Sep 2013 min read

FTX Case Study: Lessons on Governance and Risk Management

The FTX case has sent shockwaves through the cryptocurrency industry, exposing significant flaws in risk management and corporate governance within the sector. This high-profile collapse of one of the world's largest crypto trading platforms has brought to light the urgent need for enhanced due diligence and regulatory oversight in the rapidly evolving digital asset landscape. The downfall of FTX and its founder, Sam Bankman-Fried, serves as a stark reminder of the potential consequences when proper checks and balances are absent in financial systems.

This case study dives into the rise and fall of FTX, examining the signs of trouble that preceded its collapse and the regulatory failures that allowed the situation to escalate. It explores the intricate relationship between FTX and Alameda Research, the role of the FTT token in market manipulation, and the subsequent bankruptcy proceedings. Furthermore, it analyzes the ethical implications of the FTX collapse, criminal charges against key figures, and its impact on investor protection. By scrutinizing this watershed moment in cryptocurrency history, we aim to draw valuable lessons on corporate governance and risk management to help prevent similar incidents in the future.

The Rise of FTX and Sam Bankman-Fried

Early success with Alameda Research

Sam Bankman-Fried's journey in the cryptocurrency world began with a profitable arbitrage opportunity known as the "Kimchi Swap" in 2017. He noticed significant price differences for Bitcoin across various exchanges, sometimes as high as 60% [1]. This observation led him to establish Alameda Research, a quantitative trading firm, to capitalize on these market inefficiencies.

Alameda Research quickly gained traction, with Bankman-Fried claiming the firm sometimes made as much as a million dollars a day [1]. The company's success attracted notable investors, including billionaire computer programmer Jaan Tallinn and investor Luke Ding, who provided early funding [2]. By 2021, Bankman-Fried owned approximately 90 percent of Alameda Research, solidifying his position in the crypto trading landscape [2].

Founding of FTX

Building on the success of Alameda Research, Bankman-Fried founded FTX, a cryptocurrency derivatives exchange, in April 2019 [2]. The exchange opened for business the following month, marking the beginning of a rapid ascent in the crypto industry [3]. FTX quickly distinguished itself by offering innovative products, including derivatives and highly leveraged tokens, catering to professional traders [4].

The exchange's growth was remarkable, even by crypto industry standards. In just a few years, FTX transformed from a niche platform for sophisticated traders into a global behemoth offering a wide range of crypto services [4]. The company's expansion strategy included attracting retail investors by offering competitive fees and diverse product offerings.

Rapid growth and investments

FTX's growth trajectory was nothing short of extraordinary. By 2022, the exchange was processing an average of USD 2 billion in spot trades daily, a significant increase from just USD 100 million in 2020 [4]. This rapid expansion culminated in a record-breaking day on June 13th, 2022, when FTX processed more than USD 6 billion in spot volume during a market downturn [4].

The company's valuation skyrocketed alongside its trading volumes. In July 2021, a USD 900 million funding round valued FTX at USD 18 billion [5]. By January 2022, the company's valuation had soared to USD 32 billion, making it one of the most valuable entities in the crypto space [4] [5].

FTX's growth was not limited to its core exchange business. The company made strategic investments and acquisitions to expand its reach. In April 2022, FTX acquired a stock trading platform, IEX Group Inc., to gain a foothold in the U.S. stock trading market [4]. The company also purchased Bitvo, a Canadian regulated trading platform, to strengthen its presence in North America [4].

Bankman-Fried's influence extended beyond FTX. He emerged as a prominent figure in the crypto industry, often referred to as the "J.P. Morgan of crypto" [6]. His public profile grew as he courted celebrities to promote FTX, bailed out failing crypto firms, and testified before the U.S. Senate and federal regulators to advocate for increased regulations in the crypto market [6].

The rapid rise of FTX and Sam Bankman-Fried showcased the potential for explosive growth in the cryptocurrency industry. However, this meteoric ascent would soon face significant challenges, leading to one of the most dramatic collapses in crypto history.

Signs of Trouble

Conflict of interest concerns

As FTX grew rapidly, concerns about potential conflicts of interest began to surface. The relationship between FTX and Alameda Research, both under Sam Bankman-Fried's leadership, raised eyebrows across the cryptocurrency industry. This intertwined business model, with FTX's FTT token propping up both entities, turned Bankman-Fried into a crypto hero but also posed significant risks [7].

