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Sam Bankman-Fried’s trial began last week. The 31 year old founder of the third largest crypto exchange, FTX, stands accused of committing fraud which caused billions of dollars in customer losses. If convicted he faces a lengthy prison term.
Over the next month we’ll hear insiders testify about how SBF’s empire handled the money entrusted to it by customers and investors. We have a short summary of the testimony from the first week and some legal maneuverings, but the criminal trial doesn’t impact on the recoveries customers will receive in the bankruptcy process.
On that note, it’s possible that gains in FTX’s venture portfolio will enhance the recovery rate for creditors (although we think talk of a full recovery is too optimistic). More on this later.
Whether SBF is legally guilty or not is a matter for a jury.
It doesn’t affect the outcome for creditors.
But the FTX insolvency will drag on for years and cost many hundreds of millions of dollars in fees before the final distribution is made. For those who just used FTX as a fiat ramp or kept a small altcoin portfolio there temporarily, it’s not a major issue.
For those who used it as their main crypto platform it may be life-changing losses.
And life-changing opportunity cost. Over a 3 year horizon, buy and hold / DCA of crypto has worked. Prices of majors are up significantly despite the boom and bust.
If you’re reading a crypto newsletter you probably know someone who lost money in FTX, or any of the Fake DeFi lending companies we warned about (BlockFi, Celsius).
The main theme of this post is learning the lessons from the last cycle to avoid losses when investing in crypto and DeFi. Avoidance / opportunity cost is also a loss. There’s a reason our team is composed the way it is - we get to operate at the intersection of software, security, and finance. Everyone wants to skip the foundational knowledge required to truly understand crypto, but our goal is to constantly hammer on the fundamental principles.
If you’re reading DeFi Education today, you’re probably going to avoid this error:
Crypto is associated with frauds and scams, it might get banned, I’d better not invest anything (until I jump in at the top of the next cycle due to envy and fear of missing out).
But avoiding the other errors isn’t so easy.
FTX had many causes, but for today we’ll focus in on the themes of trust and risk.
People who were over-exposed to FTX trusted an opaque, centralized intermediary.
This is ironic because the innovative step which gives crypto its value is a disintermediated, decentralized, permissionless system where (for the first time) people aren’t forced to trust others. Instead you can choose your level of trust.
So why did people trust SBF rather than Vitalik, or Satoshi, or the CEO of Ledger hardware wallets, or themselves?
Individual reasons may vary, but we think in the general case it must have *seemed riskier* to learn the tech, be responsible for self custody, risk making an error or succumbing to a hack or fraud. People are used to trusting companies to perform services, including trading and banking, in everyday life. Many people are intimidated by high technology. And humans aren’t naturally good at judging risk at all. Managing risk is a trained specialism.
Here are some cognitive biases humans have which affects judgment on risk:
Authority Bias: The tendency to attribute greater accuracy to the opinion of an authority figure and be more influenced by that opinion.
Availability Cascade: A self-reinforcing process in which a collective belief gains more and more plausibility through its increasing repetition in public discourse.
Bandwagon Effect: The tendency to do or believe things because many other people do or believe the same.
Confirmation Bias: The tendency to search for, interpret, and remember information in a way that confirms one's preconceptions.
Framing Effect: Being influenced by the way information is presented rather than the information itself.
Loss Aversion: Preferring avoiding losses over acquiring equivalent gains.
Negativity Bias: The inclination to give more weight to negative experiences.
SBF appeared in public with politicians and other authority figures, FTX received celebrity endorsement and near constant publicity on crypto-related media during the bull market. Using FTX was as easy as installing a phone app. “Real” crypto, including DeFi and self-custody was complicated, novel, and plagued by the risk of hacks.
The first takeaway from today’s post is to make a study of how cognitive biases affect you and your financial decisions. Having awareness of these biases will prime you to notice when you’re affected by them, potentially helping you avoid the next FTX (or LUNA, OHM, or over allocating to PEPE meme coins).
The Trial Begins
We’re not going to comment on the trial or the innocence / guilt of anyone, just provide factual summaries and quotes (based on reporting, mostly by InnerCityPress)
SBF is represented by lawyers Mark Cohen and Christian Everdell, both former prosecutors of financial crimes. Both also previously defended Ghislaine Maxwell.
