Since FTX is due to lodge a big filing in bankruptcy court today, which among other things is expected to provide more detail on the unwind, it seems prudent to wait for more scandalous revelations…save for making sure a couple of juicy details already public don’t get lost in the shuffle.

Even though there’s a widespread assumption that Sam Bankman-Fried and his main partners did a whole bunch of things not on the up and up beyond operating a trading business while insisting staff be high on drugs known to blunt inhibitions about risk and then lose boatloads of money on bad wagers and investments, we don’t yet know that for sure.

But turn over a few obvious rocks that do not require expertise in crypto and one finds far too many creepy-crawlies. We described how the shockingly amateurish customer agreement, the so-called Terms of Service, was the investment version of a Nigerian scam letter, designed to sort for marks.

Given that both of Bankman-Fried’s parents were Standford law professors and crypto was a perceived-to-be hot place to be, it would not seem to be hard to find a hot-shot young partner who thought being the general counsel of a rising star firm would be career and wallet enhancing. Or alternatively, a high-flying senior associate as general counsel, with a good Silicon Valley law firm looking over his shoulder.

Nope. Instead FTX hired a lawyer who for a while served as general counsel, then regulatory counsel, whose big resume item was having been general counsel at a major online poker betting firm that collapsed in a cheating scandal. Oh, and said lawyer, Dan Friedberg, was implicated in the misconduct.

Oddly there hasn’t been much uptake of his story.I admit I’m late to it; reader britzklieg pointed it out a few days ago, but as of then, only some poker-oriented Twitter accounts had taken note. Even as of now, only the New York Post1 seems to have written up this angle of the story.

The reason this matters, as anyone who has worked in finance and investments would likely tell you, is that the job of the general counsel is to keep you out of trouble. He is supposed to tell you very bad things will happen if you cross certain line, and care enough about it to threaten to or actually quit if his bosses seem set to do Bad Things despite his stern advice.

Having a general counsel with a clean and credible resume is also normally important in reassuring investors, customers, and lenders. So it’s weirdly par for the course that so many acted like lemmings, assuming that somebody else in the wall of money that for a while flowed towards the FTX empire had done due diligence.

From the New York Post:

The top “regulatory officer” at fallen crypto exchange FTX once served as an attorney for a company that was embroiled in a notorious online poker cheating scandal more than a decade ago — and was caught on tape allegedly aiding the perpetrators of the fraud, according to reports.

Dan Friedberg — a lawyer who was FTX’s chief regulatory officer in the months leading up to its collapse and who also did a stint as its general counsel — also had served as an attorney for UltimateBet, whose collapse was considered one of the largest online gambling scandals in history at the time.

In the alleged scheme — which reportedly claimed actor Ben Affleck among its victims — employees between 2005 and 2008 were accused of using a software exploit dubbed “God mode” to bilk players out of anywhere between $20 million and upwards of $50 million…

The UltimateBet scandal arose after revelations that some of the site’s employees were using the software exploit to peek at online opponents’ cards during hands and bet accordingly.

In 2008, the Kahnawake Gaming Commission, the Canada-based regulatory body that licensed UltimateBet, said it “found clear and convincing evidence” that Russ Hamilton, a UltimateBet co-owner and consultant, “was the main person responsible” for the scam, along with a handful of accomplices.

Friedberg’s involvement surfaced after recordings of his conversations with the poker site’s top brass was leaked to the public in 2013. The recordings were taken during a meeting in early 2008 between Hamilton, Friedberg and other executives and were reportedly leaked by Travis Makar, Hamilton’s longtime assistant. Friedberg was never personally accused of wrongdoing and there is no indication that he was ever even investigated by prosecutors or regulators.

Friedberg can be heard on tape discussing how UltimateBet should respond and handle media inquiries. Friedberg also advised company executives on a strategy to limit payouts to victims by withholding the extent of the scheme.

“I think, for the public, it just has to be, ‘Former consultant to the company took advantage of a server flaw by hacking into the client, unable to identify exactly when,’” Friedberg allegedly said on the tape, dictating a script in a bid to shortchange victims of the fraud.

Friedberg even advised Hamilton to claim he also was a victim of the scandal because “otherwise it’s not going to fly.” He acknowledged on tape that the liquidator for Excapsa, the software firm that owned UltimateBet, had $47 million on hand for potential payouts – but that executives wanted to limit the total to no more than $5 million.

“If we can get it down to five, I’d be happy,” Friedberg added regarding potential payouts….

In its 2008 segment, “60 Minutes” reported that “jurisdictional issues” had prevented any criminal charges from being filed against Hamilton or others implicated in the scandal. The audio tapes revealing Friedberg’s involvement did not surface until years after the Kahnawake Gaming Commission released its findings.

