This article is written by Arka Biswas pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions). This article discusses how the FTX crash can be a lesson for the Indian crypto regime.
This article has been published by Sneha Mahawar.
On November 11, 2022, FTX, a significant cryptocurrency exchange, and FTX.US, its American subsidiary, filed for Chapter 11 bankruptcy. Sam Bankman-Fried, the company’s former founder and CEO, was detained on December 12 in the Bahamas and extradited to the United States. He was charged with eight crimes, including wire fraud and conspiracy to deceive investors. He later entered a not-guilty plea to all of them.
The Securities and Exchanges Commission (SEC) filed a lawsuit alleging that Bankman-Fried exploited client cash as a “personal piggy bank” to invest in real estate and contribute to political campaigns.
John J. Ray III, the previous CEO of FTX, oversaw the bankruptcy and liquidation of the famed energy conglomerate Enron roughly twenty years ago. Ray revealed the depth of FTX’s unclear financial situation in the bankruptcy declaration on November 17, noting a “complete failure of corporate controls” and a “complete absence of trustworthy financial information.”
The FTX crisis had wide-ranging effects on the whole cryptocurrency market as exchanges and cryptocurrencies with exposure to FTX or its native token, FTT, saw a decline in pricing and other financial difficulties.
What happened to FTX
Due to a lack of liquidity and poor money management, the US plummeted, which was followed by a significant amount of withdrawals from uneasy investors. FTT’s value fell, dragging other currencies down with it, including Ethereum and Bitcoin, which as of November 9, hit a two-year low. The FTX failure has impacted other exchanges, notably BlockFi, which declared bankruptcy on November 28.
Initial reports and sales: November 2–November 8
Sam Bankman-Fried launched the now-defunct FTX cryptocurrency exchange in 2019. He presided as CEO from January 1 to November 11, 2019. By volume as of Nov. 9, the exchange, which had its own token called FTT, was the fourth-largest cryptocurrency exchange.
Alameda Research, a cryptocurrency trading company that Bankman-Fried also started, has a problematic balance sheet as of Nov. 2, according to CoinDesk. According to research, FTT is worth billions of dollars and is its biggest asset.
Changpeng Zhao, popularly known as CZ, the CEO of competing exchange Binance, tweeted on November 6 that he intended to sell out Binance’s stockpile of FTT due to “recent revelations that have come to light,” alluding to the CoinDesk article from November 2 about FTX and Alameda’s muddled money. The collapse of TerraUSD and LUNA in 2022, which wrecked the cryptocurrency market and lost investors billions of dollars, was likened to FTX’s predicament by the speaker. However, such actions usually are not made public.
Zhao’s revelation caused a sharp drop in the value of FTT during the next day as concerns developed that FTX lacked the liquidity required to support transactions and remain afloat. Other currencies, including BTC and ETH, also saw a dip in value as Bitcoin hit a two-year low. In a tweet on November 10, Bankman-Fried reported that $5 billion had been withdrawn from the platform on November 6.
Withdrawals freeze, a deal falls through: On Nov. 8–11
Zhao and Bankman-Fried agreed for Binance to buy the FTX branch outside of the United States. On November 8, the CEOs of the exchanges agreed to a non-binding statement of intent, basically pledging to save the faltering exchange and avert a further market catastrophe.
On November 8, FTX stopped all withdrawals from non-fiat customers. FTX’s liquidity problems were explained in a series of tweets by Bankman-Fried, who also promised greater openness.
Binance pulled out of the transaction. Zhao said on Twitter on November 9 that Binance has finished its “corporate due diligence” and will not be purchasing FTX. Zhao said in a tweet that his choice was influenced by news stories about “mishandled customer funds” and “alleged U.S. agency investigations.” In a mysterious tweet that ended with the words, “Well played; you won,” Bankman-Fried seemed to be alluding to Zhao’s impact on FTX’s decline.
Hacking and bankruptcy: November 11
On November 11, FTX made the voluntary Chapter 11 bankruptcy filing for FTX, FTX.US, and Alameda. In contrast to Chapter 7 bankruptcy, which involves liquidating assets, Chapter 11 bankruptcy enables businesses to restructure their debt and carry on with operations.
FTX.US briefly stopped accepting withdrawals on November 11, when FTX announced its bankruptcy, despite prior assurances that FTX.US was unaffected by FTX’s liquidity issues. Later, withdrawals were reopened. On the evening of November 11, there appeared to be a hack that emptied US wallets. According to CoinDesk, more than $600 million was stolen from the wallets. On its help page on the messaging app Telegram, FTX announced the attack, writing, “A hack was made on FTX. FTX applications include viruses. Take them out. The chat window is open. Avoid visiting the FTX website as it might download Trojans.” Trojan horses are malware that poses as trustworthy programmes.
Hackers were reportedly attempting to access FTX-related bank accounts, according to a Twitter user. The US Plaid, a company that links consumer bank accounts with financial apps, blocked FTX’s access to its products in response to “concerning public reports,” even though they could not see any evidence that their tools had been misused illegally. The same evening, FTX general counsel Ryne Miller announced on Twitter that due to the “unauthorised transactions” or suspected breach, the business would swiftly move any remaining assets to cold storage, which is inactive.
