FTX Disaster Exposes Weak Due Diligence From Top Investors?
The stunning implosion of FTX Ltd. has derailed its plans to officially launch in Canada, but it’s unclear if regulators in this country were even able to peer into the books of the cryptocurrency exchange as part of their due diligence on the company that now faces potentially criminal liability.
Months before it filed for bankruptcy amid a scandal that continues to reverberate across the global crypto industry, FTX was on course in June to acquire Bitvo Inc., a Calgary-based crypto exchange regulated by all 13 provincial and territorial securities commissions in Canada. It was one of several opportunities Canadian regulators were ostensibly provided to look closely at FTX’s finances.
Bahamas-based FTX had already been operating in Canada, despite not having regulatory approval. Retail investors were able to hold digital wallets on FTX’s platform to store their crypto, with many using VPN technology, which anonymized their Canadian location and created a private network from a public internet connection.
Still, FTX wanted a “real Canadian footprint” and this was only the beginning of its move into this country, the company’s founder and former chief executive officer Sam Bankman-Fried had told The Globe and Mail then.
“We’re looking to expand in places where regulators are working with the sector to create meaningful opportunities,” Mr. Bankman-Fried had said. The Alberta government had hailed the launch, calling it a vehicle to “further grow our reputation and our opportunities in technology, and innovation.”
Now, all of that has fallen apart.
Bitvo announced Tuesday that owner Pateno Payments Inc. has terminated the deal with FTX, which was previously expected to be finalized in the third quarter of this year.
On top of that, FTX is facing a criminal investigation in the Bahamas, according to a news release by the Caribbean country. And U.S. prosecutors – including the Justice Department, the Securities and Exchange Commission and the Commodity Futures Trading Commission – are investigating how FTX had been handling customer funds, Reuters first reported this week.
FTX was funneling customer assets worth nearly US$10-billion to an affiliated trading firm, Alameda Research, which is also owned by Mr. Bankman-Fried and has since suspended its operations, the Wall Street Journal and crypto publication CoinDesk reported.
Alameda allegedly invested FTX assets in risky bets, in contravention of FTX’s own terms of service and against common industry norms, which require market brokers and exchanges to keep customer funds separated from company assets.
A spokesperson for FTX declined to comment.
It is a situation that raises many questions for Canadian regulators, which have struggled to control international crypto players skirting rules to operate here. The CEO of the Ontario Securities Commission, Grant Vingoe, recently called it a dilemma on multiple levels: insufficient co-ordination in developing a cross-country regime for crypto platforms, finite resources and non-compliance by companies in the sector when facing sanctions.
In an interview Tuesday, Bitvo CEO Pamela Draper said her company does not have any material exposure to FTX or the company’s cryptocurrency, FTT, beyond the now-cancelled acquisition deal.
When the deal was first announced, neither FTX nor Bitvo revealed the exact terms or valuation. It was pending regulatory approval and Bitvo was not allowed to look into FTX’s books, though FTX had been able to go over Bitvo’s finances.
“We were not given an opportunity to perform due diligence,” Ms. Draper said.
Due diligence is what first revealed the cracks in FTX’s finances last week.
FTX was planning to sell itself to rival Binance Holdings Ltd. after announcing a “liquidity crunch.” But shortly after performing due diligence, Binance said it was walking away from the rescue takeover, issuing a statement that alluded to discrepancies in FTX’s books and expressed concerns about how it was handling customer assets.
The Ontario Teachers’ Pension Plan had its own opportunity to conduct due diligence into FTX. Teachers said last week that it invested a total of US$95-million in FTX over two rounds: US$75-million in October, 2021, followed by US$20-million in January, 2022.
This week, Teachers spokesperson Dan Madge would not say whether it performed due diligence before it invested in FTX.
The Financial Services Regulatory Authority of Ontario (FSRA) said in a statement that it expects Teachers and other pension funds it regulates to follow “robust risk management practices.”
“Pension plan administrators are expected to understand and manage investment risks as per the standard of care required by the Pension Benefits Act,” FSRA spokesperson Russ Courtney said in a statement. “The Act requires pension plan administrators to oversee the plan with the same care and diligence expected when an individual deals with someone else’s property.”
Mr. Courtney declined to say if due diligence on FTX was done by Teachers.
In the case of Bitvo, due diligence would be the purview of the Alberta Securities Commission (ASC), which was spearheading the approval for its deal with FTX and is a principal regulator for the operations at the Calgary company, according to the OSC. JP Vecsi, a spokesperson for the OSC, declined to comment further and referred The Globe to the ASC.
