By Financial Editor Samuel Insull
with Legal Correspondent Saori Shirosaki
It's almost Christmas time and that means we'll all gather 'round the old tube and watch It's a Wonderful Life, which tells the story of George Bailey, who always wanted to see the world but never left Bedford Falls, N.Y.
You'll remember that George, ready to leave on his around-the-world honeymoon, had to change his plans to quell a run on his family's two-bit bank. The problem was panic: his bank had properly used its depositors' assets to underwrite mortgages to the locals. But when the depositors wanted all their money at once, he couldn't satisfy their demands because he didn't have the cash on hand.
Now George Bailey was a honest man and – spoiler alert – his story has a happy ending.
But the same cannot be said of the 2022 remake starring Sam Bankman-Fried, the disheveled boy-man who sent $10,000,000,000 of his depositors' money up the chimney. Somehow when Sam jumped onto the Foosball table in his Bahamas penthouse/office/sin bin and explained, “the money's not here, it's in my worthless crypto currency,” the customers were not comforted.
Cue flashback:
Out of control, according to the normally-staid New York Times. Tell us more:
In 2019, Mr. Bankman-Fried hit upon an idea: Why not build a cryptocurrency exchange that could bring in revenue to help fund Alameda’s activities?
FTX was born. It moved from Hong Kong to the Bahamas, where Mr. Bankman-Fried built his base of operations, and the exchange took off. In financial presentations to investors, the company claimed in 2021 that it was raking in $1 billion in annual revenue by charging fees to customers who wanted to trade cryptocurrencies on its platform. It marketed itself aggressively to ordinary investors eager to trade the hot new thing.
Both FTX and Alameda benefited from [Sam's FTT] token’s rising value. The exchange began using FTT to make dozens of investments worth billions of dollars in other crypto companies. A 2019 investor presentation for the new exchange said, “FTT will be the backbone of the growing FTX ecosystem,” and promised investors and customers “guaranteed liquidity,” or the ability to always get back their money.
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| FTX investors want their money back |
At the same time, Alameda, which held a large stake in the token, began using its FTT holdings as collateral for more loans to facilitate its trading activities. As of Sept. 30, Alameda had roughly $13 billion in assets, according to Thursday’s bankruptcy filings, although Mr. Ray, the restructuring lawyer and newly appointed chief executive, said he had no confidence in the numbers.
The intertwined business model, with FTT propping up the two entities, turned Mr. Bankman-Fried into a crypto hero. Even if many backers and supporters of the exchange didn’t quite understand how it all worked, they were taken in by his compelling pitch. He styled himself as an idiosyncratic genius willing to engage with regulators and call out the scams plaguing the crypto industry. He also expressed a commitment to give away much of his wealth to charity.
Charity? He's like the Paul Newman of crypto, if there was nothing in the Newman's Own salad dressing bottles.
Before we even wade into the crypto nonsense, let's spend a minute on these two entities, Alameda and FTX.
FTX claimed it was an “exchange.” If only anyone could help us define what an exchange is. We found this thing called the “Securities Exchange Act of 1934.” Let's see what it has to say!
The term “exchange” means any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities.
15 U.S.C. § 78c(a)(1). (This means it's actually the law of the land as enacted by the Congress.)
So an exchange is a place, perhaps an online space, or perhaps a street corner in Lower Manhattan where buyers and sellers can meet and, um, exchange stuff. Central to this definition is the idea that the exchange never owns the objects it's trading, so if it goes toes up, the buyers and sellers can take their marbles and trades elsewhere.
Can any Tom, Dick or Sammy run their own exchanges? Well,
An exchange may be registered as a national securities exchange...by filing with the Commission an application for registration in such form as the Commission, by rule, may prescribe containing the rules of the exchange and such other information and documents as the Commission, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors
15 U.S.C. § 78f. Regulated to protect investors? What a ridiculous idea! Sam would never allow anyone to protect his investors, you'll be shocked to learn, even as he swanned around Washington distributing campaign cash and acres of sincere b.s. on a bipartisan basis.
