Case1 – The FTX Collapse – Financial Innovations

HBP# HK1435

RUJING MENG HENRI ARSLANIAN

THE FTX COLLAPSE: DUE DILIGENCE AND COUNTERPARTY RISK MITIGATION WHEN

INVESTING IN CRYPTO COMPANIES

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” 1

– John Ray, newly appointed CEO for FTX in Bankruptcy A comment on FTX’s November 2022 collapse

Raffi gazed out the window of the taxi carrying him back to his apartment in Dubai, deep in thought about the conversation he had just had with his direct supervisor.

As an experienced analyst at a leading Sovereign Wealth Fund (SWF) in Dubai, Raffi frequently encountered deals that required his expertise in conducting due diligence.

The SWF Raffi worked for had a reputation for also investing in cutting-edge technology companies and was open to exploring opportunities that more conservative investors might shy away from.

It was May 2023, and the crypto industry was still reeling from the collapse of FTX, one of the most significant financial scandals in recent memory. Numerous crypto companies had gone under in the aftermath, leaving investors wary of the sector.

Despite the challenges, the SWF's investment committee (IC) had been presented with several opportunities to invest in digital asset companies. They recognized the potential of digital assets as a key driver of future economic growth and were keen on including such companies in their

1 A. Saeedy and S. Biswas, “FTX’s New CEO Faults Lax Oversight in Bankruptcy Filing,” Wall Street Journal, 17 November 2022, https://www.wsj.com/articles/ftxs-new-chief-says-complete-failure-of-oversight-contributed-to- firms-downfall-11668696069, accessed 17 March 2023.

Henri Arslanian prepared this case under the supervision of Dr. Rujing Meng for class discussion. This case is not intended to show effective or ineffective handling of decision or business processes. The authors might have disguised certain information to protect confidentiality. Cases are written in the past tense, this is not meant to imply that all practices, organizations, people, places or fact mentioned in the case no longer occur, exist or apply.

© 2023 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be digitized, photocopied or otherwise reproduced, posted or transmitted in any form or by any means without the permission of The University of Hong Kong.

Ref. 23/772C

Last edited: 17 October 2023

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

portfolio. However, they also understood the importance of identifying and mitigating potential risks, ranging from investment to reputational, that could arise from these investments.

In light of the FTX collapse and its impact on several prominent institutional investors like Temasek, Sequoia Capital, and the Ontario Teachers’ Pension Plan (see Exhibit 1), the IC asked Raffi to analyze the FTX incident and develop recommendations on how to minimize similar risks going forward, particularly when considering investments in crypto exchanges.

He had to prepare a report that was due for the next IC meeting of the SWF to help them navigate the risks associated with investing in crypto companies. This was a big assignment, and one that Raffi knew would be critical as to whether the SWF would consider investing in such companies.

After a quick dinner, Raffi sat down and started thinking about how to put together this report.

The Crypto Exchange Ecosystem

Any asset class, including crypto-assets, needed a marketplace where they could be bought and sold. For example, equities were traded on exchanges like the New York Stock Exchange or London Stock Exchange.

The crypto-asset ecosystem had its equivalent service providers that came in many shapes and sizes but were broadly separated into two categories: centralised exchanges and decentralised exchanges.

Centralised Crypto-Asset Exchanges

Centralised exchanges operated in a way not dissimilar to the operations of a stock exchange, matching buyers and sellers of crypto-assets and acting as middlemen for all trades without revealing the identity of the buyer or seller. In many cases, they may also serve as the custodian of the assets.

When looking at centralised crypto exchanges, it’s important to note there were two main types of centralised exchanges: fiat-to-crypto and crypto-to-crypto. There were also crypto-derivative exchanges that were generally part of the crypto-to-crypto exchange family.

 Fiat-to-Crypto Exchanges

A fiat-to-crypto exchange allowed users to deposit fiat funds in their account (e.g., USD, EUR, AED) and converted that into the desired crypto asset. For most individuals, a fiat-to-crypto exchange would be the first on-ramp to the crypto industry.

Operating a fiat-to-crypto exchange was challenging for many years, mainly due to the difficulties of opening and maintaining a traditional bank account. Until 2020, having a bank account with a “traditional” bank was very challenging, and only a handful of banks globally were publicly comfortable dealing with crypto firms. Whilst some were in niche markets (e.g., Deltec in the Bahamas or Bank Frick in Liechtenstein), U.S.-based Silvergate and Signature were the two primary on and off-ramps up until their March 2023 collapse. Following their collapse in March 2023, opening a bank account became even more difficult for any crypto company globally.

