Why is SBF so difficult to defend? One article to understand the jury’s focus

Original author: Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor at Dealbreaker, worked in the investment banking group at Goldman Sachs, served as an M&A attorney at Wachtell, Lipton, Rosen & Katz, and served as an associate judge on the U.S. Court of Appeals for the Third Circuit.

accusation

The main charges against Sam Bankman-Fried are:

Customers deposited billions of dollars on his crypto exchage FTX to buy cryptocurrencies.

Bankman-Fried’s trading firm, Alameda Research, secretly used the money to gamble on cryptocurrencies and make some bizarre illiquid ventures.

Additionally, it appears that much of the money was diverted to make political donations, purchase celebrity endorsements, purchase real estate in the Bahamas for Bankman-Fried and his family, and more.

When customers started asking for refunds last November, the money was gone.

This is really bad! The combination between "the client's money is missing" and "you live in a $30 million penthouse" is too deadly. This is the most basic description of financial fraud: the customer has no money, and you have money.

But Bankman-Fried is going on trial tomorrow, and Michael Lewis, when asked on 60 Minutes, "Do you think he knowingly stole money from clients," replied: "So, no." So I guess there will be a defense. Rhetoric.

So what is the defense? I think the defense goes something like this: "The crypto market crashed, there was a run on the 'banks', and it was the run that caused the disappearance of customer funds. It was an accident, maybe a careless one, but not theft." That's really it. A difficult situation to defend yourself from.

The first difficult thing is that on crypto exchage like FTX we don’t usually feel like a “run” is going to happen. An intuitive way of how a crypto exchage should work is:

• I deposited $100.
• I bought $100 of Bitcoin on an exchange.
• The exchange marked $100 of Bitcoin for me.
• When I want to withdraw my $100 in Bitcoin, if it's not there, that means someone stole it.

That's not how FTX works most of the time. It is a futures exchange. It works more like:

• I deposited $100.
• I used the money to gamble $1000 of Bitcoin on an exchange.
• The exchange held my $100 in collateral, but the $1,000 in Bitcoin didn't exist; it was just a bet between me and another customer.
• If Bitcoin goes up 20%, that $1,000 in Bitcoin is now worth $1,200 and my $100 bet is now worth $300.
• Likewise, the other party, the person I was betting against, took out a $100 mortgage to bet $1,000 in Bitcoin; now that Bitcoin has gone up, his $100 bet is now worth negative $100.
• When I go to withdraw the $300, if it's not there, that means the loser of the bet didn't pay out - or the losers of other bets on the exchange didn't pay out, causing the exchange to not have enough money to pay me.

The exchange stands between the winners and losers of the bet, and it cannot pay out what is owed to customers unless the customers who owe it money pay. Usually, customers will provide collateral and the exchange will perform risk management on positions, etc., so there will be no problem, but in the case of sudden and violent market fluctuations, the exchange may not have enough funds. This does happen on legitimate, regulated exchanges; it almost happened on the London Metal Exchange last year.

But no one believed this; it was far more complicated than the jury wanted to hear. Intuitively, if you accept cash from customers, you should have it, and if you don't, it looks suspicious. (FTX cash-only customers, including those on FTX.US who really should have been all-cash and segregated, also fell into bankruptcy.)

Even if you have convinced the jury that the bank run was possible, this defense faces many problems. I would like to mention three of them, although it is not difficult to think of more.

First:

It wasn’t some fluctuation in cryptocurrency prices that wiped out a large number of FTX customer funds, leaving them indebted to FTX and leaving FTX unable to repay other customers. Some volatility in cryptocurrency prices emptied the account of one FTX customer: Alameda. It turned out that Alameda had a large amount of unsecured or undersecured debt to FTX: when customers' money wasn't there, it was almost entirely because Alameda lost money.

This in itself is fishy: if the basic economic structure of an exchange is that it owes money to all its customers, but only its largest customer (a trading firm owned by the exchange's CEO), then this is very Bad. Structurally, it's "we take money from customers and use it to gamble for ourselves."

But every detail of doing so is terrible. Alameda owed FTX a lot of money, but no one else did - no one else was wiped out due to the huge price movement, causing it to create an uncollateralized negative position in FTX - because FTX did have a reasonable risk management system in place. If you run some unaffiliated hedge fund and you want to use $20 of your own money and borrow $1 billion from FTX to buy some illiquid, volatile, speculative cryptocurrency, FTX’s computers will say “Absolutely No". It’s something FTX is proud of, it’s what they promote, it’s what they brag about to regulators and Congress, and it’s what Bankman-Fried is talking about on Twitter.

But Alameda is allowed to do this: There are settings in FTX's code that allow Alameda to have an unlimited negative balance and borrow freely without any collateral. Alameda used this during last year's cryptocurrency market crash as it struggled to borrow money elsewhere. A key part of the trial will be about whether Bankman-Fried authorized the conduct. In a conversation with the New Yorker's Sheelah Kolhatkar, "Bankman-Fried was adamant" that prosecutors would not be able to produce any documentation proving he authorized unlimited borrowing because, he said, there was no such document. ” But basically everyone else who worked at FTX would probably testify that he did. This is very self-serving testimony: The implicit agreement provided by prosecutors was “If you say Bankman-Fried did this, you probably can Avoid going to jail, if you say otherwise we may put you in jail forever. ” Still, it didn’t help that prosecutors appeared to have recordings of his colleagues saying this before the government got involved.

second:

It’s not just Alameda that has made a series of cryptocurrency trading bets, all of which happen to run counter to it. Alameda wasn't bothered by the likes of cross-border Bitcoin arbitrage gone wrong, or even really by the Terra /Luna debacle, which brought down so many other crypto companies. The trouble with Alameda, effectively, is that it owes FTX (and its clients) billions of dollars, and its assets are largely made up of weird illiquid assets tied to FTX – FTT, SRM, MAPS and other tokens:” Samcoins” were invented by Bankman-Fried and were owned primarily by Alameda, representing a bet for his own speculative activities. Customers come to FTX to stake Bitcoin and Ethereum and other kinds of non-affiliated cryptocurrencies, and Alameda takes their money and puts it all into FTX’s own cryptocurrency.

