FTX spent its customers' money. That was the business

FTX filed for Chapter 11 bankruptcy on 11 November, and its collapse will go down as one of the most brazen balance-sheet frauds in modern business. In forty-eight hours a company once valued at thirty-two billion dollars, praised by Silicon Valley venture capitalists and big asset managers as the grown-up way into digital assets, became a hole several billion dollars deep. Strip away the talk of decentralised finance, tokens and algorithmic arbitrage and the failure was entirely conventional. FTX took the deposits it held for customers and spent them covering the trading losses of an affiliated proprietary trading firm.

For centuries the first rule of custodial brokerage has been that client money is kept apart. An exchange supplies the matching engine, the margin rules and the settlement machinery. It does not bet on markets with the cash and securities it holds in trust. FTX tore that rule up. It secretly gave Alameda Research, its proprietary trading arm, an unlimited and uncollateralised credit line, and Alameda drew billions of dollars of client cash to pay for illiquid speculative investments, political donations and property purchases.

Nine days from leak to filing

The unravelling began on 2 November, when CoinDesk published details of Alameda's balance sheet showing that a large share of its assets consisted of FTT and other tokens closely tied to FTX. On 6 November the chief executive of Binance, the largest exchange, said it would sell its FTT holdings. Withdrawals from FTX surged. On 8 November Binance signed a non-binding agreement to buy its stricken rival, and on 9 November it walked away, citing what it had found in due diligence and reports of mishandled customer funds.

By the time of the filing, Sam Bankman-Fried had resigned as chief executive. His replacement is John Ray, the restructuring specialist who oversaw the unwinding of Enron, an appointment that tells creditors what kind of process to expect. The filing covers FTX, its American arm, Alameda and a long list of affiliates, which means sorting out who owes what to whom will take years.

Collateral printed in-house

The transfers rested on collateral of remarkable fragility: FTT, the platform's own utility token. Alameda and FTX created billions of dollars' worth of FTT from nothing, gave the tokens a market value based on thin secondary trading, and then pledged them back to FTX as collateral against customer deposits. Nothing was being intermediated. The arrangement was a closed loop, and the balance sheet it produced was fiction.

It held together while the token price stayed high and customers asked for little of their money back. Then rival exchange operators said publicly that they would sell their FTT holdings, and the price collapsed. The paper equity propping up Alameda's multi-billion-dollar liabilities disappeared overnight. When retail and institutional clients rushed to withdraw, the exchange found itself eight billion dollars short of cash. The customer money had long since been turned into shrinking venture stakes, real estate and losing trades.

The mechanism is the same as any run on a bank that has lent out deposits it promised were available on demand. The difference is that a bank's loans are at least to outside borrowers and backed by capital; FTX's were to itself, backed by its own scrip. When the scrip lost value, the losses and the withdrawals arrived together, and there was no equity layer in between to absorb either.

A precedent from 2011

Commingling client money is an old offence with a recent example. When MF Global, a futures broker run by a former governor of New Jersey, failed in 2011, more than a billion dollars of segregated customer funds turned out to have been used to meet the firm's own obligations. Customers eventually got their money back, but only after a long liquidation of a firm whose remaining assets were mostly liquid securities.

FTX customers are likely to fare worse. The assets bought with their money include illiquid venture stakes, tokens with no market outside FTX's own ecosystem, and property in the Bahamas, where the company is based. A liquidator can sell a government bond in minutes. A stake in an early-stage crypto start-up may be worth little to anyone once its most prominent backer is bankrupt.

Investors skipped the checks

The episode is also an extraordinary failure by traditional finance. Leading venture firms, sovereign wealth funds and established asset managers put hundreds of millions of dollars of equity into FTX without asking for basic corporate hygiene. The company had no formal board of directors and no internal audit department, and it kept books that an ordinary high-street shop would reject. Investors took a reputation for technical genius in place of checking the balance sheet. Sequoia Capital, one of its best-known backers, said on 9 November that it had marked its stake down to zero.

The damage will spread through crypto for quarters to come. BlockFi, a lender that FTX had rescued in the summer, paused customer withdrawals on 10 November. Lenders that made unsecured loans against crypto collateral will be pushed into insolvency. Asset managers will write their stakes in FTX down to zero. Regulators around the world will probably move fast to demand strict segregation of custody assets and full-reserve rules for digital asset intermediaries.

Proof of reserves is not enough

Rival exchanges have hurried to promise proof-of-reserves disclosures, publishing the wallets that hold customer assets. The idea has merit, and any disclosure is better than none. Its limit is that it shows only one side of the ledger. An exchange can prove it holds a certain quantity of tokens at a moment in time while saying nothing about its liabilities, whether those tokens were borrowed for the snapshot, or whether an affiliate has a claim on them.

The stronger objection to this column's conclusion is that most exchanges are not FTX, and that a well-run, audited venue with segregated custody should be no riskier than a traditional broker. That is true, and it is exactly the point. The protection comes from segregation and audit, the same safeguards that conventional brokerage has used for a century, not from blockchain transparency.

The lesson is as old as banking. An intermediary that mixes customer balances with its own trading is an unhedged Ponzi scheme that lasts until the first run, and FTX customers found that out in two days; any exchange still lending client money to an affiliate is probably next. Faster digital settlement sped up the unwind, but FTX is simply the latest case of the oldest balance-sheet theft there is, and its customers should expect to wait years for a partial recovery while the lenders that dealt with Alameda face their own runs within weeks.