Key witnesses include Caroline Ellison, the CEO of Alameda during its alleged borrowing of FTX customer funds; FTX co-founder Gary Wang, and head of software engineering Nishad Singh. These witnesses have previously pleaded guilty to fraud charges relating to FTX/Alameda and are cooperating with the government.
SBF’s lawyers requested but did not succeed in keeping out of evidence seen by the jury a photograph from the Bahamas showing yachts.
Their comment “[SBF] did not buy expensive things” is particularly ironic on the same day a forfeiture notice was filed against SBF himself in respect of a Bombardier Global 5000 long range private jet which costs around $50 million dollars (new).
Sidebar: Cognitive Biases In Criminal Law
A cynic might say that the practice of law (as in courtroom advocacy) is chiefly the manipulation of biases to influence and persuade a judge or jury. Rather than expecting the outcome to turn on a nuanced understanding of the law applied to a particular fact pattern by a dozen ordinary people (laughter), experienced criminal attorneys are apparently focused on shading the presentation of the case to make the defendant conform - or not conform - to the existing model of a “bad”, “greedy”, “guilty” man which exists in the minds of the jurors.
This is why SBF’s defense team asks that pictures of yachts not be shown to the jury, tells the judge “he did not buy expensive things”, are at great pains to refer to the $35mm apartment shared by FTX executives as a “dormitory” or “housing project”, and will try to “lead” witnesses that SBF drove a modest Toyota automobile (no evidence of this). And they’ll over-emphasize Sam’s childhood activities at math camp where he met some of his future colleagues turned witnesses. A hint that they don’t have much of a substantive case to make for the defense is that over-reliance on these tactics have led to multiple reproaches from the Judge in only the first few days of the trial. But these guys are at the top of their field so we wouldn’t dismiss their tactics as ineffective simply because they’re obvious to us. They work.
We’re not even making a case that it’s immoral or unfair to use such tactics: average jurors might be unfairly biased against anyone who has been able to afford luxury purchases and not give them a fair trial out of envy, or the rationalization “I’m not rich, so it’s probably likely that someone who got rich quickly committed fraud.”
The point is that cognitive biases are as much at play in determination of innocence or guilt as they are in investment decisions.
Opening Arguments Summary
The government told the jury that SBF was committing a massive fraud, stealing billions of dollars of customer deposits. Customers thought their money was safe, but he was taking and spending it. He even went to DC to tell Congress that FTX did not take customer’s money. But in reality, he set up bank accounts at Alameda and told FTX customers to deposit there. Even though FTX showed their deposits on the app, the money never went to FTX. As the financial position of the companies worsened, he directed the creation of false financial statements, pulled even more customer money to pay Alameda debts, and continued to lie to customers, investors, and the public. Now his case will be that the downturn in crypto prices and other people are to blame, but the evidence will show that he committed fraud.
SBF’s lawyer opened with “Sam didn’t defraud anyone. He acted in good faith. There was no theft. Sam did not steal from anyone”. The defense case is that crypto is a volatile industry, many companies have failed for reasons unrelated to crime. It wasn’t possible for SBF to oversee everything in a fast growing firm with 300 employees, but that the financial activity including the loan agreements were fundamentally legal. The cause of the business failure was alleged to be Caroline Ellison failing to hedge risks as instructed, not any criminal wrongdoing by SBF. Business failure and bankruptcy aren’t crimes. Making inter-company loans isn’t illegal if you believe the money will be paid back.
As is customary, the defense lawyer told the jury that they’ll ask for a Not Guilty verdict at the end of the trial.
Witness Testimony Summary
Gary Wang - Co-founder & CTO of FTX
Government lawyer: Did you commit crimes at FTX?
Gary Wang: Yes. With Nishad Singh, Caroline Ellison and Sam Bankman-Fried
Wang admitted that Alameda’s account had special privileges: it could trade faster than other accounts, was exempt from liquidation, and had an “allow negative” balance feature (large line of credit from FTX); and these abilities weren’t disclosed.
The negative balance feature was coded up by Nishad Sing and added in 2019. In 2019 when FTX and Alameda shared an office, Wang heard about Alameda having a negative balance. He ran a database query in 2020 which shows Alameda’s balance was negative (~$200mm) more than FTX’s revenue (~$150mm).
