How FTX bought its way to become the 'most regulated' crypto exchange

Hawick Data NV

18/11/2022 01:12

(Contains language some readers may find offensive, paragraph
10)

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      FTX bought a 10% stake in IEX with an option to acquire
100%
    

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      FTX spent $2 billion on 'acquisitions for regulatory
purposes'
    

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      Documents show FTX saw its regulatory status as a way of
luring
new capital from major investors 
    

  
    By Chris Prentice, Angus Berwick and Hannah Lang
       Nov 18 (Reuters) - Before it collapsed this month, FTX
stood apart from many rivals in the largely unsupervised crypto
industry by boasting it was the "most regulated" exchange on the
planet and inviting closer scrutiny from authorities. 
    Now, company documents seen by Reuters reveal the strategy
and tactics behind founder Sam Bankman-Fried's regulatory
agenda, including the previously unreported terms of a deal
announced earlier this year with IEX Group, the U.S. stock
trading platform featured in Michael Lewis's book “Flash Boys”
about fast, computer-driven trading. 
    As part of that deal, Bankman-Fried bought a 10% stake in
IEX, with an option to buy it out completely in the next two and
half years, according to a June 7 document. The partnership gave
the 30-year-old executive the opportunity to lobby IEX’s
regulator, the U.S. Securities and Exchange Commission, on
crypto regulation. 
    That deal and others referenced in the documents, which
include business updates, meeting minutes and strategy papers,
illuminate one of FTX's broader goals: quickly crafting a
congenial regulatory framework for itself by acquiring stakes in
companies that already had licenses from authorities,
shortcutting the often drawn-out approval process.
    FTX spent some $2 billion on “acquisitions for regulatory
purposes,” the FTX documents seen by Reuters from a Sept 19
meeting show. Last year, for example, it bought LedgerX LLC, a
futures exchange, which gave it three Commodity Futures Trading
Commission licenses in one swoop. The licenses gave FTX access
to U.S. commodities derivatives markets as a regulated exchange.
Derivatives are securities that derive their value from another
asset. 
    FTX also saw its regulatory status as a way of luring new
capital from major investors, the documents show. In documents
to support its ask for hundreds of millions of dollars in funds,
it held out its licenses as a key competitive advantage. The
“regulatory moats,” it said, created barriers for rivals and
would give it access to lucrative new markets and partnerships
beyond the reach of unregulated entities.
    “FTX has the cleanest brand in crypto,” the exchange
proclaimed in a June document presented to investors. 
    Bankman-Fried did not respond to a request for comment on
questions about FTX's regulatory strategy. FTX did not respond
to requests for comment.
    An SEC spokesperson declined to comment for this article.
The CFTC also declined to comment.
    In a text exchange this week with Vox, Bankman-Fried made an
about-face on regulatory matters. Asked if his prior praise of
regulations was “just PR,” he said in a sequence of texts:
“yeah, just PR... fuck regulators... they make everything
worse... they don't protect customers at all.”
    An IEX spokesperson declined to confirm details of the
transaction with FTX, except to say that FTX's “small minority
stake” in IEX cannot be sold to a third party without its
consent. “We are currently evaluating our legal options with
respect to the prior transaction,” the spokesperson said.
    PATCHWORK OF REGULATORS
    FTX collapsed last week after a futile bid by Bankman-Fried
to raise emergency funds. It had come under some regulatory
oversight through the dozens of licenses it picked up via its
many acquisitions. But that didn’t protect its customers and
investors, who now face losses totaling billions of dollars. As
Reuters reported, FTX had been secretly taking risks with
customer funds, using $10 billion in deposits to prop up a
trading firm owned by Bankman-Fried. 
    Four lawyers said the fact that Bankman-Fried was courting
regulators while taking massive risks with customer funds
without anyone noticing exposes a yawning regulatory gap in the
cryptocurrency industry. “It’s a patchwork of global regulators
-- and even domestically there are huge gaps,” said Aitan
Goelman, an attorney with Zuckerman Spaeder and former
prosecutor and CFTC enforcement director. “That's the fault of a
regulatory system that has taken too long to adjust to the
advent of crypto.”
    A person familiar with the SEC's thinking on crypto
regulation said the agency believes crypto firms are illegally
operating outside of U.S. securities laws and instead lean on
other licenses that provide minimal consumer protection. "Those
representations, while nominally true, don't cover their
activity," the person said.
    'STEP 1: LICENSES'
    Bankman-Fried had big ambitions for FTX, which by this year
had grown to more than $1 billion in revenues and accounted for
about 10% of trading in the global crypto market, from a
standing start in 2019. He wanted to build a financial app,
where users could trade stocks and tokens, transfer money and
bank, according to an undated document titled, “FTX Roadmap
2022.”
    “Step 1” toward that goal, the “Roadmap” document said, “is
to become as licensed as reasonably possible.” 
    “Partially this is to make sure that we're regulated and
compliant; partially this is to be able to expand our product
offering,” the document said.
    That's where FTX's acquisition spree came in, according to
the documents. Instead of applying for every license, which can
