Matt Stankiewicz, Partner at The Volkov Law Group, joins us with a comprehensive blog series that will breakdown the various legal issues facing the fallen cryptocurrency exchange FTX and its disgraced founder Sam Bankman-Fried.  He can be reached at [email protected].

The cryptocurrency world is in shock watching the events unfold around the stunning collapse of FTX, one of the largest crypto exchanges in the world.  The exchange seemed untouchable just days before everything fell apart.  Sam Bankman-Fried, the enigmatic CEO (commonly referred to as “SBF”), was the darling of Silicon Valley and Wall Street.  The company was able to raise an immense amount of funds from investors, including most recently $400 million in January 2022 at a valuation of $32 billion.  This brought the company’s total equity raise to $1.8 billion to that point.  

The company seemed to be throwing an endless war chest of cash at its marketing efforts, purchasing the naming rights to the Miami Heat basketball arena, displaying an FTX badge on every MLB umpire’s uniform, and enlisting an endless roster of marketing juggernauts including Tom Brady, Gisele Bündchen, Steph Curry, Naomi Osaka, Trevor Lawrence, Larry David, Shohei Ohtani, and Shaquille O’Neal.  Behind the scenes, various executives were able to purchase multi-million-dollar properties in the Bahamas and elsewhere, living lavish lifestyles.  The company and its executives also donated heavily to political parties and their candidates. FTX was a behemoth and appeared to be the gold standard for the industry.

As it turns out, this was all a farce.  Following a rapid series of events that caused a bank run on the exchange (sparked by its biggest competitor, Binance, which has its own issues), FTX suddenly found itself well short of the assets necessary to cover user withdrawals and quickly became insolvent.  The precipitous flow of information that followed suggested that the company was frequently and egregiously dipping into customer deposits to fund its endeavors.  The whole project was a fraud. 

Currently, it is believed that FTX customers are facing $8 billion in losses, and everyone is wondering – where did all the money go? 

For some background, FTX was a cryptocurrency exchange headquartered in The Bahamas.  It had a significant number of subsidiaries spread out across various jurisdictions, including a prominent one in the US named FTX US.  The primary business of FTX was to allow users to trade various cryptocurrencies, including various derivative products.  It was easily one of the most popular exchanges in the industry, with only Binance operating in the same stratosphere.

In addition to the exchange, FTX was also closely tied to Alameda Research (“Alameda”), a cryptocurrency trading firm.  According to past records, SBF owned approximately 90-percent of Alameda.  This entity appears to be key to many of the current issues.  At its core, the company traded high volumes of cryptocurrency, taking advantage of various arbitrage trades or market making opportunities.  Unfortunately, it appears they were not very good at the one thing they were set up to do. 

Alameda was rumored to receive preferential treatment on the FTX platform at the expense of FTX customers.  Reports suggest that Alameda would amass large positions of tokens prior to their announcements that they would be listed on FTX exchange, which inevitably spiked the price.  Alameda may have enjoyed faster execution on the platform.  Alameda was also exempt from FTX’s automated liquidation process when margin trading. 

Despite these advantages, reports began to leak that Alameda was suffering large losses.  To plug the losses, FTX granted Alameda large loans that were paid from customer deposits – rumored to be half the total customer deposits on the FTX platform.  Alameda then essentially gambled these user funds through the downward swing of the cryptocurrency market, losing virtually all of it through bad trades.  These loans were made through a bookkeeping “back door” to circumvent the exchanges (now known to be embarrassingly weak) controls.  Alameda CEO Caroline Ellison and FTX executives Nishad Singh and Gary Wang were the others that were allegedly aware of the loans, and it is rumored that at least one of these individuals is cooperating with authorities. 

Following the drastic loss of customer deposits, FTX’s balance sheet consisted primarily of large holdings of its own token – the FTX Token, also known as FTT.  The token’s worth was ultimately pegged against the health of the exchange, or, more appropriate, the perceived health.  As rumors circulated regarding potential liquidity issues, the value of the token began to plummet.  Other than the FTX token, much of FTX’s remaining assets were tied up in various illiquid cryptocurrency projects.  A leaked balance sheet noted $3.2 billion in “less liquid” assets.  For example, FTX held a significant amount of Serum tokens, however there was not nearly enough liquidity in the market for them to ever “cash out” those tokens into the value they claimed them to be.  

All of this led to a spectacular and unprecedented collapse of what was believed to be the gold standard of cryptocurrency exchanges.  In addition to a staggering loss of customer funds, these events will leave a long-lasting scar and cause immense reputational damage to the entire industry.  The company has already initiated bankruptcy proceedings, and the initial comments from the law firm spearheading this effort reveals a stunning lack of basic compliance controls.  Furthermore, considering the severity of the issues, law enforcement and regulators worked quickly to bring charges against SBF for his central role in the activities here.  The U.S. Department of Justice, U.S. Securities and Exchange Commission, and Commodity Futures Trading Commission have all brought actions in recent days.