Learning from the Crypto Breakdown

Anne-Marie Henson:

The investigation into Bankman-Fried and other members of FTX and Alameda is ongoing. The discussion here is based on information made public as of March 15th, 2023.

Narrator:

Welcome to Accounting for the Future, a BDO Canada podcast for financial leaders to navigate, change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday but will definitely have to manage for the future.

Anne-Marie Henson:

Hello and welcome to Accounting for the Future. I'm your host, Anne-Marie Henson. On today's episode, I'm joined by two BDO Partners, Mary Mathews, a partner in our accounting advisory group, and Michael Crolla, who does both accounting advisory and audits. I get the pleasure of working closely with both of you and talking about interesting accounting issues almost on a daily basis. Mary and Michael, welcome to Accounting for the Future.

Mary Mathews:

Thanks so much for having us, Anne-Marie.

Anne-Marie Henson:

Today, what we're going to talk about is a very current topic, cryptocurrencies, but more specifically, what's been happening in recent months and how it could be impacting our clients and businesses and what to watch out for and really to help people understand what this means for a company that might be interested in investing in cryptocurrencies. We've all heard in recent months the term "crypto apocalypse" being thrown around as a term, and cryptocurrencies have certainly been extremely volatile in the past couple of years. Looking back on the price of, say, Bitcoin, as an example, reached a high somewhere around $65,000 in 2021 and is trading at about $24,-$25,000, so obviously huge volatilities in that market.

Everyone hears about it on the news, what's been going on in particular with regards to the infamous company now, FTX and its owner, Sam Bankman-Fried, who's well-known as the abbreviation SBF. Now that FTX is a bankrupt company and is no longer anymore, that was one of the largest cryptocurrency exchanges, I guess with reading everything that's going on and trying to keep up to date, and for myself in particular, I'll be completely honest, I know about cryptocurrencies, I've never owned one or part of one, I don't own a coin, I generally understand how they work, but it can be confusing sometimes when you read all these different things that are happening in the news and what to believe, what not to, and really what it means for us on an everyday basis. I want to maybe start off with that is getting a better understanding, Mike, in terms of how you can explain to us what's happened with FTX as an example. How did we end up where we are today in this world of cryptocurrency?

Michael Crolla:

Yeah, it's interesting, and maybe I can give a little bit of background on what exactly FTX did and how the events unfolded. FTX operated as a cryptocurrency exchange in hedge fund. It was founded in 2019 and quickly grew to become one of the largest cryptocurrency exchanges in the world. At one point, they had evaluation of about 32 billion US and continued to raise significant funds from various types of investors, whether various PE firms, celebrities. They had a lot of different backing, and really grew in stature very, very quickly. They had a bunch of high-profile acquisitions, and they promised very significant returns for their investors. At one point, they even created their own token, FTT, and in late 2022, a news site, CoinDesk, revealed that there were problems with one of the FTX-affiliated trading firms, Alameda Research, and whose main asset was the token itself, FTT, and they were using that as collateral. That article raised some concern with both the lenders and customers about the company's leverage and solvency.

After that news broke, one of the more significant holders of FTT announced that they intended to sell all their holdings in this token, so that just created a huge drop in value. Investors rushed to withdraw funds from FTX, and the company couldn't process all these requests, so that caused a pause on withdrawals, and led to a liquidity crisis. There was a potential buyout that failed very quickly on a due diligence front, and ultimately, FTX filed for bankruptcy protection. The founder, he stepped down as CEO. Later, he was arrested in The Bahamas and extradited to the US on multiple security fraud charges. So, this left a lot of people financially devastated, costing investors a lot of money, and just more scrutiny. As you kind of mentioned on the crypto space. You have high volatility, an asset or a space that a lot of people don't understand, and now, with these fraud charges coming out, it's just putting a lot of eyes and different lenses from a regulatory perspective back on crypto.

Anne-Marie Henson:

Right. Yeah, you're right. I think there's been a lot of crypto sceptics, you would say, and this event seemed to give fuel to their concern around the cryptocurrency space. But I understand FTX being the largest failure, and certainly it's not just a failure, there seems to be alleged fraud and mismanagement in there as well, so it's not just specifically tied to cryptocurrency itself. But it's certainly not the only company that's been under scrutiny, so Mary, can you talk to us a little bit about other things that you've seen recently in the news?

