FTX was scrambling to plug the hole in their balance sheet, but ended up filing for Chapter 11 bankruptcy. The Binance Letter of Intent (“LOI”) was contingent on a Due Diligence (“DD”) process that fell through within 36 hours. What made them walk away from the deal?

According to a bare-bones legal filing in the U.S. Bankruptcy Court in Delaware, the range of FTX assets and liabilities were stated to be between $10 to $50 billion. Using the expertise of a former “big 4” auditor to examine the numbers (remotely), this article estimates the net deficit to be in the region of $6.5 billion.

To caveat:

• This is at a point in time, and given the pace with which the news is evolving, there may be elements that are outdated by the time it is published and read.

• It also relies on the accuracy and completeness of information obtained from external sources, such as the Financial Times (“FT”), and announcements around known subsequent events.

• Background

• Approach

  • Understand the Business

  • Identify the Key Risks

  • Apply Materiality

  • Form an Opinion

• Application to FTX

  • Assets

  • Liabilities

  • Related Party Relationships

• Other Considerations

• Closing Remarks (TL;DR)

For background on the timeline of events, this has been summarized on the following FTT price chart.

The following approach is typically taken when assessing the numbers. For those interested in the assessment, skip to “Application to FTX”.

Before we can identify the key risk areas, we first need to understand the business (“UTB”) to properly grasp how certain accounts and processes can be inherently more risky than other areas.

In the context of FTX this would be:

• The relationship between Alameda and FTX.

• The related party transactions, how they are recorded and processed in the company financials.

• The other parties within the FTX ecosystem, including creditors, debtors, and those potentially affected by contagion that could flow from the collapse.

• The systems used and the integrity or reliance we can place on the completeness and accuracy of the data being provided.

• The tone from the top and how this permeates through the company. Is it a culture of hiding mistakes and errors, or is it an environment that fosters how the information flows to the top for informed decision making?

Once we understand the business, we can focus our resources on the highest-risk areas. In the context of FTX this would be:

• The existence, accuracy/valuation, and rights in relation to its assets.

• The completeness, accuracy/valuation, and obligations in relation to its liabilities.

• The related party arrangements, and how they impact the numbers.

Some key focus areas in the context of FTX could be:

• The related party transactions with Alameda.

• The processes around its clients’ deposits and whether these were mismanaged, so as to identify further implications/ramifications and associated liabilities.

• The FTT holdings and other impaired assets that would need to be marked down to fair value to establish how big the “black hole” in the balance sheet is.

• The extent of its liabilities and whether these can be met with its liquid assets. The difference between the verified assets and complete list of liabilities is the black hole and would dictate whether an acquisition is feasible.

Materiality can vary from one audit firm to the next, but depending on the type of business can be based on (example %):

• Profit before tax (5%)

• Revenue (1%)

• Total Assets (1%)

• Net Assets (1%)

The percentage used can vary depending on several factors, but for a high-profile entity with known issues, we would use a lower materiality threshold given there would be a higher likelihood of error. Similarly, if the company has established controls and processes, we could take a higher threshold, as we can rely on their processes for a reasonable level of assurance.

For FTX, we would probably veer towards using a low threshold based on its assets. The volume and associated revenues would likely be too high to pick up any meaningful balances. The company is realistically in a net deficit (black hole), given the illiquidity and overstatement of some tokens on its balance sheet. But we can use the pre-adjusted net assets as a base before we kick the tires and make the adjustment.

1% of net assets ($7.2m) could be selected as planning materiality. Then we would apply various reductions on this at the account level to accumulate any misstatements we find. This would then be totalled up and compared to a “tolerable error” or “performance materiality.”

Once we have applied all the above to FTX, we can then form a conclusion as to whether the numbers are reasonable and free from material misstatement due to fraud or error.

We’ve managed to obtain consolidated financials from FTX + Alameda to perform the above procedures from the FT.

Let’s take a look.

From reviewing the FTX balance sheet, there are $6.6 billion of proposed downward revaluations leading to an overall net deficit (black hole) of $5.9 billion.

There is a further $0.6 billion of misappropriated assets after the Chapter 11 bankruptcy announcement. This results in a final net estimated deficit of $6.5 billion.

To put this plainly: of the estimated $8.9 billion liabilities, less than $2.4 billion will be returned to these creditors. That equates to 27 cents on the dollar, excluding legal fees and interest accrued. It’s extremely unlikely that customer deposits will receive anything in return.

The discounts and deductions are associated with:

• Liquidity;

• Duration, or assets being locked for a period;

• Known impairment of assets, i.e. the market value is below the current value recorded, and;

• Known misappropriation of assets.

Let’s look into why these adjustments have been proposed for each line item.

Risk: Are these assets overstated, does FTX have the rights to those assets, and do the assets exist?

As at today, there are indications of impairment given the economic downturn, so the valuation of these assets would need to be further marked down to fair value using a mark-to-market adjustment.

There are some assets that are locked for a period of time that could arguably be written down.

