A Historic Fraud: The Rise of FTX
Stories of the fall of crypto darling FTX, and its founder Sam Bankman-Fried (SBF), are draped all over the internet. It is a riveting story that combines cryptocurrency greed with the deregulated nature of decentralized finance. For many, it is their first look behind the curtain of the crypto market. Many of these online stories discuss SBF’s background and the facts leading to FTX’s fall. However, none of the publications have told that story with an eye on the criminal indictment that followed. This post aims to comprehensively fill in the gaps in the current articles and thoroughly analyze the criminal case against SBF.
For clarity, this post will be broken into four parts. Part one will cover the history of SBF and the creation of FTX. Part two will look into the actions that led to FTX’s collapse. Part three will review the current charges against SBF and outline where the government is headed. The fourth post will look at regulatory changes that may prevent large scale fraud in the crypto market.
The Rise of SBF in the Crypto Market
SBF grew up in Northern California. His parents were professors at Stanford law school and SBF had access to elite private schools in his early years. After graduating from high school, SBF enrolled at the Massachusetts Institute of Technology (MIT). He graduated with a degree in physics and a minor in mathematics in 2014.
After graduation, SBF obtained a job with a Wall Street Firm known as Jane Street Capital. SBF worked as a trader for the investment firm for three years. In 2017, SBF left Jane Street and started his own firm focused on crypto trading, Alameda Research. Alameda generated a huge amount of wealth for SBF as they were known for pocketing millions a day in active trading. They commonly took advantage of the arbitrage opportunities in the market (buying BTC at one price on Exchange X and selling at another price on exchange Y). These small percentage differences produced huge gains when hit with large volume.
Alameda continued their large growth in 2018-2019 becoming a well-known trading entity. By 2019, Alameda and SBF were worth over a billion dollars. SBF became a celebrity in crypto circles as he continued to amass great wealth through his trading practices.
In May of 2019, SBF teamed up with a former Google employee, Gary Wang, to start their own cryptocurrency exchange, FTX. In August of 2019, FTX closed their first round of funding raising millions for the project. The investors included big names such as Binance Labs and Pantera capital.
SBF knew he would have to separate himself from the other large crypto exchanges for FTX to succeed. He decided to run a blitz marketing campaign which would put FTX on center stage. The campaign included licensing deals with Major League Baseball (MLB), the Miami Heat, the Golden State Warriors, and California-Berkley’s football stadium. In addition to the licensing deals, FTX retained multiple celebrities to promote the exchange, including Tom Brady, Steph Curry, and Shohei Ohtani. From 2020-2022, FTX’s logo was stapled across major sporting events. It became one of the more respected and trusted exchanges in the world.
By 2021, FTX’s daily volume rivaled the largest competitors. At its peak, FTX hit $21 billion in trading volume over a 24-hour period. That figure placed them in the top 3-4 crypto exchanges in the world. That figure would beat out every exchange during the 2023 bear market. During FTX’s rise, Alameda Research continued to generate large returns for SBF in the background. By 2022, SBF’s total net worth was over $26 billion. At thirty years old, SBF was one of the richest people in the United States.
The Structure of FTX and How it Generated Value
The FTX exchange was a centralized system that allowed users to trade various cryptocurrencies. FTX offered standard trades through Bitcoin, Ethereum, USDT, and fiat pairs. It also had an expansive market for derivatives, futures, spot markets, prediction markets, and MOVE contracts. FTX was not a fly by night exchange. They offered traders a one stop tool kit for advanced trading. FTX also had a user friendly mobile application to allow users to trade from anywhere.
FTX generated income by charging fees for user activity. These included trading fees, listing fees, withdrawal fees, and deposit fees. If the exchange had numerous users conducting billions in daily volume, the company could amass large profits by siphoning commissions at every stage of the process. This reality was not unique to FTX as nearly all crypto exchanges utilize these fee structures for revenue generation.
Though fee collection was central to FTX’s business model, the company extracted significant value in other areas of the crypto market. Significant additional value was created through: 1) the FTT token price, 2) staking assets, and 3) investing user capital.
FTT Value and its Role at FTX
The FTT token price created value for FTX. Following Binance’s lead, FTX developed their own native token to trade on the FTX platform. If a trader used FTT to buy another token or held FTT on the exchange, they would receive various benefits. These benefits included discounted trading fees, higher percentages on referrals, free withdrawal fees, and access to airdrops.
FTX incentivized users to use their native token on the platform. This model created a demand for the FTT token on FTX and other exchanges. Based on supply limitations found in all crypto projects, the demand would increase the price of FTT. This simple economic argument combined with speculative investing created a large value increase for FTT. On September 6, 2019, FTT was worth $.83 on major exchanges. This price was its all time low following its launch in August of 2019. By September of 2021, FTT was worth $79.53. This explosion over two years resulted in a gain of nearly 100x for the FTT token.
To understand the windfall this represents, we have to look back at the creation of FTT and its investment history. When a project decides to create a native token, there are no real parameters for its value. Unlike an IPO, where revenue, profit, and existing shares guide the initial stock price, an IEO (initial exchange offering) has no true dimensions. There is a valid justification for placing a total market capitalization (numbers of coins x price) at most any number.
