The Spectacular Collapse that Keeps on Teaching: More Lessons From the FTX Failure

$32 billion. That was FTX's valuation prior to its spectacular collapse. That's similar to the GDP of Iceland and Moldova combined, and it all but evaporated in the blink of an eye. Some of those billions are now being recovered, but few investors will be made whole.

The failure of FTX, then a leading crypto exchange, was a shock to the entire market. But the story behind its downfall can teach us important lessons about the risks of investing in crypto assets.

FTX benefitted from a fundamental disconnect between how we treat Web2 and Web3 assets. While traditional financial instruments are heavily regulated and must adhere to stringent compliance rules, crypto assets are still largely unregulated. This allowed FTX to grow rapidly, but it also exposed the exchange to significant risks.

FTX was not actually decentralized, and its fall shows that centralized systems have a single point of failure. Similar to the 2008 financial crisis, this demonstrates the importance of true decentralization in order to create a resilient system that is not dependent on any one entity. In the crypto world, “rug pulls” are a similar risk and demonstrate the importance of decentralized systems.

To better understand how $32 billion can simply vanish in 2022, all while most of the FTX team remains free of legal repercussions, let's delve deeper into the lessons behind FTX.

The Importance of Accounting

Modern business needs accounting for several very serious reasons. It helps investors understand the financials of a company, and it allows the company to properly manage its finances. More than that, it helps regulators keep an eye on potential fraud and money laundering.

Without proper accounting, FTX was unable to accurately track its assets or liabilities. This allowed for a number of discrepancies between what was reported on the books and what was actually happening. This lack of transparency also made it difficult for regulators to understand how the exchange operated, and how much risk it was exposed to.

For one, FTX minted its own token, FTT, that it used as collateral for margin trading. FTT was not fully backed by the underlying assets, which meant that the exchange was running an unsecured loan business. This practice is illegal in many jurisdictions, and it contributed to FTX's eventual collapse.

Moreover, expenses were approved with emojis and not through a formal process. This is a major red flag, as it indicates a lack of financial oversight and a disregard for regulatory requirements. 

Further, the lack of an in-house accounting team meant that there were significant gaps in the company's financial records. This is inexcusable for even a medium-sized company, let alone a 32-billion-dollar one. Even sole proprietorships must have an accurate record of their income and expenses, and one of crypto's most valuable companies fell short of this basic requirement.

One must wonder why Sam Bankman-Fried, the CEO of FTX, lapsed so badly in the governance of his own company. Perhaps he was overwhelmed by the sheer complexity of the situation, as he was dealing with billions of dollars, thousands of customer accounts and assets, and likely millions of transactions. 

A solution to these challenges could be to use a Web3-tailored accounting solution. Traditional solutions may not be well-suited to this new financial landscape, and as such, a custom solution may be necessary. Some startups are offering blockchain-based accounting solutions that can help crypto exchanges and investors to track their assets and liabilities.

The Importance of True Decentralization

The old expression, “the emperor has no clothes,” is a fitting analogy for the FTX debacle. FTX's lack of true decentralization meant that a single entity was in charge of the entire system, making it vulnerable to a single point of failure.

In contrast, decentralized networks are resilient, as they are not dependent upon any one entity. Decentralized networks are also more transparent, as they are open-source and can be audited by anyone. This increases accountability and reduces the risk of fraud or mismanagement.

For instance, Bulla Network is building fully decentralized accounting tools that could help prevent the next FTX-style collapse. While no business can be forced to adopt a truly Web3 stack, it's telling that the core spirit of decentralization is the one that survives.

The Need For Corporate Governance

More broadly speaking, FTX's failure highlights the importance of corporate governance. Corporate governance is the system by which companies are managed and operated, and it is essential for any organization.

FTX had an extremely loose corporate structure. The company was run by Bankman-Fried, with a few other executives assisting him. Without any proper checks and balances in place, Bankman-Fried was essentially running the show.

That's putting it lightly, as the firm's executives were involved in a "polycule" – a polyamorous relationship between multiple people. This was a major distraction for the company, and it likely led to slack management practices, as the executives were more focused on personal matters than the business at hand.

The lack of a formal corporate structure also meant that FTX's board of directors had little to no oversight over the company's operations. This is a crucial failing, as a board of directors is responsible for ensuring that a company is operating in an ethical and responsible manner.

The board's absence also meant that there was a lack of independent oversight. This allowed for significant conflicts of interest, as Bankman-Fried was essentially making decisions that benefitted himself and his friends, rather than the company's shareholders.

Conclusion

FTX's failure is a cautionary tale for all Web3 participants. It shows the risks of investing in unregulated and highly complex assets, and it serves as a reminder that proper accounting and corporate governance are essential to the success of any venture.

We must learn from FTX's mistakes and ensure that the same fate does not befall other crypto companies. We must also remember that proper accounting and corporate governance are not only necessary for compliance, but also for the long-term success of any venture.