A Post-Mortem for a Crypto Exchange: Is FTX worse than Bernie Madoff?

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December 7, 2022

The number one story in the crypto world this year (or decade? or century?) must be the FTX crypto platform collapse. It’s mindblowing how quickly FTX went from one of the largest crypto exchanges with a 150-second Superbowl commercial in February 2022, naming rights to sports arenas, numerous A-list celebrity endorsements, etc., to become the pariah of the financial world in just one short week in November 2022.

And likewise, FTX’s founder Sam Bankman Fried (SBF), went from a modern-day J.P. Morgan to Bernie Madoff 2.0. Is it even appropriate to compare SBF with Bernie Madoff? Isn’t that a bit of an insult? You bet! It’s an insult to the late Bernie Madoff! Along several dimensions, the FTX collapse is actually more outrageous than Bernie’s decadelong Ponzi Scheme. Let’s take a look at why…

Before we even get started, I like to state for the record: I’m crypto-curious but also a crypto skeptic. I find the technology and the opportunities quite intriguing, but I have never put a single dollar into a crypto coin or a crypto exchange. In a post earlier this year, I pointed out that even if we ignore the multitude of fraudulent rug-pull coins and worthless NFTs and focus on the mainstream players like Bitcoin and Ethereum, then the return patterns are not very attractive in the context of an efficient frontier analysis, even if we were to assume double-digit percent expected returns for Bitcoin and Ethereum. The crypto volatility, equity correlations, and equity betas are simply too high to justify any major engagement in this asset class. If you wanted de-facto crypto exposure, you could do that more safely and with less volatility by simply investing in stocks and bonds with leverage through equity and bond futures; please see the chart below:

From my 4/25/2022 post: You can achieve a better risk/reward tradeoff without crypto by simply going 4x or 5x the tangency portfolio. Assuming historical (2020-2022) Variance-Covariance matrix and calibrated expected returns.

The one time I almost invested in crypto…

The closest I came to putting actual money into crypto was at the 2021 FinCon, where I talked to the folks from BlockFI, one of the main sponsors of the event. In fact, BlockFI threw an awesome party in Austin, renting out an entire bar on 6th Street, the main downtown Austin party street, essentially a smaller version of Bourbon Street in New Orleans. Offering free drinks and appetizers to the FinCon influencers! The 8% return on USD balances sounded pretty nice, too. They also had a very generous affiliate program.

The BlockFI reps I chatted with also tried to boost their credibility, proudly announcing that the company has several former Goldman Sachs whiz-kids on their team. I’m glad they told me because that convinced me not to trust them with my hard-earned money. If the lavish spending for the FinCon party and the too-good-to-be-true interest on USD cash balances felt a bit icky, then the Goldman Sachs name-dropping certainly sounded the alarm bells. Google the words “Jon Corzine MF Global,” and you know why; more on that case below.

And because I never endorse any product or service I wouldn’t use, I never signed up for their affiliate program either. So, I hope my readers didn’t invest with BlockFI because BlockFI just declared bankruptcy on November 28. This makes me wonder: do I have to pay back the value of the two beers I had at the event to the bankruptcy administrator? It would be only a drop in the bucket, but hey, every dollar helps.

But let’s move to FTX…

What went wrong at FTX?

Normally brokerage companies and exchanges don’t go bust. Running a brokerage or an exchange is actually a relatively safe and profitable business. You should have relatively little direct market risk. You make money off the transactions of your trading customers. Rain or shine, bull or bear market. There could be two scenarios where an exchange gets in trouble: 1) trading volume declines so much that the commissions don’t cover your operating expenses, and 2) in derivatives markets, exchanges must pay close attention to participants’ risk-taking. If a trader ever fails to come up with the money to pay his/her counterparty, then the exchange would be on the hook for the losses. That’s why you have daily mark-to-market and strict margin constraints when trading derivatives.

Obviously, FTX failed for other reasons. Before FTX was even founded, SBF started the crypto hedge fund Alameda Research. It started as a profitable small crypto hedge fund arbitrating price differentials between exchanges. For example, buy Bitcoin at one exchange and sell it elsewhere at a higher price. In the heydays of the crypto craze, even a plain long-only crypto strategy would have made you double- and even triple-digit returns every year. But we all know what happened; as the crypto market matured, many low-hanging fruits, like the price differential arbitrage, were, well, arbitraged away. Long-only strategies suddenly lost money. Yield-farming is often just a Ponzi Scheme.