FTX ran multiple investment rounds from 2019-2022. Each round allowed investors to pump capital into FTX in exchange for FTT tokens. Those tokens started at .20 in the first public investment round. The specifics of each investment cycle is still unknown. Though selling a newly developed token in an investment round is a well understood tactic that was borrowed from IPOs in the stock market and made popular during the initial coin offering (ICO) craze of 2017.
SBF created value for FTX by holding the IEOs. That baseline value came from the sale of FTT tokens directly to investors. However, those sales were pennies when considering FTX’s eventual asset profile. The real value came from the huge gains for the token from 2019-2021. When FTT was created only a portion was made available for investor purchase. The vast majority of the tokens were created and held by FTX at no cost. In 2019, FTX withheld roughly 25% of the total FTT supply for the team and other insurance programs. Only 50% of the total token supply was in the hands of retail investors.
25% of the token supply in 2019 consisted of roughly 81.25 million tokens. During the seed rounds, this would have been worth an estimated $16.25 million. Yes, that is correct. FTX created $16.25 million out of thin air. In November of 2021, FTX’s team tokens were worth an estimated $6.5 billion.
The FTT token creation and valuation created a significant portion of SBF’s wealth by 2021. The tokens alone were worth a significant percentage of FTX’s valuation.
Staking FTT on Crypto Exchanges
The FTT tokens create value in two relevant ways: 1) the price of the token on exchanges (discussed above) and 2) their use as a vehicle for passive income through staking. A little background on staking will help to understand FTT’s value in this area. Staking is the process of locking tokens in a smart contract for rewards.
There are two types of staking relevant to this post. The first involves locking up a native token on the parent network to assist in validating transactions. ICON provides a good example. ICON is a layer one blockchain protocol similar to Ethereum. ICON runs its own chain, has applications built on top of the chain, and has a native token (ICX) which can be staked. If a user stakes ICX, they are locking their tokens into a smart contract to assist in validating transactions. In return for the lock up, they receive rewards in ICX. Today, a user can lock their ICX tokens for ~10% return on the investment yearly.
The second type of staking has nothing to do with validating transactions or securing a layer one protocol. This type of staking exists on exchanges where the exchange owner serves as a bank. The exchange agrees to pay the token holder a set percentage for giving the exchange custody of their tokens.
FTT is not a native token of a parent protocol. FTT is an Ethereum based token (ERC-20) built as a smart contract on Ethereum. FTT has nothing to do with validating the parent protocol’s (Ethereum’s) transactions. However, exchanges, including FTX, allowed holders to stake FTT tokens on the exchange for a return. For example, a user could enter the Binance exchange and transfer their tokens into Binance’s staking program. In return, Binance would agree to pay the user a percentage return for that action. The duration of the lock up period often affects the return. This is similar to the certified deposits (CDs) we see at established financial institutions.
FTX created value using this staking procedure for FTT (and other tokens). FTX held millions of FTT tokens. If Binance was offering 12% returns on staked FTT, the team could allot a portion of their tokens to the staking protocol. If the team staked 40 million tokens in 2020, the return would be roughly 4 million tokens by 2021. That return would have been worth $320 million during FTTs peak. In addition to the staking reward, the team would effectively remove millions of tokens from circulation on exchanges or otherwise. This removal lessens the total supply available and further increases the price of the token on exchanges.
Operating the FTX Staking Protocol
FTX was able to generate revenue by staking their own FTT tokens. While this created some revenue, it pales in comparison to the revenue generated by the FTX exchange’s staking protocol. In the last section, we discussed the process of staking a token on an exchange for a return on the investment. Importantly, we discussed the ability of the exchange to take custody of the staked tokens based on a promise of delivering a percentage return.
By 2021, FTX supported staking for four major tokens; FTT, Serum (SRM), Solana (SOL), and Raydium (RAY). Solana is one of the largest projects by market capitalization in the crypto space and Serum and Raydium were decentralized exchange tokens. The staking program allowed FTX to take custody of millions of staked tokens pursuant to a contract to pay out certain returns.
There was/is no stipulation on what the exchange owners can do with the staked tokens. Just like banks can use deposited money for investments, crypto exchanges can use the staked tokens in their custody for other ventures. It is unknown how much money FTX made/lost on these ventures, but we do know FTX had a ton of free capital through the staking program. I have little doubt FTX leveraged millions through their staking protocol. As will become apparent later, those investments played a large role in both the downfall of the exchange and the criminal indictment.
Transitioning to the Downfall
By 2022, SBF was a legend in crypto circles. He had amassed billions in the market, ran a seemingly legitimate exchange, donated millions to political circles, and appeared to have perfectly played his hand.
SBF had exploited every angle available in the crypto space by creating his own valuable token, taking custody of user’s assets through staking, and running his own investment firm in the background. “Things are not always as they appear” could never be more true. In one month’s time, SBF went from the king of the mountain to fighting for his financial and physical freedom.
In the next post, we will review the story behind the downfall of FTX. This review will include discussions of SBF’s poor investments, overleveraging of assets, fraudulent activities, and intermingling of Alameda and FTX funds. All these factors led to the bank run on the FTT token in 2022, the collapse of FTX, and ultimately, the criminal charges.