Lessons from the collapse of FTX

Jax.Network

Published in

Jax.Network Blog

8 min readJan 25, 2023

by Iurii Shyshatskyi, Chief Scientist at Jax.Network

Introduction

The swift collapse of the cryptocurrency exchange FTX was a major newsmaker in the crypto space at the end of 2022. Numerous publications in the media exposed fraudulent activity which was going on behind the scenes of the major industry player.

FTX managers were accused of violation of user agreements, commingling user funds, transferring them to the sister company Alameda Research, and using them to buy luxury properties and give generous donations to influencers and officials. As time goes by, we continue to learn new details of this fraud story¹.

Fortunately, the collapse of FTX and Alameda Research has not affected our project directly. We have never got any funding from entities associated with FTX. Nevertheless, this event has brought down the cryptocurrency market as many people are losing confidence in crypto exchanges, altcoins, and cryptocurrency investment.

We are not going to contribute to media coverage of this scandal since our blog has other goals. Nevertheless, we want to use this major event as an opportunity to share some thoughts and leave a few comments on the subject matter.

Low interest rates

There is no doubt that 2022 will be commemorated in the crypto space as the year when multiple big Ponzi schemes collapsed. Definitely, this is a consequence of multiple factors. However, we can point at the fundamental one. It’s the policy of low interest rates.

For many years, central banks have been minting fiat money and subsidizing economies in the form of credits with low interest rates. In these market conditions, many companies have adopted rather risky business strategies fueled by leveraged money. Often, they burned money to scale their businesses and took new credits to pay back already existing debts.

On the other hand, the stock market and venture funds were flooded with capital and were looking for any opportunity to invest money and get profit. A typical venture capitalist had to look through hundreds of high-tech startups, do a due diligence on sparse, inaccurate, misleading and complicated documentation and then wisely distribute billions of dollars.

The proper due diligence of high-tech startups often requires top-notch experts in multiple sciences and a lot of money and effort. However, even top-notch experts often make mistakes. In many cases, the proper due diligence is not cost-effective for VCs.

As a result, venture capitalists often rely on simplified due diligence procedures based on certain patterns. Sometimes their risky investments could be compared with betting at the casino.

The FTX fraud story became a notorious failure of venture capitalists. Venture funds neglected numerous “red flags” and invested hundreds of millions in the offshore centralized exchange in multiple rounds². Many investors put money into FTX, assuming that their colleagues had already done the proper due diligence.

Sam Bankman-Fried, the Founder of FTX, managed to convince VCs that their investment was almost risk-free. Many investors had to tolerate the lack of transparency in order to become a part of the deal and dock their excessive funds in the “safe haven”.

The collapse of FTX and other DeFi projects gave investors a painful lesson. However, there is no doubt that it was a natural consequence of the policy of low interest rates that laid the foundation for many similar accidents last year. The accessible leverage dramatically accelerated the growth of various Ponzi schemes.

Cooking the books in DeFi

The FTX failure has already been compared to the fraud case of Enron³. Both of these events caused multi-billion dollar damage and changed the landscape of the market.

However, the most striking similarity between the two fraud cases is so-called “cooking the books.” Both companies used accounting tricks to make their financial results look better than they were. Cooking the books allowed them to borrow money at good terms to cover their existing liabilities.

Enron used to portray itself as an innovative company⁴. However, the investigation after its collapse revealed that its main innovation was a way to deceive auditors.

Cooking the books played an important role in the FTX business strategy too. The first thing to mention is a strong tie between the FTX exchange and Alameda Research. From recent publications, we know that the second entity was used for shady operations with the money of FTX users. However, I want to focus on one important tool used in this fraud. That is the FTT token.

FTT is a typical utility token issued and managed by a centralized exchange. Its initial value comes from its utility: it can be exchanged for a fee discount at the FTX exchange. So we can describe it as follows: the issuer of FTT tokens wraps a fraction of its potential future revenue in the form of a token and sells it at the market. The market price of the token is determined by the anticipated volume of transactions that will occur at the exchange in the future.

This approach is not unique and we know multiple utility tokens similar to this one operating on the market. A great example is BNB issued by Binance. However, this approach has multiple caveats.

From the very beginning, the price of the utility token is highly speculative. Nobody knows for sure what will be the future performance of the exchange. Those who trade the token have to make a prediction based on the current data. In their predictions, people often rely on positive indicators such as a large user base, transaction count, and transaction volume.

However, all these positive indicators could be easily forged⁵. It’s very easy and cheap to create fake transaction volumes on CEXs. Market making of artificial transaction volumes often occurs at exchanges with low transaction fees. Moreover, many altcoins require such market making in order to remain listed on exchanges.

