FTX Filings Highlight Crypto Industry Risk Management

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

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

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 filing with the Securities and Exchange Commission (SEC), FTX’s governing white paper announced that the exchange was built on state-of-the-art risk management systems and boasted that the FTX liquidation engine was a secure and reliable for the platform to manage risk.

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

In reality, and due to the specific way the crypto-trading platform was centralized to support the activities of sister hedge fund Alameda Research with unlimited credit, there were no internal risk controls on the use not guarantee of funds.

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

By contrast, last week (January 3), Bankman-Fried pleaded not guilty to eight criminal charges brought against him relating to 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 FTX’s bankruptcy and restructuring, said of the crypto exchange’s implosion that, nearly every situation I’ve been involved in has been characterized by any deficiencies 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 trustworthy 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.

While PYMNTS research shows that developing an infrastructure risk and control strategy to prepare for black swan events is critical to sustaining growth while mitigating risk, repeated assertions made by FTX and Bankman-Fried and also submitted to regulators have been inherently compromised by a separate internal process. control allowing FTX’s sister hedge fund, Alameda Research, to use client funds for its own trading purposes, rendering the Bankman-Frieds 24/7 automated risk monitoring engine essentially moot.

According to the SEC’s allegations, FTX’s operational realities, dating back to at least 2019 and now exposed by its bankruptcy filings, were little more than a brazen, multi-year scheme to defraud customers and investors.

After all, a properly functioning risk management program is not something to dangle in front of investors or throw wool in the eyes of regulators, rather it represents the critical set 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 the absence of an independent CFO or board of directors, and fundamentally flawed risk management procedures that allowed assets and liabilities of 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 exchanges’ native positions, which is why FTX-like management controls promoted externally while flouting internally are so important to establishing lasting safeguards for growth.

The reality of FTX’s operations constantly 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 managed 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 admitted in a TV interview after his company’s stunning collapse, I wasn’t even trying, for example, to spend time or effort 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 hindsight flaws meant to obscure the fact that, as Ray said during his testimony, the operations of business amounted to nothing more than an old-fashioned embezzlement. just take money from the customer and use it for your own purposes.

A silent majority of the digital asset industry operates in regulatory 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 bedrock of financial regulation in the United States, but disclosures are largely absent in crypto, with existing attempts often lacking in 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 regulators.

As Ron Kruszewski, President and CEO of Stifel, one of those same traditional financial companies, told PYMNTS, if I were running a crypto fund, I would be sitting in front of you saying we need to ensure our customers that putting money into crypto is really no different than depositing money in a bank, which we welcome the settlement. What I find amazing about all of this is that I have yet to see the crypto leaders come out and say: We separate our client funds from our client securities. Until they say yes, the industry will not move forward.

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

For all PYMNTS cryptocurrency coverage, subscribe to the Daily Crypto Newsletter.

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See More In: Alameda Research, bankruptcy, Crypto Exchange, cryptocurrency, Featured News, FTX, internal controls, John J. Ray III, news, risk management, Sam Bankman-Fried, SEC

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