2

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

 

 

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

Fiat-to-crypto exchanges played an essential role in the ecosystem, as they were often the first point of entry for someone entering the crypto space. The dominant fiat-to-crypto exchanges were also often different from the dominant crypto-to-crypto exchanges.

As of Q1 2023, the crypto exchanges with the most significant market share for fiat-to-crypto were Coinbase, Kraken, Binance.US and LMAX Digital, quite different from the top five crypto-to-crypto exchanges, which were Binance, Upbit, OKX, Gate.io and ByBit.2

 Crypto-to-Crypto Exchanges

A crypto-to-crypto exchange did not touch currencies and only facilitated the exchange of one crypto-asset for another. To use the service, a user must send a crypto-asset to the exchange, like Bitcoin, Ether or a stablecoin (which they may have gotten from a fiat-to-crypto exchange) and use that crypto-asset to buy other crypto-assets.

As of Q1 2023, the crypto exchanges with the most significant market share for crypto-to- crypto were Binance, Upbit, OKX, Gate.io and ByBit.3

o Approach to Compliance

Many crypto-to-crypto exchanges traditionally focused less on Know Your Customer (KYC) and Anti Money Laundering (AML) than fiat-to-crypto exchanges. However, this started changing in 2018. Initially, many exchanges implemented gradual KYC that only applied when users tried to redeem funds. For instance, no KYC information was required when you opened or funded an account, but users had to provide identification if they attempted to withdraw more than 2 Bitcoin (BTC) a day.

Many exchanges thought this was a good way to comfort regulators whilst not affecting the user experience during the onboarding process. The thinking was that a user would be keener to provide information when trying to get their money back rather than at the start when opening an account.

However, this approach showed a need for more understanding of basic regulations. Whilst any serious criminal organisation would have a hard time laundering meaningful amounts of money if it planned to only stay under the 2 BTC limit a day, the reality was that there was often no de minimis threshold when it came to AML regulations.

In addition, such an exchange may deal with individuals on a sanctioned list or from a sanctioned country, which was automatically an offense in many jurisdictions. This was why many crypto-to-crypto exchanges gradually established KYC frameworks.

One of the reasons was clarification from various authorities that such exchanges were not outside the law, even though they were not touching fiat currencies and only dealt in crypto. A good example was the accusations from both the U.S. Commodity Futures Trading Commission (CFTC) and the Department of Justice against BitMEX, a significant crypto-to-crypto derivatives exchange, due in part to the fact that it did not have KYC in place until 2020.4 The fact that criminal procedures were taken against BitMEX reminded the entire industry that not

2 The Block, “USD Support Exchange Volume,” https://www.theblock.co/data/crypto-markets/spot, accessed 27 March 2023.

3 The Block, “Cryptocurrency Monthly Exchange Volume,” https://www.theblock.co/data/crypto-markets/spot, accessed 27 March 2023.

4 J.Stempel, “U.S. charges BitMEX cryptocurrency founders with failing to prevent money laundering,” REUTERS, 2 October 2020, https://www.reuters.com/article/usa-crime-bitmex-idUSKBN26N08O, accessed 1 January 2023.

3

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

taking this seriously could have serious consequences. Numerous similar actions took place against crypto exchanges including actions from the US CFTC against Binance in March 2023.5

o Crypto Derivative Exchanges

Derivatives also existed in the crypto space. As in the traditional financial services industry, volumes in crypto derivatives were pretty significant. For example, from December 2020 to August 2022, the monthly volumes of Bitcoin futures alone had been over $1 trillion a month, many times the volume of spot Bitcoin.6 Data showed that the ratio between spot Bitcoin and Bitcoin futures had hovered between 0.2 and 0.77 since January 2020. Whilst there were now regulated Bitcoin futures offered by players like the CME, the reality was that most Bitcoin and crypto derivatives take place in crypto-to-crypto exchanges like Binance, OKX, Bybit, BitMEX and, until November 2022, FTX.

Many crypto derivatives platforms banned clients from markets like the U.S.8 However, ensuring compliance with these rules could be challenging without investigating the actual customers of those exchanges, especially since users could easily resort to VPNs to mask their true location. According to a research report by Inca Digital, where the crypto derivatives traders resided were far more diverse than what was often divulged by the exchange operators (see Exhibit 2).9

Decentralised Crypto-Asset Exchanges

Centralised exchanges had many benefits, including that they were increasingly regulated, suited for retail investors with customer support and often offered other services like custody, perfect for beginner traders.