The fallout: On Nov. 14
The Financial Times released FTX’s balance sheet, which was dated Nov. 10 and showed $9 billion of liabilities and only $900 million in easily tradable assets. It had a jumble of entries, one of which was a “hidden, erroneously labelled ‘fiat@’ account” with a negative $8 billion balance.
In the Bahamas, where that exchange is situated, FTX is now the subject of a criminal investigation. According to CoinDesk, Bankman-Fried resided there with nine coworkers and intermittent romantic partners who assisted him in managing his enterprises. Former FTX workers who were questioned by CoinDesk said that only this tight circle was aware of the complicated financial situations involving the firms.
In a court document submitted to the District of Delaware’s U.S. Bankruptcy Court on November 17, FTX’s new CEO, Ray, gave a bleak picture of the company’s financial situation. According to him, FTX failed to maintain “appropriate books or records, or security controls, with respect to its digital assets.”
There is “credible evidence,” according to an emergency motion attached to the FTX bankruptcy filing on November 17 that Bahamian officials gave Bankman-Fried instructions to access FTX monies “unauthorizedly” and transfer them to the Bahamian government. These transfers would have taken place around the same time as the hack. Thus it is unknown if or when they occurred. These reports appear to be supported by a news statement from the Bahamas Securities Commission.
Authorities in the Bahamas detained Bankman-Fried on December 12 in response to a request from the United States government for his extradition because of eight criminal offences, including wire fraud and a conspiracy to deceive investors. The House Financial Services Committee had scheduled a hearing with Bankman-Fried for the next day.
Instead of Bankman-Fried, FTX CEO John J. Ray III gave testimony to the House committee on December 13. He stated to MPs that FTX had “absolutely no record-keeping.”
Federal prosecutors stated that on December 19, former Alameda Research CEO Caroline Ellison and co-founder of FTX Gary Wang entered pleas of guilty to “charges arising from their participation in schemes to defraud FTX’s customers and investors, and related crimes,” In the FTX case, the two are assisting the government.
Bankman-Fried appeared in a New York court on January 3 and entered a not-guilty plea to all of the accusations levelled against him. Due to Bankman-determination Fried’s to dispute the accusations, a criminal trial over the situation may take place.
Lehman Brothers’ Moment
The cryptocurrency market is infamous for its rapid turns, roller-coaster values, and fortunes that appear and go quickly. However, what occurred this week was insane, even by crypto standards. The news of FTX, one of the biggest cryptocurrency exchanges in the world, collapsing may seem dull or esoteric to people who do not follow the cryptocurrency market; they may be the kind of people who would happily scroll past the news in favour of reading about Elon Musk’s most recent Twitter outburst.
But among the cryptocurrency community, it is already being referred to as the sector’s “Lehman moment” in reference to the 2008 fall of Lehman Brothers, which sparked a worldwide financial crisis and made it plain to laypeople exactly how much danger Wall Street was in.
Is Lehman, however, the appropriate comparison after all? After all, the collapse of the illustrious investment bank affected the whole economy, not just a small portion of it. There is a scale issue. According to some estimates, FTX may have cost investors between $10 billion and $50 billion. Lehman, however, came to represent the subprime mortgage crisis, which the GAO estimates resulted in trillion-dollar economic losses.
“The demise of FTX may impact the cryptocurrency market, but it is not taking down the established financial system. In this regard, it reminds me more of Enron/Theranos/Madoff than Lehman”, Hanna Halaburda, Associate Professor at New York University’s Stern School of Business (Department of Technology, Operations and Statistics), said to Cointelegraph.
However, the term “Lehman moment”, as it is now used, may not signify “spillover” to the actual economy, according to Elvira Sojli, an associate professor of finance at the University of New South Wales.
What Yellen means when she refers to a “Lehman moment” is not that Wall Street would see a spillover effect onto Main Street. She is alluding to the Lehman Brothers collapse-related restructuring and increased regulation in the financial sector.
However, even this weaker Lehman analogy might not be valid. What if the FTX case is just one of outright fraud and not one of insufficient or inefficient regulation, as with Lehman Brothers? If so, it may resemble Enron’s bankruptcy in 2001, which was the biggest in American history at the time. In other words, the executives of FTX and Enron both knew what they were doing was unlawful and illegal, yet they nonetheless carried it through.
Lesson for India
For governments all across the world, including India, the FTX explosion’s wide blast radius is a sobering realisation. This sends the Indian government a loud and obvious message: regulate cryptocurrencies or outright outlaw them.
Let us examine why. With $1.9 billion in investor wealth under management, FTX was the second-largest cryptocurrency exchange in the world.
Investors cannot immediately get their money back, not even for a huge company like FTX operating in an established market with superior oversight. Investors in FTX might lose their money or face a protracted wait.
