Blog Post

FTX Shattered: A False Idol of Global Compliance

November 17, 2022

$32 Billion Crypto Titan FTX Collapses Under Liquidity Crisis Despite Adhering to Global Compliance Standards – Proof of Reserve is Thrust Into the Due Diligence Spotlight.

On November 7, 2022, a hurricane originated in the Bahamas.  Within a week’s time, it had caused tens of billions in damages to the crypto and web3 industry. This hurricane was named FTX – born of moral hazard, hidden beneath a smooth surface of seeming compliance. This was the beginning of the end for one of the two most powerful digital assets exchanges in crypto history:  an empire built from the ground up – seemingly the model exchange for a crypto culture of compliance, brought to life by the poster boy for crypto wealth-building, Sam Bankman-Fried.  

Bankman-Fried seemed to have it all together: a successfully scaling business, the favor of investors, and even the eyes and ears of legislators and regulators around the globe. He was once known as the industry-dubbed “White Knight” of crypto, who salvaged failing competitors despite their shortcomings. But behind closed doors, the recipe for financial disaster stewed, slowly simmering toward the boiling point.

FTX seemed healthy, strong, and ever-compliant. The exchange itself was incorporated in Antigua and Barbuda. Its trading subsidiary, FTX Digital Markets Limited, was licensed under The Bahamas Digital Assets and Registered Exchange Act of 2020 and regulated by the Securities Commission of the Bahamas. Subsidiary Zubr Exchange Limited, of Gibraltar, was a crypto derivatives exchange licensed by the Gibraltar Financial Services Commission as a distributed ledger technology provider. Australian customers were serviced via FTX Express Pty Ltd, an AUSTRAC-registered digital currency exchange provider, and FTX Australia Pty Ltd, an Australian Financial Services Licensee. Venue shopping – strategically locating subsidiaries based on favorable regulatory and tax environments – a smart move, even for the compliant.  

Limitation of involvement with FTX Digital Markets Ltd was appropriately scoped in its homepage help article on “Jurisdiction regulations, licensing, and practices”.  Users from Japan, The Bahamas, Australia, and Singapore were not facilitated by the trading subsidiary. Trading tokenized stocks, and prediction markets were not services offered in those regions. However, FTX did offer tokenized stock trading in partnership with K-DNA and FTX Switzerland Gmbh, leveraging a German license and through a regional trading subsidiary, FTX Trading GmbH. FTX Switzerland GmbH provided financial and limited custody services, was registered with SRO Treuhand Suisse for anti-money laundering compliance and was a member of Finanzombudsstelle Schweiz (FINOS), the Swiss financial service providers Ombudsman organization. FTX was registered with FINTRAC, the Canadian financial intelligence unit (FIU), and was pursuing the appropriate license to operate.  

The list goes on, the compliance measures seemingly all in place as Sam Bankman-Fried and his crypto empire courted regulators (and investors) throughout Europe, the Middle East, Asia, and the Americas.

Investor funds poured in from around the globe.  The FTX empire was erected and fortified with over $2 Billion in financial support from partners in the United States, Canada, Singapore, Switzerland, Australia, Japan, South Africa, Ghana, the British Virgin Islands, the United Kingdom, Liechtenstein, and France.  Investors included powerful, well-trusted names: NEA, IVP, Iconiq Capital, Third Point Ventures, Tiger Global, Altimeter Capital Management, Lux Capital, Mayfield, Insight Partners, Sequoia Capital, SoftBank, Lightspeed Venture Partners, Ribbit Capital, Temasek Holdings, BlackRock and Thoma Bravo.  Nearly 60 sources of funding are spread over 12 countries around the world.  Perhaps it is not surprising, then, that as of the time this blog was published, The Bahamian Supreme Court had approved liquidators for FTX’s assets and media reported that FTX’s new leadership is in touch with regulators, with now over a million creditors in tow.  What was once given, soon to be taken.

The past year has presented more than a few Black Swan events for the Cryptoverse…but none with such a global impact as the shattering of the FTX empire. Terra Luna, Voyager, Three Arrows Capital, FTX…they all suffered from a similar ailment – toxic lending practices made infamous in traditional finance, shot full of steroids through real-time transaction speed and pseudonymity of digital assets, and pushed beyond recovery by lack of proper governance and risk management. Perhaps ironically, FTX’s most worthy adversary – Binance – has thrust the concept of “Proof of Reserve” from relative obscurity into the spotlight of crypto risk management vernacular.

Proof of Reserve has become the rallying cry of the virtual asset service provider industry, with almost every notable exchange sending frenzied newsletters and publishing hastily drafted blogs aimed at assuring customers of their commitment to transparency, their lack of association with FTX and its native token, and proving their stability through identified reserves. The onus is on these businesses, as the custodians of their client’s funds and assets, to meet their fiduciary obligations (in part) by verifying that they indeed hold the assets they claim to possess.

Proof of Reserve now joins the ranks of non-negotiable compliance and risk management controls like anti-money laundering (AML), know your customer (KYC), know your transaction (KYT), and can be categorized under a new due diligence model called know your VASP (KYV).  KYV is an evolving hybrid compliance category that combines the traditional counterparty due diligence concepts of KYC with the transactional risk assessment and monitoring of KYT, but adds a third angle of visibility by providing insight into liquidity. Accordingly, KYV completes the due diligence trifecta and allows the most comprehensive view of risk in digital assets, to date. Blockchain analytics like AnChain.AI’s CISO platform and BEI – API provide the KYC (attribution) and KYT (source of funds) elements through attribution and monitoring capabilities.

This brings us to introduce Proof of Reserve, AnChain.AI’s newest product feature designed to provide you with live updates and unparalleled insights regarding an exchange’s proof of reserves – fully integrated into our CISO blockchain analytics tool. Add all this to the insights regarding open source intelligence (OSINT) of licensure and registration status. You now have a holistic view of counterparty risk unlike any the digital assets space has seen before. Your two-dimensional risk assessment now enjoys the third dimension.

Post-FTX, regulators around the world are acutely aware of the true risk of an under-regulated Cryptoverse. Compliance on paper is no longer enough. Virtual Asset Service Providers (VASPs) must take overt action to fulfill their duty as fiduciaries and as stewards of the global digital economy. Compliance, transparency, due diligence, scaling responsibly through proper governance, and ongoing oversight for potential risk are essential pieces of meeting this responsibility. VASPs will be held to this newly elevated standard by both regulators and stakeholders.

The unprecedented challenges of virtual asset mass adoption demand enhanced due diligence tools to meet the occasion. Schedule a call with an AnChain.AI representative today to learn how we can help manage your Web3 risk exposure.