FTX — Snaring defeat in the jaws of victory
The FTX implosion has jeopardized billions and created fear and loathing in the crypto markets. Which VC funds took the biggest hits, and what can Silicon Valley learn?
What the F*ck happened?
Much has been written about why the third-largest crypto exchange by volume flamed out along with its ‘wunderkinder’ founder, Sam Bankman-Fried. Mr. Bankman-Fried had promoted FTX as ‘the most trusted exchange,’ which we have all learned was quite the opposite of the truth. ‘This is the direct result of a rogue actor breaking every basic rule of fiscal responsibility,’ says Patrick Hillman, chief strategy officer at the largest crypto exchange Binance. ‘What a shit show … and it’s going to be crypto’s fault (instead of one guy’s fault),’ Binance founder and CEO Changpeng Zhao (CZ) tweeted on the day FTX collapsed.
John Ray, the new CEO and Chief Restructuring Officer at FTX, who previously restructured the infamous energy company Enron in 2001, summed it up in the company’s bankruptcy proceeding filing.
‘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 ‘very small group of inexperienced, unsophisticated and potentially compromised individuals’ at FTX Mr. Ray refers to include Mr. Bankman-Fried and cofounder Zixiao ‘Gary’ Wang, along with twenty-eight-year-old Caroline Allison, the former Co-CEO of Alameda Research, a quantitative trading firm founded by Mr. Bankman-Fried and Mr. Wang in 2017. Founded in 2019, FTX moved its headquarters to the Bahamas to allow its clients to place crypto bets not permitted in the US. All three face charges for various misdeeds by the Justice Department and the Securities and Exchange Commission.
Mr. Ray amplfied his previous remarks to the Wall Street Journal on December 13, 2022: ‘This is really old-fashioned embezzlement. This is just taking money from customers and using it for your own purpose, not sophisticated at all.’ In the same article, The Journal reported:
Prosecutors say Mr. Bankman-Fried ‘engaged in a scheme to defraud customers of FTX.com by misappropriating those customers’ deposits.’ The money was diverted to Alameda Research, SBF’s crypto hedge fund. The indictment alleges he defrauded lenders as well, and prosecutors also threw in a campaign-finance violation for excessive political donations made ‘in the names of other persons.’
The SEC complaint is more voluble. ‘From the inception of FTX, Bankman-Fried diverted FTX customer funds to Alameda,’ it says, to the point that ‘there was no meaningful distinction.’ Then SBF ‘used Alameda as his personal piggy bank to buy luxury condominiums, support political campaigns, and make private investments.’ He took enormous loans, ‘including two instances in which Bankman-Fried was both the borrower in his individual capacity and the lender in his capacity as CEO of Alameda.’
Mr. Bankman-Fried claimed Alameda had no special privileges on the FTX platform. Yet the SEC says his hedge fund was granted a ‘virtually unlimited’ credit line and was exempt from the ‘automated risk mitigation protocols’ that SBF trumpeted as ensuring FTX’s stability. The mixing of funds was obfuscated in internal accounts. The beginning of the end arrived when crypto prices fell and ‘many of Alameda’s lenders demanded repayment of loans.’
— Wall Street Journal, ‘Sam Bankman-Fried’s Crypto Crash‘, December 13, 2022
The SEC announced that Ms. Ellison and Mr. Wang have been cooperating with the agency and have entered a settlement agreement. Ms. Ellison told a judge at her plea hearing that she had agreed with Mr. Bankman-Fried to hide from FTX’s investors, lenders, and customers that Alameda was borrowing billions of dollars of their money to cover bad investments. She also admitted lending this money back to top FTX executives for personal use. Before the settlement, Ms. Ellison and Mr. Wang faced the prospect of 110 years in prison.
Court documents also show Mr. Bankman-Fried allegedly borrowed over $3 billion from Alameda Research to purchase a 300 million personal stake in the trading app Robinhood Markets (HOOD), buy luxury properties in the Bahamas, and make significant contributions to political candidates and causes. He also threw in some customer money to fund Ukrainian relief from their war with Russia.
On December 11, 2022, Mr. Bankman-Fried was arrested in the Bahamas, extradited to the US, and released on a $250 million bond — the largest bond in the history of criminal proceedings in the US. Mr. Bankman-Fried has since pleaded not guilty at his arraignment in Manhattan federal court to all eight US criminal charges levied against him. A tentative trial date of October 2, 2023, has been set.
A recent report indicates that Mr. Ray has already recovered more than $5 billion, but the extent of customer losses in its collapse is still unknown. ‘We have located over $5 billion of cash, liquid cryptocurrency, and liquid investment securities,” Andy Dietderich, an attorney for the restructuring team, told a U.S. bankruptcy judge John Dorsey in Delaware. Mr. Dietderich also said that the company plans to sell additional investments with a book value of $4.6 billion.
