Original Article "SBF’s Defense Will Be Tough", compiled by Odaily Planet Daily jk.

Original Author: Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz, and a clerk for the U.S. Court of Appeals for the Third Circuit.

Accusations

The main accusations against Sam Bankman-Fried are:

• Clients deposited billions of dollars into his cryptocurrency exchange FTX to purchase cryptocurrencies.
• Bankman-Fried's trading firm Alameda Research secretly used this money to gamble on cryptocurrencies and made some strange illiquid investments.
• Additionally, a significant amount of money seems to have been diverted for political donations, celebrity endorsements, and for Bankman-Fried and his family to purchase real estate in the Bahamas.
• When clients began requesting refunds in November last year, the money was gone.

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

But Bankman-Fried will be on trial tomorrow, and when Michael Lewis was asked on "60 Minutes" if he thought Bankman-Fried intentionally stole clients' money, he replied, "I mean, no." So I guess there will be a defense.

So what is the defense? I think the defense is roughly: "The crypto market crashed, there was a run on the bank, and the run on the bank caused the disappearance of client funds. This is an accident, maybe a careless accident, but not theft." This is really a very difficult case to defend.

The first most difficult thing is that in a cryptocurrency exchange like FTX, we don't usually think of "runs on the bank." An intuitive way for a cryptocurrency exchange to work is:

• I deposit $100.
• I buy $100 worth of Bitcoin on the exchange.
• The exchange marks $100 worth of Bitcoin for me.
• When I go to withdraw my $100 worth of Bitcoin, if it's not there, that means someone stole it.

FTX doesn't usually work like this. It's a futures exchange. The way it works is more like:

• I deposit $100.
• I use that money to bet $1,000 worth of Bitcoin on the exchange.
• The exchange holds my $100 as collateral, but the $1,000 worth of Bitcoin doesn't actually exist; it's just a bet between me and another client.
• If Bitcoin goes up 20%, then the $1,000 worth of Bitcoin is now worth $1,200, and my $100 bet is now worth $300.
• Similarly, the other side, the person I bet against, put up $100 as collateral to bet $1,000 worth of Bitcoin; now that Bitcoin has gone up, his $100 bet is now worth negative $100.
• When I go to withdraw $300, if it's not there, that means the losing bettor didn't pay—or the exchange didn't have enough money from other losing bets to pay me.

The exchange is in the middle of winners and losers of bets, and it can't pay out what it owes to clients unless the clients who owe it money pay up. Usually, clients provide collateral, and the exchange manages the risk of positions, so there's no problem, but in the event of sudden and severe market fluctuations, the exchange may not have enough funds. This has indeed happened at legitimate, regulated exchanges; it almost happened last year at the London Metal Exchange.

But no one believes this; it's far more complicated than what a jury would be willing to hear. Intuitively, if you take clients' cash, you should have that cash, and if you don't, it looks suspicious. (FTX's cash-only clients, including those who should really be fully cash and segregated clients on FTX.US, have also been caught up in the bankruptcy.)

Even if you've convinced the jury that a bank run is possible, this defense faces many problems. I want to mention three of them, although it's not hard to think of more.

First:

It wasn't some fluctuations in cryptocurrency prices that caused a lot of FTX client funds to be wiped out, leaving them owing FTX and FTX unable to pay other clients. It was some fluctuations in cryptocurrency prices that wiped out one FTX client: Alameda. The upshot is that Alameda owes FTX a lot of money, and almost entirely because Alameda lost money.

This is suspicious in itself: if the basic economic structure of the exchange is that it owes money to all clients, but the one client who owes it money is its largest client (a trading firm owned by the exchange's CEO), that's bad. Structurally, this is "we take money from clients and use it to gamble for ourselves."

But every detail of this is very bad. Alameda owes a lot of money to FTX, but no one else does—no one else got wiped out by huge price moves, leaving it with an uncollateralized short position at FTX—because FTX does have reasonable risk management systems. If you run some unaffiliated hedge fund and you want to use your $20 and borrow $1 billion from FTX to buy some illiquid, volatile, speculative cryptocurrency, FTX's computers will say "absolutely not." This is FTX's pride, it's what they advertise, it's what they brag to regulators and Congress about, it's what Bankman-Fried talks about on Twitter.

But Alameda was allowed to do this: FTX's code had some settings that allowed Alameda to have an unlimited negative balance, to borrow freely, without any collateral. Alameda used this during last year's cryptocurrency market crash, because it was hard for it to borrow elsewhere. A key part of the trial will be about whether Bankman-Fried authorized this. In a conversation with Sheelah Kolhatkar of the New Yorker, "Bankman-Fried insists," prosecutors won't be able to produce any evidence that he authorized unlimited borrowing, because, he says, there is no such document. But basically everyone else who worked at FTX might testify that he did. It's a very self-serving testimony: the implicit offer from prosecutors is "if you say Bankman-Fried did this, you might avoid prison, if you don't, we might put you in prison forever." Nevertheless, it doesn't help him, and prosecutors seem to have recordings of his colleagues saying this before government intervention.

