All the pigs at the trough: Some remarks about the collapse of FTX
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All the pigs at the trough: Some remarks about the collapse of FTX
We're just getting started with this story that will be with us for a while. So much great reporting!
I have written quite a few stories here about the crypto economy and various crypto assets such as tokens, including several stories on ICOs at MarketWatch, stablecoins, NFTs, and bitcoin on public company balance sheets.
Believe me when I say I really did not want to.
I have been a huge crypto skeptic from the start. I thought I could avoid writing about the industry. However, the growing presence of crypto-related assets on public company balance sheets, the interest of traditional financial firms in crypto, and then the IPO of a crypto exchange — Coinbase in April 2021— made digging in a necessity.
I searched on Twitter to see when was the first time I mentioned FTX, or I was mentioned, in a Tweet related to FTX.
On December 23, 2020, Sam Bankman-Fried, FTX co-founder and CEO, referred to commonly as SBF, replied to a tweet that I was tagged into by Tyler Gellasch.
That tweet was about how FTX had created a way to trade Coinbase pre-IPO, filed under the heading “FTX Crypto Derivatives Exchange”.
“CBSE, a pre-IPO contract that tracks Coinbase's market cap divided by 250 million. After Coinbase's first public trading day, CBSE will convert into the equivalent amount of Coinbase stock.”
So, holders of this derivatives contract became holders of Coinbase shares? FTX was also a broker dealer in equities?
Not exactly. This was supposed to be a “tokenized stock” but that page of the website is no longer functioning.
Back on Dec. 15, 2020, six days before the reply to Tyler and me, FTX had told The Block “it could launch contracts tied to Robinhood and Coinbase if it can figure out a way to properly structure them.”
FTX ended up taking a nearly 8% stake in Robinhood in May 2022.
Make no small plans
So, the plans were always bigger than crypto. Was anyone at the SEC or CFTC paying attention except in terms of finding a job for themselves or placating the boy genius SBF so their friends in politics could continue to get donations?
The American Prospect’s Dave Dayen recently painted the picture of Securities and Exchange Commission Chairman Gary Gensler valiantly trying to rein in crypto excess only to have his efforts thwarted at every turn by evil Congress persons of every political persuasion who had been the beneficiaries of millions in donations from FTX, Sam Bankman-Fried, and his accomplices.
The Securities and Exchange Commission was seeking information from collapsed cryptocurrency exchange FTX earlier this year, the Prospect has confirmed, bringing a new perspective to an effort by a bipartisan group of congressmembers to slow down that investigation.
The March letter from eight House members—four Democrats and four Republicans—questioned the SEC’s authority to make informal inquiries to crypto and blockchain companies, and intimated that the requests violated federal law.
Rep. Tom Emmer (R-MN), whom the Republican caucus just elected as majority whip, the number three position in the House GOP leadership, led the letter. In a contemporaneous Twitter thread, Emmer wrote:
“My office has received numerous tips from crypto and blockchain firms that SEC Chair GaryGensler’s information reporting ‘requests’ to the crypto community are overburdensome, don’t feel particularly … voluntary … and are stifling innovation.”
There’s that word “innovation” clouding their ability to snif out the scam right under their noses.
(Matt Stoller at Big wrote an equally strong defense of Gary Gensler’s futile efforts to whack at the moles — the crypto initiatives popping up everywhere.)
Dayen goes on to document some inconsequential individual donations to the letter-signers before getting to the big burrito in the room.
More consequentially, Emmer was the head of the National Republican Congressional Committee, the campaign arm for House Republicans, this year. The NRCC’s associated super PAC, the Congressional Leadership Fund, received $2.75 million from FTX in the 2022 cycle; $2 million from Salame in late September, and $750,000 from the company’s political action committee.
Dayen blames that money for the Democrats’ loss of the majority in the House at the midterms. Dayen also makes the astute point that the money was spread around on a bipartisan basis.
FTX has been portrayed as a Democratic firm, thanks to the high profile of former co-CEO Sam Bankman-Fried, but the company sprinkled around campaign donations fairly evenly, with a shade over 50 percent going directly to congressional Republicans and a shade under 50 percent to Democrats this cycle.
And today news broke that even Mitch McConnell had his snout in the trough.
FTX US, a part of Sam Bankman-Fried’s crypto empire that catered to American customers, contributed to a super-PAC fighting for control of the Senate in the midterm election just days before the company’s collapse.
The Senate Leadership Fund, which is aligned with Senate Republican Leader Mitch McConnell and was the top spender in the 2022 midterms, received the $1 million donation on Oct. 27, according to its most recent filing with the Federal Election Commission. Only a couple of weeks later, more than a 100 FTX-related companies, including the US arm, filed for bankruptcy, and Bankman-Fried resigned as head of the corporate group.