The FTT flywheel suggests that a lot of these tokens have in fact been printed out of thin air and used as collateral for loans. Those tokens are worth a fraction of the value at the time of the CoinDesk article.

Many of these liquid assets are able to be sold with little to no market movement in price.

A - Robinhood

The main challenge here is the “HOOD” investment of $472m which equates to a 7.6% stake in the Robinhood investment platform. FTX would be unable to sell this portion of equity without moving the market so would need to execute with an over the counter (“OTC”) trade.

As such, recording 100% of this balance would require finding a buyer for the entire holding. An arbitrary discount of 10% has been applied to this to allow for the illiquidity.

Now this is where the real discounts and high-risk areas for assets appear. Typically we would categorize these as level 2 or 3 investments, given the lack of observable inputs. What this means is that there is illiquid, relatively opaque OTC transaction activity as opposed to readily traded assets on an open market.

The big 4 audit firms would involve valuation specialists to benchmark other similar assets to establish an appropriate value. This can be subjective from one experienced valuations partner to the next, with a peer review from a second partner often being included on high risk or complex engagements. This article performs an “illustrative” line by line assessment of what a discount could be calculated as, but will change when specialist involvement is sought.

B - FTX Token

Why did the FTT token have value?

• A third of the commissions received from transaction volume was used to buy back the token. Tokens redeemed were burned, acting like a deflationary mechanism, reducing the supply and hence increasing the inferred value.

• Reduce trading fees on FTX if used to pay (rather than using USDC, for example).

• Profit sharing mechanism - Profits from market movements are distributed evenly to holders.

FTX is now not operational, and thus there is no volume commission, trading activity, nor profit distribution. The current market value of FTT ($1.33) is associated with the potential future recovery of the token, which is speculative at best.

The FTX token (“FTT”) has experienced a 95% reduction in value to a current price of $1.42 from a pre-announcement value of $26. The total market cap is currently $441m, of which Binance owns a significant portion, so arguably the token holding value is close to zero,particularly given that the exchange has ceased operating so the benefits of the FTT asset are close to nil. As such, a $554m downward adjustment has been made.

C - SRM Token

The SRM token balance is heavily overstated. The recorded balance is in excess of the coin’s market cap of $65m.

There has since been discussion of an SRM token fork following rumors of additional tokens being printed. Regardless, selling the tokens on the open market would be difficult given the lack of liquidity.

Valued to nil, adjustment downwards of $2.2B.

D - Locked USD

Arguably this is a relatively liquid investment in comparison to other tokens listed within the same bucket. The issue is the lock period and hence one could sell this asset OTC at a slight discount to compensate for the duration risk.

Arbitrary discount of 10% applied, resulting in a $50m downward valuation.

E - APT token

Aptos has a market cap of $548m, of which FTX holds a significant portion of this.

It would be incredibly difficult to shift this investment on the open market without forcing sell pressure down close to zero, particularly with limited bidding. For the purpose of this analysis we have discounted it heavily at 90%, or $280m downward revaluation.

F - OXY Token

The OXY token is Oxygen, which is a DeFi prime brokerage service built on Solana and powered by SRM’s on-chain infrastructure.

FTX is an early investor on the SRM DEX. The total market cap of OXY is $820k, therefore a revaluation downward of 90%, or $48m is appropriate to account for the lack of liquidity/not being able to sell a significant amount of the tokens without moving the market.

G - STG Token

The Stargate Finance token is majority owned by FTX and hence being able to find a buyer without moving the market would be difficult. Downward revaluation of $45m to nil due to lack of liquidity.

H,I,J - ETHE, FIDA, MSOL

All of these tokens are recorded in excess of the total market capitalizations, hence all have been revalued down due to liquidity concerns and the unlikely odds of finding an OTC buyer.

Combined downward revaluation of $116m to nil.

K - ASD

AscendEX is a global digital asset financial platform founded by a group of Wall Street quantitative trading veterans.

FTX owns most of the token holding, hence the stock would be difficult to liquidate. Liquidity discount applied for the associated liquidity risk. Downward revaluation of 90%, or $31m.

L - BITW

Bitwise 10 crypto index fund has low volume traded, but the fund is being actively traded on the open market. Market cap unknown, but applied a 50% discount to allow for liquidity risk, resulting in a $13m downward revaluation.

M - Other

The above tokens were material enough to split out, but most were either highly illiquid, trading with minimal volume, or expected to be difficult to sell without an OTC counterparty. “Other” tokens tend to be smaller numbers and even less liquid, and as such they have been revalued downward by 90% or $16m.

N - GBTC

Greyscale Bitcoin Trust (“GBTC”) has a lockup period. As such, a discount of 20% has been applied for the duration risk. This equates to a discount of $0.7m.

These highly illiquid investments have been written down to nil.

While most financial statements are prepared on a going concern basis, FTX is not a going concern and hence a wind up basis is required. This results in assets being valued at a different level compared to how they would be valued in a typical solvent entity. Even under going concern, one would value level 3 investments, like these opaque VCs, with discounts for liquidity and duration discounts.

