Saturday, December 3, 2022

FTX: The Collapse of a Cryptocurrency Exchange

FTX: The Collapse of a Cryptocurrency Exchange (2022)  

By Ian Pahl  

Abstract  

FTX Logo
Once thought to be a safe investment for many, the cryptocurrency exchange FTX lost billions of dollars and lied to its investors and clients through their fraudulent acts with customer funds. FTX funneled customer funds illegally to Alameda Research to participate in high-risk trading, which ultimately led to their demise. They were forced into bankruptcy by November 11 because the value of one of their largest volatile investments, FTT, crashed and they were unable to return their clients' money since they had none left.  

Individualists support the ideology that an entity's only ethical goal should be maximizing profits as long as it remains inside the law. An individualist would not support the actions that took place at FTX, as Sam Bankman-Fried participated in illegal activities through the use of customer funds for his own personal gain. A Utilitarians' ethical focus is to maximize happiness for the majority. They would look down upon FTX as the controversy continues to unravel, we find more and more fraud and lies that SBF told to keep himself and a handful of others safe. A very selfish act that ignores the millions of people that lost an enormous amount of money due to his actions. Kantians look at the decisions made by an individual person, focusing on the motivation behind each action. A Kantian would evaluate the CEO of FTX, Sam Bankman-Fried, and his decision to use customer funds to make risky investments as unethical because it is against the law, and they disrespected their customers by using their hard-earned money for personal gain. Lastly, virtue theory looks at the character of an individual through the four virtues of character: courage, temperance, justice, and honesty. FTX violated all these virtues, first by lying to their customers, taking their money, and then avoiding the law by denying their participation in illegal acts. To this day SBF actively participates in interviews trying to polish his image by denying his involvement in the actions that took place. I believe regulations need to be added to the cryptocurrency market so exchanges and trading firms can be monitored more closely, and it will likely reduce the amount of fraud inside the industry.  

Background  

When talking about FTX, we must talk about Sam Bankman-Fried, the supposed reason that FTX collapsed. SBF is well-known for his altruistic behavior, stating that he has donated upwards of $40 million to the Democratic Party. He was born into wealth, as both of his parents are successful Stanford Law Professors who regularly donated money previously. SBF attended MIT (Massachusetts Institute of Technology) (Massachusetts Institute of Technology), where he obtained a summer internship with JSC (Jane State Capital), a trading firm, then continued his career full-time in market

Picture of Sam Bankman-Fried
trading at JSC after graduating with a BA in physics and a minor in math. After working at JSC for a couple of years, SBF created his own trading firm alongside Tara Mac Aulay, an employee of the Centre for Effective Altruism, which he previously took part in when he moved to Berkley, California, and developed Alameda Research in September 2017. Alameda Research was able to generate its earnings through an arbitrage trade cleverly set up by SBF, moving bitcoin from the USA to Japan. SBF used his newfound fortune to venture into the cryptocurrency world, eventually launching FTX with a former Google employee and friend, Gary Wang, in May of 2019; FTX was purposely based in Hong Kong, where digital assets are not clearly regulated. In September of 2021, FTX would move its headquarters to the Bahamas due to the harsh COVID-19 restrictions in Hong Kong and the favorable regulatory environment created by the newly passed Dare Act, where it now resides to this day.  

