The financial press has been all over the untimely demise of crypto “exchange” FTX and probable prosecution of its founder Sam Bankman-Fried. It’s too bad that for the most part, the financial press is still promoting the fraud-friendly Wild West of crypto by employing nomenclature that crypto touts use when talking to the press and customers that they disavow in their own legal agreements. FTX, for instance, disavowed that it was an exchange, as presumably most crypto “exchanges” do.1
We’ll start at the 50,000 foot level. FTX went bankrupt last Friday, with under $1 billion in liquid assets versus $ 9 billion in liabilities. Mind you, this black hole developed after Sam Bankman-Fried transferred $10 billon from FTX to his affiliated hedge fund, Alameda Research.
Many have taken to bandying about the term “Ponzi scheme”. But that’s doing a disservice to Ponzi schemes. Ponzi are well-ordered affairs and can carry on for quite a long time as long as there is enough new money coming in to satisfy the cash demands of those already in enterprise. Bernie Madoff’s ran for more than 20 years.
By contrast, setting out to falsify books and records sure looks like a plan to steal. From Reuters:
Bankman-Fried showed several spreadsheets to the heads of the company’s regulatory and legal teams that revealed FTX had moved around $10 billion in client funds from FTX to Alameda, the two people said. The spreadsheets displayed how much money FTX loaned to Alameda and what it was used for, they said.
The documents showed that between $1 billion and $2 billion of these funds were not accounted for among Alameda’s assets, the sources said. The spreadsheets did not indicate where this money was moved, and the sources said they don’t know what became of it.
In a subsequent examination, FTX legal and finance teams also learned that Bankman-Fried implemented what the two people described as a “backdoor” in FTX’s book-keeping system, which was built using bespoke software.
They said the “backdoor” allowed Bankman-Fried to execute commands that could alter the company’s financial records without alerting other people, including external auditors. This set-up meant that the movement of the $10 billion in funds to Alameda did not trigger internal compliance or accounting red flags at FTX, they said.
Get a load of the lack of agency: “FTX had moved around $10 billion of assets” as if no one in particular were responsible. Bankman-Fried denied creating the backdoor to Reuters, but he’s also trying to pass of the transferred and then disappeared $10 billion as just some sort of spreadsheet thingie that everybody missed.
And that’s not the only another backdoor. FTX let Bahamanian investors withdraw, citing regulatory preference. Wellie, someone profited from that:
– Algod realizes that he may not get his money, so thinks: What if I just did identity fraud? Openly offers $100K on his Twitter if someone from FTX would process his fake KYC application as a Bahamian to make this happen. pic.twitter.com/lucPxbAWZ4
— ∱allibilist (doppelgänger) (@TFallibilist) November 11, 2022
– Algod gets his withdrawals, also 1 to 1 on the distressed accounts he bought, making 10x on them.
– His wallet is doxxed, and that's where the money went, leaving a clean trail. Numbers running into the millions.https://t.co/sQxCiJGyJA
— ∱allibilist (doppelgänger) (@TFallibilist) November 11, 2022
Oh and this theft of the few remaining customer coins was set in motion by none other than FTX. From the Financial Times:
The Bahamas market regulator also said that it “has not directed, authorised or suggested to FTX Digital Markets Ltd the prioritisation of withdrawals for Bahamian clients”. FTX, which is based in the island nation, said after it halted customer withdrawals last week that it would allow redemptions of Bahamian funds “per Bahamian HQ’s regulation and regulators”.
Now FTX just happens to be headquartered in the Bahamas. Bankman-Fried is being detained by Bahamian authorities (they have a cute formulation, “under supervision“). It is not hard to surmise that FTX took this step to allow the execs and any staffers and friends in the Bahamas to hoover out the remaining monies.