There are “Other Venture” capital investments included in this illiquid asset bucket. Likely related to the FTX Ventures investment vehicle. Most of these funds could have already been extended to the projects or entities. Without knowing the individual contract terms, it is difficult to establish whether the funds can be clawed back or recovered. As such, until proven otherwise, this would typically be revalued downward.

According to Crunchbase, there have been 48 companies, totalling $2.3 billion, that FTX Ventures has invested in since its inception in January 2022.

The other listed ventures are in regards to an AI research company, high frequency market data for DeFi applications, tokenized TWTR (Twitter) stock, and a speculative play on an election bet. It’s difficult to establish whether these assets have any immediate realizable value given the requirement to find an OTC counterparty.

The nature of VC funding is to invest in the early phase of a company’s lifecycle, which entails a high degree of risks. The corporate failure rate of web2 VC funding is 75%, with crypto arguably being higher. Most VC investments won’t see a return until a subsequent acquisition, late-stage private round, or IPO.

We can see from the CoinDesk article that the liabilities were quoted as $7.4 billion. These have since been revalued to $8.9 billion per the FT article:

Risk: The key risk here: the liabilities are understated; they have accrued additional fines and late penalties due to payment terms being missed; and there are other liabilities that have been missed altogether from their reconciliations.

These liabilities are taken at a time where they were able to liquidate assets to cover short term obligations; this is no longer the case given the bankruptcy. The additional interest will be accrued, thus increasing the liability.

There are now sizable, ongoing legal and consulting fees included in the process given the circumstances that will need to be included as part of the process.

There may be increased bad debts as recoverability from debtors or certain assets being liquidated at a loss to realize more quickly. This could be recognized as reduced asset recovery value or an increased provision for debts.

There is a significant risk that the $8.9b liability valuation is understated. We have no visibility over the process for recording transactions and completing reconciliations for creditors; based on the media articles/information leaked regarding record keeping, this is a high risk.

While we can verify the existence and valuation of assets, the greater concern is around the understatement of liabilities. Particularly if the assets are recorded net (inconsistent with accounting standards, but possible). If they are net, then there could be both long and short positions that need to be unwound that could make the gross liabilities and assets magnitudes of sizes larger than what we know from the FT article. Hence this is a huge caveat around completeness, for after all, we don’t know what we don’t know.

Prior to FTX, SBF founded Alameda Research (quantitative trading firm) in October 2017. This is a Sister Company to FTX, with SBF owning 90% of the equity in Alameda (a controlling interest).

This ownership structure enables SBF to dictate what is done with both FTX and Alameda, ultimately resulting in unusual trading activity between the two entities.

The lack of disclosure enabled the activity to go unchallenged for too long and meant the financial positions of the companies deteriorated. Had this been challenged sooner, then the predicament may have been mitigated.

The tone from the top tends to dictate how the entire firm acts. Setting a culture of doing the right thing, with no repercussions will help to mitigate the risk of negligence or harmful events occurring. There will likely always be bad actors in the space, but having a good culture throughout the business can reduce the risk of this happening.

This is embedded as part of the entity level controls and enables a better attitude to complying with control frameworks which further improves the reliance we can place over the accuracy and completeness of data/information produced by the entity.

It is typically the duty of an auditor or due diligence practitioner to perform reasonable assurance procedures about whether the financial statements are free of material misstatement due to fraud.

Typically we refer to the fraud triangle when assessing the risk of fraud within an organization:

There are set processes to go through to avoid tipping off a perpetrator. An audit or due diligence team can walk away from the engagement if they suspect malpractice.

We do not have much information on the internal activities of FTX, but we do know the legal team had resigned and the due diligence engagement was finalized within 36 hours, concluding with Binance withdrawing its LOI to acquire FTX.

FTX has entered into chapter 11 bankruptcy. As such, the company has appointed an administrator to settle the related liabilities using the remaining assets of the company.

Typically there is a pecking order to receive the assets, which is determined after lengthy legal battles and appeals. The rights of these assets are effectively in the temporary possession of the liquidation proceedings before they are allocated to the creditors.

Prior to this, the assets would belong to the owner of the private keys, FTX.

The systems, processes and controls can prevent errors (intentional or otherwise) by having sufficient levels of review including detective and preventive controls. Without automated controls, it opens the company up to human error, so as a company scales, it is expected to implement more robust process and control frameworks.

We don’t have access to the internal processes, so we have to piece together a perspective externally from the paper trail.

FTX supposedly used Google sheets to manage the company balance sheets.

This is not fit for purpose. The concern is that there are known balances missing from the spreadsheet. Typically, when an auditor pulls the data, they are required to test the completeness and accuracy of the report. If this cannot be provided, then the audit could issue a limitation of scope within their opinion. This means they were unable to verify the numbers were reasonable due to insufficient information.

The company raised $400m in Series C funding at a $32 billion valuation in Jan 2022. This is a significant sized entity and as such would be expected to have robust controls, systems, and processes in place to prevent errors from occurring.