The ASC declined to comment. “It is premature for us to comment upon the circumstances surrounding Bahamas-based FTX at this time,” said Theresa Schroder, communications adviser at the ASC, referring The Globe back to Bitvo.
Michelle Celarier of Institutional Investor also asks how did so much 'smart money' get tangled up in FTX?
For much of this year’s rolling crypto crash, Sam Bankman-Fried and his FTX Exchange — until last week the second largest in the world — looked like the white knight charging in to save the day.
The 30-year-old crypto kingpin offered to prop up peers reeling from the collapse, including bankrupt crypto banks Voyager and Celsius as well as BlockFi, another exchange. But last week, when Bankman-Fried could not raise $8 billion to fill a massive hole in his own balance sheet, critics could be forgiven for wondering whether he was trying to save himself all along — and why investors didn’t notice.
There was certainly plenty of smart money along for FTX’s wild ride — notably Sequoia Capital, SoftBank, and Tiger Global, among the most sophisticated investors in the world. Sequoia said it has written down its entire $210 million investment, and SoftBank is reported to have lost $100 million. Tiger Global lost about $38 million, according to an individual familiar with the situation.
Millennium Management’s Izzy Englander and Brevan Howard’s Alan Howard were also counted among FTX’s gold-plated investors. Even the Ontario Teachers’ Pension Plan said it ponied up $95 million, though a statement on its web site did not say whether it was writing the investment off.
All told, investors plowed $1.9 billion into FTX since 2019, according to PitchBook.
“We are in the business of taking risk,” Sequoia wrote in a letter to its limited partners, saying it had written down its FTX investments to zero. Sequoia also said it does “extensive research and thorough diligence on every investment we make.”
But critics scoff at that notion. “The many crypto investors, enablers and legitimizers weren't ‘seduced’ by FTX and SBF [Bankman-Fried's nickname]. They were just willing to accept whatever a billionaire with a ‘vision’ said without doing the most basic due diligence or asking the most obvious questions if they thought it would make them rich,” Dennis Kelleher, president and CEO of Better Markets, said in a statement Monday. Kelleher said his firm had been offered “seven figures” by FTX, but his team met with FTX and Bankman-Fried, and “when we asked tough factual questions that were not answered satisfactorily, it really didn’t take much to see that there wasn’t much to that ‘vision’ other than hope, smoke, and the desire to make a quick buck (in fact, lots and lots of bucks).”
In the end, FTX was not too big to fail. After learning that the exchange was using customer deposits to trade in a related hedge fund vehicle called Alameda Research, the investors who’d bankrolled Bankman-Fried’s climb refused to bail him out.
That left FTX Group, with its numerous associated companies, no other choice but to file for bankruptcy on Friday — almost a year to the day after crypto prices peaked. Since then, Bitcoin has fallen from $69,000 to under $17,000, including a 20 percent drop on the FTX news last week.
Tiger Global first invested in FTX in a Series A round in 2019, which raised only $8 million, but the hedge fund would go on to invest in two more rounds. Others in the Series A round included SoftBank, Lightspeed Venture Partners, Temasek, and Binance Labs. (Binance — now the largest crypto exchange — backed out of a deal to buy FTX last week, leading to the bankruptcy.)
Crypto began to take off during the pandemic, and by July 2021, FTX was able to raise $1 billion, with additional brand name investors including Dan Loeb’s Third Point Ventures, Coinbase Ventures, and Thoma Bravo.
At that time, Englander and Howard also got in on the action. (Spokespeople for Englander and Howard declined to comment.)
In October, FTX went to the well again, raising another $420 million that would put the firm’s value at a stunning $24.5 billion. Tiger Global was in that round, as was Lightspeed, Temasek, and a new hedge fund — Senator Investment Group — along with dozens of others.
The biggest fundraising round occurred in January, just as crypto was beginning its descent. According to PitchBook, the $500 million Series C, which valued FTX at $32.5 billion, attracted investors SoftBank, Lux Capital, Tiger Global, Lightspeed, and Temasek, among others.
“With venture investing, there’s always a chance an investment goes to zero,” Coinbase tweeted in response to the FTX debacle. Third Point declined to comment, while spokespeople for Lightspeed, Lux Capital, Senator, SoftBank, Temasek, and Thoma Bravo did not provide a comment by press time.
On paper, FTX looked good. Its revenue reportedly soared more than 1,000 percent in 2021 to $1.02 billion from $89 million the prior year, according to a leaked investor deck that CNBC obtained. FTX claimed net income of $388 million last year, up from just $17 million a year earlier, according to CNBC.