We don’t know whether there was such market making on the FTX exchange, however, we have to admit that the issuer of the FTT token had an ample opportunity to conduct market making through its proxies. Moreover, recent publications claim the majority of FTX supply was controlled by only a few entities, including Alameda Research.

The second big issue with the FTT token is that it was extensively used as collateral and a reserve asset in various operations executed by FTX and Alameda Research managers. The FTT token and its derivatives constituted the major part of reserves in Alameda Research. As a result, malicious managers were able to put anticipated future revenues into the existing balance sheet.

Here we can see a similarity between FTX and Enron. Enron managers did the same thing. They put anticipated future revenues from bogus contracts into the existing balance sheet. As a result, they exaggerated revenues and reserves in their annual financial statements. So we can conclude that FTX managers replicated the same accounting trick using the FTT token.

The example of the FTT token raises the question whether other utility tokens involve the same risk. We don’t know. However, we can say for sure that the value of such tokens shouldn’t rely on one utility case and market speculations. The second lesson is that such tokens can’t be considered as primary reserve assets on one’s balance sheet.

Crypto criticism

Following the collapse of FTX, we have witnessed a debate between crypto skeptics and crypto enthusiasts⁶. Many observers blamed cryptocurrency and decentralized technologies. They argued it was insecure and unreliable compared to the traditional finance system. Some opponents called for strict regulations of the crypto industry.

This critique was answered by proponents of blockchain technologies. They highlighted that FTX and Alameda Research were far from the principles of decentralization.

FTX and Alameda were traditional financial institutions in the worst meaning of this word. They used cryptocurrency in their business, however, it didn’t justify the fact that the committed fraud was traditional in nature. Location in the offshore jurisdiction allowed FTX customers to avoid regulations and enjoy financial freedom. But the lack of financial watchdogs made the fraud scheme less evident.

Some observers proposed conspiracy theories that the oversight of financial crimes in FTX was intentional. They suggested government and financial watchdogs allowed this fraud to be executed in order to put the blame on crypto, call for regulation, and gain more influence over financial markets.

The aforementioned debates have occurred for many years since the discovery of Bitcoin. These discussions are focused on the same issues and go around the same arguments. We can consider them as a symptom of a deep misconception about the nature and purpose of blockchain networks and related technologies.

There is a problem that the general public doesn’t understand, namely, where the border between cryptocurrency and the traditional financial system lies. Furthermore, development of the Decentralized Finance ecosystem and the hype around it generated even more confusion in the space.

Many people perceive blockchain technology as a piece of a constructor. They mistakenly believe that a decentralized blockchain network is a universal base layer that delegates the property of being trustless to any centralized solution built on top of it. Unfortunately, it’s not true. Security and reliability of the solution are determined by the reliability of its weakest component.

Many entrepreneurs exploited this misconception to promote their products. The term “DeFi” became a trademark, a meaningless label which could be put on any centralized solution in order to mislead customers.

A good example here is cryptocurrency lending platforms such as notorious Celsius⁷. Their failure was a major contributor to the crypto crisis of 2022. In promotional materials, these products were misrepresented as a DeFi alternative to traditional banks. Fundamental risks associated with these platforms were often downplayed by founders.

In contrast to trustless blockchain networks, crypto lending platforms often rely on various counterparties such as cross-chain bridges and price oracles. These parties could get hacked or can perform market manipulation on their own. Moreover, developers or maintainers of these platforms should be trustworthy too. They determine the list of DeFi applications and the list of crypto assets which could be used as collateral.

These vulnerabilities are very similar to those which are common for traditional financial institutions. However, traditional banks have real addresses and sometimes go through an audit. As we know, in the case of failure, they could be bailed out by the government.

The idea that some magic properties of underlying blockchain networks could mitigate crypto lending vulnerabilities was misleading and harmful for investors. Last year was rich with the evidence that banking, debt, and leverage should be considered as a part of the traditional financial system.

Conclusion

The collapse of FTX is a valuable lesson taught by the year 2022. It exposed fundamental vulnerabilities of various DeFi platforms and fraudulent activity which was going on behind the scenes.

Last year confirmed that it’s difficult for institutional and retail investors to orient in the ever-growing crypto space. The industry requires proper guidelines and classification of blockchain solutions. Existing guidelines are often biased and inaccurate.

The absence of the rigorous and complete theory of blockchain networks is a great source of misconceptions. The accurate blockchain network theory could refine permissionless decentralized blockchain networks from pseudo-decentralized entities which should be strictly regulated. If everything goes well, decentralization can become a primary trend for the new market cycle.