What if a similar incident occurs in a nation like India where the government’s ability to oversee such organisations or handle a crisis is in doubt?
At the time, there were no cryptocurrency-related laws in India. This makes it possible for cryptocurrency businesses to attract new investors. Despite the fact that the industry is unregulated, one of the biggest cryptocurrency exchanges in India claims that investing in cryptocurrencies is lawful. Such ambiguous statements are readily misleading to the ordinary investor.
Experts have repeatedly cautioned that, in the lack of government and Reserve Bank of India rules for these instruments, Indians investing in cryptocurrencies may be making a very hazardous gamble. A concerned RBI has advised investors to steer away from the cryptocurrency frenzy, and one of the deputy governors has even called for its outright prohibition. According to deputy governor T Rabi Sankar in February 2022, “Investors who have purchased these products have done so with their eyes fully open, at their own risk, and do not justify any regulatory dispensation.”
The RBI forbade all banks from conducting cryptocurrency business in 2018. However, following a petition from the Internet and Mobile Association of India, the Supreme Court reversed the restriction (IAMAI).
The SC ruled that while the RBI had the authority to regulate virtual currencies, the business of dealing in these currencies should be treated as a legitimate trade that is protected by the fundamental right to engage in any occupation, trade, or business under Article 19(1)(g) of the Constitution in the absence of any legislation. As a result, only the government is now able to remedy the issue by passing legislation that either limits activities or outright prohibits cryptocurrencies.
If the government decides to outlaw cryptocurrencies in India or if there is a significant collapse or scam like the FTX, investors in cryptocurrencies may be at severe risk because there is no regulatory certainty.
Future of cryptocurrencies vis-a-vis the abrupt collapse of FTX
What will happen to FTX’s clients and their funds first? Deposits on cryptocurrency exchanges are not government-insured, unlike deposits in conventional bank accounts, and it is unclear whether FTX has enough assets to compensate its surviving clients. Investors could be forced to battle for their money — or what is left of it — through the courts if the company declares bankruptcy, as cryptocurrency companies Voyager Digital and Celsius Network did this year.
Second, is the regulation of cryptocurrencies in jeopardy? After all, FTX was one of only a select few U.S. cryptocurrency companies that had extensively engaged in lobbying, and Mr. Bankman-Fried was regarded as a “white knight” with the best chance of convincing politicians who were dubious of the value of cryptocurrency. Now that such attempts seem to have, at best, stagnated, officials who wish to depict cryptocurrency as an unruly Wild West will have another example to cite. It was a “truly sickening news day- can not even begin to assess the potential damage our industry will have to face,” cryptocurrency investor Katherine Wu tweeted on Tuesday.
Third, would the fall of FTX trigger a wider market failure, as did the bankruptcy of Lehman Brothers in 2008?
The story has already spread to the rest of the cryptocurrency market. On Tuesday, the prices of Bitcoin, Ether, and Solana—a cryptocurrency that FTX has supported—all decreased. Solana’s price plummeted by almost 20%. Additionally, shares of publicly traded cryptocurrency firms like Coinbase fell. Sequoia Capital, Lightspeed Venture Partners, and SoftBank were among the investors in FTX, and it seems probable that they will lose most or all of their money. It could take some time before we fully understand the magnitude of the damage, considering how closely FTX was tied to the rest of the crypto ecosystem.
Of course, the expectation is that the consequences of FTX’s failure would mostly be confined to the cryptocurrency business, as opposed to 2008, when Wall Street’s collapse triggered a worldwide financial crisis that resulted in millions of Americans losing their jobs and homes. However, it is still too soon to know.
What will happen to Mr. Bankman-Fried, finally? He was the unquestioned king of cryptocurrency up until last week and, with his significant contributions to Democratic politicians and causes, a rising political force in America. Before the Binance sale, his fortune—which was pegged at more than $15 billion—had supported philanthropies, media outlets, and businesses both inside and outside of the cryptocurrency space.
In light of everything said above, it is evident that neither the underlying technology nor the industry as a whole could be seen as a driver, much less the cause, of FTX’s collapse. If the current allegations are true, the cause will seem to be fairly straightforward: massive misconduct on the part of a group of people in charge of the company who managed to allegedly break almost every rule and regulation that they were supposed to follow when offering services to their clients.
Having said that, responses from those in traditional finance who claim that “crypto cannot be trusted” and that this sort of thing was inevitable will be seen as rather malicious and inaccurate if one considers all the “hiccups” that the financial services industry has experienced in recent decades, from the collapse of Lehman Brothers to the countless scandals that the world’s largest investment banks always managed to survive.
While DeFi and self-custody may be ideal safe harbours for some groups of investors, the sector has to win greater public confidence in order to achieve broad acceptance. To make this happen, more credible centralised venues that can handle client assets in line with the stated terms of service and relevant laws and regulations must be demonstrated to the public. It goes without saying that a clearer regulatory environment in important jurisdictions that offers sufficient regulatory requirements on protecting and managing the assets of customers, along with appropriate regulatory enforcement and supervision of required entities, can play a crucial role in this process.
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