Decentralised crypto exchanges operated differently from their centralised counterparts (see Exhibit 3). Instead of acting as a middleman, trading occurred directly between buyers and sellers. Decentralised exchanges saw tremendous growth starting in the summer of 2020 as part of the overall surge of interest and awareness in decentralised finance (DeFi).

Decentralised exchanges achieved the same goal of letting you buy or trade digital assets but did so in a different way, as there was no central counterparty. Trades were made peer-to-peer (P2P) between two users via smart contracts, and each user managed their assets in individual wallets. These exchanges were typically suited for more advanced traders, as individuals new to crypto first dipped in a toe using centralised exchanges.

Decentralised exchanges had numerous advantages in terms of lower fees and their permissionless nature; however, they were also much more complex to use, particularly for the average retail investor.

Whilst most crypto trading had taken place on centralised exchanges, trading volumes on decentralised exchanges began to rise rapidly in the summer of 2020. On certain days in August

5 CFTC, “Wilful Evasion of Federal Law and Operating an Illegal Digital Asset Derivatives Exchange,” https://www.cftc.gov/PressRoom/PressReleases/8680-23, accessed 6 April 2023.

6 The Block, “Volume of Bitcoin Futures,”https://www.theblock.co/data/crypto-markets/futures/volume-of-bitcoin- futures-monthly, accessed 27 March 2023.

7 The Block, “BTC Spot to Futures Volumes (30DMA),” https://www.theblock.co/data/crypto-markets/spot/btc- spot-to-futures-volume, accessed 10 April 2022.

8 A. Osipovich “U.S. Crypto Traders Evade Exchange Banks,” Wall Street Journal, 30 July 2021 https://www.wsj.com/articles/u-s-crypto-traders-evade-offshore-exc hange-bans-11627637401, accessed 1 January 2022.

9 T. Christina, S, Sedlova, E, Dmitriev and A. Zarazinski, “Geotagging Crypto Derivatives Traders With NLP,” Inca Digital, 2021, accessed 1 April 2023.

4

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

2020, the daily volume on a decentralised exchange like Uniswap was higher than that of established centralised exchanges like Coinbase (see Exhibits 4 – 5 on centralised and decentralised exchange trade volume).10

Whilst decentralised exchanges still represented less than 15% of the volumes of centralised exchanges,11 many expected their market share to rise (see Exhibit 6).

The Background of FTX

In 2017, 25-year-old Sam Bankman-Fried (SBF) founded a crypto hedge fund called Alameda Research.12 He had studied physics and mathematics at MIT and previously worked at the U.S. hedge fund Jane Street.

In 2019, SBF and Gary Wang launched FTX Trading Ltd., commonly known as FTX (short for “Futures Exchange”). FTX was branded as an exchange built by traders for traders.13 SBF served as the CEO of FTX and Wang became the exchange’s Chief Technology Officer.

FTX attracted professional traders and institutional clients with its comprehensive suite of derivatives offerings, such as futures, options, and leveraged tokens. It also offered both fiat- to-crypto and crypto-to-crypto offerings, as well as a range of innovative products like prediction markets and tokenized stocks. Its trading platform was known for its low fees, deep liquidity, and advanced order types, which set it apart from competitors.14

FTX experienced rapid growth due to high-profile acquisitions, an extensive marketing budget, and a robust platform.15 Initially based in Hong Kong, SBF relocated the company to the Bahamas to capitalize on a favourable regulatory environment.16

However, FTX's corporate structure was complex and convoluted. It consisted of more than 100 interconnected companies, subsidiaries, partnerships, and investment vehicles, all under SBF's control. The corporate structure spanned multiple legal and tax jurisdictions, with substantial cash flows moving throughout the network without proper accounting.17

FTX was also seen as an agile organisation despite its size. SBF was widely regarded as someone who could make decisions fast. However, this would later be a major flaw. For example, the liquidators' investigation later revealed that FTX had a weak corporate governance structure. Decision-making was highly centralized, with SBF having significant influence over the company's operations.18

10 J. Young, “DeFi Explosion; Uniswap surpasses Coinbase Pro in daily volume,” Cointelegraph, 31 August 2020, https://cointelegraph.com/news/defi-explosion-uniswap-surpasses-coi nbase-pro-in-daily-volume, accessed 1 January 2022.

