FTX: A failure of due diligence

Michael Freeman

What happened to FTX, and more importantly, what should we think about going forward?

I feel horrible for the people who lost money in FTX and am enraged by the actions that led up to the collapse. Investments have risks, but no one should be subject to what happened here. As a due diligence professional, these are the exact circumstance we work hard to avoid and protect investors from.  

What Happened To FTX:

Sam Bankman-Fried’s FTX (a crypto exchange) and portfolio of companies, including hedge fund-like firm Alameda filed for bankruptcy this past week due to what is commonly known as a run on the bank; clients wanted to withdraw their money. What started the run was FTX's rival Binance's CEO Changpeng Zhao, who tweeted

"As part of Binance's exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have came to light, we have decided to liquidate any remaining FTT on our books."

FTT is a cryptocurrency that FTX created (yes, basically printing its own money).

What happened next uncovered a series of fundamental issues in the FTX companies.

  • Alameda made some bad investments; therefore, FTX moved some money to Alameda to cover the losses.
  • Some of this money came from client accounts which worked until the clients asked for their money back (sounds a lot like the Bernie Madoff scheme).
  • When the money ran low, just print some more money, this is where FTT was sold to clients.
  • But when a major holder of FTT calls to sell the currency, the price drops, clients get worried and ask for dollars back, and the whole thing comes down.

This is the short version, with many more issues under this global enterprise.

What Does All This Mean:

When I was in the dot.com era at a startup, some key buzzwords were Eye Balls and, my favorite, it's all about Net Future Expectations (earnings per share (EPS) doesn't matter anymore). This last phrase was from a prominent big 5 accounting firm. Many great things came out of the internet bubble and its eventual collapse, but it was not Eye Balls or Net Future Expectations.

Drawing these parallels to the Crypto, Blockchain, and the FTX issues of today, these are three separate items to talk through.

Crypto – aka Eye Balls

Crypto will have a future in our financial lives, with many predictions as to how, but it has two major issues in broad adoption.

  • The price has too much fluctuation to be a "real" currency. It either needs to be called a speculative investment or find a way to stabilize the currency. Speaking from a person who believes in calling things what they are (i.e., Due Diligence Works, guess what we do). Cryptocurrency is currently a bad name (so the name needs to change to match the product, or the product needs to change to match the name).
  • If a particular currency can keep creating coins unregulated (by regulated, I do include community regulations as well), then this will never work. Think about the US government's control of the money supply and what happens when the money supply is too plentiful.

Blockchain technology – This is the internet of 90s

  • This is the technology that, in simple terms, allows someone to uniquely own something digitally. Used for coins or NFT (Non-Fungible Tokens) but can certainly have much broader applicability. Think content, patents, bank accounts, basically distributing the ownership right to the digital world versus relying on the government or a financial institution.

FTX – A victim of Net Future Expectation

FTX’s growth was clouded by Net Future Expectations which attracted money from many smart people with deep pockets. The New York Times reports that Iconiq Capital, Lux Capital, Mayfield, Insight Partners, Sequoia Capital, SoftBank, Lightspeed Venture Partners, Ribbit Capital, Temasek Holdings, BlackRock, and Thoma Bravo are all on the list of FTX investors.

In moving so fast, even the smartest among us missed some basic steps, it's called due diligence. This one was pretty easy in hind site….

Due Diligence Review Area Pass / Fail What Due Diligence Would Have Found
Officers and Principles Fail No track record (you could argue that no one has a track record here, but then everything else needs a careful review).
Organizational Structure Fail Conflicts exist between sister companies having the same ownership (Alameda was FTX's biggest client).
Compliance Structure Fail Certainly not enough with the right oversight.
Conflicts Fail Too many to count.
Custody Fail Client assets were moved to its sister firm.
Valuation Fail FTT was basically an in-house cryptocurrency with no real market value.

To loosely quote Charlie Munger (Warren Buffet's right hand) from a recent interview with CNBC

"The guy says I’m gonna sell you plenty of nothing and nothing is plenty for you."

…which loosely comes from the song by Frank Sinatra, "I Got Plenty of Nothing."

I can go on and on from here. Sam Blankman-Fried is undoubtedly a brilliant person in the crypto space, which in itself is the biggest problem. He created, monitored, policed the network, and told everyone else what to think. When you have this much power, experience and ethics are what you have to fall back on. Both seem to be short here, and what occurred is criminal (I don't mean in the legal sense, I will let others opine on this, but in the ethical sense of the word).

When we perform Due Diligence on companies or products, sometimes we are questioned why we need to ask specific questions and why we need to review certain documents, or an experienced principal believes they are above answering questions. Rest assured, everyone caught up in the FTX disaster wishes they paused and did a little due diligence first.

From the dot.com era, many companies no longer exist, like the one I worked for at the time. The era provided the foundation for numerous tech benefits we take for granted now: fiber optic cables, broadband, and e-commerce. As this unfolds and time passes, I am sure similar advances will be created, but it is painful to watch history repeat. Take a pause and do your due diligence.

MORE INFORMATION:
MikeFor more information about the author DDW's products and services, contact Mike Freeman, President of DDW.

917.328.7498 | michael.freeman@duediligenceworks.com

 

Leave a Comment

Blog posts

Related Articles

Michael Freeman

What We Learned at the National Society of Compliance Professionals’ (NSCP) National Conference

 

There were 4 primary themes that ran throughout the compliance conference.

Read more
Michael Freeman

Takeaways from the FINRA Small Firms Conference - Los Angeles, November 2022

Key Themes Discussed:  Reg BI,  Complex Products,  Best Ex Reviews 

Read more