However, potential investors who asked pointed questions were told to “take it or leave it,” according to the New York Times.
Other skeptics say they risked losing their jobs by talking their firms out of investing in FTX.
“FTX caused me real pain last year. For my day job, I was able to kill an investment in the company, but doing so almost cost me big,” tweeted an anonymous account called The Kook Report that talked about the difficulty of going against the “cult of personality.”
“It's like the telephone game,” said Herb Greenberg, the former journalist and short seller analyst who is now a senior editor for Empire Financial Research. “What I learned doing research and dealing with [hedge funds] is that while everybody gives lip service to originality and research, in the end they prefer to be where their pals are, assuming THEY did the work,” he tweeted.
As Better Markets’ Kelleher believes, due diligence may have gone by the wayside for many firms during peak VC fever in 2021. Tiger Global, for one, was criticized that year in a blog post by Everett Randle, a partner at the Founders Fund, for doing so many deals that its due diligence was lacking. Tiger Global has denied the accusation.
There were plenty of warning signs about FTX. A 2019 lawsuit brought in federal court against FTX, Alameda, Bankman-Fried, and other executives by an entity called “Bitcoin Manipulation Abatement LLC” accused the defendants of manipulating crypto markets, according to a recent NBC report, which said “numerous cryptocurrency traders” lost $150 million as a result. The suit was dismissed with prejudice, indicating a deal was struck, after the company sought to have it thrown out, NBC reported.
In September media reports that FTX was on the cusp of another big capital raise — suggested to be $1 billion — failed to materialize.
Bankman-Fried, FTX, Alameda Research, and other executives are now reportedly under investigation by the Securities and Exchange Commission and the Department of Justice. California regulators have said they are also probing the firm’s collapse.
“I'm really sorry that we ended up here,” Bankman-Fried tweeted last Friday.
Last week, I discussed OTPP's exposure to FTX and said it's meaningless relative to its overall assets.
After I wrote that comment, OTPP released a statement on FTX:
In October 2021, Ontario Teachers’ invested a total of US$75 million in both FTX International and its US entity (FTX.US). In January 2022, we made a follow-on investment of US$20 million in FTX.US. These investments were made through our Teachers’ Venture Growth (TVG) platform, alongside a number of global investors, to gain small-scale exposure to an emerging area in the financial technology sector.
TVG was established in 2019 to invest in emerging technology companies raising late-stage venture and growth capital. TVG’s investments are structured to provide Ontario Teachers’ with returns commensurate with the risk undertaken and to provide proprietary insights that inform investing elsewhere across the Plan. Naturally, not all of the investments in this early-stage asset class perform to expectations. However since inception, TVG has delivered solidly on intended objectives. While there is uncertainty about the future of FTX, any financial loss on this investment will have limited impact on the Plan, given this investment represents less than 0.05% of our total net assets.
It is a short statement which confirms 1) OTPP invested a relatively small amount alongside a series of high profile investors and 2) taking a writedown on the investment will have a negligible impact on its portfolio.
I was willing to move past this investment but then it turns out that this Sam Bankman-Fried (aka, SBF) was running a scam, illegally transferring funds from FTX to his "hedge fund" called Alameda Research which took all sorts of "risky bets" (aka, he had no clue what he was doing and blew up).
According to Reuters which published an exclusive on FTX's fall, SBF was reeling from those losses earlier this summer:
This May and June, Bankman-Fried’s trading firm, Alameda Research, suffered a series of losses from deals, according to three people familiar with its operations.
These included a $500-million loan agreement with failed crypto lender Voyager Digital, two of the people said. Voyager filed for bankruptcy protection the following month, with FTX's U.S. arm paying $1.4 billion for its assets in a September auction. A Voyager spokesman said the company only used $75 million of Alameda's credit line.
Reuters could not determine the full extent of losses Alameda suffered.
Seeking to prop up Alameda, which held almost $15 billion in assets, Bankman-Fried transferred at least $4 billion in FTX funds, secured by assets including FTT and shares in trading platform Robinhood Markets Inc, the people said. Alameda had disclosed a 7.6% share in Robinhood that May.
A portion of these FTX funds were customer deposits, two of the people said, though Reuters could not determine their value.
Bankman-Fried did not tell other FTX executives about the move to prop up Alameda, the people said, adding he was afraid that it could leak.
On Nov. 2, however, a report by news outlet CoinDesk detailed a leaked balance sheet that allegedly showed that much of Alameda’s $14.6 billion in assets were held in FTT. Alameda CEO Caroline Ellison tweeted that the balance sheet was merely for a “subset of our corporate entities,” with over $10 billion of assets not reflected. Ellison did not return requests for comment.
