14 April 2023 by Andrew Cummins
FTX Group was established in 2019 and briefly operated in 250 countries. It “controlled” tens of billions of dollars’ worth of assets, had millions of customers, and processed millions of transactions a day. Prior to John J Ray III’s appointment as the FTX Group’s CEO, almost six months ago, it did not have a complete staff list, there was no central register of the approximately 1,000 bank accounts and it had approximately 80,000, yet to be identified, transactions in the QuickBooks “Ask my Accountant” general ledger account.
On 9 April 2023 Ray issued his first report into the Group’s failure. The report provides sober reading for those already invested in the space and some guidance for those contemplating future investment.
The FTX Group was controlled by three individuals with virtually no experience running a business of the size and scale of FTX. In particular Ray notes: “….while the FTX Group’s failure is novel in the unprecedented scale of harm it caused in a nascent industry, many of its root causes are familiar: hubris, incompetence, and greed.”
Ray identified the reasons for the FTX Group’s failure as:
GOVERNANCE AND MANAGEMENT
The FTX Group suffered from the lack of an effective and independent Board of Directors. There appeared to be no separation of duties. Those that worked there and had authority did not have sufficient experience. It appears many staff were not allowed to operate with a desirable level of independence from the founders of the business. Ray notes:
“…a handful of employees had, among them, virtually limitless power to direct transfers of fiat currency and crypto assets and to hire and fire employees, with no effective oversight or controls to act as checks on how they exercised those powers.”
Most tellingly Ray concludes:
“…the FTX Group lacked independent or experienced finance, accounting, human resources, information security, or cybersecurity personnel or leadership, and lacked any internal audit function whatsoever.”
FINANCIAL AND ACCOUNTING SYSTEMS
Whilst FTX Group operated in numerous jurisdictions and had hundreds of subsidiaries Ray notes it had virtually no senior finance, accounting or risk personnel. To the extent financial data was produced it was manually transferred from FTX Groups’ systems to QuickBooks accounting software.
The Groups’ intercompany transactions were not properly recorded and one related party had virtually unlimited access to the FTG.com trading platform and was not subject to the controls normally imposed on customers.
Ray’s comments in respect of the (lack of) financial and accounting systems suggests that the FTX Group did not (and probably could not) prepare statements of assets and liabilities and its financial data was largely incapable of being audited. The FTX Group from an accounting perspective was “flying blind” with no ability to accurately report its financial position.
ASSET MANAGEMENT, CONTROL AND SECURITY
Ray’s report confirms that the FTX Group did not employ sufficient experienced staff to ensure an appropriate level of digital asset management, information security and cyber security controls were in place.
Cryptocurrency was largely not held in cold wallets (not accessible online) and was therefore more susceptible to loss from hacking. Indeed on the day of Ray’s appointment some $US430 million was lost to a hacker.
Passwords and seed phrases for hot wallets were not maintained in a central register and many FTX Group employees had inappropriate levels of authority in respect of these access points.
BANKRUPTCY OF THE FTX GROUP
These reasons for failure have presented Ray (and his team) with a unique set of challenges as they seek to determine the financial position of the FTX Group and to locate, secure and protect its assets for the benefit of creditors and investors.
The financial position will only be determined from a piecemeal forensic review of source documents and financial statements will need to be prepared effectively from the ground up.
The cost of this exercise is, as you would expect, eye watering. Reported costs of Ray and his team for their involvement thus far are said to exceed $US38 million.
FTX will be studied by insolvency students in the years ahead as a textbook case of business failure. It exhibits all the usual reasons for business failure including:
- Inadequate and inexperienced management.
- Poor, inadequate or non-existent financial and accounting systems.
- An inability to produce accurate and timely financial information.
- Not subjecting founders and related parties to the systems and controls placed on third party trading clients.
- Poor or non-existent controls over assets including those held in custody for third parties.
It almost defies belief that with these systemic issues the FTX Group morphed into a cryptocurrency powerhouse with revenue of more than $US1 billion per year. One can only wonder at the due diligence conducted by counter parties who now find themselves as creditors of the FTX Group.
As Bitcoin passes $US30k and increasing government regulation likely it appears there are some interesting times ahead for the block chain industry.