11 The Block, DEX to CEX Spot Trade Volume (%), “https://www.theblock.co/data/decentralized-finance/dex-non- custodial/dex-to-cex-spot-trade-volume, accessed 27 March 2023.

12 E. Rosenberg, “Who is Sam Bankman-Fried,” Investopedia, 18 February 2023, https://www.investopedia.com/who-is-sam-bankman-fried-6830274, accessed 1 April 2023.

13 T. Smith, “FTX: An Overview of the Exchange and Its Collapse,” Investopedia, 5 January 2023, https://www.investopedia.com/ftx-exchange-5200842, accessed 10 April 2023.

14 T. Smith, “FTX: An Overview of the Exchange and Its Collapse,” Investopedia, 5 January 2023, https://www.investopedia.com/ftx-exchange-5200842, accessed 10 April 2023.

15 “Ibid.” 16 F. Chaparro and A. Keely, “FTX will begin to move key operations to Bahamas as part of HQ shift,” The Block,

24 September 2021, https://www.theblock.co/linked/118663/ftx-will-begin-to-move-key-operations-to-bahamas- as-part-of-hq-shift, accessed 10 April 2023.

17 B. Elder, “Untangling the knotty empire of Bankman-Fried and FTX,” Financial Times, 10 November 2022, https://www.ft.com/content/c28e0570-d4c4-433c-b0a0-c99fba613822, accessed 26 April 2023.

18 Kroll Restructuring Administration Cases, “NOTICE OF FILING FIRST INTERIM REPORT OF

5

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

Many would raise questions about the potential links between FTX and Alameda. But SBF would publicly mention numerous times how the two entities were completely separate and had no interaction. The reality, as it would unfold, was very different, with a back door being created that ensured that Alameda had a limitless ability to trade and withdraw from the exchange regardless of the size of its account balance and an exemption of Alameda from the auto- liquidation process that applied to other customers.

While FTX claimed to prioritize strict governance processes and procedures, its actual practices would later come under scrutiny. It would turn out the company had very poor processes and procedures when it came to governance and client asset segregation, with employees sometimes joking how they would lose track of millions of dollars.19

SBF also presented himself as the role model of legal and regulatory compliance. However, it would turn out that the reality in practice was way different. FTX faced multiple compliance issues, with inadequate adherence to local and international regulations, especially when it came to the segregation of client assets.20

Financially, FTX appeared to be in good shape. By the end of 2021, the company was valued at $32 billion.21 However, this valuation masked underlying issues with its financial records, accounting practices, and the extent of its liabilities. Additionally, early warning signs pointed to potential problems, such as the company's opaque corporate structure and SBF's tendency to push the boundaries of regulation.

SBF became a prominent figure in the crypto world, presenting himself as the face of the institutional, mature and regulated crypto industry and was able to attract a list of influential investors by the end of 2021 (see Exhibit 7).22

His attitude and presentation were very atypical. He would often be seen only wearing an FTX t-shirt and shorts and even went on stage at important events in such attire (see Exhibit 8).

FTX also led the charge in mainstream marketing during the 2021 crypto bull run, signing an impressive roster of celebrity ambassadors and securing high-profile partnerships with sports and entertainment organizations.23

FTX would be the sponsor of the NBA’s Miami Heat and Golden State Warriors, the University of California at Berkeley’s football stadium, the Formula One racing team Mercedes-AMG Petronas, Major League Baseball umpires and a number of esports teams worldwide. The

JOHN J. RAY III TO THE INDEPENDENT DIRECTORS ON CONTROL FAILURES AT THE FTX EXCHANGES,” https://restructuring.ra.kroll.com/FTX/, accessed 8 May 2023.

19 V. Cavaliere, “FTX Failure Rooted in ‘Hubris,’ ‘Greed,’ Debtors Report Says,” Bloomberg, 9 April 2023, https://www.bloomberg.com/news/articles/2023-04-09/ftx-failure-rooted-in-hubris-and-greed-debtors-report-finds, accessed 26 April 2023.

20 Kroll Restructuring Administration Cases, “NOTICE OF FILING FIRST INTERIM REPORT OF JOHN J. RAY III TO THE INDEPENDENT DIRECTORS ON CONTROL FAILURES AT THE FTX EXCHANGES,” https://restructuring.ra.kroll.com/FTX/, accessed 8 May 2023.