In the civilized world, there should have been a strict firewall between the FTX exchange and the Alameda hedge fund. But not in the crypto wild west. Apparently, Alameda had “borrowed” customer funds from the FTX brokerage/exchange. Borrowing the funds, even when able to pay back the money eventually, is already a big no-no. Borrowing the money, losing it on risky crypto bets, and then not being able to pay it back is even more criminal.

In any case, let’s look at how the FTX collapse is worse than the Madoff scandal…

1: Hedge fund investors should expect losses. Money deposited in a brokerage account should be safe!

If you invest in a hedge fund, you pretty much sign away all your rights. Hedge fund investments are often also very illiquid. There is relatively little investor protection, which is one of the reasons hedge funds are normally reserved for a select small number of sophisticated, high-net-worth individuals. You need to certify minimum net worth and/or income levels to show that you are an accredited investor, which the SEC defines as someone with a…

“Net worth over $1 million, excluding primary residence (individually or with spouse or partner) [and/or] Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expects the same for the current year”

Source: SEC

FTX, on the other hand, marketed itself as a platform for the masses. No SEC certification required! People were encouraged to deposit their paychecks there. FTX would take the last few dollars from widows and orphans. So, even though the total size of the Bernie Madoff scheme was larger, the FTX scam seems more outrageous. It’s like comparing two fatal accidents, one at a base jumping event and one at a chess tournament. Both are tragic and sad, but adjusting for your ex-ante expectations, a fatal accident at a chess tournament is more outrageous!

That said, there has been one prominent case of a brokerage going bust. MF Global used a playbook similar to SBF: illegally borrow client assets to fund proprietary trading activities. When losses piled up in November 2011, the fraud was exposed. Investors holding accounts at MF Global were eventually made whole, but it took several years to sort things out. The CEO at MF Global at that time? Jon Corzine, a former Goldman Sachs executive. So, when the BlockFI people started the name-dropping and “former Goldman Sachs” came up, I thought, “Thank you, but no thank you.” And I also noticed that BlockFI’s Chief Compliance Officer was a former MF Global compliance analyst (during the time the MF Global fraud was going on!). You can’t make this up! My appetite for crypto went from “low” to “hell, no” at that point.

2: Calling FTX/Alameda a Ponzi Scheme is an insult. To actual Ponzi Schemes!

First, in a Ponzi Scheme, a portion of the fault always lies with the victims; sorry to say that! Clients fell for a “too-good-to-be-true” pitch of outlandish returns. But FTX customers merely put their money into a USD or stable-coin cash balance account and/or kept their volatile crypto in FTX accounts. In a traditional brokerage company, your cash balances and money market funds are normally FDIC-insured. And you would expect risk from underlying assets but not from an exchange or brokerage company going bust and sinking your investments in the process. A brokerage company has to hold my assets strictly separate from its own balance sheet at a third-party custodian. Of course, one can blame the FTX victims considering that everything crypto is unregulated. But I’m sure many victims were lured by celebrity endorsements and the impression that FTX, as one of the major players, works just like all the other brokers and exchanges.

Second, the Bernie Madoff Ponzi scheme did not cause anything close to a total loss. That’s because Bernie Madoff didn’t invest the funds entrusted to him. Rather, he paid back early investors, which is the definition of a Ponzi Scheme. True, money likely went to fund Bernie Madoff’s lavish lifestyle. But also remember that Bernie already had a legitimate business that probably paid a good chunk of his bills, so he might not have squandered that much client money. So, a good chunk of the lost client money has been clawed back from earlier clients that cashed out their ill-gotten phantom profits before the collapse. Indeed, more than a decade after the collapse, entities representing the Madoff victims are still busy filing lawsuits and clawing back money. The most recent estimate I could find was from September 2022, announcing that another $372m of forfeited funds were added to the Madoff Victim Fund, bringing the recovery ratio to over 88%.