Control Improvements (General)

Following the catastrophic failings, there are several observations for performance improvement that can be made. To caveat: these are general in nature and could be made more specific depending on the individual crypto entity:

• Proof of solvency should be periodically disclosed or reported to a regulator for each of the centralized exchanges.

• Numerous controls facilitating segregation of duties should be implemented to prevent fat-fingered mistakes, or a single executive from extracting funds from the company without a secondary signature.

• Multi-signature wallets using cold storage should be used as a minimum. Appropriate custodians should be used for customer deposits and insurance taken out in the event of lost customer funds.

• Periodic testing on segregation of customer deposits should be done by a third party institute and a certificate obtained to provide market confidence that deposits are secure.

• Increased disclosure and reporting on related party arrangements, including transactions between related entities like FTX and Alameda.

• Increased background checks on employment to be performed to mitigate the opportunity for bad actors to return or work in the sector. This is particularly relevant in a service-based sector where human capital is a key aspect of the industry.

• There’s a significant lack of “basic risk controls” in high risk crypto funds. Aligning internal control frameworks with typical financial institutions would mitigate the “wild west” approach to funds within the crypto industry:

  • Implementing thresholds for approval of certain trade sizes.

  • Reviewer and approver requirements on trade executions.

  • Appropriate audit trails and SOX style controls over financial reporting.

The other parties within the FTX ecosystem, including creditors, debtors, and associated contagion needs to be considered.

We have covered this in a separate article.

CZ has started an “industry recovery fund” to prevent further spread of the contagion, as the impacts of unwinding a behemoth of this size can be catastrophic. It remains to be seen whether it will prove sizable and effective enough to have any lasting effect.

https://twitter.com/cz_binance/status/1592044496174612482?s=20&t=1gvt8xocrw1YtRyl1QKTfg

Dapp Radar has also performed an assessment of decentralized applications impacted by the FTX contagion. As the effects unwind, we will likely see more announcements from projects around being adversely impacted.

Hopefully initiatives like CZ’s above will stem the pain, but probably with a return required to the “White Knight.”

Since the Chapter 11 bankruptcy announcement, several events that have taken place, including:

• Hack totalling $515 million, as per the NYT. The identity of the user was said to be known, but recovery has not been completed.

• FTX Bahamans temporarily reinstating local withdrawals.

• Unusual means of extracting liquidity from the exchange.

  • Some bought NFTs that appear to be owned by Bahamian citizens, at astronomical prices leading to concerns around a loophole for bypassing FTX withdrawal restrictions.

  • SBF did not pause trading for FTX, leading to alleged wash trading on multiple perp pairs, whereby a user would intentionally lose against an account that was able to withdraw in order to cash out.

• TronDAO formed a credit facility to allow part of FTX's users to withdraw capital via assets associated with the @tron network. This led to a massive premium in $TRX price on FTX.

The FTX General Counsel, Ryne Miller, stated they were moving the remaining funds to cold storage to mitigate the impact of the unauthorized transactions. This has further reduced the assets remaining to be distributed to creditors.

The collapse of FTX and Alameda will likely be documented as one of the most severe in crypto history, more so than Mt GOX or the crypto contagion earlier this year.

The deficit in the consolidated balance sheet of FTX and Alameda is still being quantified while the positions are being unraveled, and chapter 11 bankruptcy proceedings are being processed. But based on the information available we can estimate this to be $6.5 billion:

• $6.6 billion of proposed downward revaluations, with a further $0.6 billion of misappropriated assets resulting in final net estimated deficit of $6.5 billion to be distributed to creditors as part of chapter 11 bankruptcy proceedings.

• Deposit holders are unlikely to receive any of their funds given net deficit. Particularly given the legal fees and interest accumulated on the liabilities.

• Downward revaluation driven by liquidity, duration, and simple overvaluation of holdings.

• Misappropriated assets from hacks and reinstated withdrawals unlikely to be recovered.

• Risk around understated liabilities given the poor record keeping, systems and controls.

• Severe lack of controls around related party reporting, disclosures, and transactions.

• Fraud remains a significant risk within the firm, particularly given internal legal team resignation, Binance pulling the LOI to acquire, and rumors around internal involvement over extraction of funds.

• Severe deficiencies in internal systems and controls. Several general control improvements could be implemented.

• Proof of solvency should be an industry standard for opaque centralized crypto institutions.

• Contagion is unraveling and will cause a lot more damage before it improves.

• The tone from the top of FTX was not a standard one would expect from a firm of this size. The activity after the collapse on Twitter was unprofessional and hints at the type of leader setting the culture within the firm.

• The subsequent events have further exacerbated the deficit in the balance sheet.

The hole is sizable and arguably could have been mitigated to a certain extent with an improved internal control framework. The crypto market is the wild west, and until regulation arrives, the retail investors will continue to fall victim to bad actors.

At OriginsNFT we leverage data-driven decision making, educational resources, and proprietary analytics to remain ahead of the curve with respect to blockchain tech and specifically NFTs. To find out more, please visit our website or Twitter.

