FTX filings highlight crypto industry risk management

The FTX collapse provides a masterclass in crypto industry risk management and accounting lapses without warning.

This, as court documents confirm that what was once the world’s third largest cryptocurrency exchange was set up from the start so that user funds entrusted to the platform could come without the knowledge or consent of their owners.

Disgraced FTX founder Sam Bankman-Fried has in the past called risk management “probably the most important thing we do at FTX.”

According to a recent Securities and Exchange Commission (SEC) filing, FTX’s lead white paper advertised that the exchange was built on “industry-leading risk management systems” and boasted that FTX was a “liquidation engine” that was safe and reliable a way for the platform to manage risk.

The “engine” allegedly applied a series of rules designed to automatically trigger certain actions that would reduce risk in client accounts, such as selling collateral in the event that the account was overextended.

In reality, and as a result of the specific way in which the crypto trading platform was centralized to support the activities of sister hedge fund Alameda Research with “limitless credit”, there were no internal risk controls over the use of uncollateralized funds.

In their guilty pleas, Alameda’s former CEO, Caroline Ellison, as well as Gary Wang, the software engineer and co-founder of FTX responsible for writing the code that gave Alameda Research special permissions, confirmed an improper organizational setup that allowed the funds to come and that Alameda was making increasingly large trades with the conversely reduced control attached to them, and they agreed to cooperate with the authorities.

In contrast, just last week (Jan. 3), Bankman-Fried pleaded not guilty to eight criminal charges filed against him in connection with the collapse of his company and the loss of billions of dollars in client assets.

Red flags were everywhere in retrospect

Regardless of the industry, when a company is privately held and not subject to the disclosure requirements that public companies face in their jurisdictions, it can be a difficult task to determine how effective any controls are in place, until the moment things start to go awry. bad.

John J. Ray III, the interim CEO appointed to oversee FTX’s bankruptcy and restructuring, said of the failed crypto exchange: “Almost every situation I’ve been involved in has been characterized by deficiencies of some kind in internal controls, regulatory compliance, human resources and system integrity. Never in my career have I seen such a complete failure of corporate controls and such a complete lack of reliable financial information as has occurred here.”

Strong words from the man responsible for what most creditors believe was a surprisingly successful unraveling of the Enron scandal two decades ago.

While the PYMNTS research shows that developing an infrastructural risk and control strategy to prepare for black swan events is critical to sustaining growth while mitigating risk, repeated claims by FTX and Bankman-Fried that were also submitted to regulators were inherently compromised by separate an internal control that allows FTX’s sister hedge fund Alameda Research to use client funds for its own trading purposes, making Bankman-Fried’s “24/7” automated risk monitoring mechanism essentially moot.

According to the SEC, FTX’s operational reality, dating back to at least 2019 and now exposed by its bankruptcy filings, was little more than a “sleazy, multi-year scheme” to defraud customers and investors.

After all, a properly functioning risk management program is not something to flaunt in front of investors or roll the eyes of regulators, but instead represents a critical collection of systemic processes that support the business.

Innovative benefits for me, not you

As reported in the SEC filing, FTX had extremely poor internal controls — including no chief financial officer or independent board — and fundamentally “deficient” risk management procedures that allowed assets and liabilities “of all forms to be generally treated as mutual replaceable”.

For a financial exchange designed to facilitate the trading of digital cryptocurrency assets, the lack of distinction between those of users’ assets in custody offers a clear advantage to the exchange itself, while posing a clear and present danger to clients whose trust money is collected and invested without their approval or knowledge.

It also creates huge exposure to the risk created by the stock market’s original positions, which is why FTX-type management controls that are promoted externally while belittled internally are so important in establishing sustainable hedges for growth.

The reality of FTX’s operations has consistently been in stark contrast to claims repeatedly made by senior executives about its risk management processes and controls that have helped create an image of FTX to the public and investors as a mature company that manages assets and risk in a rigorous manner . and a conservative way.

Most of the FTX entities never held board meetings, and CEO Ray indicated during the bankruptcy proceedings that he did not trust any of the financial statements submitted by the FTX companies.

As Bankman-Fried eventually admitted in a television interview after his company’s stunning collapse, “I didn’t even try, like, I didn’t spend time or effort trying to manage the 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 faults in the laundry

From corporate governance to risk management to false advertising touted by celebrities, FTX was riddled with glaring flaws in retrospect meant to mask that, as Ray said during his testimony, the company’s operations were nothing more than, “really just old-fashioned embezzlement … just taking money from the customer and using it for one’s own purposes.”

The silent majority of the digital assets industry operates among regulatory gray areas and offshore jurisdictional gaps chosen for their lax oversight. The failure of FTX led to the dangers inherent in this existence of choosing celebrity spokespeople over regular, audited financial data.

Risk disclosure is a cornerstone of financial regulation in the US, but disclosure is largely absent in cryptocurrency, and those existing attempts often lack good faith.

Because crypto companies often offer a variety of products and services on platforms that perform many functions, their operating lines are often blurred and increasingly conflicted, to the detriment of their customers.

In contrast, traditional financial firms that provide different services usually register their separate lines of business with the respective regulators charged with oversight.

As Ron Kruszewski, chairman and CEO of Stifel, one of those same traditional financial firms, told PYMNTS: “If I were running a crypto fund, I would be sitting in front of you and saying that we have to convince our clients that investing money in cryptocurrency is not really differs from putting money in the bank, we welcome the regulation. What I find amazing about all of this is that I have yet to see crypto leaders come out and say, ‘We’re separating our clients’ funds and our clients’ securities.’ Until they can say ‘yes’ to that, the industry will not move forward.”

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

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