Binance bails on FTX bailout but won’t dodge regulatory scrutiny

Binance founder Changpeng ‘CZ’ Zhao’s decision to back out of a bailout of FTX may have less to do with the rival cryptocurrency exchange’s financial shortcomings and more to do with lowering CZ’s regulatory profile.

This week’s dramatic implosion of FTX and the subsequent announcement that Binance had made a non-binding offer to acquire the troubled exchange took another whiplash turn on Wednesday when Binance backed out of the deal upon realizing the size of the unfunded liabilities on FTX’s balance sheet. Binance claimed that “the issues are beyond our control or ability to help.”

Also factoring into the decision was “the latest news reports regarding mishandled customer funds and alleged U.S. agency investigations.” Bloomberg reported Wednesday that the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are probing FTX to determine whether the exchange was gambling with customer funds.

The SEC’s probe, which also involves FTX’s sister firm Alameda Research and the U.S.-facing FTX.US exchange, reportedly began “months ago” but has obviously taken on new urgency given this week’s events.

The fact that the CFTC are also digging into FTX’s operations is significant, given how slavishly SBF used to praise the agency in the hopes that it—and not the SEC—would be granted primacy over digital currency regulation. No doubt many CFTC commissioners are feeling more than a little betrayed by the cuddly crypto-muppet they so eagerly celebrated over the past year or so.

With Binance out of the picture, FTX is reportedly warning its investors that it’s staring down bankruptcy unless someone with deep pockets and shallow morals steps up to the plate. The beleaguered FTX is reportedly facing an $8 billion shortfall after clearly ignoring the mandated church-state separation of customer funds and operating capital.

HOLY SHIT

In front of a room of lawmakers… pic.twitter.com/7aGWdJ0l9W

— MrChief (@HaloCrypto) November 9, 2022

The fiat value of most digital assets was already taking a serious hit before Wednesday’s announcement but the overall market promptly took an epic swan dive, not just in terms of digital tokens but also the publicly traded firms linked to the sector, including MicroStrategy (NASDAQ: MSTR), Coinbase (NASDAQ: COIN), Block (NASDAQ: SQ) and various crypto-based exchange traded funds.

With the market in chaos, the situation remains as fluid as ever. At this rate, we half expect the day will end with reports that FTX founder Sam Bankman-Fried is secretly the sister of Elizabeth Holmes and that both are the illegitimate offspring of Bernie Madoff. Sound farfetched? Compared to what?

CZ: it wasn’t me

Prior to Wednesday’s blockbuster news, CZ released an internal memo that was previously reported on by the Financial Times. In it, CZ claimed that “we did not master plan this or anything related to it” and warned that the prospect of “FTX going down is not good for anyone in the industry. Do not view it as a ‘win for us.’” In addition to shaken consumer confidence, CZ stressed that “regulators will scrutinize exchanges even more … and people now think we are the biggest and will attack us more.”

First off, the founder doth protest too much, methinks, regarding his/Binance’s presumed role in FTX’s undoing (which is certainly a ‘win’ for Binance by removing an upstart rival from the race). Among the chief unanswered questions in this saga are who supplied the Alameda balance sheet that led to the initial reporting that kicked off this whole imbroglio, and why.

Clearly, the leaker was someone with access to Alameda’s internal documents, but this individual had to have known that exposing the lies that underpinned the ‘fully-funded’ assertions of both Alameda and FTX would have a disastrous impact on both companies, with resulting misery for their customers, investors and staff.

Which begs the obvious question: why would this staffer willingly start a fire that would ultimately consume their own position? It seems likely that this individual expected (a) a financial reward that exceeded their expected loss of income, or (b) the guarantee of a similarly lucrative role at an even larger company.

This in turn begs the larger cui bono question of who/what was willing/capable of supplying such compensation/employment? Not for nothing, but CZ’s memo warned staff “do not comment on the deal, publicly or internally … Things will play out.”

Target acquired

As for CZ’s warnings about increased regulatory scrutiny, he’s not wrong. CZ’s blowing smoke when he claims people “think” Binance is the biggest exchange, as his outfit dominates trading volume for both spot trades and derivatives.