Controversy  

FTX was created in May of 2019 by SBF and Co-Founder Gary Wang; its beginnings can be traced back to a trading firm referred to as Alameda Research. Alameda Research was started by SBF and his close friends, along with previous employees from his last place of employment, Jane Street Capital. The controversies surrounding FTX began to appear when it was leaked that SBF's own Alameda Research was heavily invested in FTX's crypto token, FTT. With this information, two things became apparent: FTX was using their clients' investments as a safety net to invest in otherwise risky businesses, and they must be lacking significant funds to be investing in a source of income that is highly volatile. It soon became apparent that this entire situation is a textbook Ponzi scheme in which investors are promised a higher return on their investment with little risk to the investor, creating new money from new investors and repaying previous investors. FTX invested its customers' funds in its own FTT token, promising investors a higher return on their investment. This effectively inflated the value of FTT and generated revenue from customers continuing to invest. The foundation of this scheme for FTX was their FTT token; provided that the value of this token remained at a constant or increasing value, they could make money and pay back the investor funds they used to inflate its value. SBF also used customer funds to pay off loans for Alameda Research and make risky investments, which is very illegal but also keeps the trading firm afloat and made him more money. Further investigation revealed that many of these cryptocurrency exchanges, one of which is Binance, use a similar method, using their own crypto tokens to back up their business, showing the volatility of the entire industry. Realistically, these exchanges can't afford to stay in business without investing money to create more money, very similar to a bank, but since the crypto market is unregulated, there are no promises as to what could happen to investors' money, creating business models that will almost always fail in the long run. One of the top exchanges, Coinbase, has proven that they aren't backed by their investors' investments, making money by taking a percentage of a customer's investment for themselves, but even then, we can see the rapid decline of Coinbase as there isn't enough profit being made to stay in business.   

Following the discovery that the value of the FTT token was the exact amount of the customers' deposits and that the entire exchange was based on this token, people realized that if everyone asked for their money back, they would not be paid the amount promised because the value of the token would decrease as it was sold. The divulgence of this information led the CEO of Binance, Changpeng Zhao,

The price of the FTT after it plummeted
to sell his holdings of FTT tokens, in which he was heavily invested in, which in turn caused the token's value to diminish greatly. People quickly realize that they won't make their money back and frantically sell their holdings to maintain the cash amount they initially invested, effectively crashing the entire worth of the token; FTX completely collapses, they have no money left, and the outcome is looking bleak. To prevent the destruction of the market, larger corporations like Binance, one of FTX's rivals, attempted to buy out the business entirely, not realizing the amount of debt they were truly in. Binance, as well as many other companies, decide not to purchase FTX, as doing so would make them lose money in the long run; FTX is unable to pay back their investors, leaving many celebrities and companies, such as TSM and Tom Brady without their return on investment, losing them hundreds of millions of dollars.  

Throughout the demise of FTX, the Securities Commission of The Bahamas, the U.S. Securities and Exchange Commission (SEC), and the U.S. Department of Justice (DoJ) launched their investigations into FTX. The Securities Commission of The Bahamas took it upon themselves to freeze all assets related to FTX along with those affiliated with them, releasing a statement saying, "The Securities Commission of The Bahamas (the Commission) took action to freeze assets of FTX Digital Markets and related parties. The Commission also suspended the registration and applied to the Supreme Court of The Bahamas for the appointment of a provisional liquidator of FTX Digital Markets Ltd." (Securities Commission of The Bahamas 1).  On November 11, FTX would quickly file for bankruptcy after this regulation was put in place, and CEO Sam Bankman-Fried resigned, appointing John Ray to liquidate the company. In a statement submitted to the United States Bankruptcy Court in the District of Delaware, John Ray, a well-known liquidator of large corporations that were involved in scandals similar to FTX, claims on November 17, "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," (IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF DELAWARE  5) demonstrating the extent of fraud associated with FTX. On November 14, a few days after the declaration of bankruptcy, it was found that between $1 billion and $2 billion of FTX customer funds had seemingly disappeared. SBF has publicly stated that he transferred upwards of ten billion dollars of customer funds to his trading firm, Alameda Research; the majority of that money has also seemingly vanished, raising suspicions and indicating fraudulent acts towards FTX's financial bookkeeping. The involvement of the SEC and the DoJ will likely produce an unfavorable outcome for the crypto market, putting more regulation on crypto which was purposely created so the government wouldn’t be involved. The future of this case remains unknown as it is ongoing, but some sort of regulation of the crypto market seems to be imminent.  