That’s reminiscent of how the Big Four global audit firms spread money around Congress — on a bipartisan basis to committee leaders who control legislation that may help or hurt their business and their clients’ businesses, especially for how PwC and EY lobby Congress on behalf of clients’ tax-related interests.
To use a hockey metaphor: The audit firms put their money more often where the puck is rather than where it’s going and hardly ever chase the puck for strictly ideological reasons.
The money that’s donated by the Big 4 comes from the firms’ Political Action Committees (PAC), donations to candidates from individuals in the firms, and from lobbying efforts for the firms’ interests and their clients’ interests. The audit firms also support lobbying by their trade group, the AICPA, and other hired lobbyists.
The WSJ came out with a story on Nov. 17 mentioning that FTX had been audited but the firms were more cheerleaders than watchdogs.
When FTX faced a liquidity crunch, the auditor of its U.S. unit seized the moment to promote its services for other crypto companies that were under the spotlight.
It is a “great time to remember” Armanino LLP’s specialized crypto assurance, the firm tweeted last week, referring to a product that verifies customer assets held by crypto firms.
When FTX’s former chief executive, Sam Bankman-Fried, gave evidence to a congressional committee in December, the firm, which is in the Top 20 firm by revenue, cheered him on. “Let’s go buddy!” the firm tweeted.
There is a race among crypto brokers, lenders and exchanges to calm their anxious clients by getting the blessing of an auditor. But the type of audits they are getting and the collapse of an audited firm such as FTX shows how far that sector is from a traditional regulated, scrutinized industry.
The December 31, 2021 audit reports
That brings me to the question I answered for Coindesk on November 18, not long after an FTX liquidity problem became a crisis when sharp reporting by Ian Allison at Coindesk on Nov. 2 exposed the FTX “house of cards”. The company quickly filed for bankruptcy nine days later.
We know what the limited assurances that check assets backing stablecoins like Tether and USDC miss.
What did the FTX financial audits miss?
CoinDesk obtained the audited financial statements of West Realm Shires, also known as FTX US, and FTX Trading Ltd., the offshore Bahamas-based entity that includes an exchange catering to non-U.S. customers.
We found out later via the bankruptcy court filings that a separate proprietary trading firm, Alameda, has apparently never been audited.
I wrote that the first red flag I noted was the choice of firms.
It’s not clear why FTX commissioned two different audit firms to audit its 2020 and 2021 financial statements. The reports by Armanino LLP, which signed the report for the U.S. operation, and by Prager Metis LLP, which signed the opinion for the offshore operations, were issued at the end of March 2022.
These are two small outfits, not even on the next tier to the Big Four global audit firms – Deloitte, Ernst &Young, KPMG and PricewaterhouseCoopers. Armanino and Prager Metis do audit a few public companies but none of the size or complexity of FTX. Because the firms are so small, the audit regulator, the Public Company Accounting Oversight Board (PCAOB), inspects them only once every three years.
Prager Metis has a poor recent track record with the PCAOB (first reported by the Financial Times but publicly available here) and Armanino does, too.
In 2019, the PCAOB published its private comments about deficiencies in Armanino’s overall quality-control processes related to its 2018 inspection because the firm hadn't corrected them within a year.
Forbes had previously reported that Deloitte and PwC were also advising FTX. What were they doing for FTX? My story makes some guesses, but maybe add advising on how to spread campaign donations around Congress to gain maximum influence to the list of possibilities.
I go into a lot of detail in the Coindesk story about the number of related party transactions just between FTX executives and owners and FTX Trading, the offshore operation. Too many to detail here…
Recent reporting from Reuters based on property records documents hundreds of millions in real estate purchases in the Bahamas by FTX, executive staff, even SBF’s parents, whose deed had as the reason for purchase “vacation home”.
One noted in the audit report, for example, said that related entities serve as “conduits of fiat, or crypto transactions, maintaining an intercompany account for and on behalf of the Company that is repayable on demand, and the provision of the same day conversion of revenue and expense transactions of crypto to USO, all at the Company's direction. A significant percentage of the Company's bill-paying activities have been facilitated through these related party service transactions.”
As of December 31, 202 l, that intercompany account held $1.2 billion, presented as "Related party receivable" on the Consolidated Balance Sheets. Related parties had control of a bank account with $1.2 billion as of Dec 31, 2021. This is a clear and egregious internal control deficiency and introduced significant fraud risk and conflicts of interest.
On the US operations audit report, Armanino noted that there were several related party transactions already on the US firm books, even though US operations had only launched its services in 2020 with the incorporation of West Realm Shires Inc. on January 29, 2020 as a Delaware corporation.