Acquiring another top-five exchange would not only have demolished any lingering sense that the ‘crypto’ sector was in any way ‘decentralized,’ it would have created a behemoth that would compel action by competition watchdogs.

But backing out of the deal won’t save CZ from increased regulatory scrutiny. Binance was an early investor in FTX and reportedly received $2.1 billion in tokens (FTX’s native FTT and Binance’s BUSD in-house stablecoin) when it divested itself of its FTX stake in July 2021. At the time, the most recent FTX fundraising round valued the exchange at around $18 billion, meaning Binance’s divested share represented a significant chunk of its rival.

That sizable stake presumably gave CZ no small influence over FTX decision-making, which could provide an avenue for the SEC/CFTC probes to trace what role CZ may have played in some of FTX’s more ill-conceived decisions. The legal concept of ‘piercing the corporate veil’ can extend the liabilities of a corporation to its individual shareholders, particularly if said liabilities involved blatantly fraudulent practices.

Similarly, the concept of ‘joint and several’ liability also makes both CZ and SBF prime targets for the torrent of civil litigation that will be unleashed before rigor mortis begins to stiffen FTX’s corpse.

20) At some point I might have more to say about a particular sparring partner, so to speak.

But you know, glass houses. So for now, all I'll say is:

well played; you won.

— SBF (@SBF_FTX) November 10, 2022

Any connection that U.S. authorities can draw from Binance/FTX to their respective U.S.-facing sites will spell doom for CZ. Internal documents have shown that CZ is very much calling the shots at the supposed ‘arms-length’ Binance.US, which was set up to serve as a regulatory lightning rod to distract the authorities from the dot-com mothership’s routinely sketchy operations.

BetOnHubris

Just because the U.S. federal authorities have yet to indict CZ doesn’t mean the documents aren’t being typed up as we speak. As someone who spent years documenting the online gambling industry, I recall all too well the collective industry shock when the Department of Justice arrested David Carruthers, CEO of the now defunct BetOnSports gambling site, in the summer of 2006.

BetOnSports had been one of the more egregious marketers of its services to U.S. residents, including driving custom-painted ‘bet buses’ onto the parking lots of U.S. college sports venues and signing up new customers on the spot. This, despite the fact that the U.S. was more than a decade away from lifting the prohibition on single-game sports betting outside Nevada.

Carruthers, a U.K. resident, was arrested in Dallas during a stopover on the way to his company’s offices in Costa Rica. It didn’t matter that sports betting was legal in the U.K., where BetOnSports was based and even listed on the London Stock Exchange. Carruthers ultimately spent close to five years in U.S. custody before being repatriated to the U.K. to finish the remaining time of his sentence.

Carruthers made the mistake of setting foot on U.S. soil, a fateful decision that CZ appears uneager to replicate. But CZ and his employees appear all too vulnerable to the same racketeering charges that brought down BetOnSports and led to Carruthers’ lengthy incarceration.

Carruthers was convicted of racketeering conspiracy, reflecting the government’s view that he was part of a criminal organization. Originally intended to target Mafia groups, the Racketeer Influenced and Corrupt Organizations (RICO) Act has long been used against all manner of groups the government perceives to be coloring outside the lines. RICO predicate offenses include money laundering, fraud and other activities long associated with the ‘wild west’ crypto community.

Oh, and if the online gambling analogy seems out of place, remember that FTX’s chief regulatory officer is/was none other than Daniel Friedberg, who in 2008 oversaw the coverup of an insider cheating scandal at Ultimate Bet that cost the site’s poker players millions of dollars. Old habits die hard, it seems.

CZ may feel untouchable given his unwillingness to set foot on U.S. soil but Binance’s role in allowing Iranian individuals to skirt U.S. economic sanctions—the full extent of which was laid bare in a recent Reuters report—means other nations may be more willing to comply with U.S. requests to detain certain individuals it suspects of facilitating this sanctions-dodging.

A willingness to play nice with the U.S. may also be on the uptick following Tuesday’s mid-term election results, which strongly suggested America’s desire to shift away from MAGA isolationism and back towards the type of international cooperation that predated Trump’s tenure at 1600 Pennsylvania Avenue. In the meantime, CZ may wish to pack some extra tissues in his carry-on bag in case he sweats a little more than usual while clearing customs.

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Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.