Even an 88% recovery ratio is still a tremendous loss for most investors. That’s because you will never recapture your phantom capital gains, only 88% of the principal you handed over to Bernie. In other words, your loss is not just 12% of your initial investment but also a significant opportunity cost because a) you might have invested with Madoff for years or decades before the failure and missed out on the capital gains of the past bull markets, and b) it took you years to get that money back. But under the circumstances, Madoff victims got off relatively easily. It’s likely the highest recovery ratio ever recorded in a Ponzi Scheme.

In contrast, FTX clients will probably suffer more severe losses. First, both FTX and especially Alameda Research seem to have, shall we say, very unconventional accounting systems. As in, no accounting systems at all. The bankruptcy administrator stated that this is the worst mess he had seen – and he had worked on the Enron bankruptcy. So, even if ill-gotten gains had been paid out to hedge fund clients, it might be hard to find the proper records if SBF used “Snapchat accounting.” But it’s more likely that money is lost permanently. Money likely went into losing bets on crypto speculation and bailing out smaller crypto players that are equally bankrupt, like BlockFI, Voyager, etc. You are not going to recover much there.

3: The number of FTX victims is likely much larger

When the Madoff fund blew up, most people had never even heard about it. The Madoff victim fund mentions 40,000 individuals benefiting from the recovery efforts, quite a large figure for a hedge fund. But even that number pales compared to the about one million FTX victims. And I won’t even count the additional victims associated with the FTX equity investors, like the Ontario Teachers pension fund. So, FTX certainly touches a lot more lives than Madoff, even though the total loss may be smaller.

4: FTX produced a lot more people with egg on their faces

The Bernie Madoff scandal was an embarrassment, mostly for the victims. And true, there was also the issue that the SEC had gotten numerous tips over the years that Madoff might be running a scam, most notably by Harry Markopolos. The SEC eventually launched an investigation, and – surprise, surprise – Madoff produced fake records to get the regulator off his back. It wasn’t the SEC’s finest hour. That embarrassment, though, pales in comparison with the current shitshow of morons, such as…

  • Venture capitalists. Sequoia Capital is one of the largest VC firms. They put out a cringe-worthy posh piece, “Sam Bankman-Fried Has a Savior Complex—And Maybe You Should Too,” on their page, which has now been deleted on their site but luckily, someone archived it here. Read it for a good laugh, but if you’re an FTX victim, keep some Pepto Bismol handy.
  • Other large institutional investors like Blackrock (iShares ETFs!) and the Ontario Teachers Pension Fund, one of the largest and most well-regarded and well-run public pension funds. Both were early investors in the FTX business.
  • Celebrities like A-list athletes (Tom Brady, Steph Curry, Shaq O’Neal, etc.) and comedian Larry David. Even though Larry, in the Superbowl commercial (linked here), very clearly pointed out his objection to crypto investing: “Naaaaah, I don’t think so. And I’m never wrong about this stuff. Never!”
  • Influencers, especially on YouTube, allegedly earned six-figure monthly affiliate revenues shilling the FTX and BlockFI platforms. But then again, they probably don’t even feel too embarrassed and simply move on to the next affiliate program. Did you know that you can buy a square foot of land in Scotland and then call yourself Lord or Lady? Oh, wait, that scam has been exposed now, too! But there must be some other scam of the day now.
  • Politicians. I won’t name names because these folks are too powerful. I don’t want my tax returns to show up in public.
  • Finance “experts.” Jim Cramer compared SBF’s efforts to bail out smaller crypto players to J.P. Morgan’s work stabilizing the U.S. financial sector during the 1907 banking panic. Or Kevin “Mr. Wonderful” O’Leary proclaimed – before November 2022 – that we can all trust SBF because his parents are law professors. That didn’t age well!
  • Forbes Magazine and others that put SBF on their magazine covers!
  • Authorities, especially the SEC (again!). Even though the SEC has been actively going after crypto scammers, they missed the biggest scammer right before their eyes. Cynics have argued that because of family connections and political contributions, the regulators put a blind eye to SBF/FTX.

For the record, though, here is one good guy, a Youtuber named Coffezilla. I’ve been watching his channel for more than a year, and he’s one of the few trustworthy YouTube financial influencers! Seven months before(!) the scandal, he pointed out that the FTT token business resembles a scam. Hats off to that guy.

