One of the most interesting stories in crypto in the last month has been the implosion of FTX, one of the top exchanges by trading volume in the industry. At its height, FTX had a $32B valuation, handled over $10B in trades per day, and received $2B in venture funding from top tier investors such as Sequoia and Softbank. But FTX's fortunes changed rapidly in early November when a CoinDesk reporter published an article showing a leaked balance sheet from Alameda, a hedge fund owned by FTX founder Sam Bankman-Fried. The balance sheet showed the hedge fund had an unusually close relationship with its sister exchange, with its assets dominated by a token created and issued by FTX called FTT. Within days of the revelation, customers started to lose confidence in both FTX and FTT, resulting in a 90%+ drop in the token price and investors rushing to withdraw their assets from the exchange. Unable to keep pace with customer withdrawals, the company declared bankruptcy on November 11th.

Since the implosion, the question everyone is asking is: was FTX a fraud all along? If you listen to Sam Bankman-Fried, the failure was just an honest mistake. Access to customer funds by Alameda was the result of a historic approach used by customers to wire fiat currencies into the exchange via a bank account owned by the hedge fund. As the story goes, while the wire transfers from customers were correctly credited to FTX accounts, they were mistakenly not debited from Alameda, allowing the hedge fund to inadvertently access billions of dollars in customer assets. As for the bankruptcy, in Bankman-Fried’s own words on Good Morning America:

“Best I can tell, Amameda did have a big position on FTX. That position, I think, was very over collateralized a year ago. There is a total market collapse, and specifically a large correlated collapse of its assets over the last month - and to some extent last year - that threatened that position quite a bit. And I think that’s, as best as I can discern, a lot of what happened there.“

Pretty clear right? 😉

While I'm sure a full forensic audit is underway on FTX, those of us on the outside are left with limited data to make sense of what happened. What little we know is mostly coming from the Bankman-Fried Apology Tour 2022, as the former CEO talks to everyone willing to interview him about how sorry he is he lost his customers' money. But there is one piece of evidence that hasn’t received enough attention: the balance sheet the Financial Times published on November 12th, which they claimed was used by Bankman-Fried in his last ditch attempt to raise venture capital before the collapse. In reviewing the spreadsheet, several oddities jump out:

#1: Customer Assets Were Not Backed 1:1

On November 6th, FTX customers raced to withdraw $5B in assets from the exchange, after which the company shutdown withdrawals for all customers except those in the Bahamas (where Bankman-Fried and his company were located). This spreadsheet appears to show the balance sheet in the aftermath of the withdrawals, revealing a company that supposedly was illiquid but not insolvent. If true, all FTX needed was some short term liquidity to get through this crisis, after which they could continue operating an otherwise healthy business. But given the fact FTX had only $899M in liquid assets on its balance sheet at the time of the shutdown, it seems almost certain the company was not backing customer assets 1:1. Put more bluntly: what you saw in your portfolio on the exchange was almost certainly not what was in the company teasury.

#2: FTX Claimed Customer Assets On Its Balance Sheet

Since an exchange is a custodian of customer assets, there are two possible ways to reflect them on a balance sheet: (1) don’t show any customer assets or liabilities, or (2) show both the customer assets and liabilities, but clearly denote them as such. A great example of a correct handling of customer assets for which a company has custodial ownership can be seen on the Coinbase 10-Q, which is a publicly traded / regulated US-based crypto exchange. It appears as though Bankman-Fried may have invented a new non-GAAP way to show customer assets on a balance sheet: claim them as company owned assets, but ignore them as company liabilities.

#3: Customer Assets Appear To Be Backed Only On-Demand

You will notice the suspicious absence of Bitcoin and Ethereum from the list of assets on the balance sheet. Since BTC and ETH represent 55%+ of the overall crypto market, it seems virtually impossible these currencies would not be held on a balance sheet at least as custodial assets. There are two possible explanations: (1) no customers held BTC or ETH on FTX, or (2) FTX was re-allocating / purchasing assets to reconstitute customer balances at time of use and/or withdrawal.

#4: One of the Biggest Liabilities Is Missing

As mentioned previously, the treatment of customer assets is confusing if not deceptive. But possibly even more concerning is the absence of what I expect was the single largest liability: customer losses for which FTX had a contingent liability. One of the ways FTX attracted customers was to offer no-risk interest on assets by simply allowing them to be borrowed by other customers. These loans were invisible to the loaning customers, could be turned off at any time, and FTX was responsible for making the account whole in the event a borrower defaulted on losses to some or all of the assets. Given the volatility of crypto in 2022, I would expect spot margin and open future position losses to have been in the billions of dollars. While the borrowing customers would of course have been responsible to return the borrowed assets, FTX had a contingent liability to its customers to ensure this did not impact their portfolios. But somehow this contingent liability is missing from the balance sheet.

#5: Company Borrowed Heavily From Itself

A typical balance sheet will show liabilities such as accounts payable, rent, and outstanding loans. I know I am a technologist and not an accountant, but I’ve never seen a balance sheet with cryptocurrency and US dollars as a liability. You will notice these include one stablecoin (Tether), two cryptocurrencies (Bitcoin, Ethereum), and US dollars. These appear to be loans the company made to itself from assets it had on the books. Is it possible for a company that had taken $2B in venture capital while producing less than $500M in profits in its 3+ years of operations could borrow $7.2B in assets from itself without tapping into customer funds? What does my Magic Eight Ball say to this question? Don’t count on it.

#6: “Less Liquid” FTT Assets Seem Like Straight Up Fraud

The “less liquid” liabilities shows the company holding pre-collapse a total of $5.9B of an unregulated security they created and issued called FTT. At this time, the total market capitalization for FTT was under $3.4B, of which 2% was trading daily. How could FTX claim this volume of their own token as an asset, knowing both it was illiquid and its existence would almost certainly have dramatically impacted its price? This is sort of like a publicly traded company having a yet to be created stock for a possible future public offering as an asset on its books. Ironically the abudent existence of this token on Alameda's balance sheet is what started the FTX collapse.

#7: The Burn Rate Was... Staggering

FTX is reported to have entered 2022 with $2.5B in cash, and was on track to generate $1.1B+ in 2022 revenue with a 75%+ gross margin. The company was employing about 300 people at the time of bankruptcy. In addition, their sister company Alameda had historically been a revenue generating machine, producing over $1B in profits in 2021. But somehow FTX still managed to incur almost $8.9B in liabilities in its three years of operations. That is nothing short of staggering.

Last Thoughts

Was FTX a fraud? There is no doubt FTX was a highly overextended business, acting as an exchange, a market maker, a hedge fund, an issuer of unregulated securities, a bank, a broker, a venture capitalist, its own regulator, and a lender of last resort. But it's also possible FTX was really just the crypto equivalent of a Ponzi Scheme, running an exchange solely to gain access to customer funds for use as a personal piggybank.

I honestly have no idea if FTX was a fraud, and expect a definitive answer can only come from a detailed review of company systems and data. But if Bankman-Fried hoped this balance sheet would help him raise $8B in emergency capital to save his company, it seems likely to have raised more questions than answers.

Image by Gerd Altmann from Pixabay