The market in the 1920’s was flooded with fraudulent activities, dangerous investments, and easy credit.[1] A bubble formed due to “exponential growth in high-volume, low-quality securities investments,” leading to the stock market to crash, or the bubble burst.[2] When the stock market crashed in October 1929, so did public confidence in the U.S. stock market.[3] To restore the country’s faith in the economy, Congress, in the peak year of the Depression, passed the Securities Act of 1933.[4] The following year, it passed the Securities Exchange Act of 1934, which created the Securities and Exchange Commission (SEC).[5] With the creation of the SEC, Congress aimed to restore investor confidence after the Great Depression by reducing deceitful trading, ensuring investment transparency, and limiting the practice of buying stocks on margin.[6] However, the SEC is yet to protect investors and they must continually rely on a bubble burst to unearth bad actors.
In the mid-1990s, there was a dramatic change in mortgage lending standards designed to promote home ownership, but as a secondary effect, a bubble formed.[7] The SEC did not thwart the high volume, low-quality securities investments that ultimately resulted in the burst¾or¾the Great Recession.[8] The bubble burst exposed bad actor, Bernie Madoff.[9] Madoff operated “history’s largest Ponzi scheme[.]”[10] After the burst, he did not have enough money to cover his investors’ redemption requests, and new investor money was hard to find in the economic downturn.[11] Even though the SEC conducted three examinations, two investigations and had ample resources[12] to expose Madoff, his Ponzi scheme remained unchecked.[13] After its colossal failure,[14] the SEC investigated its missteps and issued a report, stating “that the SEC received more than ample information in the form of detailed and substantive complaints over the years to warrant a thorough and comprehensive examination and/or investigation” of Madoff for operating a Ponzi scheme.[15] So, if the bubble did not burst resulting in the Great Recession, Madoff most likely would have continued his Ponzi scheme. Unfortunately, the SEC’s investigative report mentioned above did not stop history from repeating itself. It took another bubble burst to expose FTX founder, Sam Bankman-Fried.
Before explaining the fall of FTX, it is important to give a short background on what FTX was—a centralized exchange (CEX).[16] Centralized exchanges—like Binance, Coinbase and FTX—are organizations that coordinate cryptocurrency trading on a large scale, using a similar business model to traditional asset exchanges like stock exchanges.[17] Centralized crypto exchanges directly participate in markets by acting as clearing agents[18] in trades.[19] They typically keep digital order books, which are lists of open buy and sell orders, consisting of volumes and prices.[20] They match up buyers and sellers and announce current market prices based on the last price an asset sells for.[21]
The FTX story starts in 2017, when Sam Bankman-Fried founded a small trading firm, Alameda Research (Alameda).[22] Alameda’s business model consisted of buying Bitcoin and other crypto tokens in one part of the world, selling them somewhere else, and pocketing the difference.[23] At first, the business was lucrative, but as more hedge funds began to do the same thing, such trades were less lucrative.[24] Initially, this was not an issue because the price of digital tokens continued to soar, so he had no problem paying back loans he took out to grow the firm.[25] Bankman-Fried built FTX in 2019, a CEX that could bring in revenue to fund Alameda directly.[26] The CEX, based in the Bahamas, quickly rose to international prominence through a series of high-profile acquisitions, risky trading options (that are not legal in the United States), and low trading fees.[27] In 2021 and early this year, FTX raised nearly $2 billion in equity from more than two dozen high-profile investors, including Sequoia Capital, SoftBank, Tiger Global and BlackRock.[28] With the influx of investor money, Bankman-Fried started a giant publicity campaign for FTX, signing branding deals with sports leagues, advertising on television, and hiring celebrities to endorse its platform and woo retail investors.[29] However, this fame and fortune was short-lived.
