Explaining the FTX Implosion, and How VCs can avoid being tricked by obvious frauds

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.

From compromised systems integrity and faulty regulatory oversight abroad to the concentration of control in the hands of a very small group of inexperienced, unsophisticated, and potentially compromised individuals, this situation is unprecedented.

The debtors did not have the type of disbursement controls that I believe are appropriate for a business enterprise. For example, employees of the FTX Group submitted payment requests through an online ‘chat’ platform where a disparate group of supervisors approved disbursements by responding with personalized emojis.

John Ray III on FTX’s?complete lack of governance

Newly appointed FTX CEO John Ray III, who formerly served as CEO of Enron after the implosion of the energy titan, certainly minced no words in the FTX’s filings with the U.S. Bankruptcy Court for the District of Delaware. With damning evidence revealing FTX misappropriated both investor and customer funds, Ray promised to work with regulators to investigate FTX founder and former CEO Sam Bankman-Fried.

The Origin

Located in the Bahamas, FTX is one of the main cryptocurrency exchanges that also owns a much smaller U.S. exchange called FTX.US. Sam Bankman-Fried, known as SBF, also runs a trading firm called Alameda Research. Together, Alameda and FTX allowed SBF to amass an enormous $16B fortune, which he promptly set about donating to various “effective altruism” causes (and to politicians). Once compared to titans such as Warren Buffett and JP Morgan, SBF had become the face of crypto in recent years.

The Implosion

On November 2nd, 2022, Coindesk, a crypto news site, discovered that Alameda was holding quite a lot of the FTT tokens created by FTX, and had borrowed huge amounts of money – some $7.4 billion from FTX — presumably using these tokens as collateral. Learning about this, Binance, FTX’s main rival, decided to dump its holdings of FTX’s tokens. The sale of the tokens led to their precipitous price drop, rendering Alameda abruptly insolvent. This in turn has rendered FTX itself insolvent. Failing to reach a bailout agreement from Binance, FTX has filed for bankruptcy.?

The Crypto Contagion

Soon after FTX’s bankruptcy filing, the crisis caused problems for a growing list of firms, some considered cornerstones of the crypto industry.

Among them is crypto lender BlockFi, one of a handful of companies FTX bailed out in recent months, which is considering filing for bankruptcy just days after the company paused client withdrawals due to its significant exposure to FTX and associated corporate entities.?

( Update: BlockFi has just filed bankruptcy as FTX fallout spreads )

The crisis also touched a high-profile crypto lender run by the billionaire twins Cameron Winklevoss and Tyler Winklevoss, forcing them to halt withdrawals from their Gemini Earn crypto lending program.

The domino fall of these crypto lenders is a classic case of contagion. That’s when the failure of one institution sets off a “bank run” where customers rush to redeem their money, which makes the institution's lending and borrowing impossible — ultimately generating a cascade of similar closures from other firms.

The Terra/Luna Meltdown - the first episode of the crypto bank run

Stablecoins like the one that melted down recently. Basically, the Luna and the Terra were sorts of their own version of “borrow short lend long” to create fake safe and liquid assets. As long as everybody thought this fake safe and liquid was a non-fake and was indeed safe and liquid, then the combined value of the cryptocurrencies ( Terra and Luna ) was really high. As soon as they thought it wasn’t going to be so great which it clearly wasn’t going to be, the combined value goes down. Then there’s a run on the cryptocurrency.??

But pretty much anything that looks like it might make people a lot of money. So if you lent money in the Terra, you got a 14% return. If someone is offering a 14% return when the interest rate is zero, you know it’s not going to give you a real return. So that would be my advice that financial products in the crypto space headed toward households are probably fraudulent.?

University of Chicago Douglas Diamond, co-winner of the 2022 Nobel economics prize, explains how the crypto Terra/Luna meltdown can lead to a bank run.?

As Professor Diamond explained, a 14% return is too good to be true when the interest rate is zero. And it is exactly the type of loan that BlockFi had extended to 3 Arrows Capital ( 3AC ). With the Terra/Luna crash, 3AC can no longer pay BlockFi back since its collateral Terra/Luna stablecoin had just lost all of its value. BlockFi in turn had become insolvent.?

As part of its money-looting scheme to sweep in BlockFi’s depositor funds into FTX’s, FTX stepped in and bailed out BlockFi.?

Professor Douglas Diamond’s explanation of the Terra/Luna meltdown starts at 24:56

Apologies from Sequoia

Despite its extensive research and thorough due diligence, Sequoia, one of the storied VCs behind FTX, had to apologize to its LPs on a call and said they would do better, by maybe using the Big 4 to audit all startups.

Strong Governance is Needed

What they should have known however are the basic red flags - does this $25 Billion company, going on a trillion by all accounts, have an actual accountant? Is there an actual management team in place? Do they have, like, a back office? Do they know how many employees they have? Do they engage professional services like lawyers to figure out how to construct the corporate structure maze? Do they routinely lend hundreds of millions of dollars to the CEO??

Sure Temasek didn’t get a Board seat, but did they know there was no Board at all? Or how exactly Alameda and FTX were intertwined, if not all the other 130 entities? It seems sensible to ask these things, even if you’re only risking 0.09% of your capital.

Rohit Krishnan on the governance red flags of FTX

The FTX meltdown has brought to light the criticality of governance.

At Good AI, as ESG ( Environmental Sustainability, Social Responsibility, Governance ) is core to our investment strategies, we took the issues of governance seriously.

To pass our due diligence process, a startup needs to have a board with well-qualified directors. We would take a board seat if it makes sense. A data room with audited financials, corporate formation documents, a cap table with transparent equity ownership, and customer contracts will also be required for our investment due diligence.

With our focus on governance, we also have a strong interest in cybersecurity, customer privacy, data protection, and compliance. We are very interested in startups that can leverage AI/Machine Learning to automate complex tasks, providing the highest level of protection and transparency.

Failure is common. Losing money on investments like Fast or Volt or Katerra or Quibi or CommonBond or Reali are par for the course - you invest hoping for a particular future that turns out to not be real. And while those can be criticised for being obviously silly, or only viable in low interest rate environments, that’s the risk that VCs are paid to take. The job is to take risks, but not all risks are built the same. The risk you shouldn’t take is to ignore the pile of rubble strewn about you while dreaming about building Arcadia.

Rohit Krishnan advice for VC investment after the FTX crash