21 R. Browne, Cryptocurrency exchange FTX hits $32 billion valuation despite bear market fears,” CNBC, 31 January 2022, https://www.cnbc.com/2022/01/31/crypto-exchange-ftx-valued-at-32-billion-amid-bitcoin-price-plunge.html, accessed 26 April 2023.

22 C. Weinberg, Inside the Venture FOMO Machine That Powered SBF’s Meteoric Rise,” The Information, 11 November 2022, https://www.theinformation.com/articles/inside-the-venture-fomo-machine-that-powered-sbfs-meteoric-rise?rc=xrnyxn, accessed 10 April 2023.

23 Wall Street Journal, "Tom Brady. Stephen Curry. Shaq. See the Celebrities With Ties to FTX," 10 November 2022, https://www.wsj.com/articles/the-celebrities-including-tom-brady-tied-to-ftx-see-the-list-11668109684, accessed 10 April 2023.

6

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

exchange also signed a number of athletes as brand ambassadors, including Tom Brady, Steph Curry, Naomi Osaka and Shohei Ohtani.24

As FTX's presence expanded, SBF became a regular fixture in Washington, D.C., working with policymakers to develop a comprehensive regulatory framework for the crypto ecosystem.25

FTX was seen as not only a leading crypto exchange but also as probably the most transparent crypto exchange globally. And investors liked that, with the company being valued as high as $32 billion26 in January 2021. In May 2022, FTX surpassed Coinbase as the second-largest centralized crypto exchange.27

SBF also emerged as one of the most significant political donors within the crypto industry and beyond, contributing tens of millions of dollars to various campaigns.28

As several crypto firms began to unravel in the summer of 2022, starting with Terra's implosion,29 SBF embarked on a rescue mission. He acquired struggling crypto lender BlockFi for $240 million, bid for bankrupt exchange Voyager's assets, and considered purchasing Celsius's remaining assets.

SBF's actions drew comparisons to John Pierpont Morgan, who used his financial prowess to save America's banking system in the early 20th century (see Exhibit 9).

SBF also published his views on how to regulate crypto companies in October 2022, only weeks before the collapse of FTX.30 In a blog published on the FTX US website, SBF outlined a path forward for crypto self-regulation, covering different areas like more disclosures around crypto advertising, regular audits for fiat-backed stablecoins and a checklist to determine whether a token qualifies as a security.31

The FTX Collapse

The Key Events Leading Up to The FTX Bankruptcy

 July 2021: Binance, an early investor in FTX, sold its stake in the firm for $2.1 billion, with a portion of that amount being paid in FTX’s native exchange token – FTT. At the time, Binance’s decision to sell its stake in FTX was covered in the media as a parting of

24 “Ibid.” 25 L. Fang, K. Klippenstein and D. Boguslaw, “NEW FTX FILING PULLS BACK THE CURTAIN ON SAM BANKMAN-

FRIED’S MASSIVE INFLUENCE-PEDDLING OPERATION, The Intercept, 30 January 2023, https://theintercept.com/2023/01/30/ftx-sam-bankman-fried-lobbying-pr/, accessed 10 April 2023.

26 R. Brown, “Cryptocurrency exchange FTX hits $32 billion valuation despite bear market fears,” CNBC, 31 January 2022, https://www.cnbc.com/2022/01/31/crypto-exchange-ftx-valued-at-32-billion-amid-bitcoin-price-plunge.html, accessed 27 March 2023.

27 C. Moura, “FTX surpassed Coinbase as second-biggest centralized crypto exchange in May” The Block, 1 June 2022, https://www.theblock.co/linked/149654/ftx-surpassed-coinbase-as-second-biggest-centralized-crypto- exchange-in-may, accessed 10 April 2022.

28 L. Fang, K. Klippenstein and D. Boguslaw, “NEW FTX FILING PULLS BACK THE CURTAIN ON SAM BANKMAN- FRIED’S MASSIVE INFLUENCE-PEDDLING OPERATION, The Intercept, 30 January 2023, https://theintercept.com/2023/01/30/ftx-sam-bankman-fried-lobbying-pr/, accessed 10 April 2023.

29 C. Ostroff and A. Osipovich, “Crash of TerraUSD Shakes Crypto. ‘There Was a Run on the Bank.’,” Wall Street Journal, 12 May 2023, https://www.wsj.com/articles/crash-of-terrausd-shakes-crypto-there-was-a-run-on-the-bank-11652371839, accessed 10 April 2023.