On top of that, there’s allegedly a hack. It’s not clear whether it overlaps with the backdoor, the Bahamian two-step, or is a completely different scam, but it looks like the last. Needless to say, it’s awfully sus, or convenient, depending on your point of view, that it kicked in right after accounts were supposedly frozen as part of the bankruptcy process and regulatory interventions. From the Wall Street Journal:
Bankrupt cryptocurrency exchange FTX is probing a potential hack and asked customers to stay off the FTX website, the company said. More than $370 million worth of crypto funds appears to be missing, according to crypto analytics firm Elliptic Enterprises Ltd.
A rival crypto exchange said Saturday it knew the identity of the alleged hacker and would help authorities in their investigation.
The potential hack occurred Friday after FTX filed for bankruptcy. Ryne Miller, FTX US’s general counsel, said in a Saturday tweet that FTX and FTX US had started moving all digital assets to cold storage—crypto wallets that aren’t connected to the internet—after the bankruptcy filing….
Approximately $371 million in crypto assets appeared to be taken from FTX without permission, according to Tom Robinson, co-founder of Elliptic. More than $220 million of the tokens were quickly converted to the stablecoin dai or ether, the second-largest cryptocurrency, on so-called decentralized exchanges.
Such platforms process transactions automatically, making them popular among hackers to prevent funds from being seized, he said.
Another $186 million was also moved out of FTX’s accounts. Mr. Robinson said those assets were likely moved by FTX itself into secure storage after the bankruptcy filing.
Elliptic previously estimated that more than $500 million had been stolen in the hack. The analytics firm updated the figures after receiving new information about which transactions were authorized and which fund movements were part of the bankruptcy proceedings, according to Mr. Robinson.
Crypto exchange Kraken said it has been able to identify the user of the account associated with the unauthorized withdrawals from FTX.
So, based on this sketch, which might be too sketchy, one might speculate that this “hacker” purloined funds by moving them in a way that was essentially under cover of the transfer by FTX into cold storage, to the degree that Elliptic couldn’t tell them apart. And even though Kraken identified “the user,” is their KYC (“Know Your Customer”) process good enough that they can identify a real world person?
And yes, FTX was loosely run, to put it politely:
News is coming out from a @CoinDesk report that $32B exchange FTX was mostly being run by 10 people out of a Bahamas penthouse-
“All 10 are, or used to be, paired up in romantic relationships with each other.”
Gotta say, that might be the most profitable commune of all time.
— Danny Baldus-Strauss (@BackpackerFI) November 11, 2022
Now let’s turn to the FTX customer agreement, or more accurately, Terms of Service, which you can find on the Wayback Machine.
It’s the financial services industry version of a Nigerian scam letter. It would embarrass even a first year law student who’d gotten a C in contracts. One wonders if this is accident or design, given that Bankman-Fried’s father is a famously sanctimonious tax law professor at Stanford.
There are warning signs even before you give the document a good look, like its brevity (14 pages for the main agreement) and New York being a prohibited jurisdiction (presumably out of fear of New York State’s securities law, the Martin Act).
For instance, the agreement has some real howlers, like sweeping indemnification language followed by a Limitations of liability section which is unnecessary in light of the indemnification, and more limited.
The Your Content section flagrantly lies to customers. It declares “FTX.US does not claim any ownership rights in any User Content” and immediately contradicts that:
By making any User Content available through the Services you hereby grant to FTX.US a non-exclusive, transferable, worldwide, royalty-free license, with the right to sublicense, to use, copy, modify, create derivative works based upon, distribute, publicly display, and publicly perform your User Content in connection with operating and providing the Services.
Sorry, licenses do represent ownership rights. FTX’s terms suck out all their value.
Let’s get to the money part, where FTX was just as dishonest at it was in the [No Longer] Your Content section. Not that this sort of thing is uncommon in crypto-land, hence your humble blogger from the get-go calling crypto currencies “prosecution futures.”
