The original article “SBF’s Defense Will Be Tough” was translated by Odaily Planet Daily jk.
Matt Levine is a Bloomberg Opinion columnist covering finance. He was previously an editor at Dealbreaker, worked in the investment banking division of Goldman Sachs, was an M&A lawyer at Wachtell, Lipton, Rosen Katz, and served as an associate judge on the U.S. Court of Appeals for the Third Circuit.
Allegations
The main charges against Sam Bankman-Fried are:
Customers deposited billions of dollars on his crypto exchange FTX to buy cryptocurrencies.
Bankman-Fried’s trading firm, Alameda Research, secretly used the money to gamble on cryptocurrencies and make some bizarre illiquid venture investments.
Additionally, it appears that a significant amount of money was misappropriated to make political donations, purchase celebrity endorsements, and purchase real estate in the Bahamas for Bankman-Fried and his family.
When customers began asking for refunds last November, the money was gone.
This is really bad! The combination of "the client's money is gone" and "you live in a $30 million penthouse" is deadly. This is the most basic description of financial fraud: the client has no money, and you have money.
But Bankman-Fried goes on trial tomorrow and Michael Lewis, when asked on 60 Minutes, "Do you think he deliberately stole his clients' money?" responded, "Well, no." So I guess there will be a defense.
So what is the defense? I think the defense is something like: "The crypto market crashed, there was a run on the 'bank', and it was the run that caused the disappearance of customer funds. It was an accident, maybe a careless accident, but not theft." This is a really hard situation to defend yourself.
The first hard thing is that on crypto exchanges like FTX, we don’t usually think of “runs” as happening. The intuitive way of how a crypto exchange should work is:
I deposited $100.
I bought $100 worth of Bitcoin on an exchange.
The exchange marked $100 of Bitcoin for me.
When I go to withdraw my $100 in Bitcoin, if it's not there, that means someone stole it.
FTX doesn’t work like this most of the time. It’s a futures exchange. It works more like this:
I deposited $100.
I used this money to gamble $1000 of Bitcoin on the exchange.
The exchange held my $100 collateral, but that $1,000 in Bitcoin didn’t exist; it was just a bet between me and another customer.
If Bitcoin goes up 20%, then that $1,000 of Bitcoin is now worth $1,200 and my $100 bet is now worth $300.
Similarly, the other party, the one I was betting against, put up $100 in collateral against $1,000 in Bitcoin; now that Bitcoin has gone up, his $100 bet is now worth negative $100.
When I go to withdraw my $300, if it’s not there, that means the bet losers didn’t pay — or other bet losers on the exchange didn’t pay, leaving the exchange with not enough money to pay me.
The exchange sits between the winners and losers of the bets, and it can’t pay what it owes its customers unless the customers who owe it money pay. Usually, customers provide collateral, and the exchange does risk management on positions, etc., so there’s no problem, but in the event of a sudden, violent market move, the exchange may not have enough funds. This has actually happened on legitimate, regulated exchanges; it almost happened on the London Metal Exchange last year.
But no one believed that; it was already far more complicated than the jury wanted to hear. Intuitively, if you accept cash from customers, you should have that cash, and if you don’t, that looks fishy. (FTX’s customers who only had cash accounts, including those on FTX.US who were really supposed to be all-cash and segregated, were also caught in bankruptcy.)
Even if you have convinced a jury that a bank run is possible, this defense faces a number of problems. I want to mention three of them, although it’s not hard to think of more.
First:
It wasn’t some volatility in cryptocurrency prices that caused a large number of FTX customers’ funds to be wiped out, leaving them in debt to FTX and preventing FTX from paying back other customers. It was some volatility in cryptocurrency prices that wiped out the account of one FTX customer: Alameda. It turned out that Alameda had a large uncollateralized or undercollateralized debt to FTX: when customers’ money was gone, it was almost entirely because Alameda lost money.
This is suspicious in itself: if the basic economic structure of an exchange is that it owes money to all its customers but its largest customer (a trading firm owned by the exchange’s CEO), then that’s bad. Structurally, it’s “we take money from our customers and use it to gamble for ourselves.”
But every detail of how this is done is terribly bad. Alameda owes FTX a lot of money, but no one else does — no one else got wiped out by a huge price move that caused it to have an uncollateralized negative position at FTX — because FTX does have a reasonable risk management system in place. If you run some unconnected hedge fund, and you want to use your own $20 and borrow $1 billion from FTX to buy some illiquid, volatile, speculative cryptocurrency, FTX’s computers will say “absolutely not.” This is FTX’s pride, it’s what they promote, it’s what they brag about to regulators and Congress, and it’s what Bankman-Fried talks about on Twitter.
But Alameda was allowed to do this: there are settings in FTX’s code that allow Alameda to have an unlimited negative balance and to borrow freely, without any collateral. Alameda used this during last year’s crypto market crash, because it was hard to borrow money elsewhere. A key part of the trial will be about whether Bankman-Fried authorized this behavior. In a conversation with Sheelah Kolhatkar of the New Yorker, “Bankman-Fried firmly stated that prosecutors would not be able to produce any documentation proving that he authorized unlimited borrowing because, he said, there was no such documentation.” But basically everyone else who worked at FTX would probably testify that he did. This is very self-serving testimony: the agreement prosecutors offer implicitly states “If you say Bankman-Fried did this, you might be able to avoid going to jail, and if you don’t, we might put you in jail forever.” It doesn’t help him, though, and prosecutors appear to have recordings proving that his colleagues said this before the government got involved.
second:
It wasn’t just that Alameda made a series of bets on crypto exchanges, all of which happened to go against it. Alameda wasn’t really bothered by things like cross-border bitcoin arbitrage gone wrong, or even really by the Terra/Luna debacle that brought down so many other crypto companies. Alameda’s trouble was that it owed FTX (and its customers) billions of dollars, and that its assets consisted mostly of weird illiquid assets associated with FTX — FTT, SRM, MAPS, and other tokens: “Samcoins” were invented by Bankman-Fried and owned mostly by Alameda, representing bets on his own speculative activities. Customers came to FTX to bet on Bitcoin and Ethereum and other assorted uncorrelated cryptocurrencies, and then Alameda took their money and put it all into FTX’s own cryptocurrency.
