The Failure of FTX:

A PRMIA Case Study

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Summary

FTX was a popular virtual asset / cryptocurrency exchange and trading platform. It was founded by
Sam Bankman-Fried and Gary Wang and became known for offering a wide range of virtual asset
trading products and services. It also operated a virtual asset hedge fund.

Virtual assets, especially cryptocurrencies, had become a very popular, if sometimes misunderstood
investment choice. Large investment gains had seen a surge of interest and investment in this area.
FTX and many other firms benefited from these investments and related attraction. For one of the
most popular cryptocurrencies - Bitcoin (BTC) – its price reached an all-time high in 2021. Values
exceeded over $65,000 USD in November 2021; in May 2013, a similar Bitcoin could have been
bought for around $130. For FTX, at its peak in July 2021, it had over one million users and was the
third-largest cryptocurrency exchange by volume.

However, there was more volatility in the price of cryptocurrencies in 2022, with the price of Bitcoin
declining to around $16,000 in November 2022. This resulted in losses for many investors in this
area, as well as financial difficulties for firms like FTX who served this market. A November 2022
CoinDesk article noted that FTX's partner firm Alameda Research held a significant portion of its
assets in FTX's native token (FTT) leading to concerns about the value of this cryptocurrency and thus
the assets of FTX.

This was followed by a spike in customer withdrawals from FTX. FTX was unable to meet the demand
for customer withdrawals. Following initial due diligence by a rival as part of a buyout, it was found
that there were issues with customer assets. On December 12, 2022, at the request of the US
government, founder Sam Bankman-Fried was arrested by the Bahamian authorities for financial
offenses.

The Company

FTX - short for Futures Exchange - was founded in 2019 by Sam Bankman-Fried and Gary Wang. FTX
began within another firm, Alameda Research, a trading firm founded by Bankman-Fried and others.
The co-founder of another crypto firm - Binance - purchased a 20% stake in FTX for approximately
$100 million, allowing funds for a rapid growth. This investment of $100 million alone was bought
out by Bankman-Fried for $2 billion in 2021 allowing a handsome return for investor Changpeng
Zhao.

Several hundred million dollars was spent on various acquisitions, and this growth help FTX to raise
$900 million against an $18 billion valuation in July 2021. It then raised a further $400 million in
funding at a $32 billion valuation in January 2022. Meanwhile, FTX moved its headquarters from
Hong Kong to The Bahamas. Also, there continued to be a close relationship between Alameda
Research and FTX.

Such relationships would have been subject to some form of supervision in more traditional finance
firms, but virtual asset firms were a new type of firm and were not subject to the same regulation or
supervision. In what would be seen to be some form of market abuse in more traditional finance
firms, Alameda Research amassed virtual assets ahead of FTX announcing the decision to list them
for trading. However, some existing regulations did apply to FTX; In August 2022, the Federal Deposit
Insurance Corporation (FDIC) issued a cease-and-desist order to FTX for making "false and
misleading representations" about deposits being covered by FDIC insurance following FTX president
Brett Harrison's tweet implying otherwise. In October 2022, it was reported that FTX was under
investigation in Texas for allegedly selling unregistered securities.

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Cryptocurrencies and Client Assets

Virtual assets refer to any digital representation of value that can be digitally traded, transferred, or
used for payment. Cryptocurrencies, also known as digital currencies or virtual currencies, are a very
popular virtual asset and serve as a form of digital money. Unlike standard currencies that used to be
exchanged physically using notes and coins, cryptocurrencies are usually only exchanged online.

The technology that makes these possible is called the blockchain. The blockchain is a decentralized
digital ledger that records transactions across multiple nodes in a related network. Its main feature is
decentralization. Unlike traditional centralized systems where a central authority maintains and
controls the ledger, a blockchain operates in a decentralized manner. It is maintained by a network
of nodes that collectively validate and record transactions. This allows one of the most interesting
aspects of cryptocurrencies versus traditional currencies. Traditional currencies are centralized and
guaranteed by a central bank that controls their supply. For example, the European Central Bank
guarantees the euro and controls its supply in the euro area. Cryptocurrencies are decentralized –
there is no central bank to guarantee them or control their supply.

Another feature is providing a distributed ledger. The blockchain consists of a distributed ledger, a
continuously growing list of records, also called blocks, linked together using a form of cryptography.
Each block contains a set of transactions and a reference to the previous block, creating a
chronological chain of blocks. Once a block is added to the blockchain, it becomes extremely difficult
to alter or tamper with the information stored within it. Additionally, the blockchain itself is
transparent, as the entire transaction history is visible to all participants, promoting trust and
accountability.