That failed to douse growing speculation over what Alameda’s financial health might mean for FTX.
Then Zhao said Binance would sell its entire share in the token, FTT, worth at least $580 million, “due to recent revelations that have come to light.” The token's price collapsed 80% over the next two days and a torrent of outflows from the exchange gathered pace, blockchain data show.
Reuters later reported that at least $1 billion of customer funds have vanished from collapsed crypto exchange FTX:
The exchange's founder Sam Bankman-Fried secretly transferred $10 billion of customer funds from FTX to Bankman-Fried's trading company Alameda Research, the people told Reuters.
A large portion of that total has since disappeared, they said. One source put the missing amount at about $1.7 billion. The other said the gap was between $1 billion and $2 billion.
While it is known that FTX moved customer funds to Alameda, the missing funds are reported here for the first time.
The financial hole was revealed in records that Bankman-Fried shared with other senior executives last Sunday, according to the two sources. The records provided an up-to-date account of the situation at the time, they said. Both sources held senior FTX positions until this week and said they were briefed on the company's finances by top staff.
Bahamas-based FTX filed for bankruptcy on Friday after a rush of customer withdrawals earlier this week. A rescue deal with rival exchange Binance fell through, precipitating crypto’s highest-profile collapse in recent years.
In text messages to Reuters, Bankman-Fried said he "disagreed with the characterization" of the $10 billion transfer.
"We didn't secretly transfer," he said. "We had confusing internal labeling and misread it," he added, without elaborating.
Asked about the missing funds, Bankman-Fried responded: "???"
FTX and Alameda did not respond to requests for comment.
CNN also reports that former former FDIC chair Sheila Bair is thinks the FTX crash is eerily similar to the Bernie Madoff scandal:
In the span of just three years, Sam Bankman-Fried built FTX into a massive crypto exchange backed by marquee investors and valued at $32 billion. It took mere days for all of that to implode in a sprawling bankruptcy filing.
Sheila Bair, a top regulator during the 2008 financial crisis, told CNN there are eerie similarities between the dramatic rise and fall of Bankman-Fried and FTX and that of infamous Ponzi scheme mastermind Bernie Madoff.
Bair notes that 30-year-old Bankman-Fried, like Madoff, proved adept at using his pedigree and connections to seduce sophisticated investors and regulators into missing “red flags” hiding in plain sight.
“Charming regulators and investors can distract [them] from digging in and seeing what’s really going on,” Bair, who chaired the Federal Deposit Insurance Corp. from 2006 to 2011, said in a phone interview on Monday. “It felt very Bernie Madoff-like in that way.”
FTX filed for bankruptcy on Friday, throwing the cryptocurrency industry into chaos and raising the specter of vast losses for customers of the crypto exchange.
‘It all feeds on itself’
Long before his Ponzi scheme collapsed, Madoff was known as a wizard on Wall Street. He was the former chairman of the Nasdaq Stock Market, served on Securities and Exchange Commission advisory panels and managed money for the rich and the famous.
For his part, Bankman-Fried was a top campaign contributor to Democrats in the 2022 election cycle. He hired multiple former US regulators to serve in senior positions at FTX, and his parents are both professors at Stanford Law School. Up until the bankruptcy filing, FTX even had an application pending with federal regulators to clear derivatives, The Wall Street Journal reported.
Better Markets CEO Dennis Kelleher said in a statement on Monday that FTX had a strategy of “revolving door hires” from the Commodities Futures Trading Commission (CFTC) and elsewhere “to use their knowledge, influence and access at the agency and in Washington to move FTX’s agenda.”
“People feel duped,” Brian Armstrong, the CEO of rival crypto exchange Coinbase, told CNN in a phone interview on Friday. “On the surface, FTX was able to garner a lot of attention. But as people looked into it, the fundamentals were not there.”
FTX garnered its $32 billion valuation with the blessing of investments from BlackRock, SoftBank, Sequoia and other top investors.
“You get this herd mentality where if all your peers and marquee names in venture capital are investing, you’ve got to, too. And that adds credibility with Washington policymakers. It all feeds on itself,” said Bair, who sits on the board of directors at Paxos, a blockchain infrastructure company (Bair said she was speaking for herself, not Paxos).
Now, authorities in the Bahamas are investigating potential criminal misconduct surrounding the FTX explosion.
Neither FTX nor a lawyer representing Bankman-Fried responded to requests for comment.
