Why FTX’s collapse is worse than Enron’s

Until recently, cryptocurrency exchange FTX was the second largest crypto exchange in the world after Binance. It had become known with the support of major investors such as Sequoia, BlackRock, Temasek and OTPP. It was once worth $32 billion and was instigated by celebrities like soccer player Tom Brady. The then-CEO of FTX was the second-biggest donor to the Democrats.

Today FTX has gone bankrupt as users of the exchange will lose large amounts of money. A new CEO to oversee the bankruptcy process. Ironically, that CEO is John J Ray III, who also oversaw Enron’s bankruptcy proceedings.

Enron is often seen as the gold standard for corporate fraud, wrongdoing and complacency, with the scandal leading to the largest bankruptcy reorganization in US history.

The Enron scandal sparked a wave of regulatory reforms, culminating in the Sarbanes-Oxley Act of 2002 and changes in listing rules on the NYSE and NASDAQ.

In FTX’s bankruptcy filing over FTX’s collapse, the new CEO shredded FTX, Alameda and FTX’s former management team. Significantly, he states:

“Never in my career have I seen such a complete failure of corporate controls and a complete lack of trustworthy financial information as here.”

What is a cryptocurrency?

A digital or virtual currency secured by cryptography. Many cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), Dogecoin and UltraCoin (UTC) are decentralized networks based on blockchain technology and hosted on blockchain platforms like Solana.

What is a crypto exchange?

A cryptocurrency exchange is a platform for buying and selling cryptocurrencies. Examples are Binance, Coinbase and FTX.

This came from the CEO overseeing Enron’s bankruptcy.

And it gets worse. It was revealed that the former CEO (Sam Bankman-Fried, or SBF for short) treated FTX as a “personal fief”. FTX funds appeared to be used to purchase real estate on the personal behalf of individuals. These are at least 19 properties in the Bahamas – where FTX is headquartered – valued at least $121 million.

And the contagion has spread. In fact, even Australian companies – like Digital Surge – have been affected and have to pause payouts. Celebrities are under scrutiny for promoting FTX, and CEOs like billionaire Elon Musk come out of nowhere to tell us they knew it all along.

Mark Humphery-Jenner, associate professor at UNSW Business School, says the problem isn’t with crypto, it’s with corporate governance. Photo: Delivered

Where has the money gone? Who knows?

Indeed, FTX had poor risk management and internal controls. The petition only touches the tip of the iceberg. Here are some highlights (or lowlights).

The problems with FTX are manifold. The bankruptcy filing noted at several points that the accounts were not reliable. The filing specifically states, “FTX Group has not maintained adequate books and records or security controls.”

Alameda Research (a company closely associated with FTX and majority-owned by SBF), states in the filing, “I have no faith in it and the information contained herein may not be accurate as of the date disclosed”…”[Alameda] did not keep complete books and records of their investments and activities”.

The cash management issues seemed broad. “FTX Group has no central control over its cash. Procedural errors in cash management included the lack of an accurate list of bank accounts.” It’s not clear how FTX could continue as a business without even knowing what bank accounts it has.

It should come as no surprise, then, that FTX’s money appeared to have been used to purchase properties that were “in the personal names of these employees” and for which there was no documented loan. There is concern that executives were treating FTX as a private piggy bank.

Not only that, FTX and Alameda appear to have been incompetent. They appear to have lost money in the pre-2022 crypto bull market. This alone should have encouraged more attention to proper risk management.

Read more: Crypto Crash: Why Did Cryptocurrency Fall?

Better governance could have prevented the situation

Much of the regulatory discussion has focused on crypto. Does it need to be regulated? As? Should we just burn down crypto assets and crypto markets and replace them with central bank digital currencies?

However, the problem is not with crypto. The problem is corporate governance: we haven’t learned the lessons of two decades ago.

After Enron, regulations changed to require companies to rotate auditors, have an independent audit committee, and have a majority-independent board of directors. These only apply to listed companies, not unlisted ones. These changes come with some costs for small businesses, but there are big benefits. Especially when this company holds other people’s money and has raised billions of dollars from investors.

Better governance could have solved this situation. FTX could still exist if outside investors had imposed more discipline on FTX, required proper internal controls and properly audited financial reports.

The board’s independence is holding back cocky CEOs, which SBF says is one of them. It subjects underperforming CEOs to disciplinary action and dismissals. This seems to be the case even where the CEO would otherwise be entrenched. The problem is that FTX didn’t have any of those internal controls. Indeed, corporate control “was in the hands of a very small group of inexperienced, inexperienced and potentially vulnerable individuals,” according to the bankruptcy filing.

Read more: What does Australian regulation mean for cryptocurrency?

Does FTX Fall Mean Regulatory Reform?

The concerns of the regulators are justified. FTX’s fall has sparked contagion and the specter of more crypto-busts ranging from Voyager to BlockFi to FTX. The contagion imposes significant financial costs on innocent ordinary investors, institutional investors, employees and other counterparties.

The problem with simply regulating “more” is that crypto isn’t accountable for substandard, complacent, inexperienced executives. Crypto is not to blame for the alleged misuse of customer funds. Crypto is not responsible for shoddy accounting.

The hope is that regulators can be fully educated on crypto and decentralized finance. This may involve crypto “exchanges” operating in broadly analogous frameworks to traditional brokers. It may require properly audited books and a technically competent executive team.

Proposed reforms include banning exchanges from using their own coins as collateral, listing those coins separately on their books, enforcing proper risk management, banning the unauthorized use of client funds, and requiring proof of reserves.

However, the situation is complex. FTX was headquartered in the Bahamas. Crypto works across borders. Finally, given the limited scope of regulations, consumer education is becoming increasingly necessary.

Mark Humphery-Jenner, Associate Professor School of Banking and Finance, UNSW Business School, can be contacted at [email protected] for comments on the above.

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