However, there have been some concerns about other elements of privacy and identity related to
cryptocurrencies. Users of cryptocurrencies can choose to be anonymous on the internet when they
are buying goods and services. This has resulted in some reputation issues for cryptocurrencies. Silk
Road was an online market that operated as a hidden service on the "dark web". It allowed users to
buy and sell products and services between each other using Bitcoin to remain anonymous. The
website was known for its illegal drug marketplace, among other illegal and legal product listings.
Between February 2011 and July 2013, the site facilitated sales amounting to 9,519,664 Bitcoins. In
October 2013, the Federal Bureau of Investigation (FBI) shut down Silk Road and arrested its
founder.

There were also concerns about people having their cryptocurrencies stolen from them. Some
people maintained their cryptocurrencies in their own electronic wallets. However, sometimes
access to these might be lost and someone might compromise the security of the wallet, remove the
cryptocurrencies and, as it is anonymous, effectively steal the cryptocurrencies.

Some services were established to allow people to have their cryptocurrencies and other funds
stored by a third party; this was one of the services provided by FTX. While FTX said it was a crypto
exchange, it also had access to some of its clients’ assets. Client assets is a major area of regulation
and supervision due to many previous cases where firms abused their handling of client funds and
assets. A previous PRMIA case study, Daiwa Bank, included the situation where poor controls
including segregation of duties had resulted in client assets being sold to try and cover up a case of
rogue trading.

Overall, while many were happy to invest in cryptocurrencies and other virtual assets, others
approached the area with a sense of caution.

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The Failure

Concerns continued to be expressed about FTX’s close relationship with Alameda Research, but as of
September 2022, these were somewhat muted. This changed on November 2nd, 2022, when
CoinDesk, a news site specializing in bitcoin and digital currencies, reported that a significant portion
of Alameda Research's assets were held in FTT, the exchange token issued by FTX.

The FTX Token (FTT) was a "utility token" for FTX. It allowed FTX users to get discounts and rebates
on their trading fees and get rewarded for referring other customers. It also was traded and at its
peak had a valuation of over $70 per token. However, as per the economic rules of supply and
demand, the circulation of the tokens was kept low, which helped to maintain their value. In
addition, much of the FTT in existence belonged to FTX and Alameda Research; it was reported that
Alameda Research held a position valued at $5 billion in FTT.

Thus, this store of FTT was a major part of Alameda Research’s balance sheet, in essence making up
a great deal of its reserves or equity. This caused some concerns about the true value of the token
and again raised the question of the close ties between FTX and Alameda Research. If these reserves
or equity had been in other cryptocurrencies, or even traditional / fiat currencies, then the exposure
may not have been so worrying.

Several days later, Changpeng Zhao of Binance, acting on his concerns, announced he was selling his
large store of FTT. With the related market being thinly traded and the related sale being around half
a billion dollars of FTT, this immediately raised concerns about the price of token. This led to a
market reaction and a quick decline in the price of FTT, and indeed other cryptocurrencies. Over the
next 3 days, in a “crypto bank run”, FTX lost an estimated $6 billion. With many customers
experiencing delays or an inability to sell their FTT, there was a resulting “crypto liquidity crisis”.

On November 8, Changpeng Zhao announced that Binance had entered into a non-binding
agreement to purchase FTX to help resolve the crisis. This purchase was based on a letter of interest
and was subject to due diligence of FTX. This is where the crisis worsened significantly; Binance
quickly withdrew from the deal, reporting mishandling of customer funds uncovered in their initial
due diligence. It was found that Alameda Research owed FTX around $10 billion. These were client
funds place on the FTX exchange for trading. These in turn had been lent, without permission to
Alameda, so that they could make investments. While this was already a concern, the revelation that
these transactions were hidden in FTX’s books and records through changes in the related software
(a “backdoor”) was a major breach of internal controls.

A later report filed by FTX as part of its bankruptcy hearing described this in more detail. There was
little if any financial and risk personnel and culture of deferring to Bankman-Fried and other senior
executives. Extending this to the rest of the 3 lines of defense, there was no internal audit function
and thus no one to provide assurance that internal controls – such as financial reporting – was fit
and proper. This extended to more daily operational aspects, such as the sharing of passwords, the
last of 2 factor authentication and no alerts on the use of powerful “root” logon and password
authentication.

Meanwhile, FTX went through a series of attempts to save the business including seeks assistance
from other companies once Binance walked away. On November 10th, the Bahamas froze FTX’s
assets and Alameda Research was wound down. The next day, FTX filed for Chapter 11 bankruptcy
protection, and Bankman-Fried stepped down as FTX CEO. The following month he was arrested and
later extradited to the U.S.

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Lessons Learned

FTX gives a set of lessons that can be linked back to several areas of risk management.