30FTX US, “Possible Digital Asset Industry Standards,” 19 October 2022, https://www.ftxpolicy.com/posts/possible-digital-asset-industry-standards, accessed 6 April 2023.

31 S. Haig, “SBF Replies to ‘Constructive Feedback’ on His Regulatory Proposals,” The Defiant, 24 October 2022, https://thedefiant.io/sbf-replies-critics-regulation, accessed 10 April 2023.

7

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

ways between SBF and Binance CEO Changpeng ‘CZ’ Zhao, who had drifted apart over competing stances on how the crypto ecosystem should be overseen and regulated.

 May 9, 2022: TerraUSD (USDT) collapsed, wiping out over $50 billion in investor value. Alameda Research suffered significant losses, which would later be revealed to have been covered by FTX client funds.

 June 12, 2022: Pointing to extreme market conditions, crypto lender Celsius informed users that it was suspending all account withdrawals.

 June 27, 2022: Crypto hedge fund Three Arrows Capital, which had invested heavily in USDT, defaulted on billions of dollars of loan payments to lenders Voyager, Genesis and BlockFi.

 July 5, 2022: Voyager filed for Chapter 11 bankruptcy.

Timeline of FTX’s November 2022 Collapse

FTX collapsed in about one week in November 2022.

 November 2, 2022: Crypto media outlet CoinDesk published an article about conflicts of interest between FTX and Alameda Research32. The article revealed that Alameda Research’s primary asset was FTX’s native token – FTT. This sparked widespread concern in the crypto ecosystem, as Alameda’s primary asset and collateral was an illiquid token created by the exchange. If FTX’s and Alameda’s assets were segregated, there should be in theory no risk for investors.

 November 6, 2022: Binance sold FTT holdings. Pointing to the revelations from the CoinDesk report, Binance CEO CZ announced on Twitter that Binance liquidated the $530 million of FTT it had received in July 2021 for selling its early stake in FTX (see Exhibit 10).

This caused the price of FTT to plummet and thus a crisis of confidence in FTX. Even though SBF continued to claim on Twitter that all customers would be made whole and that FTX had the funds to withstand the flood of withdrawal requests (see Exhibit 11), the investors rushed to withdraw funds they had on the FTX platform. FT struggled to handle customer redemptions, which soared to $6bn within 72 hours of CZ’s tweet.

If FTX held client assets and had not used them to patch a gap with their sister company Alameda, then even large redemption amounts should not cause an issue. However, FTX was using client deposits for Alameda.

Shortly after, the inevitable happened and FTX paused all customer withdrawals. Whilst FTX claimed at the time that they were experiencing a liquidity crunch, it became clear within days that FTX was not illiquid but potentially insolvent.

 November 8, 2022: Binance shocked the global crypto ecosystem when it announced that it had reached a non-binding agreement to purchase FTX (see Exhibit 12).

32 CoinDesk, “Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet,” 2 November 2022, https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds- crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/, accessed 10 April 2023.

8

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

 

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

 November 9, 2022: After performing due diligence on the tentative sale, the deal fell through, with Binance citing reports of misappropriation of funds and potential U.S. investigations33.

 November 10, 2022: A Wall Street Journal report34 revealed that FTX had lent billions of dollars in customer deposits to fund risky bets by Alameda Research, contradicting earlier denials by SBF and FTX.

 November 11, 2022: SBF stepped down as the FTX CEO. FTX and all its subsidiaries filed for bankruptcy and liquidators were appointed with John Ray succeeding SBF as the CEO for FTX in Bankruptcy 35. John Ray led the liquidation of disgraced energy titan Enron in 2000s.

Post-FTX Fallout

 November 14, 2022: After FTX (a critical lifeline for the crypto lending industry during the summer of 2022) imploded, BlockFi paused customer withdrawals, citing significant exposure to the exchange.

 November 28, 2022: BlockFi followed FTX into bankruptcy. The lender listed 100,000 creditors and liabilities ranging from $1 billion to $10 billion.

 December 12, 2022: SBF was arrested in the Bahamas after federal prosecutors in New York filed criminal charges. A week later, SBF agreed to be transferred into US custody.

 December 22, 2022: SBF was released on a $250 million bond, the largest in history, and placed under house arrest at his parents’ California home.

 January 19, 2023: Crypto lender Genesis filed for Chapter 11 bankruptcy protection.