Timeline of the events that occurred

Stakeholders  

The main stakeholders in the FTX case were the people working directly for the business, such as Caroline Ellison, Sam Bankman-Fried, Gary Wang, and Changpeng Zhao. SBF was the head of the operation during the scandal as the appointed CEO of FTX. He transferred money to and from Alameda Research with customer funds and invested in volatile currencies that produced disastrous outcomes. SBF was well known inside the industry for making promises of guaranteed money with no risk, describing his money-making method on a now-deleted podcast years before the scandal took place, inadvertently describing a thing called "yield farming," which is basically just a glorified Ponzi scheme. While SBF was the supposed mastermind, Caroline Ellison, as the appointed CEO of Alameda Research, played along with his scheme trying to conceal it, turning a blind eye to the illicit funneling of customer funds into Alameda. Little is known about Gary Wang, a co-founder of FTX, but he is thought to be the hidden cause of FTX's rise and fall. He is quite educated about the basis of price savings and the market because he was employed as the Chief Technology Officer for both FTX and Google. He even takes credit for a system that was developed to aggregate prices across public flight data while he was employed by Google. After the company declared bankruptcy, John Ray III was appointed CEO and served as a liquidator. Numerous companies were invested in FTX, some being Temasek, Paradigm, Sequoia, OTPP, and Binance, forming sponsorship agreements benefiting each other. After the collapse of FTX, these companies were left empty-handed, losing billions of dollars in the process. Many popular celebrities, like Larry David, Tom Brady, Shaquille O'Neal, and Stephen Curry, were in a partnership to promote FTX in exchange for millions of dollars in investment in the company. When FTX filed for bankruptcy, these celebrities lost hundreds of millions of dollars, similar to the corporations. Lastly, the main stakeholders in the company were the users of FTX, who provided SBF with the funds needed to continue its operations, despite losing millions of dollars in the process. It's said that the collapse caused financial issues for more than a million people who were users of FTX.  

Individualism  

From an individualist standpoint, Sam Bankman-Fried maximized his profits while doing what was best for FTX. Milton Friedman's idea of individualism was stated as "The only goal of business is to profit, so the only obligation that the businessperson has is to maximize profit for the owner or the stockholders within the law." (Salazar 15)The actions taken by FTX to increase profits were at first, legal; in fact, most of the crypto industry follows this type of business model; for example, Binance is backed by its own crypto token, which they use to pay back its investors and the price rises on the token as more money is invested in it. While not only focusing on FTX, Alameda Research, which was also owned by SBF, was able to gain profits legally through an arbitrage trade setup by buying bitcoin in the USA and selling it in Japan, not focusing on the damage it would cause to the market. Individualists would support SBF's initial actions because his main goal was to earn as much money as possible while remaining within the legal boundaries. Individualists would begin to disagree with SBF’s actions at the point in which he secretly funneled customer funds into Alameda Research. At this point, SBF violated Section 205.2(k) of the Electronic Funds Transfer Act, effectively stealing their money and moving from maximizing profits to blatantly violating the law.  

The transfer of customer funds between FTX and Alameda Research directly opposes individualists, as it's illegal and limits the profits that could be made by giving profits away through the risky investments they took. The reason this was illegal was due to the way the money was spent and where it was taken from, using these funds to make risky investments that wouldn't ordinarily be taken. All of this was taking place under the radar of auditors and investors, and the funds were taken without the knowledge of the user. SBF, who is well-known for his altruism, can be seen donating millions to the Democratic Party, which goes against the ideology of an individualist who would likely keep the money for the company. An individualist today would support SBF's early money-making methods while at Alameda Research but would disagree with his altruistic behavior and how he became corrupt at the end of FTX's lifespan.  

