crypto strategy

FTX Court Filings Highlight Key Crypto Industry Risk Management Lessons

The collapse of FTX provides a masterclass in risk management and accounting failures in the crypto industry.

This, as court documents confirm that the former third-largest cryptocurrency exchange in the world was set up from the start so that client funds entrusted to the platform could be mixed without the knowledge or consent of their owners.

In the past, disgraced FTX founder Sam Bankman-Fried called risk management “probably the most important thing we do at FTX.”

According to a recent Securities and Exchange Commission (SEC) depositFTX’s executive white paper announced that the exchange was built on “industry-leading risk management systems” and boasted that the FTX “liquidation engine” was a safe and reliable medium for the platform to manage risks.

The “engine” would have deployed a series of rules designed to automatically trigger certain actions that would reduce risk on customer accounts, such as the sale of guarantees on the occasion of an overstretched account.

In reality, and because of the specific way the crypto trading platform has been centralized to support the activities of the sister hedge fund Alameda Search with “unlimited creditthere was no internal risk control on the unsecured use of funds.

In their respective guilty pleasformer Alameda CEO Caroline Ellison, along with Gary Wang, the software engineer and FTX co-founder responsible for writing the code that gave Alameda Research its special permissions, confirmed the improper organizational setup that allowed funds to be mixed and for Alameda to make larger and larger exchanges with inversely decreasing controls, and they agreed to cooperate with the authorities.

In contrast, last week (January 3) Bankman-Fried pleaded “not guilty” at eight criminal charges filed against him regarding the disappearance of his business and the loss of billions of dollars in client assets.

In retrospect, red flags were everywhere

Regardless of the industry, where a company is privately held and not subject to the disclosure requirements that public companies face in their incorporated jurisdictions, it can be difficult to determine the effectiveness of claimed controls, until when things start to go. evil.

John J. Ray III, the interim CEO appointed to oversee the bankruptcy and restructuring of FTX, said about the imploded crypto exchange that “nearly every situation I have been involved in has been characterized by flaws of some sort in internal controls, regulatory compliance, human resources, and systems integrity. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of reliable financial information as has happened here.

Strong words from the man responsible for what was, by most creditors’ accounts, a surprisingly successful outcome to the Enron scandal two decades before.

Although PYMNTS research shows that developing an infrastructure risk management and control strategy to prepare for black swan events is critical to maintain growth while mitigating riskrepeated claims made by FTX and Bankman-Fried and also submitted to regulators have been inherently compromised by a separate internal control allowing FTX’s sister hedge fund Alameda Search to use client funds for its own business purposes, rendering Bankman-Fried’s “24/7” automated risk monitoring engine essentially useless.

According to the SEC’s allegations, the operational realities of FTX, dating back to at least 2019 and now exposed by its bankruptcy filingswere nothing more than a “brazen, multi-year plan” to defraud customers and investors.

After all, a well-functioning risk management program is not something to be dangled in front of investors or smothered in the eyes of regulators, rather it represents the critical whole of systemic processes that support a business.

Innovative benefits for me, not for you

As noted in the SEC filing, FTX had extremely poor internal controls – including no CFO or independent counsel – and fundamentally “deficient” risk management procedures that allowed assets and liabilities “in all forms to be generally treated as interchangeable”.

For a financial exchange designed to facilitate the trading of digital cryptocurrency assets, making no distinction between client assets in custody provides a clear advantage only to the exchange itself, while also representing a clear and present danger. for clients whose entrusted money is mixed and invested without their knowledge or consent.

It also generates massive exposure to the risk created by the exchange’s native positions, which is why externally promoted FTX-like management controls while internally flouting are so important in establishing lasting safeguards for growth.

The reality of FTX’s operations consistently contrasted with repeated assertions by senior executives about its risk management processes and controls that helped create an image of FTX to the public and investors as a mature company that manages funds and risks in a rigorous manner. and conservatively.

Most FTX entities have never held board meetings and CEO Ray indicated during the bankruptcy proceedings that he did not trust the financial statements provided by the FTX business.

As Bankman-Fried eventually acknowledged in a television interview after the staggering collapse of his business, “I wasn’t even trying, devoting time or effort to trying to manage risk on FTX.” Bankman-Fried added: “What happened, happened – and, if I had spent an hour a day thinking about risk management on FTX, I don’t think it would have happened. “

List of laundry failures

From corporate governance to risk management to celebrity-mediated false advertising, FTX was riddled with obvious retrospective flaws meant to mask this, as Ray said during his testimonythe company’s operations amounted to nothing more than “old-fashioned embezzlement…simply taking money from a client and using it for his own purposes”.

A Silent Majority of the Digital Asset Industry Operates Among Regulators gray areas and offshore jurisdictional loopholes chosen for their lax oversight. FTX’s failure made clear the perils inherent in this existence of choosing celebrity spokespersons over regular, verified financial disclosures.

Risk disclosure is the foundation of financial regulation in the United States, but disclosures are largely absent in crypto, with these existing attempts often being lack of good faith.

Since crypto companies often offer a variety of products and services on platforms that perform many functions, their lines of operation are often blurred and increasingly plagued by conflict, to the detriment of their customers.

In contrast, traditional financial companies that provide different services usually register their separate lines of business with the respective supervisory regulatory authorities.

As Ron Kruszewskithe chairman and managing director of Stifelone of those same traditional financial companies, says PYMNTS“If I was running a crypto fund, I would be sitting in front of you saying we need to assure our clients that putting money into crypto is really no different than putting money into a bank, that we What I find amazing about all of this is that I have yet to see any crypto leaders come out and say, “We separate our client funds from our client securities.” if they don’t say ‘yes’, the industry won’t move forward.”

After all, caveat emptor is not a sustainable strategy for long-term industry growth.

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