Taking real customer funds — dollars that customers give you to gamble with, of course, or cryptocurrencies, but at least cryptocurrencies that you don’t control — and using it to drive up the price of a crypto token that you control is kind of cool. Like a Ponzi scheme. This is the box. Bankman-Fried once expressed this idea to me in a podcast — you could just create a cryptocurrency, give it some arbitrary market value, and then borrow millions of dollars based on its fake market value.

third:

The facts remain unclear, and my assumption is that the vast majority of the roughly $8 billion in missing customer funds went to Alameda, which it lost on stupid cryptocurrency bets. But not all. Lewis told "60 Minutes" that Tom Brady was paid $55 million to endorse FTX, one of many highly paid celebrity endorsers. Millions of dollars were spent on political donations, effective altruism campaigns, real estate in the Bahamas, and FTX’s lavish operations.

You could imagine some kind of accounting where all of these fees are paid strictly out of FTX's operating income (from the trading fees it legitimately charges customers, and they pay them in cash), and $8 billion is entirely The loss was due to an unfortunate mistake in Alameda's leverage. But there's no indication that such accounting exists, and everyone agrees that FTX's actual accounting is ridiculous. For example, FTX Group employees submitted payment requests via an online "chat" platform, where a different group of supervisors approved the payments by responding with personalized emojis," the post-bankruptcy CEO complained. This made it impossible for everyone to actually Argue that all of these fees are paid out of operating income rather than client funds.

Instead, it looks more like FTX and Alameda have a kind of indiscriminate pool of money, they reward themselves with huge accounting revenue, and then because they think there's more money out there, they feel free to spend tens of millions of dollars on random Not bothered. Bankman-Fried's defense would have to be something like "When I look at our financials, I feel like we have lots and lots more money than we owe our customers, so I don't have a problem spending a few hundred million dollars on marketing and employee benefits .”

And, FTX does seem to make a lot of money through real fees. At one point Alameda had a huge balance sheet with a lot of equity on its books. Conceptually, at its peak, FTX/Alameda could have a bunch of tokens with a market value (the last sale price of tokens held by FTX/Alameda multiplied by the number of tokens) of $100 billion, and it would owe customers $300 Billions of real or relatively real funds (USD, Bitcoin, Ethereum, etc.). Bankman-Fried probably looked at those numbers and thought "well, 100 billion is a lot more than 30 billion, we're rich, we can afford Tom Brady."

But the $100 billion is fake, meaning FTX/Alameda can't get (and didn't get) anything close to the $100 billion worth of these tokens, while the $ 30 billion is real, meaning the US government is trying to shut down Bankman-Fried Go to jail because customers didn't get their money back in full.

One problem with this defense, and a problem with the "bank run" defense in general, is that it requires a lot of optimism about cryptocurrencies. It requires you to believe that Bankman-Fried looked at Alameda's vast cryptocurrency inventory - consisting in part of crypto tokens invented by Bankman-Fried, and that he and Alameda largely controlled the trading of these tokens. The market value is largely based on confidence in him - and saying "ah, this is real money, I can keep spending this money and still have enough real money to pay back my clients in USD and Bitcoin and so on."

I mean, here's a math problem:

• You have $100 billion in weird crypto tokens.
• You owe people $30 billion in real money.
• How much money do you have to spend?

My answer is "Heck no, I have to pay back that $30 billion ASAP or everything will collapse and I'll go to jail."

But that's me! There are a lot of people in the cryptocurrency space who are like, “Great, I have $70 billion, crypto is the future, $100 billion in various cryptocurrencies is at least as valuable as $100 billion in devalued fiat currencies.”

It's just that Bankman-Fried never seemed to be one of them. I once wrote about my impressions of him after the "box" podcast:

My point is, if you talk to a crypto exchange operator and he's like, "Cryptocurrency is changing the world, your outdated economics are just unfounded fears, HODL ," that's bad. A true believer in cryptocurrencies is not someone who runs an exchange. The person you want running an exchange is a smart trader. You want someone whose basic attitude toward financial assets is: "If someone wants to buy and someone wants to sell, I'll put them together and charge a fee." You want someone whose views are driven by markets rather than ideology, who care about risk rather than Not futuristic. It's probably healthy to have a certain skepticism about the products he trades.

All right. This would have been a good idea. If you were skeptical about the huge amount of cryptocurrency you had on hand, you wouldn’t borrow against your customers’ money, and you wouldn’t continue to spend real money on endorsements and donations. You would only choose to do this if (1) you are overly optimistic about the value of your cryptocurrency, or (2) you are extremely cynical and intend to steal it.

The defense was that Bankman-Fried was grossly naive. It requires you not only to believe that his lieutenants stole all the customers' money without him noticing, but that he simply made a series of innocent risk management mistakes while everyone else was building nefarious backdoors . It also requires you to believe that he believes in the cryptocurrency he has on hand, that he believes his vast fictitious fortune is real and can be spent as he pleases. Apparently, this is not the case.