Utilitarianism  

The theory of utilitarianism enforces the idea that morality advocates actions that maximize overall happiness for yourself and others. A utilitarian would not find much to support FTX; most of their actions directly impacted the happiness of others, but through lies and deception, we can find false promises that they would support. A considerable number of investors that interacted with SBF all pitched the same business plan of generating a higher return on investment with little risk, which was an absolute dream for most. This plan would most definitely maximize happiness for everyone involved, but, as we all know, it was built on false promises and led to the absolute worst for most involved. One aspect of SBF that a utilitarian would support is his selfless donations to people in need, mostly to the support of Democrats. Looking at SBF's actions, we can see that, on the surface, he is a selfless person whom a utilitarian would support, but FTX's actions do not reflect his own ideologies.   

If we only looked at the operations of FTX, a utilitarian would despise the actions that took place throughout their lifespan. They took the necessary steps to maximize their profits while ignoring the consequences for others. FTX would regularly use billions of dollars of customer funds to put money into risky investments, something they wouldn't ordinarily do. Not only is this extremely illegal, but they also did it unannounced to the users who invested their hard-earned money into the company. Evan Luthra who lost two million dollars due to FTX’s scandal states his frustration “SBF is rubbing it in on us, [Bankman-Fried] knows what he did is a crime. He is rubbing it in and, through the media narrative, he’s spinning, trying to pin it as a mistake. I have no doubt that he knew what was going on. He should be in jail.” (FTX investors who lost up to $2M lash out, 3). This practice only benefits one side and eventually leads to unfavorable outcomes. Looking at the past, Alameda Research has long been known for its use of arbitrage trading, which has had a negative impact on the market by adding to its volatility and impacting the prices and the supply and demand of a certain asset. While on hand, SBF would probably be a utilitarian himself, but the company he managed directly opposed everything they would believe in, leading me to believe he was lying to everyone.   

 Kantianism  

Kantianism is the idea that the intention of an action has more value than the consequence of the action. Kant argues that we should do the right thing for the right reasons, despite the negative results that may occur when making the decision. This ideology relies on the idea that rationality is essential when talking about morality. When FTX began illegally funneling customer funds into Alameda Research they were violating the basic principles of Kantianism. They proceeded to conduct illegal acts going as far as stating they had no idea it was illegal in the first place. SBF said in an interview “I wasn’t running Alameda, I didn’t know exactly what was going on, I didn’t know the size of their position,”(CNBC,24) Despite his claims of ignorance about the fraud occurring at his own company, I believe he knew all of this was happening and chose to ignore it. The primary rule that every Kantian will ask themselves before making a decision is that your action should be repeatable for everyone else. When an illegal action takes place then it should not be repeatable for anyone.  

Tweet that Sam Bankman-Fried made
FTX took many risks while running its business, violating a basic principle of Kantianism. The consequence of these actions led to the ultimate demise of FTX, with SBF saying on Twitter, " I'm sorry. That's the biggest thing. I fucked up, and should have done better,"(Twitter, 1) knowingly making decisions that could lead to terrible outcomes. While SBF was posting his side on Twitter he made multiple claims that in the end, he violated. He statedMy goal—my one goal—is to do right by customers. I’m contributing what I can to doing so. I’m meeting in person with regulators and working with the teams to do what we can for customers. And after that, investors. But first, customers.” (Twitter, 13) This public statement was made before the liquidation of the company where the second act of fraud was publicly seen. When 10 billion dollars of customer funds were being transferred between FTX and Alameda Research, 1-2 billion dollars of these funds went mysteriously missing. You can come to any conclusion you desire, but I believe that he took this money intentionally, lying to all his users through his contradictory statement made on Twitter. It was unethical of SBF to say one thing and do another, lying directly to his users and making decisions for the betterment of himself.  