WRSI is the holding company to Delaware corporations: West Realm Shires Services, Inc., West Realm Shires Financial Services, Inc., and Ledger Holdings Inc. formed by the acquisition by FTX of LedgerX, a Commodity Futures Trading Commission-regulated crypto-currency futures and options exchange and clearinghouse that holds certain licenses integral to being able to operate in this industry, including registration licenses as a Designated Contract Market ("DCM") Derivatives Clearing Organization ("DCO") and Swap Execution Facility ("SEF"). As of December 31, 2021, West Realm Shires Services had obtained licenses in most states in the U.S. In August 2021, WRFS also acquired 100% voting equity interest of RJL Capital Group LLC, a registered broker-dealer with the Securities and Exchange Commission.
RJL does file a Focus Report with the SEC. Its auditor is Raich Ende Malter & Co LLP, but only since 2022 for financials that were as of March 31, 2022. Raich is the sixth audit firm signing opinions for RJL since 2013.
Ledger Holdings, parent of the former LedgerX LLC, has also done a few private placements since the FTX crowd arrived. The CFTC-regulated entity, the one with all the former CFTC officials working there or on its board, also had big plans:
LedgerX LLC, d/b/a FTX US Derivatives (“FTX”), recently submitted an application requesting that the Commodity Futures Trading Commission (“CFTC”) amend its Amended Order of Registration as a derivatives clearing organization (“DCO”), thereby allowing FTX to offer margin directly to customers. In support of that application, FTX offers the following explanation of how this approach, which would not rely on intermediation, is permitted by the Commodity Exchange Act (the “CEA”) and CFTC Regulations. FTX will also demonstrate how its proposed risk management framework is comparable to the clearing-related requirements imposed on clearing futures commission merchants (“FCMs”).
As set forth below, FTX plans to lead futures markets in the United States into the 21 st century, without compromising traditional risk management, customer protection, or systemic risk mitigation expectations.
Armanino noted that FTX US says that it custodies crypto assets for its customers. The customer custodial funds at FTX US, according to its Dec. 31, 2021 balance sheet, were approximately $296 million.
The Company has committed to securely store all crypto assets it holds on behalf of customers. As such, the Company may be liable to its customers for losses arising from theft or loss of customer private keys. The Company has no reason to believe it will incur any expense associated with such potential liability because (i) the Company has no known or historical experience of claims to use as a basis of measurement, (ii) the Company accounts for and continually verifies the amount of crypto assets within its control, and (iii) the Company has established security around custodial private keys to minimize the risk of theft or loss. Since the risk of loss is remote, no liability is recorded as of December 31, 2021 and 2020, respectively.
The PCAOB, the audit regulator, has extensive guidance for auditors of broker-dealers and custodians. We see none of that extra compliance work and assessment done here.
Why? Crypto!
It turns out Armanino and Prager Metis should have seen this one coming.
FTX's new CEO, restructuring expert John J. Ray III, who was appointed after the FTX bankruptcy filing, confirmed what I thought after reading the year-end 2021 financial statements: There were no controls.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as I 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 little bank they bought
Finally, there was a recent revelation that FTX bought a small bank in Washington State. I’ll let The New York Times tell the story.
The ties between FTX and Farmington State Bank began in March when Alameda Research, a small trading firm and sister to FTX, invested $11.5 million in the bank’s parent company, FBH.
At the time, Farmington was the nation’s 26th-smallest bank out of 4,800. Its net worth was $5.7 million, according to the Federal Deposit Insurance Corporation.
Farmington has more than one crypto connection. FBH bought the bank in 2020. The chairman of FBH is Jean Chalopin, who, along with being a co-creator of cartoon cop Inspector Gadget in the 1980s, is the chairman of Deltec Bank, which, like FTX, is based in the Bahamas. Deltec’s best-known client is Tether, a crypto company with $65 billion in assets offering a stablecoin that is pegged to the dollar.
It’s unclear how FTX was allowed to buy a stake in a U.S.-licensed bank, which would need to be approved by federal regulators. Banking veterans say it’s hard to believe that regulators would have knowingly allowed FTX to gain control of a U.S. bank.
“The fact that an offshore hedge fund that was basically a crypto firm was buying a stake in a tiny bank for multiples of its stated book value should have raised massive red flags for the F.D.I.C., state regulators and the Federal Reserve,” said Camden Fine, a bank industry consultant who used to head the Independent Community Bankers of America. “It’s just astonishing that all of this got approved.”
Here's the press release when Moonstone Bank raised $11.5 million from Alameda Research in a private placement.
It's also strange that I can not find any record of a recent audit for Farmington State Bank, FBH Holding, or anything called “Moonstone Bank”, an FDIC-insured, state-regulated bank.
The MF Global connection
Which brings us back to Dave Dayen’s story in the American Prospect. How did this happen under all the regulators’ noses?