The mingling of Alameda and FTX gave birth to potential conflicts of interest that drew sharp scrutiny. Alameda, once FTX's largest trader, brought liquidity to the exchange, but the closeness of the two entities raised questions about fairness and transparency [8]. Critics pointed out that Alameda traded heavily on FTX and sometimes profited when other customers lost money [7].

Adding to the concerns, one of Alameda's co-chief executives, Caroline Ellison, was at times in a romantic relationship with Bankman-Fried. This personal connection further blurred the lines between the two companies [7]. The lack of independent governance and the absence of audited financial statements for Alameda, as later revealed in bankruptcy filings, should have been bright red flags early on [7].

Coindesk investigation

The catalyst for FTX's downfall came in the form of a November 2, 2022 scoop by crypto news site CoinDesk. The investigation revealed that the majority of assets held by Alameda Research consisted of FTT and other tokens invented and controlled by FTX and its insiders, rather than fiat currency or cryptocurrency with market-driven, time-tested value [1].

This revelation raised serious concerns across the cryptocurrency industry about FTX being overly leveraged with Alameda Research, relying on precarious financial accounting metrics, and facing associated financial management risks [1]. The leaked balance sheet showed a striking lack of diversification and an uncomfortably close tie between the two companies [2].

The balance sheet listed USD 9.00 billion in liabilities and USD 900.00 million in assets, with poorly labeled entries showing a negative USD 8.00 billion balance [2]. This alarming discrepancy highlighted the extent of the financial mismanagement within FTX and Alameda Research.

Binance's withdrawal

The situation took a dramatic turn when Binance, a major competitor and investor in FTX, announced its intention to divest its FTT holdings on November 7, 2022. This bombshell, coupled with FTT's languishing trading volume and the simmering feud between Binance CEO Zhao Changpeng and Bankman-Fried, sent FTT's value into a nosedive [8].

Binance claimed that this abrupt move was caused by "recent revelations" but provided no further details at the time [8]. The announcement triggered a bank run, with scores of investors and customers pulling their funds from FTX, forcing the exchange to become insolvent [1].

In a last-ditch effort to rescue the company, FTX and Bankman-Fried turned to Binance for salvation, seeking an acquisition. However, on November 9, Binance declared it was aborting the FTX acquisition due to FTX's purported mishandling of customer funds [8]. The collapse of this potential deal further eroded confidence in FTX and accelerated its downfall.

The unraveling of FTX lasted just ten days, from the CoinDesk article on November 2 to the company's bankruptcy filing on November 12 [2]. This rapid collapse exposed significant flaws in FTX's risk management practices and raised serious questions about the need for enhanced due diligence and regulatory oversight in the cryptocurrency industry.

The Collapse

Mass withdrawals

The downfall of FTX, once among the largest cryptocurrency exchanges in the world, began with a surge of customer withdrawals. This bank run was triggered by concerns over questionable financial valuation practices and the unusually close relationship between FTX and Alameda Research. The situation quickly spiraled out of control, with customers demanding withdrawals worth USD 6.00 billion in just 72 hours [9]. This massive outflow of funds pushed FTX and Alameda into a state of insolvency, shaking the volatile crypto market to its core.

As the crisis deepened, FTX took drastic measures to stem the tide. On November 8, the exchange removed the option for customers to withdraw their funds from the platform online, effectively blocking hundreds of thousands of users from accessing their money [2]. This move only served to heighten panic and erode trust in the cryptocurrency exchange.

Bankruptcy filing

The rapid unraveling of FTX culminated in a Chapter 11 bankruptcy filing on November 11, 2022. This petition included FTX Trading Ltd., Alameda Research, and over 100 affiliated entities [10]. The bankruptcy filings revealed the staggering scale of FTX's financial troubles, indicating that the company had assets and liabilities each in the range of USD 10.00 billion to USD 50.00 billion [4].

In a shocking turn of events, Sam Bankman-Fried stepped down as CEO of FTX on the same day as the bankruptcy filing. The court appointed John J. Ray III, an American executive known for leading Enron through its bankruptcy proceedings, as his successor [1]. Ray's initial assessment of FTX's situation was damning. In a bankruptcy court filing on November 17, he stated, "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" [1].

Missing customer funds

As the dust settled, the true extent of FTX's financial mismanagement began to come to light. Reports emerged that at least USD 1.00 billion of customer funds had vanished from the collapsed crypto exchange [11]. This revelation came from internal records that Bankman-Fried shared with other senior executives just before the bankruptcy filing.

