FTX crash is similar to Bernie Madoff scandal, says former regulator

In just three years, Sam Bankman-Fried has turned FTX into a giant cryptocurrency exchange, backed by high-profile investors and valued at $32 billion.

But it only took days for everything to implode into a full-scale bankruptcy filing.

Sheila Bair, one of the main regulators who acted during the 2008 financial crisis, told CNN that there are uncanny similarities between the dramatic rise and fall of Bankman-Fried and FTX and that of infamous Ponzi scheme mastermind Bernie Madoff.

Bair noted that Bankman-Fried, 30, like Madoff, has proven adept at using his ancestry and connections to seduce sophisticated investors and regulators to the point where they overlook “red flags” hidden in plain sight.

“The courtship of regulators and investors can serve as a distraction, preventing them from investigating and seeing what is really going on,” commented Bair, who was chairman of the FDIC (US credit guarantee fund) from 2006 to 2011, in an interview by phone on Monday (14). “It was very reminiscent of the Bernie Madoff style.”

FTX filed for bankruptcy on Friday (11), creating chaos in the crypto industry and raising the specter of huge losses for customers of the cryptocurrency exchange.

“Everything feeds back”

Long before his financial pyramid scheme collapsed, Madoff was known as a Wall Street wizard.

A former chairman of Nasdaq, he served on advisory panels for the Securities and Exchange Commission (SEC) and managed funds for the rich and famous. Bankman-Fried, in turn, was one of the main donors of the Democratic party’s 2022 election campaign.

He has hired several former US regulators to work in high-level positions at FTX, and his parents are both professors at the Stanford School of Law.

Until the bankruptcy filing, FTX still had an application pending with federal regulators to offset derivatives, The Wall Street Journal reported.

Better Markets CEO Dennis Kelleher said in a note on Monday that FTX had a “rotating hiring” strategy from the Commodity Futures Trading Commission (CFTC) and other institutions. “to use their knowledge, influence, and access at the agency and in Washington to further the FTX agenda.”

“People feel cheated,” Brian Armstrong, CEO of Coinbase (a rival cryptocurrency exchange), told CNN in a phone interview on Friday (11). “On the surface, FTX got a lot of attention. But as people began to investigate, they saw that the basic principles were not there.”

FTX achieved its $32 billion valuation with the blessing of investments from big names in the market like BlackRock, SoftBank, Sequoia, as well as other investors.

“You have this herd mentality where if all your peers and big names in the venture capital market are investing, then you have to invest too. That, in turn, gives more credibility to lawmakers in Washington. Everything feeds back,” said Bair, who is on the board of Paxos, a blockchain infrastructure company (Bair also clarified that he was speaking for himself, not for Paxos).

Now, authorities in the Bahamas are investigating possible criminal conduct related to the FTX breach.

Neither the brokerage nor the lawyer representing Bankman-Fried responded to requests for comment.

If it sounds too good to be true…

Bernie Madoff offered investors remarkably consistent wonderful returns and an unbelievable track record, something that later only proved to be possible due to a complicated scheme involving paying existing clients with deposits from new clients.

Given the speed of its fall and the press reports, a number of questions have been raised about the accuracy and soundness of FTX’s balance sheet. The brokerage’s bankruptcy filing indicates that it had liabilities in the range of $10 billion to $50 billion at the time of filing.

Bankman-Fried secretly transferred $10 billion in FTX client funds to trading company Alameda Research and used a “back door” to avoid triggering accounting warning signals, according to sources at the Reuters.

To Reuters, Bankman-Fried denied the secret transfer of funds, and blamed “confusing internal labeling”.

Bair urged caution and skepticism for investors. If it sounds too good to be true, it probably is!

Need for regulation

The good news is that the former FDIC chair is not worried that the FTX crash could threaten the entire financial system, as Lehman Brothers did in 2008. Cryptoassets are still a relatively small part of the economy and financial market .

“There is no systemic impact on the real economy,” Bair said, adding that this is all “overvalued currency in the air with speculation”.

However, the bad news is that the cryptocurrency market remains largely unregulated, which makes it a no man’s land of the financial world. This leaves investors vulnerable when there is a crash.

“The risks of crypto assets are very real,” commented acting FDIC Chairman Martin Gruenberg in a statement to be presented at a hearing on Tuesday (15). “Following the cryptocurrency platform failure this year, there have been numerous reports of consumers being unable to access their funds or savings.”

Gruenberg, who was appointed by President Joe Biden on Monday to be the full-time director of the FDIC, drew parallels between the crypto industry and the exotic financial instruments that turned out to play a key role in the 2008 financial crisis.

“Cryptoassets bring with them new and complex risks that, like the risks associated with innovative products in the early 2000s, are difficult to fully assess, especially given the market’s eagerness to quickly adopt these products,” he said. Gruenberg on the stand at a US Senate Banking Committee hearing.