Former FTX users say the crypto exchange's failure was a "Ponzi scheme".  Here's how it works and what we know about how Sam Bankman-Fried works

Former FTX users say the crypto exchange’s failure was a “Ponzi scheme”. Here’s how it works and what we know about how Sam Bankman-Fried works

Until recently, Sam Bankman-Fried, or SBF, was crypto’s golden boy, known for turning his cryptocurrency exchange, FTX, into a $32 billion giant in just two years.

But the disheveled, left-leaning 30-year-old was living a lie. SBF, who claimed to be a minimalist philanthropist, had used client funds to prop up his failing crypto empire and fund his lavish lifestyle.

Amid the revelations and the broader crypto industry downturn, FTX and its investment network — which included SBF’s trading business, Alameda Research, as well as more than 200 other crypto firms — crumbled. in a spectacular way.

Meanwhile, SBF, the former crypto “white knight” who was once worth $26.5 billion, says he is down to his last $100,000.

Former FTX Customers, academicsand even the faithful crypto alleged that the now-defunct Bankman-Fried crypto exchange was a veritable “Ponzi scheme,” leading to a barrage of civil lawsuits against him and his company. There has been no judgment on the cases yet.

Despite SBF’s allegations and admissions of errors, the lawyers contacted by Fortune said it was too early to declare that FTX was a real “Ponzi scheme” – although they say prosecutors could possibly do so.

“I don’t know if this is a Ponzi scheme, and it’s likely to be a while before we find out,” said Thomas P. Vartanian, executive director of the nonprofit Financial Technology and Cybersecurity Center. lucrative.

Vartanian, who has represented parties in 30 of the 50 largest financial institution meltdowns in US history, noted that it could take prosecutors years to dig into the complex, interconnected and poorly managed accounting of FTX and its affiliates.

“They will follow the money, and they will follow it down to the penny. And they will determine if it’s negligence, civil fraud, criminal fraud, and if it’s a Ponzi scheme, a pyramid scheme or whatever,” he said. -he declares. “But these are facts which I think will not be in anyone’s possession for some time, until all the money is followed.”

Still, Vartanian noted that the documents filed in the wake of FTX’s bankruptcy so far are “pretty devastating.”

“So to me, so far, it looks like corporate misconduct,” he said. “And whether that turns into fraud and breaking the law or a Ponzi scheme is another question.”

But Carlos Martinez, bankruptcy specialist at law firm Scura, Wigfield, Heyer, Stevens & Cammarota, went further.

“I think the legal answer would be ‘let’s wait for the investigation,'” he said. “But I think it’s pretty cut and dry. The writing is on the wall that it was – or at least if it wasn’t supposed to be a Ponzi scheme, it definitely worked like a Ponzi scheme .

How Ponzi Schemes Work

A Ponzi scheme is a scam that lures investors with promises of high returns with little or no risk. The problem is that Ponzis create these alleged returns using money from new investors, not profitable investments.

The name comes from Charles Ponzi, an Italian con man who defrauded American investors in the 1920s with a clever story and the promise of high returns.

The SEC has warned of the dangers of Ponzi schemes and their prevalence in crypto circles. And some crypto critics, like Nouriel Roubini, professor emeritus at New York University’s Stern School of Business, and CEO of Roubini Macro Associates, even argue that the entire crypto ecosystem is the ” mother of all Ponzi schemes”.

FTX shared many similarities with old Ponzi schemes. Sheila Bair, who served as president of the Federal Deposit Insurance Corporation (FDIC) from 2006 to 2011, told CNN earlier this month that SBF’s ability to charm regulators and investors was “very Bernie Madoff of a certain way”.

For more than 20 years, Madoff ran the biggest Ponzi scheme in history before his arrest in 2008, stealing $65 billion from 37,000 people. Although final accounting is not yet complete, FTX has $50 billion in liabilities to over 100,000 creditors, bringing SBF’s business closer to Madoff’s numbers.

But did SBF launch a Ponzi scheme? Or was it corporate fraud like the one that led to the collapse of Enron, the Houston-based energy company whose bankruptcy and subsequent accounting scandal rocked the markets?

If you ask former Treasury Secretary Larry Summers, Enron is a better analogy to FTX than a pure Ponzi scheme.

“I would compare it to Enron,” Summers told Bloomberg earlier this month. “Not just financial error, but – certainly from the reports – whiffs of fraud. Stage appellations very early in a company’s history. Vast explosion of wealth that no one really understands where it came from .

What we know about how FTX works

Whether FTX was a Ponzi scheme is up for debate, but SBF may also have engaged in what prosecutors could determine as “embezzlement”, “fraud” or even “a pure and simple Ponzi scheme,” Martinez said. Fortune.

For example, SBF used at least $4 billion in FTX client funds to support its trading company, Alameda Research, as crypto prices fell earlier this year, according to CoinDesk. SBF denies setting up a “backdoor” in FTX systems to do this, saying it’s “definitely not true” and that he can’t even code.

A media representative for SBF did not respond to requests for comment from Fortune.

But to New York Times Dealbook Summit on Wednesday, SBF expressed surprise at FTX’s collapse, saying, “I never tried to commit fraud. I was excited about the prospects of FTX a month ago. I saw it as a successful and growing business. I was shocked by what happened this month. And in rebuilding it, there are things I wish I had done differently.

But the former cryptobillionaire admitted that a “very mislabeled accounting thing” allowed Alameda to be “much more indebted” than he had anticipated.

FTX is also facing a flurry of lawsuits over its advertising, much like what happened to Bernie Madoff’s marketing arm in 2009 after he was arrested.

FTX has hired celebrities, including NFL star Tom Brady, for expensive Super Bowl commercials. And in a 2018 pitch deck to investors (pictured below), he offered clients what he described as “high returns with no risk” and “no downside” loans.

SBF and his team at FTX were also not shy about spending. The company lost $300 million on a Bahamas property for executives, racked up a $55,000 tab at a Jimmy Buffet’s MargaritaVille bar, and hired private jets to ferry Amazon packages to executives.

During his heyday, Madoff and his colleagues also lived a life of luxury, buying multimillion-dollar mansions and expensive jewelry, clothes and watches, some of which were auctioned off to pay off his investors after his arrest. .

Finally, before its fall, FTX’s leading international exchange held $9 billion in unsecured liabilities with only $900 million in assets, according to the FinancialTimes. Usually, total liabilities and total assets should match on a balance sheet, and the disparity shows that FTX was in a deep hole before its collapse.

While SBF insisted it simply misjudged the amount of liabilities on the books, new FTX CEO John Ray III, who also handled Enron’s collapse, called FTX’s operations “complete failure of corporate controls” with a “complete lack of trustworthy financial control”. information.”

“From the compromised integrity of systems and faulty regulatory oversight overseas, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” , did he declare.

Whether SBF was operating a Ponzi scheme through FTX will only be determined after prosecutors complete their investigations and a jury hears any criminal cases they bring. But Vartanian argued that Congress needs to pass tougher regulations on the crypto industry as soon as possible.

“I think Congress needs to write new rules to make it clear that the crypto industry is taking and using other people’s money, which means it’s a fiduciary,” he said. . “He is a custodian, and he must be treated as such under the law.”

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