The Eternal Problem of Financial Innovation

Much has been written about the FTX scandal, but while this story provides plenty of material for the next Netflix blockbuster, most of the coverage focuses on the immediate events. While they are admittingly very enthralling and packed with suspense, they disregard the bigger questions, in my opinion. Looking deeper into the peculiar case of the rise and fall of Samuel Benjamin Bankman-Fried and FTX, it is a prime example that showcases the eternal problem of financial innovation and the role lawmakers and authorities play.

The Rise and Fall of FTX

Though much has been written, a short summary is required, I suppose to understand the case and its ramifications: FTX was one of the fastest-growing crypto exchanges in the industry. Founded in 2019 by Sam Bankman-Fried, a well-known algorithmic trader and investor, FTX had quickly become a popular choice for traders, investors, and institutions alike. Prior to founding FTX, Bankman-Fried worked at the trading firm Jane Street, where he learned the ins and outs of algorithmic trading. After leaving Jane Street, Bankman-Fried founded Alameda Research, a cryptocurrency trading firm that apparently had become one of the largest and most profitable in the industry. At its core though, FTX was a cryptocurrency derivatives exchange that offered a wide range of different trading products such as futures, options, leveraged tokens, and more, all of which are built on the Ethereum blockchain.

In addition to its derivatives trading products, FTX also offered a spot trading platform for various digital assets as well as a wide range of different cryptocurrency index funds, allowing users to easily diversify their portfolios.

The platform has been called very user-friendly, making it a great choice for both experienced traders and beginners alike offering a wide range of different features and tools for traders, such as real-time market data and analysis tools.

Since its launch, FTX had become increasingly popular, and was at one point one of the largest crypto derivatives exchanges in the world.

The rise of FTX has been attributed to a number of different factors that have been listed in industry publication and message boards such as Bankman-Fried’s experience in algorithmic trading that allowed FTX to develop innovative trading products and features that appeal to both experienced traders and beginners alike. Or, how FTX has benefitted from its strategic partnerships with major exchanges, such as Binance, helping FTX to expand its reach and attract more users to the platform. Or its commitment to customer service that enabled FTX to build a loyal user base that continues to grow.

Nothing is made for eternity as we know and despite its initial success, FTX’s growth began to slow down in 2020. This was due to a number of different factors, including the increasing competition in the crypto derivatives market and the fact that FTX was not able to keep up with the rapid pace of innovation in the industry.

In addition, the platform also faced a number of legal issues due to its lack of regulatory compliance causinga number of users to leave the platform and resulted in a decrease in trading volumes.

However, the downward spiral really gathered pace when Bloomberg last September reported on a close relationship between FTX and Alameda Research, a cryptocurrency trading firm, co-founded in September 2017 by Bankman-Fried Tara Mac Aulay that acted as market maker for FTT, the native token of FTX, and was by far the biggest depositor of stable coins on FTX, providing liquidity. The article further explained that the regulatory oversight which applies to companies operating in traditional equities markets would have prohibited the relationship between the two firms were it applicable, since, among other issues, Alameda’s trading on FTX meant the trading firm was potentially in a position to gain financially when others lost money on the exchange.

The dependency between the two companies was further highlighted when at the beginning of November, Coindesk reported that a significant portion of Alameda Research’s assets were held in FTT. In fact, Alameda’s balance sheet showed holdings of $3.66 billion of “unlocked FTT”, $2.16 billion of “FTT collateral”, and $292 million of “locked FTT” – at a time when there were only $5.1 billion worth of FTT tokens in circulation emphasizing the structure of a gigantic house of cards.

The White Knight comes… and goes

Binance, FTX’s biggest rival and the largest crypto exchange globally itself, has had an interesting relationship, too. After having acquired an equity stake in FTX, the two parties agreed that Binance would receive FTT from FTX in 2021 in exchange for Binance’s initial equity stake in FTX. Shortly after the Coinbase news, Binance CEO Changpeng Zhao announced via on Twitter that his firm intended to sell all its holdings of FTT naming recent revelations that came to light as the motivation for selling FTT. Since there wasn’t a massive amount of trading volume going on in FTT, it didn’t take an oracle to figure out what the impact of these news may be on the price of FTT.

The crisis now unfolded publicly with the value in FTT and other cryptocurrencies falling sharply. Until, Zhao stepped in again with an announcement that Binance had entered into a non-binding agreement to purchase FTX due to what he referred to as a “liquidity crisis” at FTX.