The missing funds were part of a larger transfer of approximately USD 10.00 billion that Bankman-Fried had secretly moved from FTX to Alameda Research [11]. While the exact amount of missing funds remains uncertain, sources familiar with the matter estimated the gap to be between USD 1.00 billion and USD 2.00 billion [11].

Adding to the controversy, it was discovered that Bankman-Fried had implemented what was described as a "backdoor" in FTX's book-keeping system. This feature allegedly allowed him to alter the company's financial records without alerting external auditors or triggering internal compliance checks [11]. This revelation raised serious questions about the integrity of FTX's financial reporting and risk management practices.

The collapse of FTX sent shockwaves through the cryptocurrency industry, highlighting the urgent need for enhanced due diligence and regulatory oversight in the rapidly evolving digital asset landscape. The case serves as a stark reminder of the potential consequences when proper checks and balances are absent in financial systems, especially in the high-stakes world of cryptocurrency trading.

Regulatory Failures

Lack of oversight

The FTX case study has exposed significant gaps in regulatory oversight within the cryptocurrency industry. The collapse of FTX, once among the largest cryptocurrency exchanges globally, has highlighted the urgent need for comprehensive understanding and risk management strategies in this rapidly evolving sector [12]. The incident underscores the volatility and regulatory challenges in the crypto market, inviting greater scrutiny by regulators [12].

One of the primary issues identified in the FTX collapse was the absence of a cohesive regulatory regime. In the United Kingdom, for instance, there exists a patchwork of crypto regulations rather than a unified framework [12]. This fragmented approach has created higher barriers to entry for crypto firms, potentially resulting in increased compliance costs [12]. The lack of a comprehensive regulatory framework for cryptocurrencies and other digital assets has allowed companies like FTX to operate in a regulatory gray area [13].

Inadequate due diligence

The FTX case has also brought to light serious lapses in due diligence practices within the cryptocurrency industry. Court records suggest that prominent hedge funds, venture capital firms, and other investors overlooked serious deficiencies before investing in FTX and Alameda Research [14]. This failure of due diligence among large institutional investors has raised concerns about the robustness of risk assessment practices in the crypto sector [14].

One of the most glaring issues was the lack of transparency in FTX's financial statements. Unlike traditional financial institutions, the financial statements of FTX and other crypto firms were generally not audited and were not publicly available to customers [15]. This opacity made it difficult for investors and regulators to assess the true financial health of the company.

Furthermore, FTX allegedly engaged in practices that would have been strictly prohibited in a regulated banking environment. These included lending billions of dollars of customer funds to an affiliate, Alameda Research, and using customer funds for political contributions and personal expenses [15]. Such actions highlight the urgent need for stricter regulations and enhanced due diligence in the cryptocurrency industry.

Calls for stricter regulations

In the wake of the FTX collapse, there have been increasing calls for more robust regulations in the cryptocurrency sector. Many crypto companies and exchanges are now leaning toward more regulation as both a form of legitimacy and a way to gain trust with investors surrounding digital assets [12].

Policymakers and financial industry executives have emphasized the need for effective rules on the crypto industry, pointing to risks to consumers after a string of big market crashes and corporate failures [16]. Some have suggested that regulators could have provided more guidance for the crypto sector [16].

To address these issues, there are proposals for establishing procedures for digital asset exchanges to register with one of the large market regulators and require them to segregate customer funds [13]. There are also calls for expanding the authority of regulatory bodies like the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC) or encouraging them to engage in rulemaking using their existing authorities [13].

The FTX case has demonstrated that the lack of an overarching regulatory framework can fail to stop bad actors and may lead less informed participants to assume that crypto products have a regulatory 'stamp of approval' when they do not [13]. As the cryptocurrency industry continues to evolve, it is clear that more comprehensive and effective regulatory oversight will be crucial to protect investors and maintain financial stability.

Lessons on Corporate Governance

The FTX case study has exposed significant flaws in corporate governance within the cryptocurrency industry, offering valuable lessons for companies and investors alike. The collapse of this once-prominent crypto trading platform has highlighted the critical importance of robust governance structures and practices.

Importance of internal controls

One of the most glaring issues in the FTX case was the complete failure of corporate controls. John J. Ray III, the newly appointed CEO of FTX, stated that in his 40 years of legal and restructuring experience, he had never witnessed such a flagrant failure of corporate governance [17].