A key thing to understand is that organizations like FTX are for the most part running unregulated mutual funds (aside from the provisions related to the handing of conventional currencies). Unless the contract very clearly says so, your coins are comingled in an omnibus account. The crypto players that do have what amount to separate accounts typically have different terms for their mingled coin offering and segregated ones, with the segregated accounts costing more.2
This language from FTX is false on its face:
6. Account Services. As part of your FTX.US Account, FTX.US provides qualifying users access to accounts for you to store, track, transfer, and manage your balances of cryptocurrency and/or dollars or other supported currency. All cryptocurrency or dollars (or other supported currencies) that are held in your account are held by FTX.US for your benefit….
Title to cryptocurrency represented in your FTX.US Account shall at all times remain with you and shall not transfer to FTX.US. Your balances in your FTX.US Account are not segregated and cryptocurrency or cash are held in shared addresses or accounts, as applicable. A valid purchase of cryptocurrency that is accepted by FTX.US generally will initiate on the business day we receive your instructions.
“Title to cryptocurrency represented in your FTX.US Account shall at all times remain with you” is contracted by the fact that the cryptocurrency goes into a pooled account. All you have is FTX’s ledger entries of what you have and its promise to honor them. You do not have ownership of those coins any more, just a claim on FTX if things go badly…oh, which you waived by agreeing to their egregious indemnification terms.
Put it another way, in a recent Credit Slips post, Georgetown Law professor and bankruptcy expert Adam Levitin was Seriously Not Happy about Binance’s failure to describe its custodial arrangements for its customer coin holdings. Levitin depicted Binance as an outlier among “exchanges”, in a bad way. I don’t see any mention of FTX in his recent article on cryptocurrency “exchanges” and bankruptcy, so I don’t believe he included FTX in that comparison. From what I can infer from his discussion of Binance, FTX if anything is worse.
As a lawyer friend summarized it: “We took your money and we’re keeping it and we’re not guaranteeing that you get it back.”
Separately, it is also frustrating to see the press and even experts refer to FTX and its brethren as exchanges when the Terms of Service pointedly avoid using that word (except a passing mention that FTX is not regulated by the Securities and Exchange Commission). It also denies that it is acting as a broker:
For the avoidance of doubt, FTX.US does not provide investment, tax, or
legal advice, nor does FTX.US broker trades on your behalf. All FTX.US trades are executed automatically, based on the parameters of your order instructions and in accordance with posted trade execution procedures…
Sorry, automated execution does not make a difference in determining whether a party is acting as a broker. This is silly drafting to try to shore up FTX presently falling outside securities and commodities regulation. In fact, at a minimum, all of these firms should fall under Investment Company Act of 1940 and be treated as fund managers.
In the mean time, some are having fun with this fiasco:
— Viscosity🧩Solutions aka Very Stupid Very Poor (@insilicobunker) November 14, 2022
But if you entrusted your coins to FTX and didn’t use the Bahama exit, you have ever reason to be explosively angry. You are almost certainly an unsecured creditor, which means at the very end of the recovery line in bankruptcy court.
1 There are too many “exchanges” to prove that negative without investing enormous amounts of time, but Georgetown law professor Adam Levitin did look at quite a few customer agreements and his paper seems to confirm that view.
2 From Levitin’s NOT YOUR KEYS, NOT YOUR COINS:UNPRICED CREDIT RISK IN CRYPTOCURRENCY Texas Law Review article:
Cryptocurrency exchange Gemini takes a different approach that underscores the commingling issue. Gemini offers its customers two different ways of holding cryptocurrency assets: a Depository Account or a Custody Account. In a Depository Account, Gemini will pool customers’ cryptocurrency holdings, which will be tracked solely on Gemini’s own ledger.
In contrast, in a Custody Account, Gemini will segregate the customer’s holdings with unique blockchain addresses, directly verifiable via the applicable blockchain, that will be indicated in Gemini’s books and records as “belonging” to the customer. A
Custody Account is “intend[ed] to create a bailment” of the cryptocurrency assets with Gemini.
Using a Custody Account is more expensive however— Gemini charges a 0.4% annual fee and a $125 fee per withdrawal.47 No such fees exist for Depository Accounts.