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FTX was scrambling to plug the hole in their balance sheet, but ended up filing for Chapter 11 bankruptcy. The Binance Letter of Intent (“LOI”) was contingent on a Due Diligence (“DD”) process that fell through within 36 hours. What made them walk away from the deal?

According to a bare-bones legal filing in the U.S. Bankruptcy Court in Delaware, the range of FTX assets and liabilities were stated to be between $10 to $50 billion. Using the expertise of a former “big 4” auditor to examine the numbers (remotely), this article estimates the net deficit to be in the region of $6.5 billion.

To caveat:

• This is at a point in time, and given the pace with which the news is evolving, there may be elements that are outdated by the time it is published and read.

• It also relies on the accuracy and completeness of information obtained from external sources, such as the Financial Times (“FT”), and announcements around known subsequent events.

• Background

• Approach

  • Understand the Business

  • Identify the Key Risks

  • Apply Materiality

  • Form an Opinion

• Application to FTX

  • Assets

  • Liabilities

  • Related Party Relationships

• Other Considerations

• Closing Remarks (TL;DR)

For background on the timeline of events, this has been summarized on the following FTT price chart.

The following approach is typically taken when assessing the numbers. For those interested in the assessment, skip to “Application to FTX”.

Before we can identify the key risk areas, we first need to understand the business (“UTB”) to properly grasp how certain accounts and processes can be inherently more risky than other areas.

In the context of FTX this would be:

• The relationship between Alameda and FTX.

• The related party transactions, how they are recorded and processed in the company financials.

• The other parties within the FTX ecosystem, including creditors, debtors, and those potentially affected by contagion that could flow from the collapse.

• The systems used and the integrity or reliance we can place on the completeness and accuracy of the data being provided.

• The tone from the top and how this permeates through the company. Is it a culture of hiding mistakes and errors, or is it an environment that fosters how the information flows to the top for informed decision making?

Once we understand the business, we can focus our resources on the highest-risk areas. In the context of FTX this would be:

• The existence, accuracy/valuation, and rights in relation to its assets.

• The completeness, accuracy/valuation, and obligations in relation to its liabilities.

• The related party arrangements, and how they impact the numbers.

Some key focus areas in the context of FTX could be:

• The related party transactions with Alameda.

• The processes around its clients’ deposits and whether these were mismanaged, so as to identify further implications/ramifications and associated liabilities.

• The FTT holdings and other impaired assets that would need to be marked down to fair value to establish how big the “black hole” in the balance sheet is.

• The extent of its liabilities and whether these can be met with its liquid assets. The difference between the verified assets and complete list of liabilities is the black hole and would dictate whether an acquisition is feasible.

Materiality can vary from one audit firm to the next, but depending on the type of business can be based on (example %):

• Profit before tax (5%)

• Revenue (1%)

• Total Assets (1%)

• Net Assets (1%)

The percentage used can vary depending on several factors, but for a high-profile entity with known issues, we would use a lower materiality threshold given there would be a higher likelihood of error. Similarly, if the company has established controls and processes, we could take a higher threshold, as we can rely on their processes for a reasonable level of assurance.

For FTX, we would probably veer towards using a low threshold based on its assets. The volume and associated revenues would likely be too high to pick up any meaningful balances. The company is realistically in a net deficit (black hole), given the illiquidity and overstatement of some tokens on its balance sheet. But we can use the pre-adjusted net assets as a base before we kick the tires and make the adjustment.

1% of net assets ($7.2m) could be selected as planning materiality. Then we would apply various reductions on this at the account level to accumulate any misstatements we find. This would then be totalled up and compared to a “tolerable error” or “performance materiality.”

Once we have applied all the above to FTX, we can then form a conclusion as to whether the numbers are reasonable and free from material misstatement due to fraud or error.

We’ve managed to obtain consolidated financials from FTX + Alameda to perform the above procedures from the FT.

Let’s take a look.

From reviewing the FTX balance sheet, there are $6.6 billion of proposed downward revaluations leading to an overall net deficit (black hole) of $5.9 billion.

There is a further $0.6 billion of misappropriated assets after the Chapter 11 bankruptcy announcement. This results in a final net estimated deficit of $6.5 billion.

To put this plainly: of the estimated $8.9 billion liabilities, less than $2.4 billion will be returned to these creditors. That equates to 27 cents on the dollar, excluding legal fees and interest accrued. It’s extremely unlikely that customer deposits will receive anything in return.

The discounts and deductions are associated with:

• Liquidity;

• Duration, or assets being locked for a period;

• Known impairment of assets, i.e. the market value is below the current value recorded, and;

• Known misappropriation of assets.

Let’s look into why these adjustments have been proposed for each line item.

Risk: Are these assets overstated, does FTX have the rights to those assets, and do the assets exist?

As at today, there are indications of impairment given the economic downturn, so the valuation of these assets would need to be further marked down to fair value using a mark-to-market adjustment.