As a close observer of financial markets for almost two decades, personally I couldn’t help but think of another liquidity crisis, the one that led to the fall of several investment banks during the Global Financial Crisis of 2007/2008.

Taking to Twitter again, Zhao announced that Binance would complete due diligence soon, but only a day after the potential deal got called off citing claims of mishandled customer funds and alleged US agency investigations.

The rest is told quickly as all other efforts to find a suitable partner led to nothing and on November 11, FTX as well as Alameda Research, and more than 100 affiliates filed for bankruptcy in Delaware, while most people in FTX’s in-house legal and compliance teams had resigned the day before.

Since then Bankman-Fried has been arrested and extradited to the US where he was charged with fraud and money laundering among other indictments despite his best affirmations against any personal guild that would go beyond mere mismanagement and bad luck. Two senior executives of FTX, Caroline Ellison and Gary Wang, on the other hand did not hesitate to plead guilty to criminal charges in connection to a multibillion-dollar fraud allegedly orchestrated by Sam Bankman-Fried through his crypto exchange personal hedge fund, so a positive outcome  of the court affair for personally Bankman-Fried is not very likely.

The Ripple Effect

While the personal ramifications may be devastating, the impact could still be considered miniscule compared to the ripple effect the FTX downfall caused across the industry: not delving into the losses of investors around the globe or the loss in other cryptocurrencies that traded down sharply leading to significant losses for many small investors, it also took the toll on a number of other crypto companies such as, BlockFi, Gemini or Silvergate Bank as examples of firms that faced annihilation as a result of the FTX crisis and where couldn’t avert it in time, had to declare bankruptcy in some cases themselves.

Again, this brings back unpleasant memories of a wider financial crisis and raises questions about the stability of the crypto industry, in particular, when more regulated elements of the financial sector could find themselves in such turmoil, what might be the prospects of the still lightly regulated universe of blockchain-based products?

A Question of Guilt

Returning to the case of FTX before we turn to the crucial question that lies at the bottom of this case, it has quickly become clear that Bankman-Fried is not the only one to blame though. While the management of FTX and its affiliates already is being scrutinized, the effect goes beyond the inner circle.

For instance, various celebrities are among the victims of the insolvency, such as star quarterback Tom Brady, who owns more than a million shares in FTX Trading, or Brady’s former wife, model Gisele Bundchen, who owns more than 680,000 of those shares. The pair as well as other public figures received these as part of their compensation for promoting FTX. This in turn could have additional consequences that goes far beyond the loss in the once multi-billion-dollar company that was FTX: shortly after the bankruptcy filing, a class-action suit was filed against the FTX founder and various celebrities who promoted theexchange, claiming they engaged in deceptive practices to sell FTX yield-bearing digital currency accountsby unlawfully selling unregistered in the United States.

The regulatory response

Regulators and law enforcement agencies have been quick to respond once the crisis unfolded. Beyond the personal consequences the affair will have for Bankman-Fried and others, the authorities have re-issued their concerns about cryptocurrencies and their effect. For example, the US Federal Reserve, US Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) issued a Joint Statement on the risks posed by crypto-assets to banking organisations, saying that events in 2022 were marked by significant volatility and the exposure of vulnerabilities in the crypto-asset sector, and they highlight a number of key risks associated with crypto-assets and crypto-asset sector participants that banks should be aware of.

Solid advice, but once again, just as during the ICO crisis only a few years back, the regulatory response seems belated at best. And the question we could ask is whether regulators, too, are to blame for negligent behaviour in their work of overseeing financial markets and preventing situations exactly such as this?

Time will tell what role the authorities could or should have played in this specific case. There is always a parliamentary enquiry of sorts and sometimes it also discovers that the regulator should have done more without going into any specific examples.

The collapse of FTX and the current crisis of the crypto sector, however, is also an example that showcases an eternal problem of financing innovation that centres on the question of regulation: Should innovation be regulated and if so – as you would assume in all cases at least to some limited extent unless you are an ultra-libertarian – how?

A common mantra – and one that I believe in I should say – is that Regulation should not stifle innovation. Yet, do not this kind of incidents cause more damage to a sector than stronger oversight and monitoring may have done in the first instance?

It is difficult to say what measures exactly should be applied in the supervision of (financial) innovation. What is less challenging to say though is that more needs to be done, but that all that may be something for another conversation.