Dietderich said the $5 billion recovered does not include assets seized by the Securities Commission in the Bahamas. FTX’s attorney estimated the seized assets were worth as little as $170 million, while Bahamian authorities put the figure as high as $3.5 billion. The confiscated assets are primarily composed of FTX’s proprietary and illiquid FTT tokens, which are still trading at a highly volatile price. FTX could also raise additional funds via the sale of affiliate companies LedgerX, Embed, FTX Japan, and FTX Europe — which are relatively independent of the broader FTX group. Each has its segregated customer accounts and separate management teams.
The Commodities Futures Trading Commission has estimated missing customer money at more than $8 billion. When you add up the recovered funds thus far, it looks encouraging that customers may well get their money back. ‘The difficulty here [due to dubious and incomplete records] is that I don’t know who’s a customer and who’s not,’ Judge Dorsey said.
Sequoia Capital apologizes to investors for their $214 FTX write-off
In varying degrees (according to Pitchbook and published reports), a breath-taking number of name-brand crypto, venture, private equity, pension, and government investment funds lost $2 billion in combined bets on FTX: Paradigm Crypto Fund ($290M), Temasek ($275), Sequoia Capital ($214M), Thoma Bravo ($130M), Softbank($100M), Ontario Teachers ($95M), Tiger Global ($38M), BlackRock ($24M), Coinbase Ventures ($15M), and Circle ($10.6M).
Other well-established venture and crypto funds that Mr. Bankman-Fried fooled to a lesser degree include Telstra Ventures, Samsung Next, Digital Currency Group (see below), Hard Yaka, HOF Capital, NEA, IVP, Lightspeed Venture Partners, Multicoin Capital (see below), Iconiq Capital, Third Point Ventures, Altimeter Capital Management, Lux Capital, Mayfield, Insight Partners, Ribbit Capital, and Pantera Capital. Angel investors include Tom Brady, Gisele Bündchen, and tennis star Naomi Osaka.
The US Securities and Exchange Commission (SEC) has made inquiries into the due diligence processes of some investors in FTX. There have been no published reports regarding the results of these inquiries, but we will monitor this development.
Partners at the venerable Sequoia Capital formally apologized to the firm’s Limited Partner investors (LPs) in December for losing its entire $214 million investment in FTX — one of the largest write-offs in modern venture capital history. $150 million of this mark-down came from their Global Growth Fund, a late-stage fund that invested in FTX’s Series B funding round in July 2021, when cryptocurrencies were trading at an all-time high. In a note sent to investors on November 9, Sequoia said it still had $7.5 billion worth of real and paper gains in the Global fund, and the FTX write-off accounted for less than 3 percent of the fund’s committed capital. The other $63.5 million write-off was out of Sequoia’s crossover fund.
It was encouraging that Alfred Lin, who led the FTX deal for Sequoia, US leader Roelof Botha and crypto-focused partner Shaun Maguire kept the Sequoia tradition of being straight up with founders and limited partners and immediately marked down their investment to zero. Mr. Lin reportedly also told the fund’s LPs that he was misled by FTX CEO Sam Bankman-Fried, particularly about FTX’s relationship with the hedge fund Alameda Research.
Moving forward, the Sequoia partners said they would be more cautious about making substantial investments in companies whose founders they did not have a longstanding relationship with. The firm also promised investors that, in the future, they would require the financial statements of even early-stage startups audited by one of the Big Four accounting firms.
‘The answer is really simple: you hire a Big Four auditing firm, you prove that you not only have the assets, but you prove that you don’t have liabilities that exceed your assets. We have exchanges that have been around for a long time, such as Coinbase [audited by Deloitte] and Bitstamp [audited by Ernst & Young], that are transparent, audited, and regulated. There’s nothing new to this. Pantera engaged Ernst & Young to do the first audit of any crypto entity nine years ago.’
— Dan Morehead, Founder & Chief Executive Officer, Pantera Capital
Ironically, long-time Global Managing Partner for Sequoia Michael Moritz commented to the Financial Times precisely a year ago that the lack of attention paid by investors in Elizabeth Holmes and Theranos differed from the traditional due diligence practices of the Silicon Valley venture community. ‘Every industry has its share of terrible people and hype merchants,’ Mr. Moritz observed. ‘I’m more sanguine about the Valley. Those who got duped by Holmes fell victim because they did not demand answers to obvious questions.’
In response to the FTX debacle, one of Silicon Valley’s most successful VCs, Bill Gurley of Benchmark, published a ‘Red Flag Checklist’ for investors that is a must-read reminder of the due diligence principles investors should adhere to help safeguard their investments.
Sequoia slashes management fees — Will the VC sheep herd follow?
As part of their penance, Sequoia informed their investors that they had made the unprecedented move to lower management fees on their $600 million Crypto Fund, which invests in crypto companies and tokens, and their $950 million Ecosystem Fund, which backs funds managed by other investment firms. Both funds were launched early last year. Under the revised structure, Limited Partners in these two Sequoia funds will only pay management fees based on the capital deployed rather than the traditional VC model of money under management. According to Mr. Lin, Sequoia has invested only 10 percent of its Crypto Fund thus far.