 March 8, 2023: Silvergate Capital, one of the most important banks in the crypto ecosystem, announced that it was winding down operations and that its remaining assets would be liquidated. Two days, fellow crypto-friendly bank Signature was seized by regulators after a run on deposits.

Findings From FTX Debtors Report

In April 2023, FTX Trading Ltd. under the leadership of CEO John Ray III along with FTX’s affiliated debtors released a report that identified critical control failures by FTX’s previous management team under SBF.36

33 P. Kowsmann, “Binance Walks Away From Deal to Rescue FTX,” Wall Street Journal, 10 November 2022, https://www.wsj.com/articles/binance-is-said-to-be-likely-to-walk-away-from-deal-to-buy-ftx-11668020963, accessed 27 March 2023.

34 V. Ge Huang, A. Osipovich and P. Kowsmann, “FTX Tapped Into Customer Accounts to Fund Risky Bets, Setting Up Its Downfall,” Wall Street Journal, 11 November 2022, https://www.wsj.com/articles/ftx-tapped-into-customer-accounts-to-fund-risky-bets-setting-up-its-downfall- 11668093732, accessed 27 March 2023.

Kroll Restructuring Administration Cases, “FTX Trading Ltd. Case No. 22-11068,” https://restructuring.ra.kroll.com/FTX/, accessed 27 March 2023.

36 Kroll Restructuring Administration Cases, “NOTICE OF FILING FIRST INTERIM REPORT OF JOHN J. RAY III TO THE INDEPENDENT DIRECTORS ON CONTROL FAILURES AT THE FTX EXCHANGES,” https://restructuring.ra.kroll.com/FTX/, accessed 8 May 2023.

9

35

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

The report found numerous shortcomings in the company's governance, legal and compliance, AML, cybersecurity, financial management, solvency, and operational risk management.

For example, the report highlighted that FTX had invested in robust cybersecurity measures; however, the rapid growth of the company and the increasing complexity of its operations outpaced the development of its security infrastructure. This left FTX vulnerable to potential cyber threats.

The investigation also uncovered various operational risks within FTX, including over-reliance on key personnel, inadequate risk management processes, and a lack of business continuity planning. These shortcomings made FTX more susceptible to external shocks and contributed to the company's collapse.

FTX's financial management practices raised concerns as well, as the company had not maintained a clear separation of assets between FTX and its sister company, Alameda Research. The investigation also revealed that FTX had engaged in risky lending activities, using customer deposits to fund Alameda Research's speculative bets.

Next Steps

After Raffi spent a couple of hours reading about the FTX collapse, he started reflecting on the key areas of focus that any investor looking at a crypto exchange should focus on in order to have a framework that could be used when conducting due diligence on such companies. What were the key areas of focus that should have been looked at? Raffi stared at the blank screen and started putting his thoughts into a document.

10

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 1: A NOTE FROM SEQUOIA CAPITAL TO LIMITED PARTNERS MARKING FTX STAKE DOWN TO $0

Source: Sequoia Capital, https://www.sequoiacap.com/, accessed 1 April 2023.

11

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 2: SHARE OF CRYPTO DERIVATIVES TRADING BY COUNTRY

20000

25000

30000

35000

40000

45000

50000

Source: T. Christina, S, Sedlova, E, Dmitriev and A. Zarazinski, “Geotagging Crypto Derivatives Traders With NLP,” Inca Digital, 2021, accessed 1 April 2023.

12

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 3: COMPARISON OF DECENTRALISED EXCHANGES WITH CENTRALISED EXCHANGES

The key differences between centralised and decentralised exchanges broken down by levels of regulatory compliance, user accessibility, liquidity, and fee structures.

Source: H. Arslanian, The Book of Crypto: The Complete Guide to Understanding Bitcoin, Cryptocurrencies and Digital Assets (London, UK: Palgrave Macmillan, 2022), pp. 338.

13

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23 /7

7 2C

T

he F

T X

C o

lla ps

e :

D u

e D

ili g

en ce

a nd

C o

un te

rp a

rt y

R is

k M

iti g

at io

n W

he n

In ve

st in

g in

C ry

p to

C o

m p

a ni

e s

E X

H IB

IT 4

: T

R A

D E

V O

L U

M E

O F

M A

JO R

C E

N T

R A

L IS

E D

C R

Y P

T O

E X

C H

A N

G E

S B

Y M

O N

T H

So u

rc e:

T h

e B

lo ck

, C ry

p to

cu rr

en cy

M on

th ly

E xc

ha n

ge V

ol u

m e,

h tt

p s:

//w w

w .t

h eb

lo ck

.c o/

d at

a/ cr

yp to

-m ar

k et

s/ sp

ot /c

ry p

to cu

rr en

cy -e

xc ha

n ge

-v ol

um e-

m on

th ly

, ac

ce ss

ed 2

7 M

ar ch

2 02

3.

