By: Catherine Nicholson
After the collapse of FTX in November of 2022, a civil complaint was filed by the SEC on December 13, 2022, against Samuel Bankman-Fried, alleging violations of fraud in the offer or sale of securities and fraud in connection with the purchase or sale of securities. In addition to the civil complaint, a class action lawsuit was filed on December 27, 2022, against Bankman-Fried on behalf of former FTX customers. This class action suit arose out of FTX pausing withdrawals, not letting its users take out any of their money, approximately $600M in customers’ funds disappearing, and users being unable to access any remaining cryptocurrency they had within the FTX exchange.
In October of 2017, Bankman-Fried founded Alameda Research (“Alameda”), a quantitative trading firm specializing in cryptocurrency assets. Cryptocurrency assets are digital assets maintained on a cryptographically secured blockchain. At its inception, Alameda was focused on arbitrage trading strategies, but soon progressed to pooling crypto assets in exchange of interest, and volatility trading. Alameda also offered over-the-counter trading services for its customers.
In 2018, Bankman-Fried began working on building a crypto asset trading platform. Together, Bankman-Fried and his former colleagues from Alameda founded FTX, which began operations in approximately May 2019. FTX offered its customers a number of services: (1) spot market, a trading platform through which customers could trade crypto assets with other FTX customers; (2) spot margin trading, which allowed FTX customers to trade using assets they did not have by posting collateral in their FTX accounts and borrowing crypto assets through the “spot market” on the FTX platform; and (3) over-the-counter portal trading that enabled customers to connect and request quotes for spot crypto assets and to conduct trades. In January of 2020, Bankman-Fried founded FTX US, a cryptocurrency asset trading platform that was designed primarily for customers in the United States.
From May of 2019 to November of 2022, Bankman-Fried continually diverted FTX customer funds to Alameda in primarily two ways: (1) by encouraging FTX customers to deposit fiat currency into bank accounts controlled by Alameda; and (2) enabling Alameda to withdraw from a limitless line of credit at FTX. This line of credit was funded by FTX customer assets. During this period, Bankman-Fried repeatedly touted FTX’s robust risk monitoring protocols, which he termed FTX’s “Risk Engine,” to the public and prospective investors. He claimed that the Risk Engine calculated a customer’s margin level every 30 seconds. If the collateral on deposit fell below the required margin level, FTX’s automated system would sell the customer’s portfolio assets until the collateral on deposit exceeded the required margin level. These statements were essentially false due to a critical omission: Bankman-Fried failed to reveal that the Risk Engine did not apply to Alameda’s account.
The FTX funds that were transferred to Alameda were used not only for Alameda’s proprietary trading, but to fund loans to FTX executives and himself, fund personal real estate purchases, and make large political contributions. Between March of 2020 and September 2022, Bankman-Fried executed promissory notes for loans from Alameda amounting to over $1.338 billion, including two instances where Bankman-Fried was both the borrower in his individual capacity and the lender in his capacity as CEO of Alameda. Bankman-Fried also used commingled funds from Alameda to purchase tens of millions of dollars in real estate in the Bahamas for himself, his parents, and other FTX executives. The loans were either poorly documented or not documented at all. Neither the fact about the loans nor the company’s liabilities and expenditures were disclosed to investors.
On November 2, 2022, an article was published on CoinDesk stating that, based on its review of an Alameda balance sheet it had obtained, Alameda held a large position in FTX tokens. Four days later, the CEO of Binance, a cryptocurrency asset trading platform, announced via Twitter that that they would be liquidating its FTX holdings valued at over $500 million. Binance’s announcement caused many FTX customers to withdraw their funds from FTX. Approximately $6 billion USD was withdrawn within 72 hours. On November 8, 2022, FTX paused all customer withdrawals because they did not have the liquidity to pay them back. Subsequently, Bankman-Fried stepped down as CEO, declared bankruptcy, and $600 million worth of customer funds got hacked out of FTX. Now, users have no access to any of the remaining cryptocurrency they had on the platform. A lawsuit was filed on December 27, 2022, in the US Bankruptcy Court in Delaware, and four plaintiffs are representing the whole class of former FTX customers.
Moving forward, users are supporting the use of zero-knowledge auditing for different blockchain platforms in the industry. Zero-knowledge cryptography is technology that can be used in transactions and communications, assuring multiple parties that one party has an asset or information without revealing sensitive data about that asset or information. Zero-knowledge aims to provide a full scope of information while protecting user data in that process. Instead of revealing sensitive information, zero-knowledge cryptography will allow the verification algorithm to verify data between the two transacting parties.
Through this solution, platforms can take intakes and outputs without revealing sensitive customer data. This kind of auditing can be crucial – particularly in conjunction with off-chain reserve and liability auditing – for exchanges and other major platforms that want to remove any potential doubts about the ways in which they operate.
This is also critical for increasing cryptocurrency’s credibility and driving traditional Web2 company adoption of Web3 technology with more confidence. These companies must straddle the fence between preserving user privacy and adhering to the standards of transparency that we have come to expect from DeFi protocols.
The degree of malpractice with FTX was so large that it has drawn attention from around the world. This obviously has caused a general distrust in cryptocurrency. Although FTX took everyone by surprise, innovative approaches can ensure better security solutions for the future. Additionally, there has become an internal pressure for platforms to go above and beyond what is required of them to prove that they are in fact operating the way they should. In order for this to happen, the industry will have to operate with much more transparency. Implementing zero-knowledge cryptography will preserve customer privacy as well as offer a level of transparency and accountability that users yearn for in this unstable market.
Student Bio: Catherine Nicholson is a second-year law student at Suffolk University Law School. She is a staffer on the Journal of High Technology Law. Catherine received a Bachelor of Arts Degree in English and Spanish from the University of Connecticut.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