FTX clearly could have gotten someone “better” by conventional standards of “better,” as in relevant background and taint-free. The Post managed to find someone who claimed that having Friedberg aboard would legitimate FTX. That view seems to be an outlier:

Let’s go back to the guaranteed return bit. I was going to highlight that even before some Twitterati suggested Friedberg might have been the brain behind that FTX ruse.

I had seen some screenshots of FTX promising a 15% no risk return. That is another “Beware, scam ahead!” signpost. But I hadn’t seen any explanation of what role it played or whether it was significant in terms of FTX funding. If it was a meaningful money source for the FTX empire, that pretty much guaranteed that FTX would wind up engaging in Ponzi scheme type behavior. Even hedge funds that are successful over time can have wild swings in returns, like up 85% one year, down 20% the next. Even a merely flat or low return year would lead the FTX maestros to have to fill the shortfall somehow…more money promised they might not be able to meet, like loans? Or covertly borrowing from customers on the over-optimistic assumption that your return hole is temporary.

Ben Hunt nailed down this piece of the puzzle, and it explains a great deal:

SBF was early to the professional crypto trading world (he launched Alameda in 2017), and there were plenty of persistent informational asymmetries in that early market for a smart guy like SBF to skin with a portfolio of systematic quant strategies…..So I think SBF and Alameda probably killed it in 2018 and 2019, but by the time Covid hit, Alameda was just one of many crypto hedge funds competing with each other over an increasingly difficult-to-navigate market.

Here’s the thing, though: Alameda had no outside investors who would know that performance had declined from Magical Money Machine levels to non-magical levels! See, Alameda did not take on outside investors the way that most hedge funds take on outside investors, with an annual management fee (1-2% of the amount invested) and a performance fee (10-30% of the profits) on the capital account established for the investor within a limited partnership vehicle. No, Alameda didn’t take investors (LPs) in their fund at all. Instead, you lent money to Alameda and they promised you at least a 15% annual return on your loan. Also, they promised that you could cancel your loan and get your money back anytime they had even a slightly bad month.

Alameda Research 2018 pitch deck

It’s both a really interesting and really troubling offer! On the one hand, it creates an enormous mystique and reputation as a Magical Money Machine (nope, we’re going to make crazy consistent profits with your money, so much so that we’ll promise at least 15% annual returns, but we’re not going to share more than 15% with you because you’re lucky we’re even talking with you). On the other hand, this IS the recipe for a Ponzi operation (oops, we didn’t cover the 15% this year, but we can cover it with new client loans and some fudged accounting and no one will ever know) and most troubling of all, they are selling themselves as a Magical Money Machine. I mean, if the words “HIGH RETURNS WITH NO RISK” don’t give you the heebie-jeebies as a potential investor (not to mention that this sort of language would be outright illegal for a US-registered or EU-registered investment vehicle) … well, I don’t really know what to tell you. Actually I do know what to tell you. If you ‘invested’ money with Alameda on the basis of this deck, you allowed a MacGuffin to take over your decision making, and all of the bad things that are happening to you now stem from your failure to recognize and control your MacGuffins. I’m sorry, but you should not be responsible for managing other people’s money.

Ultimately, I believe, Alameda became a Ponzi, using new funds to cover the returns they promised on client loans, all while maintaining a reputation as a Magical Money Machine.

Back to the original post. I presumably missed it in all the overwrought coverage, but I have yet to see what the original FTX-Alameda funding sources were. The origin myth is that Alameda made a lot of dough early in proprietary trading and then quit making much/any money. That’s plausible because markets became more efficient. This is such a common story that I’ve had clients have to grapple with this erosion. The usual answer is to go find customers. But FTX and Alameda got lucky in that naive long positions were also very profitable as crypto enthusiasm grew, and the scuttlebutt is that they were leveraged. This part of the story also makes perfect sense, see for instance the Lehman Brothers emerging markets desk which similarly looked like a bunch of geniuses as much of their apparent trading profit was simply riding inventories as these markets went from chaotic to somewhat organized so more investors were willing to take the plunge. Then the 1997 emerging market crisis hit and Lehman nearly went under.

While again this storyline generally hangs together, it’s still curious that a trading firm would go out raising money from retail investors on what was allegedly a large scale when it was by crypto standards an established player. This smacks of being extremely eager to avoid due diligence.

This also fits with the VC and other institutional investors being essentially late stage and thus getting fairly small stakes (the initial bankruptcy filing says no one held more than 2% in any FTX entity). But I am still gobsmacked that several did not get together and get one board member among them.

I imagine we are far from the end of eyepopping FTX stories. Stay tuned.


1 The Post has long been good at reporting on hedge fund legal/personnel messes.

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This entry was posted in Currencies, Dubious statistics, Free markets and their discontents, Investment management, Legal, Payment system, Regulations and regulators, Ridiculously obvious scams, Risk and risk management on by Yves Smith.