom; he could not even cobble together a full list of employees who had worked there.”
What happens next is unclear. Given the novelty of cryptocurrency exchanges, there are bound to be a number of unanswered legal questions that arise as the court begins to tackle the administration of the joint bankruptcy.
After bankruptcies earlier this year by Voyager and Celsius, US crypto investors are likely concerned about losing some or all of their deposits. The apparent hack of FTX wallets surrounding the debacle likely compounded that concern shortly after the filings. From a tax perspective, if customers are not made whole in the bankruptcy, a tax deduction may likely be claimed. Account holders should document what crypto holdings they have on those platforms so it will be easier to recover units held on those platforms or maximize any future payout as a creditor.
In October, Aaron Jacob, Head of Accounting Solutions at TaxBit noted in Bloomberg Tax that: “Similar to what traditional asset classes experienced in 2008, cryptocurrency recently experienced its own high-profile Lehman-like bankruptcies. In the wake of the 2008 financial crisis, a speech by SEC Commissioner Kathleen Casey homed in on the need for accounting standards to promote transparency… After a chaotic crypto winter, regulatory clarity, transparency, and better accounting will let spring finally emerge again.”
Effective accounting rules demanded by investors and enforced by regulators can help prevent companies such as FTX from being able to leverage themselves using self-created tokens. The Financial Accounting Standards Board, for example, which plans to implement new and improved accounting rules for digital assets in the next year, should also consider crafting guidance for exchange-created tokens such as FTT.
Regulators should also work diligently to create better regulator clarity in a way that promotes accounting transparency and discourages entities such as FTX from operating offshore. Senator Lummis, for example, shared the following statement after the FTX collapse:
“The recent events that have transpired between FTX and Binance are the clearest example yet of why we need clear rules of the road for digital asset exchanges in the United States. Market manipulation, lending activity, and whether customer funds and assets were appropriately safeguarded are just a few of the many issues my colleagues and I need to consider in the coming days. Transparent and fair exchange regulation, which is provided for in the Lummis-Gillibrand Responsible Financial Innovation Act, is essential to ensuring customers are protected while still promoting responsible innovation.”
One of the great ironies of FTX’s collapse is that blockchain was originally created to prevent this type of meltdown. In the wake of the financial crisis, Satoshi Nakamoto, Bitcoin’s mysterious inventor wrote in 2009: “The root problem with conventional currency is all the trust that’s required to make it work… Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”
In recent days, many industry participants have encouraged on-chain transparency in order to help prevent similar meltdowns in the future. Venture capitalist Nic Carter, for example, recently explained a technique called “Proof of Reserves” via Coindesk (the same publication that broke the initial news of FTX’s fragility):
“Requiring exchanges to show they have assets to match their liabilities would improve transparency and help to win back public trust in crypto… Post-FTX, a new enthusiasm for proofs of reserve has emerged. A number of exchanges – at a minimum Binance, Gate.io, KuCoin, Poloniex, Bitget, Huobi, OKX, Deribit, and Bybit – have indicated their intention to publish proofs of reserve. A few such as Crypto.com, Bitfinex, and Binance have taken the intermediate step of releasing wallet addresses as crude proof of assets. But this is incomplete without corresponding liabilities.
The asset side is trivial: It can involve publishing wallet addresses or signing a transaction. The tricky part is matching the assets with the outstanding liabilities. To achieve that, an exchange adds up all user balances, anonymizes them, and publishes the data in Merkelized format. From there, depositors can verify that they are included in the liability set. If enough do this, they can have strong confidence that the exchange isn’t cheating by omitting liabilities. And if the process happens under the eye of an auditor, users can gain additional assurance that no liabilities are being excluded.”
To be fair, auditing still requires a “trusted third party” that can potentially be negligent or corrupt. In addition, fraudsters can potentially find innovative ways to evade discerning eyes. FTX was supposedly audited by two firms, but at the same time bankruptcy filings reported FTX held zero bitcoin on its balance sheet (despite having over a billion dollars in BTC liabilities). If FTX had been actively publishing on-chain proof of reserves, this would have been a blazing red flag for the public to transparently see.
The future of crypto requires better accounting via a combination of reputable auditors and on-chain transparency. But as an added complexity, very few firms are equipped to perform audits of companies that deal with digital assets.
At TaxBit, we are building pioneering solutions for digital asset accounting. Our technology is trusted by some of the world’s largest regulatory agencies, accounting firms, and crypto enterprises as we enable the following:
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