This was published in April 2022, seven months before the collapse!

5: FTX has the potential to bring down an entire asset class

If a hedge fund fails, people hardly ever notice. It’s like a tree falls in the forest, and (almost) nobody is there to notice. And even in the case of the relatively large Madoff fund, there wasn’t necessarily an impact on the hedge fund industry at large. More than a decade after the collapse, the hedge fund industry is alive and well.

In fact, working in the finance industry at the time of the Madoff failure, I almost sensed the opposite effect: Madoff’s fund had posted positive returns month after month while the industry as a whole got clobbered during the Global Financial Crisis. The Madoff failure almost caused a sigh of relief in the industry because it shut down the clients’ complaints like “hey, can’t you be more like Bernie Madoff?!” once and for all.

It’s a different story with FTX. Failure after failure of smaller crypto exchanges culminated in one of the largest and most reputable exchanges going under. Even the remaining ostensibly legit and honest brokers like Binance and Kraken are feeling the pain of the “crypto winter” now. If you can’t trust FTX and BlockFI, then who can you trust? Unless you go for “cold storage,” which has its own problems, it appears that the only safe place to hold your crypto is again back at the mainstream financial institutions under full government control and supervision and with BNY Mellon, State Street, and J.P. Morgan as third-party custodians. But that defeats the purpose of crypto as a private decentralized currency out of reach of a nosy government. Then I might as well hold my assets at Fidelity with all the regulations and investor protection. Long live the U.S. Dollar!

But maybe I’m completely off base. Maybe the crypto experts among my readers can educate me about how to fix this PR disaster for the crypto world. Is there currently a way to hold crypto that is a) as private as crypto was initially intended and b) as safe as the third-party custody system in my brokerage account?

6: SBF and other FTX big-wigs might even avoid criminal prosecution

Admittedly, Bernie Madoff was handled with kid gloves, at least initially. Bernie wore an ankle bracelet and stayed at his posh NYC apartment between the revelation of the fraud in December 2008 and the revocation of his bail in March 2009. Eventually, justice was served in the form of a 150-year sentence. So, I’m amazed that at the time of writing this, at least to my knowledge, no arrest warrants and/or extradition requests have been issued for any of the principal figures of FTX. Whether you’re an FTX customer, or just a regular law-abiding citizen rooting for the integrity of the financial system, it feels unjust that SBF is still walking around freely in Nassau. Not only that, he was in a star-studded lineup of speakers at the “DealBook Summit” hosted by the New York Times on November 30:

Initially, I thought this was a deep fake joke. Then I expected SBF to be uninvited from the event. But to everyone’s surprise, the event went as planned, and SBF dialed in via Zoom. And if you thought that the host, Andrew Ross-Sorkin, would ask some hard-hitting questions about where the roughly $10b of client money went, you’d be sorely disappointed. It was a softball interview. There were a few semi-hard questions, but there was no follow-up after SBF’s evasive answers. The low point of the interview was when SBF made light of the situation and quipped, “Look, I’ve Had a Bad Month!” to the great amusement of the interviewer and the audience. It was a surreal interview and an utter embarrassment for Ross-Sorkin and the New York Times. Jerry Springer would have done a better job.

One consolation is that SBF’s extreme urge to talk to the public might eventually be his undoing. Everything he says “can and will be used in a court of law,” and I hope the authorities are listening. Maybe this is all a grand plan to give SBF more rope to hang himself before the FBI makes its move. I’m the eternal optimist here. But maybe, with his political connections, he might only face civil penalties like Jon Corzine before him. At least Bernie got a 150-year sentence in the Federal Prison System, where he died in 2021. SBF might get a job with CNBC! Well, he can’t be worse than Jim Cramer and Andy Ross-Sorkin. But this injustice would still be the ultimate way FTX/SBF is worse than Bernie Madoff.


OK, time to wrap up. I wanted to write a short post pointing out that FTX is worse than a Ponzi Scheme. That’s because a Ponzi Scheme can be unwound if we have complete records and we can find the early investors that cashed out their phantom gains. And I made a rambling 3,000-word post out of it. Hope you still enjoyed it!

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