Second:

It's not just that Alameda made a series of cryptocurrency trades that went wrong, all of which just happened to go wrong. Alameda wasn't troubled by, say, cross-border Bitcoin arbitrage gone wrong, or even really by the collapse of Terra/Luna, which caused many other cryptocurrency firms to go under. Alameda's trouble, in fact, is that it owes FTX (and its clients) billions of dollars, and its assets are mainly weird illiquid assets associated with FTX—FTT, SRM, MAPS, and other tokens: "Samcoins" invented by Bankman-Fried, mostly owned by Alameda, representing bets on his own speculative activities. Clients come to FTX to bet on Bitcoin and Ethereum and other unrelated cryptocurrencies, and then Alameda takes their money and puts it all into FTX's own cryptocurrencies.

Accepting real client funds—dollars that clients give you to gamble with, or at least cryptocurrencies that are not under your control—and using them to pump up the prices of cryptocurrencies that you control, is a bit like a Ponzi scheme. That's the box. Bankman-Fried has expressed this idea to me in a podcast—he said you could just create a cryptocurrency, assign it some arbitrary market value, and then borrow millions of dollars against that false market value.

Third:

The facts are still unclear, but my assumption is that the vast majority of the approximately $8 billion in missing client funds flowed to Alameda, which lost it on foolish cryptocurrency bets. But not all of it. Lewis said on "60 Minutes" that Tom Brady received $55 million for endorsing FTX, and he was one of many high-paid celebrity endorsers. Millions were spent on political donations, effective altruism activities, real estate in the Bahamas, and the lavish operation of FTX.

You can imagine some accounting where all these expenses are strictly paid out of FTX's operating income (fees it legitimately charges clients and expenses it pays in cash), and the $8 billion was entirely lost due to Alameda's unfortunate leverage mistakes. But there's no indication of such accounting, and everyone agrees that FTX's actual accounting is absurd. For example, "FTX Group's employees submitted payment requests through an online 'chat' platform, where a different set of managers responded with personalized emoji approvals," complained the CEO after the bankruptcy. This makes it impossible to really argue that all these expenses were paid out of operating income rather than client funds.

Instead, it looks more like FTX and Alameda had a commingled pool of funds, rewarded themselves with huge accounting income, and then weren't bothered by spending tens of millions of dollars because they thought there was still plenty of money there. Bankman-Fried's defense must be something like "When I looked at our financials, I thought we had way, way more money than we owed to clients, so I thought it was fine to spend a few hundred million on marketing and employee benefits."

And, indeed, FTX seems to have made a lot of money through actual fees. For a while, Alameda had a huge amount of assets on its balance sheet, with a lot of equity. Conceptually, at its peak, FTX/Alameda might have had a pile of tokens, with a market value (the last sale price of the tokens held by FTX/Alameda multiplied by the number of tokens) of $100 billion, and it owed clients $30 billion in real or relatively real funds (dollars, bitcoins, ethers, etc.). Bankman-Fried might have looked at these numbers and thought, "Well, $100 billion is way more than $30 billion, we're rich, we can afford Tom Brady."

But that $100 billion is fake, meaning FTX/Alameda can't get (and didn't get) anything close to $100 billion in value for those tokens, and the $30 billion is real, meaning the U.S. government is trying to put Bankman-Fried in jail because clients didn't get all their money back.

One problem with this defense, and with the "bank run" defense in general, is that it requires a lot of optimism about cryptocurrency holdings. It requires you to believe that Bankman-Fried looked at Alameda's huge cryptocurrency inventory—mostly made up of cryptocurrencies invented by Bankman-Fried, and largely controlled by him and Alameda, with their market value mainly based on confidence in him—and said, "Ah, this is real money, I can keep spending this money, and there's enough real money to pay back my clients' dollars and bitcoins, etc."

I mean, there's a math problem here:

• You have $100 billion of weird cryptocurrencies.
• You owe people $30 billion of real money.
• How much money can you spend?

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

But that's me! There are a lot of people in the cryptocurrency world who would say, "Great, I have $70 billion, cryptocurrency is the future, various cryptocurrencies worth $100 billion are at least as valuable as $100 billion of depreciating fiat currency."

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

My view is that if you're talking to an operator of a cryptocurrency exchange and he's saying things like "cryptocurrency is changing the world, your outdated economics is just baseless fear, HODL," that's bad. A true believer in cryptocurrency isn't the person running the exchange. What you want from the person running the exchange is a prudent 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 view is driven by the market, not ideology, who cares about risk, not futurism. It's healthy to have a certain skepticism about the products you trade.

Well. That would have been a good idea. If you were skeptical of your huge cryptocurrency holdings, you wouldn't use client funds as collateral for loans, and you wouldn't continue to spend real money on endorsements and donations. You would only do that in a few cases: (1) you were overly optimistic about the value of your own cryptocurrencies, or (2) you were very cynical and planning to steal it.

The defense's reason is that Bankman-Fried is very naive. It not only requires you to believe that his deputies stole all clients' money without his noticing, and that he made a series of innocent risk management mistakes while everyone else was building evil backdoors. It also requires you to believe that he believed in his own cryptocurrencies, that he thought his massive fictional wealth was real, and that he could spend it at will. Clearly, that's not the case.

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