Collapse of FTX Hastens Calls for Cryptocurrency Regulations

On 11 November 2022, FTX, one of the world’s largest cryptocurrency exchanges, filed for Chapter 11 bankruptcy and its then-CEO, Sam Bankman-Fried, resigned. John Jay Ray III, who oversaw Enron’s corporate bankruptcy and restructuring, has become the CEO of the FTX Group and condemned the “complete failure of corporate control”.

While the investigation is still at a preliminary stage and the true extent of such failure will take months to be fully uncovered, this matter has demonstrated the importance of proper corporate governance.

Mr. Ray listed a multitude of unacceptable management practices at FTX Group. The most alarming practice that led to FTX’s ultimate downfall was that Alameda, the affiliated hedge fund that was founded and owned by Mr. Bankman-Fried, had the undisclosed ability to borrow customer funds held at FTX.com and use those funds for its own trading and investments. There were virtually no internal controls or separation between the two companies. Eventually, FTX secretly lent to Alameda billions of FTX customers’ deposits. As detailed in the U.S. Securities and Exchange Commission’s statement, the “virtually unlimited line of credit” culminated in Mr. Bankman-Fried making undisclosed venture investments, lavish real estate purchases and large political donations.

The other questionable practices that Mr. Ray identified include the following:-

• The use of software that gave senior management personnel access to systems that stored customer assets without any built-in security controls to prevent those assets from being redirected;
• Storing of private keys to access hundreds of millions of dollars in cryptocurrency assets without effective security controls or encryption;
• Absence of independent governance throughout the FTX Group;
• Lack of experienced personnel assuming financial and risk management roles, especially considering the size of the FTX Group;
• Absence of audited and reliable financial statements; and
• Lack of documentation for transactions involving nearly 500 investments made with FTX Group funds and assets.

Sources have said that at least USD1 billion of customers funds have now disappeared and that Mr. Bankman-Fried had held meetings to figure out how much cash was needed for FTX to cover that financial hole in its balance sheet. Mr. Ray’s primary role is now to recover and secure as much of FTX Group’s assets as possible and eventually distribute those assets back to the creditors. As of early January 2023, FTX’s lawyers have located more than USD5 billion in cash and other liquid assets and hopes to sell holdings of non-strategic investments with a book value of more than USD4.6 billion. However, the true extent of the shortfall in FTX customer funds is yet to be determined.

Whilst there has been ongoing debate and different media coverage as to whether FTX’s collapse was due to mismanagement or malfeasance, the underlying problem was the unauthorised and undisclosed use of customers’ funds, which some have described as constituting one of the biggest fraud or theft incidents in recent history. Such use was in spite of FTX.com’s terms of service which stated that the digital assets held by the customers at all times belonged and remained with the customers, and were not the property of FTX Trading. Therefore, although the cryptocurrency is known to be volatile, the risk management failures exhibited in this incident should be confined to the perpetrators at FTX, and not the industry itself.

A spokesman from Hong Kong’s Securities and Futures Commission (“SFC”) took the opportunity to warn investors “to be wary of the potential high risks associated with virtual asset arrangements”. Further, the spokesman remarked that FTX is not registered with the SFC, which is required for FTX to operate as an exchange for digital assets in Hong Kong.

The FTX case once again highlights the increasingly urgent and important need to put in place sensible regulations for cryptocurrency in the world’s major financial markets. Recently, Mr. Paul Chan Mo-po, the city’s Financial Secretary, stated that Hong Kong remains committed to becoming a crypto hub and that Hong Kong is “a quality standing point for digital asset corporates”. This is especially after “certain crypto exchanges collapsed one after another” because the city’s regulatory framework “matches international norms and standards”. He stressed that the new licensing regime for Virtual Asset Service Providers, which will come into effect on 1 June 2023, will provide investors with a level of protection akin to the standards for traditional financial institutions. Such comments were made in light of Hong Kong launching two exchange-traded funds tracking cryptocurrency futures in December 2022. We therefore expect that certainly, at least in Hong Kong, there will be comprehensive but pragmatic regulations that promote the development of fintech and crypto, and also protect investors.