Did something specific about the world of crypto cause FTX's collapse? Or was it just a garden-variety scam?
To be sure, the nature of the assets in the “crypto world” played a big role in this fiasco. Crypto assets are pure information assets. They have no tangible existence and can therefore be easily moved, stored, sold, etc., at least from a physical point of view. Crypto assets signify rights that exist only to the extent that people believe they do. For example, Bitcoin is valuable because it gives you the ability to acquire goods and services in exchange for Bitcoin. The ability to do this is dependent on whether people choose to accept Bitcoin as payment. An NFT is valuable because it represents an ownership right that you can transfer to someone else, or simply get direct satisfaction from the knowledge that you own a piece of digital property.
This is all very abstract. That makes it difficult to sort different types of crypto assets into clear categories, a first step in regulating them in efficient and effective ways. For example, is Bitcoin a currency, like the U.S. dollar or the Euro, or a security, like a share of Goldman Sachs? The answer guides the assessment of the appropriate type of regulation and selection of the appropriate regulatory body to give jurisdiction.
It is not surprising, then, that regulators have been a bit behind the curve in the crypto world. (Are they ever ahead? Can you regulate something before there is some experience with it?)
The intangible nature of crypto assets means also that volume can be cranked up very, very quickly. There are no beer barrels to store, no cars to manufacture and ship. You just move around some symbols. This is where the “garden-variety scam” comes in. Business history is full of examples of companies that grew too fast with little attention to controls and accounting, which tend to slow things down. As attorney John Ray—now FTX’s CEO—wrote in a bankruptcy filing, having control rest in the hands of “a very small group of inexperienced, unsophisticated and potentially compromised individuals” who in turn are enabled by “compromised systems integrity and faulty regulatory oversight” is a tried-and-true recipe for disaster. Even so, this situation seems quite extreme. Mr. Ray, who is extremely experienced in bankruptcies, states: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”
Are accounting tools able to keep up with everything that's happening in the world of crypto?
The essence of accounting is to organize the keeping of financial records by using the Fundamental Accounting Identity, Assets – Liabilities = Equities (or Net Assets in a nonprofit). This leads to double entry bookkeeping, which turns out to be a big help in administering accounting systems.
“There is nothing about crypto that would affect the desirability of using the standard accounting process or that would raise problems in applying it. The problem with FTX is that this approach was not applied at all.”
There are three steps in the accounting process: recognition, classification and valuation. Recognition is the decision of whether to include a piece of information in the identity, classification is the decision of what categories are affected, and (book) valuation is the assignment of the numbers to use. There is nothing special about the crypto world that would affect the desirability of using this standard approach or that would raise particularly difficult problems in applying it. The problem with FTX is that this approach was not applied at all, at least on a system-wide basis. Paragraph 58 of the Ray Declaration:
The Debtors are locating and securing all available financial records but expect it will be some time before reliable historical financial statements can be prepared for the FTX Group with which I am comfortable as Chief Executive Officer. The Debtors do not have an accounting department and outsource this function.
In fact, the problems with records went well beyond accounting. Paragraph 59 of the Ray Declaration:
The FTX Group’s approach to human resources combined employees of various entities and outside contractors, with unclear records and lines of responsibility. At this time, the Debtors have been unable to prepare a complete list of who worked for the FTX Group as of the Petition Date, or the terms of their employment. Repeated attempts to locate certain presumed employees to confirm their status have been unsuccessful to date. (Emphasis added.)
There is more in the Ray Declaration, but I think the point has been made.
How does this bankruptcy compare with the failures of other financial firms in terms of likely impact on investors and the broader financial system?
Professors Gary Gorton and Andrew Metrick are more appropriate to comment on this, but I will say that I don’t see the FTX bankruptcy as a big systemic risk. In the 2009 Financial Crisis, the big concern was contagion – i.e., that one or a few failures would spread to undermine trust in the entire financial system. There was a “run on the bank” with FTX, but the run has not spread to other financial institutions, and I do not see why it would.
Of course, there will be big effects on individuals who will lose assets in the FTX failure. At this point, it is difficult to estimate how deep the losses will run or how many people will lose. Because FTX was a trading platform, it held customer assets. The Ray Declaration contains a balance sheet for the parts of FTX labeled the WRS Silo that contains the following qualification: “Balances of customer crypto assets deposited were not recorded as assets on the balance sheet and are not presented.” (Emphasis in original.) The qualification for balance sheet for the Dotcom Silo is: “Balances of customer crypto assets deposited are not presented.” (Emphasis in original.) These customer assets likely far exceed the assets on the balance sheets of those two silos, which were $1.36 billion and $2.26 billion respectively.
So if customer assets were lost or stolen, we really have no idea how much might ultimately be lost. (The market capitalization of the 50 biggest cryptocurrencies on November 11, 2022, was slightly more than $800 billion so we could estimate that the total amount lost will be considerably less than that.) Given the state of record-keeping at FTX, we may never really know.