If it sounds too good to be true…
Madoff offered investors marvelous returns that were remarkably consistent and an improbable track record that later proved to be made possible by an elaborate scheme that involved repaying existing clients with new client deposits.
Given the speed of its demise and media reports, serious questions have been raised about the accuracy and strength of FTX’s balance sheet. FTX’s bankruptcy filing indicates it had liabilities of $10 billion to $50 billion at the time of the filing.
Bankman-Fried secretly transferred about $10 billion of customer funds from FTX to his trading firm Alameda Research and used a “backdoor” to avoid triggering accounting red flags, sources told Reuters.
Bankman-Fried denied to Reuters secretly transferring funds, blaming instead “confusing internal labeling.”
Bair urged investors to use caution and be skeptical. “If it sounds too good to be true, it probably is,” she said.
Calls for regulation
The good news is the former FDIC chair is not worried about the FTX implosion threatening the entire financial system the way Lehman Brothers did in 2008. Crypto is still a relatively small part of the broader economy and financial market.
“There is no systemic impact to the real economy,” Bair said, adding that this is all just “funny money in the ether with speculation.”
But the bad news is the crypto market remains largely unregulated, making it the Wild Wild West of the financial world. And that leaves investors vulnerable when something breaks.
“These risks of crypto-assets are very real,” FDIC Acting Chairman Martin Gruenberg said in prepared remarks to be delivered at a hearing on Tuesday. “After the bankruptcies of crypto-asset platforms that have occurred this year, there have been numerous news stories of consumers who have been unable to access their funds or savings.”
Gruenberg, who was nominated by President Joe Biden on Monday to become the full-time FDIC head, drew parallels between crypto and the exotic financial instruments that ended up playing a central role in the 2008 financial crisis.
“Crypto-assets bring with them novel and complex risks that, like the risks associated with the innovative products in the early 2000s, are difficult to fully assess, especially with the market’s eagerness to move quickly into these products,” Gruenberg said in testimony for a Senate Banking Committee hearing.
There's an old saying, "If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck."
SBF is a sitting duck, by the time the FBI, DOJ, CFTC, FDIC, SEC and others get through with him, he'll end up like Bernie Madoff or worse still, like Jeffrey Epstein.
There are so many moving parts to this FTX blowup that I wouldn't be surprised if the CIA was using it to transfer funds to Ukraine and other parts of the world and we will see another Oliver North Iran Contra type scandal in the future.
Alright, that may be a stretch but you have to wonder why it's taking so long for the FBI to extradite SBF from the Bahamas as this crypto contagion spreads.
Charlie Munger is right, crypto is "a bad combination" of fraud and delusion and we didn't need another currency to help kidnappers:
Still, some industry experts are very careful in their assessment following FTX's blowup:
Crypto VC David Pakman recently told Connie Loizos of TechCrunch that FTX was an ‘entirely avoidable tragedy':
If you want to better understand exactly how big a deal it is that the cryptocurrency exchange FTX just imploded, you could do worse than talk with David Pakman, an entrepreneur turned venture capitalist. After logging 14 years with the investment firm Venrock, Pakman -- who led Venrock's investment in the digital collectibles company Dapper Labs and even mined bitcoin at his own home years back -- leaned into his passion for digital assets and last year joined the now seven-year-old crypto venture firm CoinFund.
His timing was either very good or very bad, depending on your view of the market. Indeed, in part because CoinFund was an early investor in the collapsing cryptocurrency exchange FTX, we asked Pakman to jump on the phone with us today to talk about this very wild week, one that began with high-flying FTX on the ropes, and which ended with bankruptcy filings and the resignation of FTX founder, Sam Bankman-Fried, as CEO. Excerpts of that conversation follow, edited lightly for length and clarity. You can hear our longer conversation here.
TC: The last time we talked, almost two years ago, the NFT wave was just getting underway. Now, we're talking on a day where one of the biggest cryptocurrency exchanges in the world just declared bankruptcy. Actually, it's declaring bankruptcy for 130 additional affiliated companies. What do you make of this development?
DP: I think it's absolutely terrible on a bunch of levels. First, it was an entirely avoidable tragedy. This failure of the company was brought on by a bunch of flawed human decision-making, not by a failing business. The core business is doing great. In fact, it [was] highly profitable and growing, even in a bear market. It's one of the most-used non-U.S.-based crypto exchanges and with a big derivatives business. It wrote a lot of really good software. It's not like it was running out of capital or a victim of the macro environment. But its leadership, with almost no oversight apparently, made a bunch of terrible decisions and did things really wrong. So the tragedy is how avoidable it was, and how many victims there are, including employees and shareholders and the hundreds or even thousands of customers who will be affected [by this bankruptcy].
