FTX failings flag fintech blind spotsby
A comprehensive lack of governance and transparency, bypassing normal investor due diligence and an absence of meaningful regulation provided a heady cocktail for the swift and spectacular collapse of crypto exchange FTX.
Once the second-largest cryptocurrency exchange on the planet, valued at $32bn as recently as January 2022, the FTX collapse has been swift and spectacular. According to recent court filings, “barely a week ago FTX, led by its co-founder Sam Bankman-Fried, was regarded as one of the most respected and innovative companies in the crypto industry.”
However, on Friday, FTX and 134 of its affiliated firms filed for bankruptcy protection following a rash of customer withdrawals and a dramatic fall in the value of its native FTT token – a cryptocurrency that provided access to the FTX trading platform’s features and services.
It leaves a potential one million creditors in its wake, with depositors in the exchange treated as unsecured creditors – behind bank loans and slightly ahead of equity owners when it comes to recovering billions in lost funds.
While cryptocurrency critics have been quick to jump on the news as evidence of the movement’s failings, many of the issues involved in the collapse appear to be more prosaic: namely, a comprehensive lack of governance and transparency at the company, a bypassing of due diligence from investors and an absence of any meaningful regulatory response.
Normal due diligence ‘out of the window’
Used by both do-it-yourself crypto traders and highly sophisticated companies such as hedge funds, over a period of two and a half years from 2019, Bahamas-based FTX raised more than $2bn from investment houses such as SoftBank, Sequoia and BlackRock.
One accountant working in the crypto industry told AccountingWEB that the frenzied atmosphere around cryptocurrency in 2020 and 2021 meant that investors skipped over many of the normal checks. “Venture capital was scrambling to get in on the action, and there was a genuine fear of missing out that meant the normal due diligence processes went out of the window.”
By way of example, FTX backers Sequoia Capital told investors in a letter following the collapse that it had conducted a “rigorous” due diligence process. However, according to Bloomberg reporting, when the firm invested in two of Bankman-Fried’s companies, it was not given access to the balance sheet of Alameda Research, a crypto trading firm started by Bankman-Fried as a forerunner to FTX, which was heavily linked to the exchange.
FTX has a complex, sprawling structure encompassing 134 registered companies, shells and related entities across multiple countries and jurisdictions. As shown in this attempt to visualise the structure, getting to grips with it was tricky for even seasoned investors – although those who followed collapses such as Wirecard and Greensill, which had similarly convoluted organisation charts, may have pointed to this complexity as a potential red flag.
AccountingWEB’s crypto accountant contact also highlighted how poorly equipped investors had been to evaluate the company’s business model. “Investment houses love the idea of backing the next Facebook or PayPal, but most just don’t have the expertise to evaluate the legal and financial risks associated with cutting-edge technology businesses.”
Investors and executives kept in the dark
Bankman-Fried kept the company’s books closed to all but a small group of founders and insiders, with even high-level executives kept in the dark about crucial financial information.
Ryne Miller, FTX’s general counsel, posted: “In terms of financials – I acknowledge I have very little transparency and more is not possible without full cooperation from the founders,” on the company’s Slack channel on Thursday (before his message was deleted).
Bankman-Fried also remained the majority owner of the company and no investor joined the board – which was comprised of Bankman-Fried, former FTX executive Jonathan Cheesman and Arthur Thomas, a lawyer in Antigua who specialises in online gaming.
According to the Financial Times, a copy of an FTX “balance sheet” dated Thursday 10 November states that despite having $9bn of liabilities, FTX had only $900m of assets it could easily sell. The remainder of the assets are tied up in illiquid crypto investments the company would struggle to offload at anywhere near their assigned value.
Accounting software ‘back door’
CNBC reported on Sunday that Alameda Research, had secretly borrowed an estimated $10bn in customer funds from the exchange to ensure it had enough liquidity on hand to process withdrawals – with an alleged $1bn still unaccounted for.
