FTX: ASSET TRACING & RECOVERY

On December 18th last year, the prestigious Washington Post led with a story on the collapse of cryptos. “Crypto Winter has come. And it’s looking more like an ice age,” screamed its headline. This succinctly summed up the current sentiments about cryptos after the shocking collapse of the Futures Exchange, better known as FTX.

For more than a year, the crypto market had boomed with a rush amidst especially young upcoming people to invest in cryptos. Crypto companies promised untold wealth overnight and were being heavily subscribed for brand promotion even by sporting brands.

Then later, in 2022, the bubble burst. Prices crashed, and investors fled. The biggest blow was struck when the U.S. Department of Justice (DoJ) filed charges against the founder of FTX, Sam Bankman-Fried, on multiple grounds, including fraud and election funding violations.

The Rise Of Crypto

At its core, cryptocurrencies were formulated as a decentralised digital currency that would one day make banks redundant. The digital assets work on a blockchain mechanism, allowing the currencies to be part of an immutable record of all transactions. The use of blockchain technology has proved to help promote dig- ital artworks and platforms like the metaverse.

Many governments around the world have been suspicious of cryptocurrencies. But despite these suspicions, governments have been forced to allow crypto trading due to its popularity and revenue generation.

Cryptos essentially run on complex mathematic equations on a decentralised network of computers. The exchange establishes value without the benefit of a central bank, owner, or sovereign nation.

Normally when retail investors are confronted with the word crypto, they shy away from the jargon-laden conversation waiting to come. The mysterious software programme became well-known for two main reasonsits high returns and volatility.

Everyone from blue-collar workers to private banks wanted to invest in cryptocurrencies though they did not necessarily know how it worked or what it did. This spurred the growing popularity of various cryptocurrencies, like Bitcoin, Ethereum, Dogecoin, and Monero, even while financial experts raised concerns over their decentralised nature.

FTX was symptomatic of the rapid rise of cryptos, swiftly amassing investments valued at $32 billion by projecting an image of rock-sold legitimacy attracting hard-boiled venture capital firms and the common man on the street. As per U.S. agencies, it was nothing but a massive Ponzi scheme! Not surprisingly, the new CEO of FTX is a veteran bankruptcy lawyer who has now been tasked with recovering assets of millions of customers and creditors.

While advocates of cryptos defended digital currencies, calling FTX an aberration and asking not to tar all cryptos with the same brush, the fact is that the very decentralised nature of cryptos has become its biggest vulnerability.

Now the focus has turned to bring out legislation which can prevent another FTX from happening. More importantly, there is a need to be able to trace out the assets and enforce their recovery so that the investors and creditors get their investments back.

MS SHOBANA IYER Commercial Barrister

A Nightmare For Regulations

“Crypto assets are a digital representation of value or contractual rights that use digital distributed ledger technology and can be transferred, stored and traded electronically. Crypto assets fall into different categories like exchange tokens and pure cryptocurrency like Bitcoin, where there is no utility except for providing the means of exchange.

Then there are e-money tokens that meet the definition of electronic money. There are digital payment instruments that store a value that can be reduced at par value at any time and offers holders a direct claim on the issues.

Then there are utility tokens that have a function which will be built into the utility token. For example, the utility token may enable a token holder to access the service or a product such as an online storage or digital marketing space,” says Shobana Iyer.

These unique characteristics, intangible cryptographic authentication and the use of decentralised digital transaction ledgers, make regulation extremely difficult. In addition, a variety of tokens rapidly growing in the crypto landscape exhibit properties of commodities and electronic payments, making their classification heavily contested as to whether they should even be regulated.

To add to the complexity is the transnational reach of crypto assets requiring greater cooperation between national and international regulatory bodies. And then, we have a real concern regarding identifying controls and responsibilities, particularly when we use the blockchain,”

UK’s Financial Conduct Authority (FCA), a financial regulatory body outside the Government, has ruled that crypto assets such as trading on the FTX platform would not be covered in the existing framework.

This is in tune with the warning on crypto assets released by the European banking authority that informed consumers that they risked losing their assets if they traded through these decentralised exchange platforms and could have little hope for recovery of their assets.

SHREYAS JAYASIMHA Aarna Law (India), Simha Law (Singapore), Member Fraudnet

The Impact Of Ftx Collapse

The FTX fiasco will invariably have a long-lasting impact on the crypto world for two main reasons. The first and foremost reason is the opaque structures governing the trading platforms. Any private entity must regularly conduct internal audits and release audit reports to its investors.