There are some assets that are locked for a period of time that could arguably be written down.

The FTT flywheel suggests that a lot of these tokens have in fact been printed out of thin air and used as collateral for loans. Those tokens are worth a fraction of the value at the time of the CoinDesk article.

Many of these liquid assets are able to be sold with little to no market movement in price.

A - Robinhood

The main challenge here is the “HOOD” investment of $472m which equates to a 7.6% stake in the Robinhood investment platform. FTX would be unable to sell this portion of equity without moving the market so would need to execute with an over the counter (“OTC”) trade.

As such, recording 100% of this balance would require finding a buyer for the entire holding. An arbitrary discount of 10% has been applied to this to allow for the illiquidity.

Now this is where the real discounts and high-risk areas for assets appear. Typically we would categorize these as level 2 or 3 investments, given the lack of observable inputs. What this means is that there is illiquid, relatively opaque OTC transaction activity as opposed to readily traded assets on an open market.

The big 4 audit firms would involve valuation specialists to benchmark other similar assets to establish an appropriate value. This can be subjective from one experienced valuations partner to the next, with a peer review from a second partner often being included on high risk or complex engagements. This article performs an “illustrative” line by line assessment of what a discount could be calculated as, but will change when specialist involvement is sought.

B - FTX Token

Why did the FTT token have value?

• A third of the commissions received from transaction volume was used to buy back the token. Tokens redeemed were burned, acting like a deflationary mechanism, reducing the supply and hence increasing the inferred value.

• Reduce trading fees on FTX if used to pay (rather than using USDC, for example).

• Profit sharing mechanism - Profits from market movements are distributed evenly to holders.

FTX is now not operational, and thus there is no volume commission, trading activity, nor profit distribution. The current market value of FTT ($1.33) is associated with the potential future recovery of the token, which is speculative at best.

The FTX token (“FTT”) has experienced a 95% reduction in value to a current price of $1.42 from a pre-announcement value of $26. The total market cap is currently $441m, of which Binance owns a significant portion, so arguably the token holding value is close to zero,particularly given that the exchange has ceased operating so the benefits of the FTT asset are close to nil. As such, a $554m downward adjustment has been made.

C - SRM Token

The SRM token balance is heavily overstated. The recorded balance is in excess of the coin’s market cap of $65m.

There has since been discussion of an SRM token fork following rumors of additional tokens being printed. Regardless, selling the tokens on the open market would be difficult given the lack of liquidity.

Valued to nil, adjustment downwards of $2.2B.

D - Locked USD

Arguably this is a relatively liquid investment in comparison to other tokens listed within the same bucket. The issue is the lock period and hence one could sell this asset OTC at a slight discount to compensate for the duration risk.

Arbitrary discount of 10% applied, resulting in a $50m downward valuation.

E - APT token

Aptos has a market cap of $548m, of which FTX holds a significant portion of this.

It would be incredibly difficult to shift this investment on the open market without forcing sell pressure down close to zero, particularly with limited bidding. For the purpose of this analysis we have discounted it heavily at 90%, or $280m downward revaluation.

F - OXY Token

The OXY token is Oxygen, which is a DeFi prime brokerage service built on Solana and powered by SRM’s on-chain infrastructure.

FTX is an early investor on the SRM DEX. The total market cap of OXY is $820k, therefore a revaluation downward of 90%, or $48m is appropriate to account for the lack of liquidity/not being able to sell a significant amount of the tokens without moving the market.

G - STG Token

The Stargate Finance token is majority owned by FTX and hence being able to find a buyer without moving the market would be difficult. Downward revaluation of $45m to nil due to lack of liquidity.

H,I,J - ETHE, FIDA, MSOL

All of these tokens are recorded in excess of the total market capitalizations, hence all have been revalued down due to liquidity concerns and the unlikely odds of finding an OTC buyer.

Combined downward revaluation of $116m to nil.

K - ASD

AscendEX is a global digital asset financial platform founded by a group of Wall Street quantitative trading veterans.

FTX owns most of the token holding, hence the stock would be difficult to liquidate. Liquidity discount applied for the associated liquidity risk. Downward revaluation of 90%, or $31m.

L - BITW

Bitwise 10 crypto index fund has low volume traded, but the fund is being actively traded on the open market. Market cap unknown, but applied a 50% discount to allow for liquidity risk, resulting in a $13m downward revaluation.

M - Other

The above tokens were material enough to split out, but most were either highly illiquid, trading with minimal volume, or expected to be difficult to sell without an OTC counterparty. “Other” tokens tend to be smaller numbers and even less liquid, and as such they have been revalued downward by 90% or $16m.

N - GBTC

Greyscale Bitcoin Trust (“GBTC”) has a lockup period. As such, a discount of 20% has been applied for the duration risk. This equates to a discount of $0.7m.

These highly illiquid investments have been written down to nil.