Bankman-Fried denies the allegations. “We didn’t secretly transfer,” he told Reuters. “We had confusing internal labeling [sic] and misread it.”
According to US securities law, trading customer funds without explicit consent is illegal, and the move would also violate FTX’s terms of service.
As reported in Reuters, FTX legal and finance teams investigating the $1bn of disappeared customer funds discovered that Bankman-Fried had what sources described as a “back door” in FTX’s bookkeeping system, built using bespoke software.
This back door allowed Bankman-Fried to run commands that could alter the company’s financial records without raising red flags or triggering internal compliance or external auditors.
Hours after it filed for bankruptcy on Friday, FTX also apparently suffered a cyber attack, with research firm Elliptic estimating $477m had been stolen as a result. While investigations into the breach continue, it raises customer and creditor fears that their losses could deepen.
Where were the auditors?
In common with high-profile failures that have gone before, questions eventually turn to the company’s auditor.
Tweeting last year, Bankman-Fried hailed FTX as the first crypto derivatives exchange to complete a generally accepted accounting principles (GAAP) audit - a claim also made on its website. However, at the time the company did not share its financial statements with the public or disclose which firm had completed the audit.
Financial statements seen on Friday by trade publication CoinDesk state that FTX Trading LLC, the exchange’s international arm, worked with US mid-tier firm Prager Metis and Armanino, one of the 20 largest accounting CPA firms in the US.
Both firms have made significant investments in their digital and cryptocurrency offerings. According to its website, Prager Metis has 24 operating locations, including the metaverse, where the firm claims to have a “strong virtual presence”.
Given the number of interrelated parties in the FTX corporate structure, a lack of transparency at executive level, and the potential ability to move funds undetected uncovered by recent investigations, providing any level of assurance may have proved challenging for auditors.
Crypto standards found wanting
A lack of clear guidance from US standard setters on how companies recognise and measure their crypto holdings may also have contributed to FTX’s gap between assets and liabilities, which Bloomberg News reported as an estimated $6bn.
Companies by and large treat cryptocurrencies as intangible assets, recording them at historical cost on the balance sheet and making manual adjustments if the value declines.
Much of the reported gap between FTX’s assets and liabilities could be due to an inflated valuation of the exchange’s own crypto token, FTT.
“There is no transparency… no consistent valuation methodology… no guiding rules or overarching frameworks to help folks in accounting and tax get a handle on these assets,” Sean Stein Smith, chair of the Wall Street Blockchain Alliance’s accounting working group told Bloomberg Tax. “FTX is a poster child of how corporate governance failed, financial reporting failed, and the transparency and the auditability of the asset in question failed.”
“The problem is not with crypto, it’s with the people running these firms,” he tweeted later, responding to reports of inside-traded tokens listed on the FTX exchange.
"At the moment this space is suffering from projects or platforms that are set up with less than ideal structures leading to some huge vulnerabilities," added Ben Lee, partner at PKF Francis Clark. "Hence, the collapse of some big names in the space having huge effects on the market. I doubt we have seen the end of it yet. The tech still remains and isn't going anywhere anytime soon despite the headlines and the fall in value; the ecosystem is simply trying to find its footing, albeit with a few Netflix documentaries along the way...
"Cryptocurrency exists for us to transact with each other in a trusted transparent way without third-party interaction in a decentralised manner, yet to take part we are heavily reliant on centralised exchanges," added Lee. "HMRC's commissioned research shows 46% of owners hold their assets in wallets custodied by centralised exchanges. As recent fallouts have shown, these are not safe places to store assets."
Should accountants arm themselves with the latest information relating to crypto tax and accounting treatments? Join technology editor Tom Herbert at AccountingWEB Live on 1 December at our Expo in Coventry, as he chairs a debate between crypto experts on the pros and cons of cryptoassets for the accounting profession. To register or for more information visit the show page.