On November 2, 2022, an article from the crypto trade publication, Coindesk, cited a leaked financial document that raised questions about the relationship between FTX and Alameda.[30] The Coindesk article said that, on paper, FTX and Alameda were two separate companies that happened to be owned by the same man.[31] However, the article exposed that Alameda “rests on a foundation largely made up of a coin that [FTX] invented” called FTT.[32] This reality posed a major risk to FTX investors because Alameda’s liquidity was bound by the market value of FTT rather than hard assets.[33] If the price of FTT were to drop, Alameda would be rendered unable to pay lenders, and consequently, FTX may resort to unsavory measures.
Though the FTX scandal has become the crypto sector’s latest unwanted poster child,[34] it bears much resemblance to the bubble burst that led to the Great Recession. The fall of FTX came down to a leverage issue, which “is the source of every implosion in financial institutions, both traditional and crypto[.]”[35] Alameda began borrowing money for various purposes on the assumption that the value of digital assets would continue to increase, however, the price of digital assets significantly dropped in 2022.[36] Many digital assets filed for bankruptcy sparking lenders to ask Alameda for their money back.[37] To meet its debt obligations, FTX borrowed from customer deposits in FTX to quietly bail out Alameda.[38] This quiet bailout of Almeda with borrowed funds from FTX customers was in the billions.[39] A few days after Coindesk published the article, FTX’s biggest rival, Binance, announced its plan to liquidate $580 million worth of FTT, causing the FTT price to plummet even further.[40] This set off a firestorm of drawdowns that FTX didn’t have the cash to facilitate because Alameda used that money to pay off its own lenders.[41] In response, the U.S. attorney’s office for the Southern District of New York has charged Bankman-Fried with eight counts of fraud.[42] Separately, and after the fact, the SEC filed a civil lawsuit, alleging that Bankman-Fried has diverted funds from its FTX customers to support Alameda from the outset of FTX, and has used such funds to make venture investments, real-estate purchases, and political donations.[43] However, the SEC could have caught Bankman-Fried before billions of dollars were lost.[44] It was reported that in early 2022, the SEC sent FTX inquiries related to its handling of customer assets, but these inquiries did not lead to an enforcement action.[45] Further, in the months preceding FTX’s failure, the SEC met with Bankman-Fried and FTX executives to provide FTX with a regulatory license as a securities exchange without probing their operations at the same time.[46]
As shown, the SEC’s ex post workflow continuously fails to protect investors. The ultimate regulator is the bubble burst because it always beats the SEC to the pop. So, does it even make sense to have the SEC?
[1] See Michael Mendelson, From Initial Coin Offerings to Security Tokens: A U.S. Federal Securities Law Analysis, 22 Stan. Tech. L. Rev. 52, 64 (2019).
[2] See id.
[3] History.com Editors, SEC: Securities and Exchange Commission, History (Dec. 6, 2019), https://www.history.com/topics/us-government/securities-and-exchange-commission.
[4] Id.
[5] Id.
[6] Id.
[7] See generally Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (2011).
[8] See id.
[9] See Madoff – A 21st Century Ponzi Scheme, NASAA, https://www.nasaa.org/4303/madoff-a-21st-century-ponzi-scheme/ (last visited Mar. 10, 2023) [hereinafter NASAA].
[10] Justice Department Announces Total Distribution of Over $4 Billion to Victims of Madoff Ponzi Scheme,U.S., Dep’t Just. (Sept. 28, 2022), https://www.justice.gov/opa/pr/justice-department-announces-total-distribution-over-4-billion-victims-madoff-ponzi-scheme (quoting Assistant Director Luis Quesada of the FBI’s Criminal Investigation Division); see also NASAA, supra note 9 (“Madoff’s fraud led many to financial ruin and his name is now synonymous with what many consider one of the largest Ponzi schemes in history.”).
[11] See NASAA, supra note 9.
[12] See generally H. David Kotz, Inspector Gen., U.S. Sec. & Exch. Comm’n, Case No. OIG-509 Executive Summary: Investigation of Failure of the SEC To Uncover Bernard Madoff’s Ponzi Scheme (2009), available at https://www.sec.gov/files/oig-509-exec-summary.pdf.
[13] Id.
