The implosion of FTX: lessons from an accounting perspective

THE financial troubles of Silicon Valley Bank (SVB), Signature Bank and FTX have certain common elements. FTX was one of the largest crypto exchanges; SVB is active among tech startups; and Signature Bank has many customers who are major crypto players.

These collapses are excellent case studies of how companies can implode in a matter of weeks or even days. While the situation with SVB and Signature Bank is still unfolding, much is now known about the FTX fiasco, and some lessons can be drawn.

More than eighty institutional investors provided some US$2 billion in funding to FTX. Yet despite being such a large organisation, FTX surprisingly did not engage a Big 4 firm as its auditor.

It is clear that a huge concentration of power, coupled with a lack of oversight, caused massive customer losses. Funds were transferred to Alameda Research, FTX’s sister cryptocurrency exchange, with no accountability.

As the archetypal founder with a daring plan to disrupt traditional finance, FTX’s Sam Bankman-Fried seemed to fit what Silicon Valley venture capitalists look for. But now, with millions of dollars lost on the bankrupt platform, crypto investors and depositors face an existential dilemma: Should they even invest in crypto assets, and can they trust crypto exchanges?

Trust and accountability

Centralised crypto exchanges like Binance and FTX handle everything from margin loans and settlement to direct custody of client assets. This means that funds must entrust platforms not only with the assets they trade, but also the collateral they put up for leverage.

For traders who saw their crypto holdings evaporate in a matter of days on FTX, this is a huge counterparty risk. To avoid another catastrophe, some investors have advocated that separate entities, like custodians and trustees, hold their crypto assets instead.

Since the FTX fiasco, platforms have made full or partial disclosures outlining their assets. Binance, the largest cryptocurrency exchange, disclosed what it called a “snapshot” of its major token holdings in a blog post on Nov 10.

Yet clients’ stampede for the exits has persisted, with exchange reserves of Bitcoin, Ether and stablecoins falling sharply, according to data from CryptoQuant.

The problems are threefold. First, many of these published proofs of reserves have left out liabilities. Second, these reserves have not been vetted by outside auditors. Finally, they do not provide clarity on which, if any, of the assets have been pledged as collateral for loans.

In my view, a complete accounting of the financials is necessary to fully restore confidence. This is especially given that one of blockchain’s grandest promises is the purported transparency of records, with transactions unable to be altered by accountants.

There is also an opportunity for accountants and auditors to step up and restore confidence in the industry. For example, a Binance spokesperson said the exchange will publish audited reserves and liabilities in the near future.

The big issue remains whether crypto holdings can be entrusted to these crypto exchanges. An analogy is whether customers trust traditional banks with their money, or would rather store cash under their pillows.

Trust in crypto exchanges and other crypto-related institutions has reached an all-time low. Many crypto players have put their holdings into cold crypto wallets. Thus, crypto exchanges that want to restore standards should start by opening their books, just like a typical bank.

The FTX fiasco gives a reason to insist on proper audits to examine fund flows in greater detail, and full disclosure of related-party transactions. It also provides strong justification of the need to address governance concerns.

Audit and due diligence

Another question in this saga is why various red flags were overlooked by sophisticated investors. Why did so many experienced institutional investors seemingly have a blind spot in due diligence and auditing?

There was not a total lack of due diligence. But we now know belatedly that FTX had weaker financial controls than Enron. For example, it used the accounting software QuickBooks, which is more suited to small and medium-sized enterprises.

There appears to have been a systemic and gradual erosion of standards. Bankman-Fried refused to put investor representatives on the FTX board and engaged auditing services from little-known firms Armanino and Prager Metis CPAs.

Even when investors insisted on doing due diligence, the hands-on work usually fell to the youngest lawyers, consultants and bankers – who were less experienced at judging the adequacy of controls and other red flags. It also takes a brave junior associate to suggest to senior partners that a deal should be abandoned.

More regulations?

The collapse of FTX suggests that a proper regulatory framework is a must for any country that aspires to become the next virtual asset hub. Sound regulations should provide sufficient investor protection and adequate governance standards.

A good regulatory regime for virtual assets will also set the foundation for financial institutions to explore new and interesting blockchain-based innovations.

This is perhaps one irony of the FTX saga. While Bankman-Fried was trying to disrupt traditional finance, he might end up making crypto look more like mainstream finance.

Decentralised finance and deregulation might appeal to certain groups of people. But critics say that these have given exchanges outsized power over client assets and created a concentration of risk.

The fact that FTX was able to keep such glaring internal control deficiencies hidden for so long shows that accounts must be audited and assets valued by third parties. If there is one simple takeaway, it is that the crypto community needs regulators, accountants and auditors so that trust and accountability can be restored for this asset class.

The writer is an associate professor of Singapore Institute of Technology’s business, communication, and design cluster, as well as a chartered accountant and chartered financial analyst. The opinions in this article are his own, and do not purport to reflect those of SIT.