There's also the reputational harm to the entire crypto industry, which already suffers from questions like, 'Isn't this a scammy place with scammy people?' This sort of Enron-esque meltdown of one of the most highly valued and arguably most successful companies in the space is just really bad, and it will take a long time to dig out of it. But there are also positives.
Well, what's positive is the technology did not fail; the blockchains did not fail. The smart contracts were not hacked. Everything we know about the tech behind crypto continues to work brilliantly. So it would be different if this was a meltdown because of flawed software design, or the blockchains aren't scaling, or big hacks that injured people. The long-term promise of the software and the technology architecture about crypto is intact. It's the people who keep making mistakes. We've had two or three pretty big human-generated mistakes this year.
There are plenty of news stories out there outlining what happened in broad strokes. How do you explain it?
I don't have firsthand knowledge about what they really did or didn't do. But apparently FTX and [the trading desk also owned and run by Sam Bankman-Fried] Alameda Research had a relationship that maybe was not known to all shareholders, employees or customers. And it sounds like FTX took FTT, which is their token that was held in great amounts by Alameda, and they pledged it as collateral and took big loans in fiat against that. So they took a highly volatile asset, and they pledged it as collateral.
One could imagine if a board of corporate executives or investors knew about that, someone would say, 'Hang on. What happens if FTT goes down by 50%? It happens in crypto with high frequency, right? So, like, why are we pledging this super highly volatile asset? And by the way, half a billion dollars' worth of the asset is held by our biggest rival [Binance]. What happens if they dump it in the market?'
So just the act of borrowing against it was ill-advised. And then it sounds like they also took the proceeds of that borrowing, and they invested that in highly illiquid assets, like maybe to rescue BlockFi or all these other private companies that FTX recently bought. But it's not like they could quickly sell out of those if they needed to return the proceeds of their borrowing. They were also apparently using customer funds and loaning that out or maybe even loaning it to their trading arm. So all this stuff is just stuff that I think a board, if they knew about it, would be like, 'No, no, these are total nonstarters, we're not doing any of that stuff, it's too high risk.'
But there was no real board, which is mind blowing, considering that VCs poured $2 billion into this company. Your firm is among those firms.
I joined CoinFund a little bit more than a year ago, so the investment that the firm made in FTX was a long time ago, before my time, and it's a tiny, tiny amount. We're barely on the cap table. We didn't hold any FTT tokens.
But I will address your big question, which I think is about the governance of this company. I come from a traditional tech investing background, where maybe 99% of the time, there's just a standard set of governance that every entrepreneur agrees to when they take venture capital, which is: there's going to be a board; the board is going to be made up of investors and employees and maybe outside experts; there's going to be a set of controls; the controls usually say things like, 'You have to disclose any related party transactions so you don't shuffle coconuts between one company and something else that we don't know about.' The board also has to approve things, so that whenever you're going to pledge assets as collateral for borrowing, you can't issue new shares without [the board] knowing about it.
The fact that none of that was present here is mind-boggling. And I hope what comes of this Enron-like moment in crypto is that whatever loose norms there were about not giving that level of oversight and governance as part of investing goes away immediately.
Everything is so highly correlated. Crypto investor Digital Currency Group is reportedly giving a $140 million equity infusion to a derivatives business in its portfolio called Genesis Global Trading because Genesis has about $175 million dollars locked in its FTX account. How bad is this going to become? What percentage of your own investment portfolio is being impacted here because of FTX's failure?
How much are we at CoinFund impacted? It's negligible because we had such a tiny investment in this company from one of our funds and we held none of our assets at FTX*, either its U.S. or international business. [As for broader implications], I don't think any of us knows the full, long-term impact of what's happening here because there's like some contagion, right? Like, how many other funds when companies and investors have assets at FTX and how long will it take to get those funds back? One must assume that the entire thing goes into a massive bankruptcy proceeding that takes many months or years to unwind. And so there'll be this uncertainty, not just about when you're getting money back but how much you're getting.
The overwhelming majority of the startups that we invest in aren't trading on FTX and so they weren't customers. But FTX was very useful for providing a launching pad for tokens to become liquid, and then either making a market for those tokens or at least providing a place for them to trade and providing liquidity. A big part of crypto today is not just raising equity capital but creating tokens and using tokens as an incentive mechanism, and that requires at some point for these tokens to become liquid and trade on exchanges, and FTX was one of the largest places where those tokens traded. And now you lose that.