Wang testified that Alameda used the line of credit to withdraw funds off the exchange. (as distinct from using it for trading or market making) As much as $8 billion which belonged to FTX customers was withdrawn by Alameda. SBF told Caroline Ellison that Alameda could go ahead and repay loans to Genesis and other lenders. Wang says the money to make the repayments came from FTX customers.
“Customers did not give us permission to use their accounts like this…we had said we wouldn’t use funds like this.”
SBF’s lawyer didn’t have many good questions for Gary Wang. He tried to mitigate the obviously slanted special privileges in favor of Alameda by spinning it as an exemption from being filtered by Cloudflare, since Alameda was trusted by FTX not to DDOS attack the exchange. Then the meandering cross-examination drifted into repetitious questions about meeting SBF at math camp. The Judge rebuked SBF’s lawyer and told him to finish for the day.
Adam Yedida - long time friend of SBF, worked at FTX
Yedida testified he resigned because he learned that Alameda had used FTX customer deposits to repay its loans: “it seemed like a flagrantly wrong thing”
Government lawyer: Why did your view of FTX change?
Adam Yedida: FTX defrauded its customers.
Matt Huang - Co-founder and managing partner of Paradigm
“Customers’ deposits are sacred. We would not have invested [if we knew]. We expect people to do what they tell us. We invested $278 million. We’ve marked it to zero.”
Paradigm invested in FTX during the Series B, but were concerned about the lack of a formal board and entanglements with Alameda (including the potential for front-running, and access to the order book).
Caroline Ellison - former CEO of Alameda, will testify on October 10.
To recap, below are Ms. Ellison’s own words, as told to a Judge when pleading guilty to charges of fraud last year.
What Happened to Sam Trabucco?
The former co-CEO of Alameda Research who left the firm a few months before its failure has not been mentioned so far in the trial. We’re not aware of any prosecution or plea agreement, or even Mr Trabucco’s current whereabouts.
FTX Insolvency Update
Could FTX’s Anthropic Stake Eventually Bail Out Customers?
Creditor advocates are hoping that FTX/Alameda’s investment in the AI company Anthropic will make them whole, following news that Amazon will invest up to $4 billion in the AI startup. Following Amazon’s investment, Anthropic is reputedly in talks with Google to raise another $2 billion.
In June, FTX’s investment banker Perella Weinberg informed potential bidders that it was pausing its planned sale of FTX’s Anthropic shares. If AI valuations continue to increase, appreciation in the valuation of FTX’s stake would benefit creditors. On the other hand, if the hype dies down, the estate may find it difficult to source a buyer at the same price which could have been achieved earlier this year.
Insolvency practitioners need to walk a fine line between realizing assets for the benefit of creditors quickly, and achieving maximum value. The bankruptcy process was designed in an era where asset valuations were easier than today. Plant and machinery, real estate, and inventory can be easily valued and quickly realized. Equity in AI startups and digital tokens like Mysten Labs’ SUI are far harder.
Earlier this year, the administrators appear to have got it wrong by allowing Mysten Labs to unwind its investment contract. Recall that FTX/Alameda were a crypto industry juggernaut and negotiated excellent terms on their VC deals. For ~$100mm investment, Alameda acquired token and token warrant rights in Mysten’s SUI. Mysten bought these rights back from the estate for $96 million just months before the token launched. The tokens would have been worth ~$1.2 billion at the peak shortly following launch, and ~$344 million today.
Secondary Market For FTX Claims
FTX was one of the largest and most trusted exchanges in crypto, with many “whales” keeping most of their net worth on the platform.
Following the bankruptcy, customers were selling their claims for pennies on the dollar. A “good” offer for a seven figure FTX account balance was around $0.08. By January 2023 this had increased to around $0.15 following the appointment of John Ray III and the recovery of some “Sam coins”, notably SOL. Under Ray’s administration, the FTX estate has rounded up $7.3 billion in assets against $10.9b of customer claims according to a stakeholder presentation made last month.
Matrixport recently reported that FTX creditors have an estimated expected payout of around $0.37, the highest percentage recovery of the main crypto bankruptcies, but their methodology isn’t disclosed.
