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Dear Investor

General Market Overview

While equity markets may have had a volatile quarter, it’s not been an economic story that has dominated a segment of the markets. Instead, the Chapter 11 bankruptcy proceedings of listed crypto exchange, FTX, and related crypto trading company, Alameda Research, have caused stress within the world of cryptocurrency. Such is the interconnectedness among various crypto entities; it is estimated that over 100 other firms are likely to declare bankruptcy triggered by FTX.

The key protagonist in the FTX story is Sam Bankman-Fried (referred to as SBF on social media), supported by Caroline Ellison. To add political intrigue to the story, it is worth noting that SBF is the second largest donor to the US Democratic party.

Crypto exchanges allow crypto-market investors/traders to create accounts to buy and sell cryptocurrencies or tokens. A fact not often appreciated is that while there may be a secure login to the investor account on the exchange’s platform (web or app), unless the tokens are transferred off-exchange into a wallet controlled by the investor, the investor is reliant on the exchange to “make good” on the crypto holdings. Technically, the exchange still controls the all-important “private keys”. Additionally, many exchanges offer investors the ability to enhance their crypto returns by “staking” or “pledging” their holdings for proof-of-stake coins like Ethereum (not Bitcoin).

Investors who own a minimum number of crypto tokens can help validate transactions and are rewarded for their validation services. Investors who have an insufficient number of tokens themselves can pledge their coins with a validator to earn rewards. It’s not a riskless process since validating fraudulent transactions can result in the loss of coins.

To further complicate the environment, some platforms specialise in allowing investors to stake their holdings, known as DeFi (decentralised finance). DeFi platforms support the lending and borrowing of crypto-assets and typically offer investors large annual yields (20%) on their staked tokens. Crypto lenders are the de facto banks of the crypto world and boomed during the pandemic, attracting retail customers with double-digit rates in return for their cryptocurrency deposits. Crypto lenders are not required to hold capital or liquidity buffers like traditional lenders.

BlockFi, a prominent cryptocurrency lender, has also filed for Chapter 11 bankruptcy. BlockFi said the liquidity crisis was due to its exposure to FTX via loans to Alameda and cryptocurrencies “trapped” on the FTX platform. BlockFi listed FTX as its second-largest creditor, with $275 million owed on a loan extended earlier this year.

In an environment of loose control and regulation over investor crypto-assets, rampant fraud, and mismanagement, together with a cast of notable characters (SBF and Caroline), have allowed FTX, a company once valued at $32 billion, to become worthless. The bankruptcy expert appointed to unravel the corporate mess is John J Ray, who oversaw the Enron bankruptcy.

He remarks, “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.”

It has been found that FTX and Alameda did not keep proper accounting records. They had no records or security controls for deposited customer assets, used software to “conceal the misuse of customer funds”, never had board meetings and used group funds to buy property in the Bahamas for staff members. The software used to conceal the misuse of customer funds was a bespoke secret “back door” that allowed FTX customer deposits to be moved to Alameda without the transactions appearing in the FTX transactional logs.

Flush with customer deposits, Alameda Research (among other dubious dealings) then extended a $2 billion loan to SBF’s personal company, Paper Bird, and a further $1 billion loan to him personally. Even the FTX Director of Engineering received a personal loan of $543 million! It all boils down to nothing more than a fraudulent slush fund.

A significant component of Alameda’s supposed $14.6 billion balance sheet was the token FTT. FTT is the token minted by FTX, meaning much of the Alameda balance sheet asset value was made up of a crypto token created and priced by a very interconnected party. Alameda has over $8 billion of loans backed by its FTT holdings. It is unclear which entities were prepared to accept FTT collateral and extend loans to Alameda.

FTX’s crypto-assets, as assessed by the bankruptcy team, have an actual market value of $659 thousand rather than the $5.5 billion suggested by SBF. While they have been able to secure $740 million of customer deposits, the reported value of deposits is $9 billion.

As the proceedings uncover more profound levels of fraud, it has been revealed that on the day of bankruptcy declaration, at least $327 million of unauthorised transactions took place. One of those last transactions was at the behest of the Bahamian government. They claimed to be taking the money for “safekeeping” but have since launched a legal battle to stop the repatriation of the funds to the United States.

It’s not just naïve retail investors who have potentially lost it all with FTX. There are brand-name private equity funds like BlackRock, Sequoia Capital, and Tiger Global invested in the company, as well as celebrity figures like Naomi Osaka, Tom Brady, and Gisele Bundchen. The fear and greed of potentially missing out on the much-touted crypto rocket ship contributed to severe due diligence missteps by many who should have known better.

The unwind of FTX will also be a challenge for the bankruptcy courts to unravel. A creditor in bankruptcy proceedings is anyone who is owed money; it could be an employee owed a salary, a supplier, a lender or even the tax authorities. Tax owed tends to take the highest priority in the repayment schedule, followed by the senior secured lenders finishing with unsecured lenders and, finally, equity participants who tend to get nothing. However, the test for the courts will be where on the repayment schedule customer deposits rank. Had FTX been an FDIC or SIPC-insured entity (like all US banks and traditional brokerages), the US government would guarantee customer deposits, and the money would be returned. FTX is not regulated or insured, and the legal grey area is whether customer deposits “belong” to the customers or FTX. The top 50 customers (whose names remain redacted by the courts) have lost over $3 billion – the sums that were “sloshing around” are staggering!

General Conclusion

While we have focused on the plight of FTX this quarter, it must be remembered that SBF, Alameda and FTX itself do not represent flaws with the technology that underpins cryptocurrencies. Decentralised, blockchain technology remains viable for various applications, including preserving wealth outside of government-controlled fiat currencies.

Fraud will happen, even in highly regulated markets. Many will remember the Ponzi scheme of Bernie Madoff that attracted many Wall Street investors who should have known better. Also, the accounting fraud perpetrated by Enron (in the highly regulated energy market) that took down the “big five” auditing firm, Arthur Anderson, as well as vast sums of pension fund money.

If it seems too good to be true, it probably is.

17 January 2023

General Market Commentary Q4 2022
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