While most financial statements are prepared on a going concern basis, FTX is not a going concern and hence a wind up basis is required. This results in assets being valued at a different level compared to how they would be valued in a typical solvent entity. Even under going concern, one would value level 3 investments, like these opaque VCs, with discounts for liquidity and duration discounts.

There are “Other Venture” capital investments included in this illiquid asset bucket. Likely related to the FTX Ventures investment vehicle. Most of these funds could have already been extended to the projects or entities. Without knowing the individual contract terms, it is difficult to establish whether the funds can be clawed back or recovered. As such, until proven otherwise, this would typically be revalued downward.

According to Crunchbase, there have been 48 companies, totalling $2.3 billion, that FTX Ventures has invested in since its inception in January 2022.

The other listed ventures are in regards to an AI research company, high frequency market data for DeFi applications, tokenized TWTR (Twitter) stock, and a speculative play on an election bet. It’s difficult to establish whether these assets have any immediate realizable value given the requirement to find an OTC counterparty.

The nature of VC funding is to invest in the early phase of a company’s lifecycle, which entails a high degree of risks. The corporate failure rate of web2 VC funding is 75%, with crypto arguably being higher. Most VC investments won’t see a return until a subsequent acquisition, late-stage private round, or IPO.

We can see from the CoinDesk article that the liabilities were quoted as $7.4 billion. These have since been revalued to $8.9 billion per the FT article:

Risk: The key risk here: the liabilities are understated; they have accrued additional fines and late penalties due to payment terms being missed; and there are other liabilities that have been missed altogether from their reconciliations.

These liabilities are taken at a time where they were able to liquidate assets to cover short term obligations; this is no longer the case given the bankruptcy. The additional interest will be accrued, thus increasing the liability.

There are now sizable, ongoing legal and consulting fees included in the process given the circumstances that will need to be included as part of the process.

There may be increased bad debts as recoverability from debtors or certain assets being liquidated at a loss to realize more quickly. This could be recognized as reduced asset recovery value or an increased provision for debts.

There is a significant risk that the $8.9b liability valuation is understated. We have no visibility over the process for recording transactions and completing reconciliations for creditors; based on the media articles/information leaked regarding record keeping, this is a high risk.

While we can verify the existence and valuation of assets, the greater concern is around the understatement of liabilities. Particularly if the assets are recorded net (inconsistent with accounting standards, but possible). If they are net, then there could be both long and short positions that need to be unwound that could make the gross liabilities and assets magnitudes of sizes larger than what we know from the FT article. Hence this is a huge caveat around completeness, for after all, we don’t know what we don’t know.

Prior to FTX, SBF founded Alameda Research (quantitative trading firm) in October 2017. This is a Sister Company to FTX, with SBF owning 90% of the equity in Alameda (a controlling interest).

This ownership structure enables SBF to dictate what is done with both FTX and Alameda, ultimately resulting in unusual trading activity between the two entities.

The lack of disclosure enabled the activity to go unchallenged for too long and meant the financial positions of the companies deteriorated. Had this been challenged sooner, then the predicament may have been mitigated.

The tone from the top tends to dictate how the entire firm acts. Setting a culture of doing the right thing, with no repercussions will help to mitigate the risk of negligence or harmful events occurring. There will likely always be bad actors in the space, but having a good culture throughout the business can reduce the risk of this happening.

This is embedded as part of the entity level controls and enables a better attitude to complying with control frameworks which further improves the reliance we can place over the accuracy and completeness of data/information produced by the entity.

It is typically the duty of an auditor or due diligence practitioner to perform reasonable assurance procedures about whether the financial statements are free of material misstatement due to fraud.

Typically we refer to the fraud triangle when assessing the risk of fraud within an organization:

There are set processes to go through to avoid tipping off a perpetrator. An audit or due diligence team can walk away from the engagement if they suspect malpractice.

We do not have much information on the internal activities of FTX, but we do know the legal team had resigned and the due diligence engagement was finalized within 36 hours, concluding with Binance withdrawing its LOI to acquire FTX.

FTX has entered into chapter 11 bankruptcy. As such, the company has appointed an administrator to settle the related liabilities using the remaining assets of the company.

Typically there is a pecking order to receive the assets, which is determined after lengthy legal battles and appeals. The rights of these assets are effectively in the temporary possession of the liquidation proceedings before they are allocated to the creditors.

Prior to this, the assets would belong to the owner of the private keys, FTX.

The systems, processes and controls can prevent errors (intentional or otherwise) by having sufficient levels of review including detective and preventive controls. Without automated controls, it opens the company up to human error, so as a company scales, it is expected to implement more robust process and control frameworks.

We don’t have access to the internal processes, so we have to piece together a perspective externally from the paper trail.

FTX supposedly used Google sheets to manage the company balance sheets.

This is not fit for purpose. The concern is that there are known balances missing from the spreadsheet. Typically, when an auditor pulls the data, they are required to test the completeness and accuracy of the report. If this cannot be provided, then the audit could issue a limitation of scope within their opinion. This means they were unable to verify the numbers were reasonable due to insufficient information.

