Douwe Lycklama, founding partner at INNOPAY, formulates a lucid analysis of the context that led to the FTX collapse, while detailing the important lessons that the crypto and broader economic markets should learn and act on in the future.

The FTX collapse is the latest in a line of crypto failures in 2022 and the biggest so far, with billions missing and 1.2 million account holders turned into creditors. It will take years to settle this bankruptcy and the clients’ outlook for recovery is bleak. We are unlikely to see a similar scenario as with MtGox, which went bust in 1994. The Bitcoin that remained there appreciated in fiat value during the bankruptcy to such an extent that creditors can soon expect to be paid out handsomely in fiat, making up for the fiat value of their holdings back in 1994. FTX probably doesn’t have such a ‘nest egg’ as its assets were largely self-created tokens or lost during trading operations. The initial reports are unsettling.

In the case of FTX, customer deposits were used for speculation on the account of FTX’s sister company, trading firm Alameda. This is a banking practice from the 1920s. It was prohibited by the 1933 Glass Steagall Act which forbade banks to use customer funds for own speculation. However, the act was repealed in 1999 and this is often associated with the global financial crisis of 2008.

Then there was FTX-leveraged trading, using self-issued tokens as weak collateral. The self-issued tokens were ‘mark to market’ by trading a small amount publicly and using that price for the whole stock of tokens. This also pumped up the balance sheet, easily misleading high-profile investors who – due to fear of missing out (‘FOMO’) – were queuing up for the latest FTX investment round with a valuation of USD 30 billion. Hardly any due diligence took place. FTX’s spectacular growth numbers and high-profile marketing campaigns (including Super Bowl ads) mesmerised investors, regulators and the general public.

Amazingly, there was no oversight board. But even more astonishing was the absence of basic financial and operational controls, which John Ray exposed within a few days of becoming FTX’s bankruptcy CEO. For example, three FTX board members had huge personal loans with their company (approx. USD 1.5 billion in total). He had never seen anything like this in his 40-year career as a bankruptcy specialist – not even while working on the high-profile scandal, fraud and subsequent bankruptcy of energy conglomerate Enron at the end of 2001.

Political donations also seem to be part of the FTX fact mix. Sam Bankman-Fried and other wealthy FTX executives donated at least USD 40 million to the Democrats’ election campaign and possibly also to the republicans. More dubious facts will no doubt emerge in the coming years. For now, it is more than clear that FTX was a scam, with crypto as conduit.

HOW COULD THIS HAPPEN? THE BROADER REGULATORY CONTEXT

There is no definite answer for now. However, there are some explanatory facts. FTX was based in the Bahamas with a US professional subsidiary, while mass marketing its services globally. Regulators have a habit of focusing their energy on companies located domestically because coordinating with regulators globally can be a murky affair, certainly when new topics such as crypto are involved.

From the Bahamas, FTX was actively marketing its services in the US, yet US citizens could not officially buy on the platform. VPNs probably helped out there, and it would be interesting to know just how many US customers there were in reality. For sure, heavy marketing made investors, politicians, regulators and the public feel that FTX was trustworthy. In the space of three years, FTX became the world’s third-largest crypto service provider after Binance and Coinbase.

FTX did not seem to face heavy regulatory scrutiny. Although the regulator in the Bahamas eventually pushed back on this sentiment, it was too little, too late. There was a complete lack of operational oversight. FTX was able to offer services (e.g. certain derivatives) for which US-based crypto providers were constrained by their regulator. It was not a level playing field.

_____

Read the full article here.