1. Risk and its relationship with reward is just as important now as it has been in the past. FTX had
a quick and rewarding growth in just a few years. However, previous lessons on risk, such as
volatility being a good measure of risk is still important. Cryptocurrencies such as Bitcoin have
had spectacular gains in value, as well as worrying falls. While some people may benefit from
this, there will be others who will not. An investor in any asset, be it virtual or traditional has to
consider this. With the FTX case, seeing old risks like liquidity emerge in a few assets like the FTT
is a reminder that these old risks never really go away.

2. Internal controls are also just as important now as they have been in the past. FTX existed in the
rough and tumble world of a start-up. These firms are often founded by young and enthusiastic
volunteers who may have little time for risk management and control. However, as these firms
grow, they should consider this and start to understand how they can mature their approach to
disciplines like risk management. But it has to be recognized that this will be a challenge in such
an environment. Innovation is often used to justify the lack of internal controls. But starting to
build a related culture can make this easier to do as a firm like this grows. Staff can be told that
internal controls are not a restriction; they are a way to build trust with stakeholders like
investors and customers in an industry that can lack trust after events like FTX. Finally, making
controls part of a wider risk management framework will help embed this.

3. Having a risk management framework can be part of embedding items like internal controls
raised in the previous point. At PRMIA, a suggested approach is to have the following elements
for a risk management framework:
• Risk Capacity: A firm’s ability to withstand the worst-case outcome that could potentially
arise from the risk taking;
• Risk Appetite: A firm’s desired level of risk taking;
• Risk Policies: A detailed cascading of the risk appetite; and,
• Culture & Incentives: The policing of the risk appetite.

In turn having a board to help work within this framework is useful. Having a board at an early-
stage firm can be useful for allowing investors and others to have some control and to be able to
ensure their advice is being taken. Adding risk management tasks to the work of this body can be
useful, from using their advice to set the risk appetite of the firm and allowing this to cascade
through the firm via policies and related controls can be a major part of this.

4. Maintaining the protection of client assets is a major risk and should recognized. In traditional
finance firms, ensuring that the funds and assets held by a firm are safe is a major focus of
regulatory and supervisory engagement. Too often, a firm in some form of crisis will “dip into”
client assets to try and resolve a possibly fatal financial issue. Showing that such assets are safe
is a way to build trust in a virtual industry, but there needs to be the checks and balances to
show this is the case. Having some form of assurance, preferably independent, may be part of
this.

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Timeline of events: November and December 2022

Nov. 6: Rival exchange Binance sells all FTT tokens – over $500 million.

Nov. 7: FTX announces a liquidity crisis and seeks assistance from other companies including
Binance.

Nov. 8: Binance enters into a non-binding agreement to buy FTX’s non-U.S. business.

Nov. 9: Binance withdraws from the FTX acquisition after conducting initial due diligence.

Nov. 10: The Bahamas freezes assets of FTX’s subsidiary there; Bankman-Fried announces that
Alameda Research is to be wound down.

Nov. 11: Bankman-Fried steps down as FTX CEO and is replaced by a court-appointed CEO with
restructuring experience. FTX files for Chapter 11 bankruptcy protection.

Nov. 18: The Bahamas takes control of FTX assets held there.

Dec. 12: Bankman-Fried is arrested by Bahamian authorities and is later extradited to the U.S.

Dec. 22: Bankman-Fried is released on a $250 million bond, the largest in history, by a federal judge.

References

FTXFoundation.com website Archived September 9, 2022, at the Wayback Machine

https://restructuring.ra.kroll.com/FTX/

https://inside.com/campaigns/inside-tech-2021-07-21-28706/sections/243700

https://www.cnbc.com/2022/11/09/binance-backs-out-of-ftx-rescue-leaving-the-crypto-exchange-
on-the-brink-of-collapse.html

https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-
blur-on-his-trading-titan-alamedas-balance-sheet/

https://www.wsj.com/articles/ftx-tapped-into-customer-accounts-to-fund-risky-bets-setting-up-its-
downfall-11668093732

https://www.theverge.com/2022/8/20/23314401/ftx-money-isnt-insured-fdic-sam-bankman-fried-
crypto-cease-and-desist

https://www.bloomberg.com/news/articles/2022-09-14/trading-firm-alameda-research-powers-ftx-
ceo-sam-bankman-fried-s-crypto-empire

https://www.cnn.com/2022/10/20/business/nightcap-crypto-texas-onslaught/index.html

https://edition.cnn.com/2022/11/17/business/ftx-ceo-complete-failure/index.html

https://www.courtlistener.com/docket/65748821/1242/1/ftx-trading-ltd/

https://www.reuters.com/markets/currencies/exclusive-least-1-billion-client-funds-missing-failed-
crypto-firm-ftx-sources-2022-11-12/

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