Mary Mathews:

Yeah, of course. We've been hearing more recently, Silvergate Capital is one of those instances. Silvergate Capital is a bank that backed many large cryptocurrencies, and it started losing major clients itself, was teetering on bankruptcy just a few weeks ago, so early March 2023 at the time of this recording, and because of that, that led to a drop in the cryptocurrencies as a response to this news. Of course, I'd be remiss to say to not mention Silicon Valley Bank and Credit Suisse as of this morning. This really just reminds us of the ripple effect between companies, not just crypto itself, but something happening to some company in your ecosystem does have an impact on your own company and an undermining of confidence in any industry is going to have a ripple effect, so companies need to just be aware of those risks and opportunities and actively manage all of that.

Anne-Marie Henson:

Right, absolutely. No, it's really interesting what's happening right now and interesting, perhaps a bit scary as well, but definitely some lessons in terms of how to manage your business, and like you said, Mary, how to manage risk and better understand what those risks are.

So, coming back a second to cryptocurrency and maybe trying to break down what's been happening over the past several months in terms of the downfall of crypto and it not being valued as highly as it used to be a couple of years ago, I guess cryptocurrency is still quite a relatively young and new industry, and I think that's something for people to be aware of, that there's a lot of uncertainty around the future of crypto like there is around a lot of new technologies or new industries in general, so it is something to think about, and I think the lack of regulations, Mike, that you mentioned, I think can't be ignored. There's been a lot of throwing around of the hot potato, our cryptocurrencies, do they fall under securities regulations, and do they not? And the regulators have been conspicuously very silent on that matter, which has probably led to a lot of companies just doing what they feel is best for their company and not following a more consistent rules and regulations to be able to provide the right type of information to investors and to their stakeholders.

I guess it's important to understand how the company fell apart and looking at also how could this have all been avoided, so I'm curious to know your thoughts on that. Hindsight's always 20/20, so it's so easy for us to be talking here about what's happened and how it could have been avoided, but do you have any thoughts in terms of what things could have been put in place that would've allowed this industry to be in a better position today?

Mary Mathews:

Yeah, of course. You hit it on the head, Anne-Marie, Crypto's almost a kind of relatively newish industry, but we can't ignore just the key fundamentals of running a company with strong governance. It seemed that there were several things at play in a collapse like FTX, but poor governance was one of those failures. The board of directors at FTX was just three individuals, one of them being the majority shareholder, the controlling shareholder, Sam Bankman-Fried.

But no matter how big a company is, poor governance can always throw it into chaos, so investors or companies need to be wary of boards, which consist of just executives or just management, because the board is really there as part of to protect the investors, to make sure that management is regularly reporting on financial information, and the board is also there to ask questions of management. But if there's poor governance or a poor board structure in place, this can lead to many problems and potentially a lack of oversight where the leadership team is able to go ahead with decisions but maybe not being held to account for some of those decisions from independent directors.

Anne-Marie Henson:

Mike, do you have anything sort of to add on that topic?

Michael Crolla:

Yeah, it's interesting because when you look at the management team, they appear to be very well-connected to each other rather than independent, so if you look in some of the background of how they know each other, whether it's from various schools or childhood, some of this information is coming out now in various articles, so once again, there appears to be that lack of independence, both at the management level and as Mary mentioned, that's where a good board comes in to make sure that there are strong controls or reporting in terms of managing some of that segregation.

There also appears to be a number of transactions between various companies that appear to be related, whether that is FTX with Alameda, which could cause a bunch of problems and questions over the substance of the transaction. I do think it's interesting when we talk about crypto, and obviously, Bitcoin being probably the most famous in terms of the cryptocurrencies out there, what's interesting with companies like FTX and other companies out there is essentially they're creating their own asset, in a sense. They're creating their own currency, their own token, and in general, as an investor, I'd be very cautious of that because these newly created coins could be extremely liquid, and at the end of the day, you can't really tie back the value of this to anything, really, so there should be a lot of scrutiny as an investor going into projects like these or investing in projects like these just to really understand what you're getting into.

Anne-Marie Henson:

Yeah, no, it's a good point, Mike. Being someone, again, who doesn't necessarily know the ins and outs and the details of the cryptocurrency space, I was really fascinated to hear about the downfall and what happened at FTX. You mentioned these very large, unusual, related party transactions that weren't necessarily properly disclosed and accounted for and things like that, and that there was borrowing against this asset, which turned out to be an internally generated asset that had a value assigned to it, is that really the value that you can borrow against?