Virtue Theory  

Virtue theory is a type of moral philosophy that focuses on the character of the person carrying out an action, rather than on the action itself or its consequences. According to virtue theory, a morally good person is one who possesses positive character traits like courage, compassion, and honesty. The four main virtues are prudence, temperance, fortitude, and justiceThese virtues are accepted to be the basis of a person's character and are used to help a person make good decisions and act morally right. Since the beginning of his career, Sam Bankman-Fried has always been seen as a selfless character, with people going so far as to call him the world's most generous billionaire in multiple articles. He was given this title because of the large amount of money he gave to people—an estimated $40 million for the promotion of the Democratic Party alone.   

SBF’s commitment to prudence comes into play when he uses customer funds to invest in risky trades that he wouldn’t ordinarily make. The only reason for his investment in these risky trades is due to his new-found funds, and not thinking twice about throwing money at an uncertain investment. The funneling of customer funds between Alameda Research and FTX is a clear violation of justice as it was a clear breach of the legal realm. During the liquidation of FTX SBF transferred 10 billion dollars of customer funds between its two firms, when 1-2 billion dollars of these funds seemingly disappeared. SBF’s temperance is questioned here as we will never know with 100 percent certainty that he committed this act of thievery, but I personally believe he was the one who stole this large amount of money. He lost to his temptations and violated one of the four cardinal virtues. The last virtue that SBF is seen violating is fortitude. The aftermath of FTX led SBF into participating in numerous amounts of interviews stating his side of the collapse. In these interviews, he is adamant about remaining ignorant of the fact that fraud occurred in FTX. In the face of adversity, SBF decided the best decision was to lie about his involvement with the whole ordeal in order to save his own image. As the weeks continue, we can see the falsehoods being told by SBF slowly being unraveled and SBF is slowly crumbling around his throne of lies. Following the four cardinal virtues, SBF can be cited as violating all of them.  

Justified Ethic Evaluation  

In my opinion, FTX’s actions were unethical and unintelligent. The volatility of the cryptocurrency market makes it difficult for any firm to survive and the actions that most of these companies must take to survive in this industry are already considered unethical. As stated previously, I see the entire cryptocurrency market as a glorified Ponzi scheme, only able to make money through frowned-upon methods. If FTX remained in the legal realm for their business model, I believe they would still be thriving today, but the greed of Sam Bankman-Fried led to their demise. The decisions of FTX led to the loss of billions of dollars and negatively impacted the market for weeks.  

The crypto industry is a dying breed with a business model that will lead to the demise of everyone involved. The money in the market isn’t technically real and when the price of this fake money fluctuates so frequently eventually every company will get screwed over and be forced to shut down. I think FTX and other exchanges recognize this and are trying to figure out ways to remain relevant, and SBF chose to go the corrupt route. While I don’t support his decision to do so, I understand why he did it. This industry is cutthroat and everyday people are finding different loopholes to make more money or they too, will die out.  

The exposure to the media motivated SBF’s actions to uphold his self-image after the collapse of his company. To this day SBF continues to deny any involvement in the fraud that took place at the center of FTX. I think everyone knows that he was probably the most notable person during this time and probably conducted the fraud himself. He is also lying to avoid a harsher sentence when this case eventually gets to court. His desire to uphold his image outweighs morally correct ethical beliefs.   

Conclusion  

The collapse of FTX was a direct result of the abysmal regulation of the crypto market; it caused severe economic problems for the entire industry as well as everyone involved. The only way a crypto exchange will be able to make money is through frowned-upon methods that mimic something of a glorified Ponzi scheme. The illegal use of customer funds raised questions about what occurs within every crypto exchange, making everybody wonder how it was swept under the rug for so long. The facade that Sam Bankman-Fried portrayed was a lie to the people, and the actions he took while running FTX were made with greedy intent. Despite the economic atrocities that began because of the collapse, it showed how unpredictable the market is and put the spotlight on how we should be fixing this issue. With the government getting involved in this scandal, we can expect some sort of regulation to be put on the market, ruining the initial purpose for the creation of cryptocurrency. Hopefully, crimes like these will be eradicated in the future for the betterment of economic health.  

  

  

  

  

  

  

  

  

Sources  

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