14

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23 /7

7 2C

T

he F

T X

C o

lla ps

e :

D u

e D

ili g

en ce

a nd

C o

un te

rp a

rt y

R is

k M

iti g

at io

n W

he n

In ve

st in

g in

C ry

p to

C o

m p

a ni

e s

E X

H IB

IT 5

: T

R A

D E

V O

L U

M E

O F

M A

JO R

D E

C E

N T

R A

L IS

E D

C R

Y P

T O

E X

C H

A N

G E

S B

Y M

O N

T H

So u

rc e:

T h

e B

lo ck

, D E

X V

ol um

e, h

tt ps

:/ /w

w w

.t h

eb lo

ck .c

o/ da

ta /d

ec en

tr al

iz ed

-f in

an ce

/d ex

-n on

-c us

to d

ia l/

d ex

-v ol

um e-

m on

th ly

, a cc

es se

d 2

7 M

ar ch

2 02

3.

15

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 6: RATIO OF DECENTRALISED TO CENTRALISED CRYPTO EXCHANGE TRADE VOLUME

Source: The Block, DEX to CEX Spot Trade Volume (%), https://www.theblock.co/data/decentralized-finance/dex-non-custodial/dex-to-cex-spot-trade- volume, accessed 27 March 2023.

16

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 7: THE SBF MACHINE

FTX and SBF had a massive reach. Here is a chart of the major firms that invested in FTX, firms with funds held by FTX, significant FTX investments, celebrities who invested in FTX, companies SBF invested in and startups that Alameda Research led investments into.

Source: C. Weinberg, Inside the Venture FOMO Machine That Powered SBF’s Meteoric Rise,” The Information, 11 November 2022, https://www.theinformation.com/articles/inside-the- venture-fomo-machine-that-powered-sbfs-meteoric-rise?rc=xrnyxn, accessed 10 April 2023.

17

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 8: AN EXAMPLE OF SBF’S LEVEL OF INFLUENCE

Source: Dan Keeler [@dankeeler] 28 April 2022, Tony Blair and Bill Clinton on stage with SBF [Tweet]. Retrieved from https://twitter.com/dankeeler/status/1519780887893790724?lang=en.

18

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 9: “THE NEW JOHN PIERPONT MORGAN”

Comments equating SBF to John Pierpont Morgan became frequent by the summer of 2022.

Source: Skybridge Capital [@skybridge] 21 June 2022, SBF is the new JP Morgan [Tweet]. Retrieved from https://twitter.com/SkyBridge/status/1539337803083005957.

19

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 10: THE TWEET BY BINANCE CEO CZ TO LIQUIDATE FTT

FTX’s early November implosion occurred almost entirely on Twitter. Events accelerated when Binance CEO CZ announced the exchange would reduce its exposure to FTX Token (FTT).

Source: CZ [@cz_binance] 6 November 2022, Binance to liquidate FTT [Tweet]. Retrieved from https://twitter.com/cz_binance/status/1589374530413215744?lang=en.

20

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 11: THE TWEET BY SBF ASSURING FTX USERS

A screenshot of a now infamous tweet by SBF assuring FTX users that their funds were safe and that the exchange was experiencing a small liquidity problem.

Source: C. Hetzner, “Sam Bankman-Fried quietly deletes his claim that FTX customer funds are safe,” Fortune, 9 November 2022, https://fortune.com/2022/11/09/ftx-binance-sam-bankman- fried-customer-funds-deposits-safe/, accessed 10 April 2023.

21

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

23/772C The FTX Collapse: Due Diligence and Counterparty Risk Mitigation When Investing in Crypto Companies

EXHIBIT 12: THE TWEET BY CZ ANNOUNCING BINANCE’S INTENT TO ACQUIRE FTX

A surprise announcement from Binance CEO CZ temporarily calmed crypto markets. Within 24 hours, the deal would be dead.

Source: CZ [@cz_binance] 8 November 2022, Binance to acquire FTX [Tweet]. Retrieved from https://twitter.com/cz_binance/status/1590013613586411520.

22

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.