Physics of the FTX Bubble: Hot Air Rises Fastest

Fraud is often obvious in retrospect, and as the dust around a scandal settles, it is often easy to point fingers at the failings of those actors who could have done better.

The implosion of once-popular crypto exchange FTX and its press-friendly CEO Sam Bankman-Fried (SBF), along with his deputies at Alameda Research, shows that, ultimately, blame should — and does — lie with the individual. Especially when that individual treats his or her company like their own “personal fiefdom,” as SBF has been accused of doing.

A rising tide may lift all boats, “but when the tide goes out, you see who is swimming naked,” Warren Buffett once famously said.

FTX’s bankruptcy proceedings, which had their first-day motions heard Tuesday (Nov. 22), have revealed just how far away SBF and his deputies at FTX and its affiliates were from whatever shore they left their clothes at.

This as over a million of the exchange’s customers are resigned to losing their own shirts, with little hope of regaining their deposits, the company’s bankruptcy is establishing a formal record of a business with little oversight, or even insight, into its own operations. One where customer funds were used to falsely prop up important trading accounts, and company money spent on homes and other items for FTX employees, friends and family.

Public Opinion Cools on the Cool Kids

As PYMNTS’ Karen Webster notes, unfortunately, we’ve seen this movie before. The cast of characters changes, but the ending is always the same. The business implodes, the cool kids flame out, and people say that we should have seen the red flags and done something sooner.

“I did not realize the full extent of the margin position, nor did I realize the magnitude of the risk posed by a hyper-correlated crash,” SBF wrote in an apology letter to his so-called “FTX Family.”

“You were my family,” he told them. “I’ve lost that, and our old home is an empty warehouse of monitors. When I turn around, there’s no one left to talk to.”

What was also lost is a historic amount of evaporated wealth, as well as an impressive amount of calculatedly acquired media goodwill.

FTX reportedly spent hundreds of millions of dollars on Bahamas real estate, with most of the purchases related to home and vacation properties meant for the exchange’s executives, even including SBF’s own parents — who are now scrambling to distance themselves from their multimillion-dollar vacation home. Just two of the properties were labeled as being for commercial use, in yet another example of the hollowness of SBF’s “effective altruism.”

Company Money

How did SBF do it? Pulling the wool over the eyes of the media and hobnobbing with celebrities like Tom Brady and global leaders like Bill Clinton and Tony Blair is impressive, but not unheard of. Doing it in shorts and a T-shirt is even charming, in an aw-shucks-this-is-the-world-we-live-in-now kind of way.

But raising $2 billion from some of the world’s savviest investors, creating and scaling a financial platform and trading exchange product to a value of $32 billion (that’s roughly equivalent to a DuPont or a Hershey’s and bigger than 40% of the S&P 500’s members) with over a million active and paying users — that is a little trickier than getting one’s face plastered over the cover of Fortune and Forbes.

Having it all come crashing down in an instant is likely the thread that needs to be pulled out to its source.

Sequoia Capital, one of FTX’s many blue-chip investors, has been so buffeted by the fallout that the firm has explicitly told its LPs it is revamping its entire diligence process.

As reported by PYMNTS, FTX used customer funds to bail out its sister trading firm, Alameda Research, just as it used company money to buy up beachfront condos in the Bahamas. Exchanges must back their customer funds 1:1 to both ensure and insure liquidity, but FTX obviously wasn’t.

Failed Promise, Valid Premise

The collapse of FTX, ”calls into question the promise of the [crypto] industry,”  U.S. Sens. Elizabeth Warren, D-Mass., and Dick Durbin, D-Ill., said in another recent letter sent to SBF as well as the current CEO of FTX, John J. Ray III.

But does it also call into the question the premise of crypto?

After all, crypto is supposed to be transparent, decentralized and highly accountable — things which FTX was 0/3 on. As a so-called crypto startup, how could a collapse like FTX’s, where customer money disappeared into a black box and was moved around until there was nothing left to shuffle, even — at least on a technical level — happen?

For one, FTX’s over-leveraged empire was not in fact a decentralized, Web3-native enterprise. It was simply a cut-and-dry overleveraged financial empire of the Lehman Bros. variety. FTX and SBF alone controlled both the exchange’s trade order books and users funds.

What does that have to do with crypto? Almost nothing.

Bitcoin’s famous whitepaper establishing the creation of peer-to-peer electronic cash systems both called and provided the mathematical framework for a system of value transfer between two connected parties without the need for a third-party intermediary. The opening lines of the whitepaper state that:

“Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model.”

Sound familiar?

FTX was built, designed, and operated as a “trusted third party for processing electronic payments,” and the exchange’s collapse, outside of the intent or actions of individual actors, can be blamed squarely on “the inherent weakness of the trust based model.”

“What is needed is an electronic payment system based on cryptographic proof instead of trust,” the whitepaper continues. That certainly wasn’t FTX, which operated entirely as a financial exchange built entirely on trust, which SBF was able to use to his own personal advantage.

It was explicitly the fact that FTX did not operate according to blockchain’s decentralized principles that allowed SBF to get away with everything he was able to get away with. The benefit of decentralized systems on an immutable blockchain, or ledger, is that they are transparent and automatically record every transaction they are used for, in perpetuity. This transparent ledger provides accountability for stakeholders who know they are able to independently confirm that what they think is happening is in fact happening.

By operating off-chain, FTX was able to do business with little internal or external oversight, while simultaneously reaping the “to-the-moon” risk-appetite valuations and benefits its investors associated with the broader crypto landscape.

If the investors and users of FTX had access to the same information that the users of truly decentralized exchanges do, FTX’s collapse would have never happened. Given the hot air-fueled approach SBF took to building his company, the exchange’s rise to the forefront of the industry likely would have never been possible either — and that just might’ve been better for everyone involved.

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