We don’t think it’s this straightforward.
It will probably take another year to liquidate the majority of the estate. Assets include highly volatile crypto tokens, including concentrated positions like SOL; illiquid venture capital investments; and hundreds of millions of dollars in real estate which is already appraised at 10% below cost. It’s almost impossible to predict the final realized value.
It also isn’t clear how forfeiture actions against property purchased by FTX executives will progress (e.g. the ~$50mm private jet, or Trabucco’s yacht).
A legal technicality is that the value of the customer obligations in cryptocurrency are converted to USD at the petition date. Let’s say a customer had 4 BTC and $20,000 USD on deposit (as the first witness in the trial did). BTC was worth around $20,000 on the petition date, so his debt will be marked at ~$100,000. If he gets a “full recovery” of $100k in January 2025, but 1 BTC is worth $40,000, then his 80% BTC / 20% cash portfolio will contain 2 BTC and $20,000. Whereas he had 4 BTC and $20,000 on deposit at FTX. Not what we would call a “full recovery” and something which investors will bemoan if crypto tokens have recovered before a distribution is made.
Avoiding Mistakes
People who put most or all of their money on a CEX were probably afraid of making a mistake with their wallet / self custody, getting hacked or scammed, making mistakes when transferring funds, or just not comfortable with technology.
These beliefs turned into actions caused life-changing losses for many people.
We think it’s better to spend some time and money learning about the space before investing. That’s why we created DeFi Education.
Crypto offers huge and unique benefits:
self-custody done right means nobody can steal from you
no multi year bankruptcy proceedings or frozen accounts
assets and liabilities are public and transactions can’t be faked, making fraud hard
The challenges can be overcome with the right education and some effort. You can:
learn how to evaluate the security of a project to avoid hacks
evaluate other risks of a project and spot outright scams
design an investment process; you’ll avoid emotional decisions which lead to buying tops and selling bottoms
understanding how returns are generated to make good risk-adjusted decisions
match your time and financial investment to your goals and lifestyle
change your mindset from pure loss avoidance to maximizing your long term returns - this will involve some pain and some mistakes but this can be managed
Despite all the bad publicity from high profile arrests and fraud trials, it’s important to understand that crypto and DeFi didn’t fail.
People rushed into the hype without taking the time to understand the tech. They shortcut the effort of learning what crypto is (self custody!) and how to use it - instead they fell for “easy” marketing and celebrity endorsements. Even billionaire investor Mark Cuban lost nearly a million dollars on a simple phishing trick. Taking shortcuts instead of building knowledge can result in huge losses.
In fact, DeFi worked so well (for those who studied it) that Alameda was forced to repay its overcollateralized loans on platforms like Aave. Read that again. DeFi lenders were made whole because code - a smart contract - *enforces* full repayment before releasing collateral back to a borrower. And all DeFi lending transactions are public, allowing any investor to check the solvency of a platform before depositing.
Last cycle investors were sold on “savings” products backed only by interest paid by gamblers who borrowed huge sums of money to make risky bets. Hardly a safe savings vehicle. Crypto now has legitimate and sustainable sources of yield. Owners of Ethereum are paid a yield (around 5%) if they work with a server operator to help process network transactions. This is an essential service and it’s funded by transaction fees of people paying to make ETH payments or use DeFi or NFTs.
Last cycle avaricious con men exploited the justified excitement around the possibility of creating a new financial system and sold investors on depositing their cash and crypto into…centralized pseudo-banks and centralized brokerages/exchanges.
Now people know crypto *can* be dangerous. The cure is education. If you can do a few hours of research and then check in with important developments a few times a year, you won’t make the same mistakes that caused people to lose money in crypto.
And that’s what we’re here for.
If you want to make money in crypto and DeFi next cycle, without getting hacked or scammed, become a paid subscriber to DeFi Education.
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Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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Great article, guys. The de-fi team should partner up with Sales Guy to give a defense and prosecution frame breakdown of the SBF trial. Would be a great collaboration!
Another absolute banger, well done DeFi Ed team! As these crypto bankruptcy cases roll in, does the DeFi Ed team have any plans to write about withdrawal preference exposure and the probable process of going after depositors?