By Vivian Fang (University of Minnesota)
Note: This post is the sixth post in a series of posts on bankruptcies of cryptocurrency companies and the emerging issues they pose. Previous posts in the series include:
2. Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Reign Supreme?, by Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux
3. The Public and the Private of the FTX Bankruptcy, by Diane Lourdes Dick and Christopher K. Odinet
4. Staking, Yield Farming, Liquidity Mining, Crypto Lending – What are the Customer’s Risks?, by Matthias Lehmann et al. (University of Vienna)
5. The Treatment of Cryptocurrency Assets in Bankruptcy, by Steven O. Weise, Wai L. Choy, and Vincent Indelicato
This series is being managed by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] sjd [dot] law [dot] harvard [dot] edu.
Check the HLS Bankruptcy Roundtable periodically for additional contributing posts by academics and practitioners from institutions across the country.
The fall of the once mighty crypto exchange FTX is sometimes mythologized, but what led to its bankruptcy may be simpler than you think. In a nutshell, FTX transferred a large amount of its native tokens to a closely affiliated trading firm Alameda Research. Using these tokens as collateral, Alameda borrowed real assets, made risky bets, and lost huge sums of money. Then, to cover up mounting losses, FTX and Alameda arranged obscure transactions between themselves. In the end, they went bankrupt for the same reason many other companies do: assets were insufficient to offset liabilities.
So, what lies at the crux of this mess? Let me start with FTT, which is FTX’s native token. It is not uncommon for a crypto exchange to issue a utility token to provide users with a convenient means of accessing features and benefits on the platform, such as discounted trading fees, early access to token sales, and voting rights. By offering such a token, a crypto exchange can create an integrated ecosystem and promote growth.
While FTT may have proven valuable to platform users as a utility token, it differed from open-source cryptocurrencies especially Bitcoin, being the first and most prominent, in two important aspects. First, FTT was issued and centrally controlled by FTX, while Bitcoin is generated and governed by a decentralized community. This means that FTX—a centralized exchange—could freely move large quantities of FTTs to affiliated entities like Alameda. This also means that FTX and Alameda should not have recognized FTT tokens as assets, just like stock should not be booked as assets by the issuing company or its subsidiaries. Second, supply and demand, which ultimately determine an asset’s value, are distinctly different between the two tokens. With FTT, the demand was tied to the performance and popularity of FTX platform, and the supply was tightly controlled by FTX, through its release of tokens, regular repurchases, and token burning. With Bitcoin, the demand comes from its perceived investment value and other utilities by a broad base of investors and users, while the supply is rigidly set by its open-source algorithm. This difference explains why FTT tended to be much riskier and less liquid than Bitcoin and why the announcement of a block sale by Binance, a competing crypto exchange, triggered a sharp decline in FTT’s price.
Unfortunately, the core issues that resulted in FTX’s bankruptcy—the use of illiquid and complicated financial instruments to inflate assets, excessive risk-taking leading to huge debts and losses, and engagement in shady non-arm’s length transactions with affiliated entities—are nothing new in U.S. corporate history. For example, mortgage-backed securities (MBS), another illiquid and complicated financial instrument that packages mortgage debts into bond-like securities, played a key role in driving the 2007–2008 financial crisis. Major financial institutions’ involvement with MBS made it possible for them to inflate assets and take risks, which fueled a real estate bubble and resulted in the largest corporate bankruptcy in U.S. history (Lehman Brothers). Take Enron as another example. The company was a dominant player in the global market for energy derivatives, which are financial contracts that enable transacting companies to manage exposure to energy prices. This market was highly obscure, and Enron assumed huge risks from its counterparties. When Enron’s energy trading business turned unprofitable, it attempted to cover up by creating a network of special purpose entities (SPEs) to raise debt and hide losses.
There are, of course, unique lessons to learn from every epic corporate downfall. Three aspects of FTX’s bankruptcy warrant emphasis. First, FTX is a case of regulator shopping facilitated by the status quo of the U.S. crypto regulation. The U.S. lacks a workable regulatory framework that guides exchange platforms on how to provide crypto-based financial services and store customer funds in a transparent manner. As such, many crypto exchanges set up operations offshore where regulation and enforcement are weaker, and customer protection is likely compromised. Second, FTX is a case of an accounting scandal facilitated by the lack of crypto accounting and disclosure requirements. In the U.S., the Financial Accounting Standards Board (FASB) is reportedly working on finalizing an authoritative rule that would require the use of fair-value accounting for crypto assets. It, however, remains a question as to how well this approach will apply to illiquid tokens like FTT, the value of which could evaporate overnight. It also remains a challenge as to how to consolidate accounting for deeply intertwined crypto entities. Third, FTX is a case of failed centralized governance in the name of decentralized crypto assets. Bitcoin, which is emblematic of decentralization, was created with the mission to circumvent centralized control. However, when decentralized assets are traded on a centrally controlled platform like FTX, the platform itself is no different from a traditional financial institution. To that end, proper governance measures must be implemented to prevent problems like conflicts of interest, excessive risk-taking, and misappropriation of customer funds.