REUTERS REPORTED LAST FRIDAY on an internal FTX document, showing that the SEC had made informal inquiries earlier this year to FTX and other firms about how they handled customer deposits. As we now know, FTX was funneling customer funds to its associated trading firm Alameda Research. The newly installed CEO of FTX, John Ray, told a bankruptcy court last week about a “complete lack of corporate controls” at the company.
The SEC also asked FTX about a rewards program that gave depositors interest on their crypto assets, which could make them a security. SEC chair Gary Gensler has been adamant that crypto platforms are trading and minting securities, and that these securities needed to be registered with the agency. Crypto firms have generally failed to register anything.
In response to the inquiry, FTX asserted that the rewards program did not involve any lending and was aboveboard. The SEC then replied that it did not need further information “at this time.”
That’s very similar to what I reported happened when the SEC had a chance to nip Coinbase and all of its faux banking activities in the bud when it filed to IPO in April 2021. (In an ironic twist, Coinbase Ventures invested in FTX last round of VC funding in July 2021.)
The SEC asked about Coinbase’s Lend product, the one that ended up being scuttled, but then let Coinbase go public anyway. The SEC asked about staking and forks and airdrops and Coinbase said none of it was material.
SEC: “Please discuss here crypto asset forks and airdrops and describe the criteria you use in determining whether to support forked or airdropped crypto assets. Also please provide us the basis for your belief that you are not required to support any fork or provide any benefit of any forked crypto asset to your customers. We note the second to last paragraph of the full risk factor on page 41.”
On March 17, a week before Coinbase finally put out its last S-1/A and got the approval to move ahead, the company finally put together some answers to the SEC’s questions. In its response Coinbase says it believes that it does not have to account for crypto assets that come to customers as a result of forks and airdrops or give those customers credit for the assets.
“The Company advises the Staff that all crypto assets received through airdrops and forks are not material… Given unsupported crypto assets received through airdrops and forks are not material to the financial statements, the Company has not performed an evaluation with respect to the recognition and measurement of such crypto assets and the accounting of such crypto assets within its financial statements, as irrespective of the accounting treatment applied under relevant U.S. generally accepted accounting principles, the potential range of what would be recorded is not quantitatively or qualitatively material….”
Dayen calls reports of a revolving door between Gensler, CFTC and FTX just “conspiracy theories”.
In the wake of the collapse, Emmer has intimated that the SEC’s Gensler and FTX were “work[ing] on legal loopholes to obtain a regulatory monopoly.” With such comments, Emmer is playing into conspiracy theories that Gensler had ties to the firm and was operating in its interest.
These claims are far-fetched. One “six degrees of separation” theory involves Gensler working briefly at MIT with the father of Caroline Ellison, Bankman-Fried’s onetime girlfriend and the CEO of Alameda Research. Another notes that Mark Wetjen, a former Commodity Futures Trading Commission member when Gensler was chair in the Obama years, was hired as FTX’s chief lobbyist, and met with Gensler once.
But Gensler and Wetjen didn’t see eye to eye on the CFTC, and FTX was actively trying to get legislation passed to strip Gensler and the SEC’s authority over crypto.
In dismissing the “conspiracy theories” about the connections between Gary Gensler, the CFTC, and FTX, Dayen forgets to mention Ryne Miller and Jill Sommers. Via the Revolving Door Project:
WASHINGTON, D.C. – In response to former Commodity Futures Trading Commission (CFTC) commissioner Jill Sommers appointment to crypto exchange platform FTX US Derivatives’ board, Revolving Door Project Senior Researcher Timi Iwayemi released the following statement:
“This move further illustrates FTX CEO Sam Bankman-Fried apparently insatiable desire to accumulate a cadre of revolving door pawns to influence crypto legislations and policy in Washington, DC.”
“Sommers joins fellow CFTC alumni Mark Wetjen and Ryne Miller among FTX’s ranks just in time to support Bankman-Fried’s pleas to Congress and regulators to sideline the Securities and Exchange Commission (SEC) and make the CFTC the crypto industry’s primary regulator.”
Readers of The Dig may recall that Ryne Miller was counsel to Gary Gensler when he was Chairman of the CFTC, and at the time Gensler decided to take himself out of the investigation of his friend Jon Corzine’s uncontrolled exploit of customer funds to make risky proprietary bets on sovereign debt that ended in a bankruptcy on October 31, 2011.
Who took over the CFTC investigation of Jon Corzine and MF Global from Gensler? CFTC Commissioner Jill Sommers now on the FTX-US board. On Nov 17, 2011, approximately 11 years ago, when asked where the MF Global customers’ missing $1.6 billion was, Sommers told the WSJ:
"Trying to figure out who started the fire is not really my goal right now," Jill Sommers, a member of the Commodity Futures Trading Commission, said in an interview. "I need to get the people out of the building."
© Francine McKenna, The Digging Company LLC, 2022