The company raised $400m in Series C funding at a $32 billion valuation in Jan 2022. This is a significant sized entity and as such would be expected to have robust controls, systems, and processes in place to prevent errors from occurring.

Control Improvements (General)

Following the catastrophic failings, there are several observations for performance improvement that can be made. To caveat: these are general in nature and could be made more specific depending on the individual crypto entity:

• Proof of solvency should be periodically disclosed or reported to a regulator for each of the centralized exchanges.

• Numerous controls facilitating segregation of duties should be implemented to prevent fat-fingered mistakes, or a single executive from extracting funds from the company without a secondary signature.

• Multi-signature wallets using cold storage should be used as a minimum. Appropriate custodians should be used for customer deposits and insurance taken out in the event of lost customer funds.

• Periodic testing on segregation of customer deposits should be done by a third party institute and a certificate obtained to provide market confidence that deposits are secure.

• Increased disclosure and reporting on related party arrangements, including transactions between related entities like FTX and Alameda.

• Increased background checks on employment to be performed to mitigate the opportunity for bad actors to return or work in the sector. This is particularly relevant in a service-based sector where human capital is a key aspect of the industry.

• There’s a significant lack of “basic risk controls” in high risk crypto funds. Aligning internal control frameworks with typical financial institutions would mitigate the “wild west” approach to funds within the crypto industry:

  • Implementing thresholds for approval of certain trade sizes.

  • Reviewer and approver requirements on trade executions.

  • Appropriate audit trails and SOX style controls over financial reporting.

The other parties within the FTX ecosystem, including creditors, debtors, and associated contagion needs to be considered.

We have covered this in a separate article.

CZ has started an “industry recovery fund” to prevent further spread of the contagion, as the impacts of unwinding a behemoth of this size can be catastrophic. It remains to be seen whether it will prove sizable and effective enough to have any lasting effect.

https://twitter.com/cz_binance/status/1592044496174612482?s=20&t=1gvt8xocrw1YtRyl1QKTfg

Dapp Radar has also performed an assessment of decentralized applications impacted by the FTX contagion. As the effects unwind, we will likely see more announcements from projects around being adversely impacted.

Hopefully initiatives like CZ’s above will stem the pain, but probably with a return required to the “White Knight.”

Since the Chapter 11 bankruptcy announcement, several events that have taken place, including:

• Hack totalling $515 million, as per the NYT. The identity of the user was said to be known, but recovery has not been completed.

• FTX Bahamans temporarily reinstating local withdrawals.

• Unusual means of extracting liquidity from the exchange.

  • Some bought NFTs that appear to be owned by Bahamian citizens, at astronomical prices leading to concerns around a loophole for bypassing FTX withdrawal restrictions.

  • SBF did not pause trading for FTX, leading to alleged wash trading on multiple perp pairs, whereby a user would intentionally lose against an account that was able to withdraw in order to cash out.

• TronDAO formed a credit facility to allow part of FTX's users to withdraw capital via assets associated with the @tron network. This led to a massive premium in $TRX price on FTX.

The FTX General Counsel, Ryne Miller, stated they were moving the remaining funds to cold storage to mitigate the impact of the unauthorized transactions. This has further reduced the assets remaining to be distributed to creditors.

The collapse of FTX and Alameda will likely be documented as one of the most severe in crypto history, more so than Mt GOX or the crypto contagion earlier this year.

The deficit in the consolidated balance sheet of FTX and Alameda is still being quantified while the positions are being unraveled, and chapter 11 bankruptcy proceedings are being processed. But based on the information available we can estimate this to be $6.5 billion:

• $6.6 billion of proposed downward revaluations, with a further $0.6 billion of misappropriated assets resulting in final net estimated deficit of $6.5 billion to be distributed to creditors as part of chapter 11 bankruptcy proceedings.

• Deposit holders are unlikely to receive any of their funds given net deficit. Particularly given the legal fees and interest accumulated on the liabilities.

• Downward revaluation driven by liquidity, duration, and simple overvaluation of holdings.

• Misappropriated assets from hacks and reinstated withdrawals unlikely to be recovered.

• Risk around understated liabilities given the poor record keeping, systems and controls.

• Severe lack of controls around related party reporting, disclosures, and transactions.

• Fraud remains a significant risk within the firm, particularly given internal legal team resignation, Binance pulling the LOI to acquire, and rumors around internal involvement over extraction of funds.

• Severe deficiencies in internal systems and controls. Several general control improvements could be implemented.

• Proof of solvency should be an industry standard for opaque centralized crypto institutions.

• Contagion is unraveling and will cause a lot more damage before it improves.

• The tone from the top of FTX was not a standard one would expect from a firm of this size. The activity after the collapse on Twitter was unprofessional and hints at the type of leader setting the culture within the firm.

• The subsequent events have further exacerbated the deficit in the balance sheet.

The hole is sizable and arguably could have been mitigated to a certain extent with an improved internal control framework. The crypto market is the wild west, and until regulation arrives, the retail investors will continue to fall victim to bad actors.

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