How does that affect your day-to-day business of making investments? I did see the news that CoinFund is looking to raise a new $250 million fund, that it filed SEC paperwork on November 1 after closing a $300 million fund three months ago. Will you have to put a pin in that now? I'm sure this debacle has LPs feeling nervous.
We've talked to a lot of our LPs in the last 48 hours. I think most people are processing. They're asking, like you're asking, 'What happened here?'
I think late-stage capital will freeze up for a little bit here. The dust really needs to clear. And it's unlikely that capital is attracted to a tragedy like this.
A more immediate impact is on startup valuations. Valuing startups is an imperfect process done by investors in non-liquid markets, and one way it's done is to look at comparables. And one of the brightest star comps that just about everyone in crypto pointed to was FTX. If FTX is worth $40 billion, we're worth X. So you take the most highly valued venture-backed crypto company, and it goes from $40 billion to zero, then who is the new ceiling of crypto value? It immediately impacts late-stage valuations.
* After our interview with Pakman, he learned he'd misspoke when he said CoinFund had no assets on the exchange. It has a small amount of exchange assets on FTX International that it was in the process of transacting.
Great interview, David Pakman raises a lot of excellent points, especially on governance and operational due diligence.
This brings me to Ontario Teachers' investment in FTX and whether proper operational due diligence was performed from the internal finance department and external consultants and funds that invested alongside Teachers' into FTX's exchange.
After I posted my comment on OTPP and FTX on Linkedin, it generated all sorts of responses.
One of them from David Long, HOOPP's former CIO who is now a private investor after a brief stint at Alignvest, posted this comment:
Well, before moving on, let’s contemplate for a moment what is alleged to have occurred with FTX.
Reportedly, up to $10 billion of FTX’s customer funds have been secretly transferred to Mr. Bankman-Fried’s hedge fund, Alameda Research.
These transfers appear to be highly irregular, if not illegal.
An obvious question is what the owners of FTX, including OTPP, knew or should have known about the handling of customer funds. Another question is what liability for customer losses is borne by FTX owners.
At any rate one could say that it’s surprising and disturbing that such sophisticated investors would be partners and owners in a company engaging in this alleged conduct, and doesn’t reflect well on their decision making. Are there numerous other investments that were treated and monitored similarly?
Further, while in the executive offices $95 million may seem a trifling sum, it represents the collective savings of thousands of teachers over many years. The dismissal of this loss as trivial, with no regret or explanation, seems out of touch.
For teacher members of the pension to truly move on, they are owed answers to the above questions.
Now, David is a smart guy but he's also been around long enough to know operational screw-ups happen and some are a lot bigger than others.
Yes, $95 million isn't trivial to teachers or common people, but he knows what my point was, Teachers' has a total portfolio approach, it can make and lose money in a number of asset classes but at the end of the day, all that counts for Ontario teachers looking to retire in dignity is total portfolio returns and whether the plan is fully funded (it is).
Yes, but what about AIMCo's vol blowup during the pandemic? I've written on this numerous times, it's not the same thing and definitely not the same impact on returns.
There's definitely headline risk but I'd be careful to assume more than that at this time.
Ontario Teachers' operational due diligence team (Ops due dil team) is extremely well known in the industry.
I used to have long discussions about operational due diligence with Ron Mock, OTPP's former CEO when he was running their hedge fund portfolio.
Ron can write a book about operational blowups in hedge funds, he suffered it when one of his fixed income traders went rogue on him when he was running his hedge fund and he took full responsibility.
Still, it left a bad taste in his mouth just like this FTX blowup/ scam will leave a bad taste in the TVG group.
But they will learn from it and move on.
Knowing the board at Teachers with Lise Fournel as the Chair of the Operational Risk Committee incoming board members like Tim Hodgson who also worked at Alignvest and then moved on as he was still on PSP's board, they're not going to sit passively by.
Neither will Jo Taylor or Ziad Hindo, their CEO and CIO.
They're all going to ask very tough questions and if someone screwed up on the due diligence internally or externally, they're going to find out.
But let's stop accusing people without knowing all the facts.
No doubt, this could be a spectacular case of FOMO which suckered in a lot of sophisticated investors, not just OTPP (I keep warning you, don't chase Chase Coleman!!).
I guarantee you they're all embarrassed and looking into what exactly happened here and whether this tragedy could have been prevented.
We really don't know and I see other exchanges following FTX as crypto speculators abandon ship and I openly worry what happens if Binance also suffers a similar fate?
Anything can happen in this Wild West crypto world.