It reminded me of Enron a little bit. I said, "This reminds me a little bit..." If I'm going to bring this down to perhaps another case that's been studied a lot and that I understand, I was in university when the whole Enron debacle and fraud case occurred, and it was something that was studied for years, and it's a little bit similar in the sense that there is these sister companies that were created and those companies were borrowing with against assets that weren't really real, and none of that was being disclosed to the investors, so I did tie it a little bit into what I saw happening in FTX. It's something that could happen in any industry, not just in cryptocurrencies, but I do think because of how young and new this industry is, it's an area that really fell through the cracks for the investors and the stakeholders of companies like this.

Leading into perhaps a good segue into a discussion about how this could be avoided, it really appears like there was a lack of governance here at the company level, and there was just a general lack in of internal controls as well. We all know coming from an audit and accounting advisory background and working with companies that are trying to raise money and trying to go public, having a strong set of internal controls is really something that helps you as the company be able to capture the right amount of information to be able to understand the accounting implications and then tell the right story to your investors to be able to actually report things on a timely basis and to make things make sense for people. We all know how important internal controls are to be put in place. Mike, is there anything you can add there in terms of what maybe you would recommend as being not just a best practice, but maybe necessary in this sort of environment?

Michael Crolla:

Yeah, for sure. Financial controls are essential for all businesses, but especially those that act as exchanges, have multiple different investors, have a large presence compared to maybe an owner-managed business. In general, this can consist of two types. You got your internal controls or your external ones. Internal controls, having a good set of policies, procedures, and checks that the company can implement to mitigate their risk profile, having things like segregation of duties, dual signatures, regular reconciliations of various accounts, whether bank or other balance sheet accounts or P&L accounts, and monitoring the relationships between management. Once again, in this particular instance, it does appear the management team was very well-connected. Everyone knew each other very well as opposed to coming from various different areas, so they all had, it appears, very strong relationships. Then from an external perspective, independent audits can always help and conducted from an outside firm to ensure that the statements are not materially misstated and in accordance with an accounting framework to provide a basis of comparability to other companies out there.

To the previous point, it's just important to have good governance, which can consist of having independent board members that have a review process, that are questioning management, and taking a look, whether it's monthly or quarterly at various information. Once again, we're learning a lot of new information about this as bankruptcy reports come out and new articles come out on investigations. But it does appear that there are many issues in this area, including certain basic functions who reports to whom, improper security controls. There was an article recently from the bankruptcy report that found there was a unsecured group email account that had access to various private keys that are very important for a cryptocurrency and had sensitive data about the group of companies that just put everything at risk and also there were not any audited financial statements for some of the key components of the FTX group of companies, which may include also Alameda, so a lot of different red flags there. A lot of related party transactions, once again, as we kind of talked about, and that should obviously be heavily scrutinized as well.

With something like this, it's very interesting because in a lot of ways it's the first of its kind. We talked a little bit about Silicon Valley Bank and when bad news gets out in today's day and age compared to what we were dealing with maybe at the first, well, the financial crisis in 2008, is this happened during, we'll call it "the social media age," so FTX is probably the first of its kind in this regard. When there's panic and someone may give their opinion online or a tweet gets out, it could lead to a huge rush or panic in the financial sector, people wanting to withdraw funds, and then leading to liquidity issues. Obviously, the two may not be completely related, very different situations, and there's obviously fraud charges for something like FTX, but it's just interesting to see the dynamic now when a key person from a company can tweet something and it could just have a ripple effect across the industry.

Anne-Marie Henson:

Yeah, absolutely. No, I love that you tie that in, actually, because what's happening today, you can receive information, whether it's right or wrong. You have information that's available now, just pick up your phone, you get news alerts, you'll get tweets, someone will text you about something they just heard about a bank run, or anything that's happening out there, and I think it means that management teams really need to be a lot more conscious about what their, and Mike, you talked about this, and I really like that you were talking about internal versus external controls, but management has a responsibility to manage their role internally, and also externally, and how they're communicating information externally about their business and what's going on. Clearly, there seems to be holes in terms of the level of experience of the management team at FTX, so Mary, I wanted to know a little bit more about your thoughts there, where you think this company went wrong, and also, more importantly, what they could have done better, or what any other startup or growth-stage company could do better with regards to the appropriateness, the sufficiency, the experience of their management team.

Mary Mathews:

Yeah, companies always need to make sure that they have the right management team in place and to steer the ship, and that management team needs to match the size of the company and also the growth trajectory of the company itself. The executive team at FTX was young and relatively inexperienced, let's say, and perhaps this lack of experience might have played a role in the mismanagement and potentially the lack of oversight.