take years and sometimes uncomfortable questions, Bankman-Fried
decided to buy them.
    But the strategy also had its limits: At times, the
companies it acquired didn't have the precise licenses it
needed, the documents show. 
    One of FTX's goals, according to the documents, was to open
up the U.S. derivatives markets to its customers in the country.
It estimated the market would bring additional trading volume to
the tune of $50 billion a day, generating millions of dollars in
revenue. To do that, it needed to persuade the CFTC to amend one
of the licenses held by LedgerX, FTX's newly acquired futures
exchange. 
    The application process went on for months, and FTX had to
pony up $250 million for a default insurance fund, a standard
requirement. FTX anticipated the CFTC could ask it to increase
the fund to $1 billion, according to minutes of a March meeting
of its advisory board.
    FTX collapsed before it could get the approval, and has now
withdrawn its application. 
    Buying companies for licenses also had other advantages, the
documents reviewed by Reuters demonstrate: It could give
Bankman-Fried the access he desired to regulators. 
    A prime example is the IEX deal, which was announced in
April. In a joint interview to CNBC, Bankman-Fried and IEX CEO
Brad Katsuyama said they wanted “to shape regulation that
ultimately protects investors.” What matters the most here,
Bankman-Fried added, is that “there is transparency and
protection against fraud.” 
    Reuters could not determine how much FTX paid for the stake.
    Bankman-Fried was invited to meet SEC Chairman Gary Gensler
and other SEC officials along with Katsuyama in March.
    A source close to IEX said the purpose of the meeting was to
let the SEC know in advance about its deal with FTX, which had
not been publicly announced at that point, and to discuss the
possibility of IEX creating a trading venue in digital assets,
such as bitcoin. FTX's role was to provide the crypto-trading
infrastructure, the source said.
    SEC officials outright rejected their initial plan because
it would have involved the creation of a non-exchange trading
venue that is more lightly regulated, something the agency
opposes for cryptocurrencies, the source familiar with the SEC's
thinking said.
    Reuters could not determine the extent of Bankman-Fried's
involvement in subsequent conversations with the SEC. In their
mind, SEC officials had agreed to meet with Katsuyama in March,
and Bankman-Fried was just tagging along, the source familiar
with the SEC's thinking said. He kept mostly silent during the
meeting, with Katsuyama in the "driver's seat," the source
added.
    Whatever his involvement, FTX talked up its discussions to
its investors. In a September meeting of its advisory board, FTX
said talks with the SEC were "extremely constructive." 
    “We are likely to have pole position there,” it said,
according to the meeting minutes.
    The person familiar with the SEC’s thinking said they would
dispute FTX was in the “pole position.” Anything the SEC did to
regulate crypto trading would be open to all market
participants, the source said. 
    The source close to IEX said the exchange never entered into
any operational agreements with FTX, adding that it never got to
that point.
    A May FTX document provides a rundown of FTX's contacts with
individual regulators. The document, which has not been
previously reported, shows how in most cases FTX was able to
resolve the issues that cropped up. 
    In February, for example, South African authorities
published a warning to consumers that FTX and other crypto
exchanges were not authorized to operate there. So FTX entered
into a commercial agreement with a local exchange to continue
providing the services. “FTX is now fully regularised in respect
of its current activities in South Africa,” FTX said. 
    The regulator, South African Financial Sector Conduct
Authority, did not respond to a request for comment.
    The May document also shows that FTX had a brush with the
SEC. The SEC had conducted inquiries earlier this year into how
crypto companies were handling customer deposits. Some firms
were offering interest on deposits, which the SEC said could
make them securities and should be registered under its rules.
In the list of its regulatory interactions, FTX noted that the
inquiry was looking at whether those assets were being “lent out
or otherwise used for operational purposes.”
    This month, as Reuters has reported, it emerged that FTX had
done just that, moving billions of dollars in client funds to
Bankman-Fried's trading firm, Alameda Research.
    In the May document, FTX said the SEC's exam staff, which
scrutinizes market practices that could present a risk to
investors, was concerned about a different matter: a rewards
program that it offered to customers, under which it paid
interest on crypto deposits. 
    According to the document, FTX told the regulator it did not
have the same issues as products from other providers that the
agency had investigated. 
    "We confirmed these were solely rewards based and do not
involve lending (or other use) of the deposited crypto," FTX
wrote. The SEC wrote back, saying it had completed its "informal
inquiry" and did not need further information “at this time.” 
    The SEC had no comment on the inquiry. In an email to
Reuters, Bankman-Fried wrote: "FTX's response there was
accurate; FTX US's rewards program did not involve lending out
any assets."
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Exponential growth    https://tmsnrt.rs/3UCKKJJ
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 (Reporting by Chris Prentice and Hannah Lang in Washington,
Angus Berwick in London; editing by Megan Davies, Paritosh
Bansal and Chris Sanders)
 ((Chris.Sanders@thomsonreuters.com))