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At 30, Sam Bankman-Fried, founder of the quantitative trading firm Alameda Research and the cryptocurrency exchange FTX Trading Ltd., was seen as one of the most successful people in the cryptocurrency market. At one point, he had an estimated net worth of over $15 billion and was called the "J.P. Morgan of crypto." As Bankman-Fried's profile grew, he courted celebrities to promote FTX, bailed out failing crypto firms, and testified before the U.S. Senate and federal regulators to urge for increased regulations in the crypto market. However, his reputation as a "crypto savior" evaporated virtually overnight after reports revealed that Bankman-Fried’s Alameda had used billions of FTX's customers' funds to make risky bets and cover personal expenses. Bankman-Fried eventually stepped down as FTX's CEO, and the exchange filed for bankruptcy in November 2022.
The Department of Justice arrested Sam Bankman-Fried in December 2022 and charged him with seven counts of conspiracy and fraud. Damian Williams, U.S. Attorney for the Southern District of New York, called this "one of the biggest financial frauds in American history." His trial began on October 3, 2023.
It's hard to miss this fraud case in the news headlines, but you may be wondering, "Why is this such a big deal?" To better understand Sam Bankman-Fried's rise and fall and the significance of this trial, we spoke with Todd Phillips, associate professor of law at Georgia State's Robinson College of Business. Phillips formerly worked for a think tank on financial regulation, was a former FDIC attorney, has testified before Congress, served on the Commodity Futures Trading Commission's Market Risk Advisory Committee, and frequently advises financial regulators and members of Congress and their staffs on cryptocurrency regulation. He's also interacted with Bankman-Fried on numerous occasions.
Sam Bankman-Fried has argued that the issue boils down to an accounting error, whereas the Justice Department alleges there was an intentional effort to defraud customers and transfer their assets from FTX to Alameda. Can you tell more about the allegations?
Yes, that is the whole issue of the case. By way of background, FTX was an exchange, where members of the public come to buy and sell crypto assets, whereas Alameda was a hedge fund that traded on the exchange. They were legally separate entities, though both were owned by Sam Bankman-Fried. Somehow, FTX’s computer code was changed so that its systems didn’t treat Alameda just as any member of the public; instead, Alameda was given special privileges that allowed it to go negative and owe FTX money.
The Department of Justice is alleging that this code change was implemented at Sam’s request so that Alameda could make risky bets with FTX customers’ funds—in other words, to misappropriate or steal customers’ money. Prosecutors have put former FTX employees on the witness stand who say that Sam told them to change FTX’s code for the express purpose of allowing Alameda to improperly use customer assets. Although Sam’s defense hasn’t been argued yet, it seems like it will state that the code change was not intended to allow Alameda to go negative and that neither FTX nor Alameda had good views of their finances. In other words, this was not intentional theft or fraud but just an accounting error.
That said, the testimony given in court so far is really damning. It’s difficult to imagine how Sam’s legal team can dig out of this hole.
There are frequent financial fraud trials, but this case is getting media attention like none other. Why is this case different?
Sam Bankman-Fried and FTX were involved in political campaigns and engaged in quite a lot of political and policy lobbying in Washington D.C., making this case politically significant. Sam gave millions in campaign donations to Democrats running for Congress, and had top deputies donate equivalent amounts to Republicans. After the 2020 elections, FTX was heavily involved in, and through the hiring of former regulators helped shape, the conversation on Capitol Hill and inside agencies about the appropriate policy responses to the rise of crypto markets and how to regulate them. FTX seemed like the grownups in the room who could engage with policy makers in a sophisticated way, whereas others in the crypto markets did not have that same aura of professionalism. When FTX ended up collapsing, particularly because of fraud, that created huge waves. They seemed like they were on the up-and-up, but it sure looks like now they weren’t. That is what’s so shocking.
How has this case affected the wider cryptocurrency market?
Before FTX’s collapse, thefts and other fraud were occurring in the crypto markets, but the rising crypto markets kept them, to some extent, below the surface. The eight-billion-dollar loss that FTX’s customers experienced was too big to ignore and put a damper on the public’s opinion about crypto assets. Before all this happened, crypto markets traded at a market capitalization of about three trillion dollars, and now they’re hovering around one trillion. That’s quite a loss. It really is because people have pulled out of the markets, recognizing that they don’t want to be a part of the fraud, manipulation, and other bad things that are happening.
FTX’s collapse has also made policymakers wary of doing too much to promote this industry. Previously, members of Congress were talking about crypto as the future of finance, and when people hear that they get interested. They start looking around, and they maybe buy a token or two. We’re seeing policymakers talking about the need for legislation in terms of protecting people from scams, not about fostering a new industry.
In short, if you think about it in economic terms, FTX’s implosion decreased demand for crypto assets while doing nothing about supply, resulting in lower prices.
Regulation advocates want to take action to change the crypto market. What would potential regulations look like?
There is a big question mark on what will happen and what should happen. Many people, myself included, say that the securities laws already on the books cover quite a lot of these activities, and it’s just that too many industry players aren’t complying with the rules. We’re seeing the Securities and Exchange Commission bring enforcement actions to get traders to fall in line with the rules already on the books.
But there are many in the crypto industry and legislators on Capitol Hill who don’t want to see the securities laws applied. They think the securities laws will suffocate the industry and are pushing for different regulatory regimes that considers crypto assets as commodities subject to a different set of rules.
At a bare minimum, I think we need crypto exchanges, like Coinbase and the former FTX, to be subject to strict regulations about how they treat customer assets, how they interact with customers, and whether they can preference themselves or their affiliates to trade against or front-run customers. These institutions need to be siloed and given a strict mandate to simply allow a place for other people to trade crypto assets. They can’t be engaged in self-dealing. These are rules we have for the trading of securities and derivatives, so there’s no reason we shouldn’t have them for crypto as well.
In addition, when people issue crypto tokens, there needs to be some sort of disclosure about how the money raised from token sales will be used. Investors need to understand the inherent value, or lack thereof, of crypto tokens so they’re not just gambling instruments.
A lot of people neither trade cryptocurrencies nor have direct ties to financial institutions. How does FTX’s collapse and Sam Bankman-Fried’s case impact greater society?
This case symbolizes that the federal government is serious about cracking down on the abuses in financial markets and taking responsibility for protecting investors. It’s huge that the Department of Justice is prosecuting these actions, and it should give people faith that their government is working for them and that the traditional financial markets are safe for their investments.
Nevertheless, I would caution people against investing in crypto until there are strict rules of the road that everyone has to follow.
Written by Scott Daughtridge