Accepting real customer money — dollars that customers give you to gamble with, sure, or cryptocurrency, but at least cryptocurrency that you don’t control — and using it to pump up the price of a crypto token that you control is kind of like a Ponzi scheme. That’s the box. Bankman-Fried expressed this idea to me on a podcast once — you could just create a cryptocurrency, give it some arbitrary market value, and then borrow millions of dollars based on its fake market value.
third:
The facts remain unclear, and my assumption is that the vast majority of the roughly $8 billion in missing customer funds went to Alameda, which lost it on foolish cryptocurrency bets. But not all of it. Lewis said on "60 Minutes" that Tom Brady was paid $55 million to endorse FTX, one of many highly paid celebrity endorsers who spent millions more on political donations, effective altruism campaigns, real estate in the Bahamas, and FTX's lavish operations.
You could imagine some kind of accounting where all of these fees were paid strictly out of FTX’s operating income (from the trading fees it legally charges its customers, and which they pay in cash), and where the $8 billion was lost entirely due to the unfortunate error of Alameda’s leverage. But there is no indication that such an accounting arrangement existed, and everyone agrees that FTX’s actual accounting is ridiculous. For example, FTX Group employees submit payment requests through an online “chat” platform, where a different group of supervisors approve payments by responding with personalized emojis,” the post-bankruptcy CEO complained. This makes it impossible to really argue that all of these fees were paid out of operating income rather than customer funds.
Instead, it looks more like FTX and Alameda had an indiscriminate pool of money that rewarded themselves with huge accounting revenues, and then had no problem spending tens of millions of dollars because they thought there was more money out there. Bankman-Fried’s defense must be something like “When I look at our financials, I feel like we have a lot more money than we owe our customers, so I have no problem spending a few hundred million dollars on marketing and employee benefits.”
And FTX does seem to make a lot of money through actual fees. At one point Alameda had a huge amount on its balance sheet with a lot of equity on it. Conceptually, at its peak, FTX/Alameda probably had a bunch of tokens with a market value (the last selling price of the tokens held by FTX/Alameda multiplied by the number of tokens) of $100 billion, and it owed its customers $30 billion in real or relatively real money (USD, Bitcoin, Ethereum, etc.). Bankman-Fried probably looked at those numbers and thought “Well, $100 billion is a lot more than $30 billion, we’re rich, we can afford Tom Brady.”
But the 100 billion is fake, meaning FTX/Alameda can’t (and didn’t) get anywhere near the 100 billion value of these tokens, and the 30 billion is real, meaning the US government is trying to put Bankman-Fried in jail because customers didn’t get their money back in full.
One problem with this defense, and a problem with the “bank run” defense in general, is that it requires a lot of optimism about cryptocurrencies. It requires you to believe that Bankman-Fried looked at Alameda’s vast cryptocurrency stockpile — made up in part of crypto tokens invented by Bankman-Fried, over which he and Alameda largely control trading, and whose market value is based largely on confidence in him — and said “Ah, this is real money, and I can keep spending this and still have enough real money left to pay back my customers in dollars and bitcoins, etc.”
I mean, here's a math problem:
You have $100 billion of weird crypto tokens.
You owe people $30 billion in real money.
How much money do you have to spend?
My answer was “Alas, no, I have to pay back that $30 billion ASAP or everything will fall apart and I’ll go to jail.”
But that’s me! There are a lot of people in the crypto space who will say, “Great, I have $70 billion, crypto is the future, $100 billion in various cryptocurrencies is at least as valuable as $100 billion in devalued fiat currencies.”
It’s just that Bankman-Fried never seemed to be one of them. I once wrote about my impressions of him after the “box” podcast:
My point is that if you talk to a crypto exchange operator who is like, "crypto is changing the world, your outdated economics are just unfounded fear, HODL," that's bad. An avid crypto true believer is not someone who runs an exchange. You want someone who runs an exchange who is a sensible trader. You want someone whose basic attitude toward financial assets is, "If someone wants to buy, someone wants to sell, I'll put them together and take a fee." You want someone whose views are driven by markets rather than ideology, and who cares about risk rather than futurism. A certain amount of skepticism about the products he trades is probably healthy.
OK. That’s a good idea. If you were skeptical of the vast sums of cryptocurrency you had, you wouldn’t be borrowing against your clients’ money, and you wouldn’t be continuing to spend real money on endorsements and donations. You would only do that if (1) you were overly optimistic about the value of your cryptocurrency, or (2) you were deeply cynical and were planning to steal it.
The defense is that Bankman-Fried was incredibly naive. Not only does it require you to believe that his lieutenants stole all the client money without him noticing, but that he was just making a series of innocent risk management errors while everyone else was building nefarious backdoors. It also requires you to believe that he trusted the cryptocurrency he had on hand, that he thought his vast, imaginary fortune was real and could be spent at will. Clearly, that was not the case.