[14] The New York Times reported that “it was not Mr. Madoff’s cleverness that enabled him to fleece thousands of investors out of billions of dollars for years,” it was the fact that the SEC never took the basic steps to determine if Madoff was operating a Ponzi scheme. The article continues to state that “the most egregious lapse was the repeated failure of investigators to verify the trades that Mr. Madoff claimed to be making over the years.” David Stout, Report Details How Madoff’s Web Ensnared S.E.C., N.Y. Times (Sept. 2 2009), https://www.nytimes.com/2009/09/03/business/03madoff.html.
[15] Id. at 1. (“[B]etween June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoffs hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoffs investment operations that appeared in reputable publications in 2001 and questioned Madoffs unusually consistent returns.”).
[16] See Nathan Reiff, What Are Centralized Cryptocurrency Exchanges?, Investopedia, https://www.investopedia.com/tech/what-are-centralized-cryptocurrency-exchanges/ (last updated Aug. 27, 2021).
[17] See id.
[18] A clearing agent is “any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions.” 15 U.S.C. 78c(a)(23)(A).
[19] See Reiff, supra note 16.
[20] See id.
[21] See id.
[22] Mathew Goldstein et al., FTX’s Sister Firm, Alameda Research, Was Central to Collapse, N.Y. Times (Nov. 30, 2022), https://www.nytimes.com/2022/11/30/business/dealbook/ftx-almeda-research-sam-bankman-fried.html; see also Eric Mack, The Fall of FTX and Sam Bankman-Fried: A Timeline, CNET (Feb. 24, 2023), https://www.cnet.com/personal-finance/crypto/the-fall-of-ftx-and-sam-bankman-fried-a-full-timeline-of-events/.
[23] Id.
[24] Id.
[25] See id.
[26] See id.
[27] Id.
[28] Id.
[29] Id.
[30] See Ian Allison, Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet, CoinDesk, https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/ (last updated Nov. 9, 2022, 1:36 PM).
[31] See id.
[32] Id.
[33] Id.
[34] See Partick Coffee, Crypto Brands Reposition Themselves in Wake of FTX and Market Tumble, Wall St. J. (Feb. 7, 2023), https://www.wsj.com/articles/crypto-brands-reposition-themselves-in-wake-of-ftx-and-market-tumble-11675731537 (“[C]ompanies across the sector are using marketing and public relations efforts to defend their brands, distance themselves from dubious players like FTX and, in many cases, present a friendlier face to investors and regulators alike.”).
[35] See MacKenzie Sigalos, From $32 billion to criminal investigations: How Sam Bankman-Fried’s crypto empire vanished overnight, CNBC, https://www.cnbc.com/2022/11/15/how-sam-bankman-frieds-ftx-alameda-empire-vanished-overnight.html (last updated Nov. 16 2022, 12:05 AM) (quoting Hart Lambur, a former Goldman Sachs government bond trader who provided liquidity in U.S. Treasuries for central banks, money managers and hedge funds, and now works in decentralized finance). Financial institutions, such as “Lehman Brothers, Bear Stearns, Long-Term Capital, Three Arrows Capital and now FTX[,] all blew up due to bad leverage that got sniffed out and exploited by the market.” Id.
[36] Id.
[37] Id.
[38] Id.
[39] See id.
[40] See id.
[41] See id.
[42] See Corinne Ramey et al., FTX’s Sam Bankman-Fried Charged With Criminal Fraud, Conspiracy, Wall St. J., https://www.wsj.com/articles/ftxs-sam-bankman-fried-charged-with-criminal-fraud-conspiracy-11670951131?mod=article_inline (last updated Dec. 13, 2022, 10:42 PM).
[43] Id.
[44] See Hal Scott and John Gulliver, A Question for Congress: Why Didn’t the SEC Stop FTX?, Wall St. J.: Opinion (Jan. 18, 2023, 1:26 PM), https://www.wsj.com/articles/a-question-for-congress-why-didnt-the-sec-stop-ftx-crypto-exchange-assets-investors-bankruptcy-fraud-sam-bankman-fried-11674063645.
[45] See id.
[46] See id.