The decision to lower fees marks an unusual concession to LPs by the world’s top venture investment manager. VC insiders speculate that this move by Sequoia may spur a rippling effect among similar venture funds whose LPs will pressure them to do the same. With the VC market already reeling from NASDAQ’s 30 percent drop since its high in November 2021, an LP investor backlash demanding lower management fees in line with Sequoia Capital would be hard for other VCs to refute.
A VC fee hit with lower public company valuations will then invariably ripple into private company valuations, which are already shrinking. A case in point is a recent tweet by top early-stage investor Adam Draper, founder of Boost VC, who seeded Coinbase; he expressed that while they are still in the game to give 20 startups $500,000 in 2023, they expect to invest those funds at lower valuations.
Could FTX have adapted and endured as a regulated exchange?
The Mt. Gox debacle still looms large in the history of the crypto space. Founded in 2010 in Tokyo, Mt. Gox was one of the first cryptocurrency exchanges. Unfortunately, in February 2014, the exchange got hacked, and 840,000 BTC was stolen, causing the price of BTC to plummet from $1,000 to $111.40. At the time of the hack, the exchange accounted for 70% of all Bitcoin trading volume. As a result, the exchange was forced to stop withdrawals, filed for bankruptcy in the Tokyo District Court, and was ordered to liquidate in April 2014. While it was later able to locate 200,000 Bitcoins, the missing Bitcoins profoundly destabilized the market.
Coinbase, a fledgling crypto exchange at the time but currently the number two crypto exchange in trading volume behind Binance today — published a joint statement with Kraken, Bitstamp, Blockchain.info (now Blockchain.com), Circle, and BTC China (now BTCC) condemning the ‘tragic violation of the trust of users.’ Ironically, their statement at the time describes precisely the philosophy and solution needed today to address the kind of shady practices that have come to light in the FTX debacle:
“Acting as a custodian should require a high-bar, including appropriate security safeguards that are independently audited and tested on a regular basis, adequate balance sheets and reserves as commercial entities, transparent and accountable customer disclosures, and clear policies to not use customer assets for proprietary trading or for margin loans in leveraged trading.”
As Dan Morehead, Founder & Chief Executive Officer of Pantera Capital points out in the fund’s December 15 Blockchain Letter, ‘Exchanges that are regulated, transparent, onshore, and/or audited exchanges are seeing a dramatic increase in market share. Since October, the market share of exchanges like Coinbase, Kraken, Upbit, and Bitstamp has increased 27 percentage points.’
In the same letter, Mr. Morehead quotes Mr. Ray’s findings below. The point is that even an alleged criminal like Mr. Bankman-Fried couldn’t access the funds of the regulated exchanges in the FTX empire. Mr. Morehead aptly points out, ‘Even with all the craziness and alleged fraud that happened at FTX, they did not (or weren’t able to) loot the U.S.-regulated FTX subsidiary, LedgerX.’
“Based on our review over the past week, we are pleased to learn that many regulated or licensed subsidiaries of FTX, within and outside of the United States, have solvent balance sheets, responsible management, and valuable franchises.”
— John Ray’s FTX Press Release, November 19, 2022
Perhaps just as significantly, in addition to being unregulated, Mr. Ray points out that ‘the control of FTX was concentrated in the hands of a small group of inexperienced, unsophisticated people.’ From what we can tell, had FTX been regulated in the same fashion as its affiliated companies, recruited seasoned outside board members, implemented proper board governance and internal auditing practices, and the founders behaved within the law, FTX would still be standing and thriving today.
Summary of lessons learned
Hopefully, the new generation of global Silicon Valley players will remember the lessons learned in the crypto journey thus far, most of which previous generations had to learn the hard way as well.
To summarize the biggest lessons learned in the FTX debacle:
- Number one, if intermediaries are holding other people’s money or selling speculative securities, they must, as SEC Chair Gary Gensler has stated, ‘comply with our time-tested securities laws.’ As part of that reality, consumers must also watch out for crypto brokers, sellers, and exchanges that do not comply with these regulations — especially off-shore-based companies.
- Second, venture and institutional investors must maintain proper due diligence practices, require annual Big 4 audits, and recruit experienced board members who embrace their governance role.
- Third, as Benchmark’s Bill Gurley warns` in his Venture Capital Red Flag Checklist blog post, ‘No one operating a venture-backed startup should be simultaneously running another corporate entity with an overlapping interest, competing interests, or even potential competing interest.’ Retrospectively, the most perilous act that took down FTX occurred when the two top company operators, Mr. Bankman-Fried, and Mr. Wang, comingled FTX money to save Alameda Research, the crypto hedge fund they cofounded.
Recommended further reading
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