Lastly, one of my readers (will call him Joe) sent me his thoughts over the weekend on this FTX debacle after reading my comment:
I appreciate your analysis of the limited size of the risk taken by OTPP. But you are ignoring two things that need to be said.
First, while I agree owning an ‘exchange’ sounds safer than owning specific coins, this feeling of safety is premised on the idea that the coins themselves have some sort of intrinsic value. My opinion is that they do not. Regardless of whether I am right or wrong this is not the same as investing in biotech where there is clearly a value to society for the winners.Second, the story exposes that it isn’t good enough for OTPP to invest in what used to be considered risky equities and private placements and now must move down the curve to the super risky tech startup in order to generate the returns needed to deliver the pension promise. It will be interesting to see the calls for taxpayer bailouts if the entire investment scheme faces hard times.
I agree with him that cryptos' intrinsic value is questionable but disagree with him that Teachers' and other large Canadian pension funds shouldn't invest a small percentage of their portfolio in emerging growth companies with huge potential.
Now, I appreciate the comments and emails and I want to make it clear that I am writing this comment on my own and have not contacted Jo Taylor, Ziad Hindo or anyone else for that matter.
I love when people tell me to "stick my neck out" because they're too scared to write their thoughts and think I'm a pushover who will criticize Teachers' on FTX or CDPQ on Celsius Network.
Frankly, I've stuck my neck out plenty of times on this blog and if you think you can do a better job, by all means, start your own blog and I'll publicly support you.
Despite this FTX debacle, I remain very confident in the capabilities of Teachers' op due diligence team and TVG's investments in start-ups and late stage growth companies.
I'm also convinced this FTX debacle will not tarnish Teachers' global brand in any negative way.
Now, given this story is fluid, I will keep an eye on it but please don't email me about FTX, I've said a lot here and in my previous comment. Let's all cool it and wait to see how this situation evolves.
Below, ColdFusion explains why the FTX disaster is deeper than you think. It certainly might be, all investors need to ask themselves if there are serious contagion issues which will follow.
And Kyle Bass, founder and CIO of Hayman Capital Management, joins CNBC's 'Squawk Box' to weigh in on the collapse of FTX and discuss what it means for the crypto industry.
Lastly, Former US Treasury Secretary Steven Mnuchin talks to CNBC's Melissa Lee about the fallout from the FTX bankruptcy and his own dealings with the company.
Update: Reuters reports that FTX's new chief executive officer, John Ray, has criticized the oversight of the bankrupt crypto exchange, a court filing showed on Thursday:
"Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here," Ray said.
Ray also criticized his predecessor and FTX co-founder Sam Bankman-Fried for making "erratic and misleading public statements".
Vox on Wednesday published an interview with Bankman-Fried where he said he regretted his decision to file for bankruptcy protection and criticized regulators.
He later attempted to douse the fire, saying the basis of the interview was an exchange of messages that was not supposed to be public.
Like I said, SBF’s days are numbered, he will face serious charges once he’s back in the US and countless lawsuits from investors.
Lastly, on Thursday BNN Bloomberg reports Ontario Teachers has written off its FTX stake, citing potential fraud:
Ontario Teachers’ Pension Plan said it will write down its stake in FTX to zero, taking a US$95 million loss barely a year after making its first investment in Sam Bankman-Fried’s now-bankrupt cryptocurrency exchange.
Teachers said the writedown will have only a “limited impact” because it’s less than 0.05 per cent of the $242.5 billion (US$182 billion) pension fund. “However, we are disappointed with the outcome of this investment, take all losses seriously and will use this experience to further strengthen our approach,” the fund said in a statement Thursday.
The Toronto-based pension manager put US$75 million into FTX’s international and U.S. divisions in October 2021 through its venture capital arm, and invested US$20 million more in FTX.US in January.
Ontario Teachers said it worked closely with advisers and FTX to understand commercial, regulatory, tax, financial and technical aspects of the business. The fund had a 0.4 per cent stake in FTX International and 0.5 per cent of FTX.US when Bankman-Fried’s empire collapsed last week and filed for Chapter 11.
“Recent reports suggest potential fraud conducted at FTX which is deeply concerning for all parties,” Teachers said. “We fully support the efforts of regulators and others to review the risks and causes of failure for this business.”
It’s the second time in three months that a major Canadian pension manager has been forced to write off a crypto investment it only recently made. In August, the Caisse de Depot et Placement du Quebec marked its $150 million stake in Celsius Network LLC to zero after the cryptocurrency lender failed.
I’d be curious to know if OTPP plans on taking legal recourse to recover some of the money it lost on this investment.