I will say there's nothing wrong with a young executive team, but you do want to make sure that there's structure in place for sure for the management team to execute and to scale up and to grow and meet those goals. Actually, Michael brought up a good point. The management team was very well-connected, depending on maybe where they went to school, or who they were connected with in the market. But something that we always talk about ourselves is just diversity of thought, so maybe your management team also needs to have different backgrounds of experience and be strategic about who's on your management team to make sure that there is diversity of thought in your management team to actually make sure that the management team is putting the best plan forward.

Anne-Marie Henson:

Yeah, no, absolutely. I like that. I think it's an important lesson here that you can build up your team with people who think like you, went to school with you, that get along with you, which is great, but you also need people who can challenge the way you think, who aren't afraid to speak up about another way of doing something, and who aren't afraid to tell you when you need to maybe take a step back, look at different options, and really think in a different way, so no, I agree. I think that's really important.

Mike, I know in your role, your everyday hat as a partner, you liaise a lot with boards as well as CEOs and CFOs. We talked a little bit about the management team and lack of governance here, but what can you tell us more about the company's CEO and where things could have gone wrong?

Michael Crolla:

Yeah, in this case, we talk about there could be that communication that goes out, which may cause a bank run or may cause a liquidity issue, but on the other side, it appears where a CEO can really build himself up, in this case, especially, and almost develop what appears to be a cult of personality in a sense where people really see them as the next big thing without maybe knowing exactly what the person's about or what the company's doing, but they just developed that persona, and they're able to capitalize that and use it in a way to raise money.

We know during 2019 and onwards, especially as COVID hit, there was a lot of activity in terms of deploying funds from private capital or equity, and in some cases, there should be a little bit more care and how that got deployed. And you have to do your due diligence in terms of making sure where and who you're investing with. That's a fine balance. It's a hard thing to answer, but it also you have to know and have a proper idea of who and what you're investing in. It goes back to the person as well as understanding that, in this case, that intangible, that token that maybe you're not sure what the value is, or you're not sure how it works.

On another flip side, maybe as being a little old school here, you want to understand what you're investing in, and that's usually one of the fundamentals when it comes down to where you're putting your money, so in this case, with something that seems new and potentially exciting like crypto, definitely you have to throw caution at it to make sure you understand what you're getting into.

Anne-Marie Henson:

Yeah, absolutely. I guess it's not just understanding what you're investing in, but who you're investing in and in terms of understanding better the management team. Well, I love that you talked about due diligence because when I was watching this whole story unfold, the first question I asked myself is, "How could this have happened with seemingly quite sophisticated, experienced investors?" FTX itself, the company may have been quite new. Sam Bankman-Fried is a very young CEO, so didn't have a lot of experience, but the investors into this company did, and so it made me really curious about what their due diligence process was and where things could have fallen apart.

I guess we've seen this a lot in the past couple of years. It's obviously slowed down a little bit since partway through 2022 in terms of slightly more difficulty in raising, lower valuations, more scrutiny as well in the due diligence process, whereas if you think back to 2019, and definitely 2020 and '21, it felt like investors were racing to have the shortest term sheet to give themselves the biggest chance at the table. Again, looking back on that, maybe it wasn't the best approach because that's great when things are going well. When things don't go well, that's when you start seeing holes in that strategy. Mary, do you have anything to add, or any thoughts on that?

Mary Mathews:

Yeah, I think it's really investors being responsible themselves and not getting swept up at the shortest term sheet and the fastest turnaround to close. Of course, that's just how we as investors protect our capital and making sure we understand and scrutinize any potential investments beforehand, and that we need to do our property due diligence so we're not... Even though we don't want to miss out on the next big thing, we do want to avoid getting caught up with a costly mistake costing any investors money in the long run. That's just a key fundamental, again, with any type of investment decision: do your due diligence, understand what the company is, who the company is, and who's on that team.

Anne-Marie Henson:

Yeah, no, absolutely. I love that. I guess a couple of takeaways from an investor perspective, like you just mentioned, just do your due diligence, take the time you need. Don't necessarily give in right away to that fear of missing out and look into not just the financials of the company but look into what is their governance structure, who's on their board? Who is the management team? What kind of track record do they have? What kind of internal controls does that company have in place? Or are they at least moving towards putting strong controls in place so that you have confidence that the company is really trying to do the right thing? I think there's a lot of takeaways we can take back, not just in terms of the cryptocurrency space but to all different types of companies of various sizes and in industries.

Mary and Mike, I want to thank you so much for your insights on this topic today. I learned a lot, and myself and the audience really appreciate your expertise. I'd also like to thank you, our listener, for tuning in today. This has been BDO's Accounting for the Future podcast. Please let us know if you found the topic interesting, and remember to subscribe if you liked it. See you next time.