And how was he supposed to know about the arcane provisions of the fundamental securities law of the United States? Was he just supposed to ask his dad? What would he know about it?
Just because your dad holds a chair in law and business at Stanford Law School doesn't mean he knows anything about the basics of financial markets, apparently.
A course on anxiety psychoeducation at Stanford Law School? Probably something all those Silicon Valley geniuses who lost hundreds of millions of their investors' money in his son's scam might be interested in about now.
And mom wouldn't be much help either, would she?
Distributive justice? That's the branch of philosophy where you learn the ethical basis for redistributing wealth from investors into your own pocket. As a member of the Class of 1976, she would have been able to hear about distributive justice from John Rawls himself, and pass along his wisdom to her boy Sam.
But we digress. As we said earlier, FTX was not an exchange because it took control of assets and then invested them for its own purposes, mostly in its affiliated unregulated hedge fund, Alameda.
When an institution does that with your cash, we call it a “bank.” Like George Bailey's Building & Loan. Let's go back to the Securities Exchange Act:
The term “bank” means any...banking institution or savings association, .. a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks...and which is supervised and examined by State or Federal authority having supervision over banks or savings associations.
So when an institution reduces you to the status of an unsecured creditor, and then invests your assets someplace, it's acting like a bank. And it has to be regulated because that's a dangerous business. There are thousands of pages of bank regulation and multiple agencies all sticking their noses in bank business exactly to prevent your bank from doing what FTX did.
To be fair, sometimes the regulation is so nobbled that the financial institution invests in crap deals for the benefit of bank management and the bank fails. Generally, however, the small depositors are protected by insurance and the big investors bribe Congress for a bailout. Just ask the “Keating Five.”
We could quote even more fascinating provisions of federal law, but let's cut to the truth about regulation of crypto crap. As our old friend Dennis Kelleher explained,
Too many (again, who should know better) are still repeating industry talking points that the FTX collapse shows that new legislation and regulation is needed. That is not true. The current laws and rules are fully adequate to address the lawlessness going on in crypto. It has been estimated that around 80% of the crypto tokens comfortably fall within the longstanding, clear, black letter law definition of a security (around since 1933) and the remaining fall within the equally longstanding definition of commodity (around since 1936). The problem is that the crypto industry refuses to comply with the securities and commodities laws (that exist to protect investors, customers and financial stability) and, therefore, the vast majority of crypto products are unregistered securities and commodities being traded on unregistered exchanges
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| Last meeting of FTX Compliance Committee |
All of these made up tokens, including Sam's own FTT, are securities. It's illegal to sell unregulated securities to the general public. If you sell them by fraudulently failing to disclose material information, like you put a supposed $10 billion worth in an affiliated hedge fund for your own benefit, you can go to jail.
Why haven't our vast armies of financial regulators done anything up to now? One sad truth is that financial regulators don't step in until it's too late, as was the case with the S&L crisis and the 2008 market meltdown. Another less charitable view belongs to the aforementioned Mr. Kelleher, who has spent his entire professional life working in the financial-services sector:
Sure, some in the industry said they wanted to “engage” with regulators (on terms they dictate) and even wanted to be regulated (albeit as little as possible), but the clear strategy has always been to just break the law and at the same time buy as many politicians as possible to get special interest legislation that would give it the weakest, most friendly possible regulator and regulation. They wanted the form and appearance of regulation without the substance of real regulation. That’s why the industry keeps pushing for the CFTC to be its regulator: the CFTC is the smallest and least funded financial regulator. Crypto believed it would be the easiest to capture, dominate, manipulate, and keep defanged.
Stop beating around the bush, Dennis, and just tell us what's on your mind.
We suspect that the brazenness of Jughead Bankman-Fried's thievery will bring down the regulatory hammer, but we also suspect that those who entrusted their life savings to him are, to use one final term of art in the field of securities regulation, s*** out of luck.
We suggest that the poor sods whose lives have been ruined by this finagle enroll as quickly as possible in a course of “anxiety psychoeducation.” And if you live in Palo Alto, you're in luck, because you can walk across the Camino Real and sign up today!
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