The company lacked basic internal controls, including:

Compromised systems integrity
No centralized control of cash handling
Inaccurate bookkeeping
Luxury purchases made by employees with corporate funds
Inaccurate registering of assets with government authorities [17]

These failures underscore the critical need for comprehensive internal control systems in cryptocurrency exchanges and other digital finance firms. Proper internal controls help prevent errors, identify problems, and provide a pathway to corrective action [18]. Common internal controls for crypto businesses should include segregation of duties, access controls for wallets and passwords, secure storage of private keys, and approval processes for actions and transactions [18].

Board oversight

The FTX case also highlights the importance of effective board oversight. The company's board of directors consisted of only two members: Sam Bankman-Fried and an attorney from Antigua [19]. This lack of diversity and independence in the board structure allowed for major transactions to be approved without proper scrutiny or record-keeping [19].

A healthy board of directors serves as a critical component of corporate governance, acting as a guardrail to prevent mismanagement and ensure that capital is wisely managed [19]. In the case of FTX, the absence of a robust board structure left the company vulnerable to poor decision-making and potential conflicts of interest.

To address these issues, crypto companies should strive to establish diverse and independent boards with members who possess relevant expertise in finance, technology, and risk management. Additionally, boards should implement clear processes for approving major transactions and maintaining accurate records of their deliberations.

Transparency and disclosure

The FTX collapse has also emphasized the crucial role of transparency and disclosure in maintaining trust and accountability in the cryptocurrency industry. The lack of transparency in FTX's operations and financial statements made it difficult for investors and regulators to assess the true health of the company [15].

To enhance transparency, crypto exchanges should:

Provide comprehensive, clear, and transparent information regarding their operations, risk profiles, and financial conditions [20].
Implement robust reporting mechanisms for user activity tracking [21].
Clearly display trading parameters and fee structures 21].
Adopt security measures that allow users to verify the safety of their assets independently [21].

By promoting transparency, crypto exchanges can build trust with their users and attract new customers. This increased transparency can also help to enhance the legitimacy of the cryptocurrency industry as a whole, potentially attracting more investors and facilitating integration into mainstream financial systems [22].

The FTX case serves as a stark reminder of the importance of sound corporate governance in the rapidly evolving cryptocurrency industry. By implementing robust internal controls, ensuring effective board oversight, and promoting transparency and disclosure, crypto companies can better protect their users, maintain regulatory compliance, and contribute to the overall stability and credibility of the digital asset ecosystem.

Conclusion

The FTX case study sheds light on the pressing need for stronger governance and risk management in the cryptocurrency industry. The rapid rise and dramatic fall of FTX has an impact on investor confidence and regulatory scrutiny, highlighting the dangers of unchecked growth and insufficient oversight. This incident serves as a wake-up call to crypto firms, investors, and regulators alike, emphasizing the importance of robust internal controls, transparent operations, and effective board oversight to protect user funds and maintain market stability.

Moving forward, the lessons learned from the FTX collapse offer valuable insights to improve the crypto ecosystem. The industry must prioritize implementing stricter governance standards, enhancing transparency, and fostering a culture of compliance. Regulators, too, face the challenge to develop comprehensive frameworks that strike a balance between innovation and investor protection. By addressing these issues head-on, the cryptocurrency sector can work towards rebuilding trust and establishing itself as a more mature and reliable part of the global financial

system.

FAQs

Q1: What were the key issues in corporate governance at FTX?

FTX faced several corporate governance challenges despite being a relatively new company. These included compromised system integrity, inadequate regulatory oversight, and a lack of centralized control over the funds they managed.

Q2: What ethical issues did FTX encounter?

FTX encountered numerous ethical issues, such as producing unreliable financial statements, mishandling confidential data, using corporate funds to purchase homes for employees, poor recordkeeping, and failing to maintain centralized control over company cash.

Q3: What were the shortcomings in FTX's internal controls?

FTX's internal controls were notably deficient, highlighted by their use of a shared, unsecured group email account for accessing confidential private keys and other sensitive data, which is a fundamental security lapse for any business operating online.

Q4: Can you explain the collapse of FTX in simple terms?

FTX collapsed due to poor management of funds and a lack of sufficient liquidity, which led to a high volume of customer withdrawals. Initially, Binance intended to acquire FTX to stabilize the market, but they withdrew their offer after further issues regarding the mishandling of customer funds were revealed.