Last week, the bankruptcy advisors to the collapsed crypto-exchange FTX filed a second interim report detailing their investigations into the commingling and misuse of customer assets at FTX.com. On a more positive note, the report also confirms that the Chapter 11 debtors have recovered approximately $7 billion in liquid assets and anticipate more recoveries, raising the prospect of a significant dividend to creditors in the coming years.
The latest report follows a first interim report released in April which detailed alleged management and control failures at the FTX group, and included scathing criticism of Sam Bankman-Fried (SBF) and other FTX senior executives. In the second report, John Ray III, the veteran restructuring advisor who now acts as CEO of FTX, said:
From the inception of the FTX.com exchange, FTX Group commingled customer deposits and corporate funds, and misused them with abandon.
The report was filed in the US Bankruptcy Court for the District of Delaware and details the following findings with respect to the misappropriation of customer funds by the FTX Group:
FTX Senior Executives (which includes SBF, Gary Wang and Nishad Singh) and others at their direction, used commingled customer and corporate funds for speculative trading, venture investments and the purchase of luxury properties, as well as political and other donations.
As of the petition date, the FTX.com exchange owed customers approximately $8.7 billion. The $8.7 billion in customer-deposited assets was misappropriated from the FTX.com exchange, the vast majority of which – over $6.4 billion was in cash and stablecoins.
FTX misled Congress, federal agencies, and other third parties by claiming that it “regularly reconcile[d] customers’ trading balances” against funds held by the exchanges. In fact, there is no evidence that the FTX group performed any meaningful reconciliation of customer assets .
While the FTX group claimed publicly that it protected and separated customer deposits, FTX Trading made no such representation in its Terms of Service with customers. In fact, the Terms of Service were silent on what FTX Trading would do with customers' fiat currency, and made no claim that the company would segregate, custody, secure or otherwise protect it.
The FTX exchanges did not distinguish or differentiate between cash and stablecoin held in customer accounts, but treated them collectively as “e-money.” As a result of this lack of recordkeeping, the Chapter 11 Debtors are unable to provide a breakdown of the cash and stablecoin in customers' accounts.
It is extremely challenging to trace the substantial assets of the Debtors to any particular source of funding, or to differentiate between the FTX group's operating funds and deposits made by its customers. This is caused by:
FTX Senior Executives and the FTX group funnelling customer deposits and withdrawals in fiat currency through bank accounts of Alameda Research Ltd (Alameda) and other affiliates, and misrepresenting to banks the purpose for which it was using the accounts.
The FTX group made no meaningful distinction between customer funds and Alameda funds.
The FTX group incorporated North Dimension Inc to open bank accounts through which it could operate the FTX.com exchange.
After FTX Digital Markets (FTX DM) was set up in July 2021 and opened US bank accounts in December 2021, the FTX group used the FTX DM accounts, like other accounts, on a commingled basis for many purposes, including the cycling of money to and from customers to meet withdrawal requests when necessary and various investments, donations and expenditures. The FTX group appears to have used the FTX DM accounts in part as a pass-through vehicle to funnel at least $5.4 billion in customer deposits to FTX Trading.
The report also contains the following chart which shows the significant complexity and difficulty in tracing the sources and use of customer funds by the FTX Group:
As more details have been revealed by the Chapter 11 advisors of the FTX group's alleged management failures and mishandling of customer funds, it increasingly appears that the spectacular collapse of FTX was largely due to these failures rather than crypto specific business risks. However, more stringent licensing and custody rules and regulatory supervision may have helped prevent the misappropriation of customer assets, such as the stringent cold-wallet custody requirements introduced by Japan following the Mt. Gox collapse and which are now being implemented in various jurisdictions around Asia. To that end, the report is a further reminder of the need to establish fit-for-purpose regulation for digital assets businesses to better protect consumers.
In a further important development last week, the Delaware court also set a deadline for FTX customers to file claims in the Chapter 11 proceedings of 29 September 2023.
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