In the case of FTX, there were little to no internal audit reports presented to clients and investors. No one raised any concerns since the platform was making record-breaking profits year after year. Once the balance sheet of Alameda Research was released, FTX investors did not know how it would affect FTX since they had access to limited data.

Like other major financial meltdowns like the Lehman Brothers crash in September 2008, most decisions were made recklessly by one or a few people assuming their play would not be exposed.

In the case of FTX, Bankman had the power to transfer resources between two of his firms without any oversight or barriers. He used FTX tokens to fund his side project, hoping that Alameda would eventually become profitable, but this backfired when the balance sheet was released.

The second important reason would be the role of the Government. Many governments around the world have been suspicious of cryptocurrencies. But despite these suspicions, governments have been forced to allow crypto trading due to its popularity and revenue generation.

With the FTX crash, this will change. Governments will take a more proactive role in monitoring crypto exchanges and bring new legislations that could force them to periodically reveal their internal audits to investors.

But once governments start interfering with the functioning of these exchanges, they would eventually become more institutionalised. Any form of institutionalisation goes against the core values of cryptocurrencies created to make a decentralised system. The downfall of FTX has created a conundrum for the crypto world that is challenging to resolve.

SURAJ SREENATH, Cofounder of Platter Finance

Why we Need Cryptos?

Probably crypto today is at a very early stage, comparable to automobiles when they were invented. Before automobiles came into the picture, the commute used to take place on horses, and there was no problem with ‘Drunken Driving’; very few accidents occurred, and there were no breakdowns.

Hence one may ask, was there a need to invent automobiles? However, once automobiles started coming out in larger numbers, the problems they created were solved systematically over the years, including the registration of vehicles and the issue of driving licences to operate them.

The last big revolution in the financial ecosystem was probably in the 15th century when the Double Entry accounting system was invented in Italy. The Meducci bank was the first bank to adopt a double-entry accounting system.

Today’s crypto brings to the table is an immutable ledger for the first time in history. I want to stress the word immutable here because this has never happened before. The ledger is not only immutable but also decentralised as it is a distributed ledger, a public ledger. So, for a regulator, this should be great news.

For the first time, it is public and is distributed with multiple copies of it and is accessible to anybody and everybody. The oversight need not be done only by the regulator; anybody can do the oversight.

And for the first time, it brings out accountability. A interested common man can participate in any kind of due diligence over any asset. Having said that, if you ask me how Terra-LUNA happened, how do you wipe out millions of dollars in one year? So how does it work?

There are two kinds of businesses today. One is access to crypto assets like FTX and Indian companies like WazirX, which we call centralised exchangers. Then there is a second set of businesses that uses crypto as an asset class to follow every other ideology that fundamentally uses blockchain.

Now some businesses or companies will say how we can truly adopt an ideology of non-custodial asset solutions. What happened with FTX was because of the custody of assets or who had control of the ledger. The whole crypto movement is hinged on no centralised entity, be it the Government or any other entity, because anybody who has control over the ledgers can modify the ledgers as they need.

Regulating them will be much harder because regulators can only see what you want them to see. Once you have a public ledger and a distributed ledger, it can not only be validated by the common man, but more importantly, it can be validated by the court.

If you see the advances in technology over the last 25 years, every problem is tackled by technology. Look at any industry and say how technology revolutionised that industry.

Technology has done nothing to finance. So today, we stand in a unique position where we are given an opportunity for technology to revolutionise finance by taking us out of the suppressive economy we have been facing for the last 20 years.

Be it Amazon or Youtube, anybody who has made money was a true entrepreneur who could be creative. Now, there is an equal opportunity for everyone who can access any asset class today. Entrepreneurship works with freedom, allowing people to be creative. And that’s the opportunity we are looking at if we can ease the economy and say that we didn’t give entrepreneurs the freedom to operate.

Assets Recovery

It is important to understand that crypto trading platforms and digital assets have a purpose, a benign purpose- to diversify options for investment, to buy, to sell, to trade and to receive a loan.

There are implications in a widespread multi-jurisdictional case while trying to retrieve the assets that have been lost. The first act is mapping the entities and the commercial aspects and activity of each entity to classify them and understand where the assets were directed to and what the initial purpose of the assets was.

This is a figure that comes out of the filing and the first declarations from the CEO, which are in the file. The different activities include block file loans, NFT’s gaming, capital markets, derivatives, etc. The different aspects would be classified according to themes and topics, which is the most challenging part of the recovery process.

Then a team of professionals who specialise in security assets locally are called to start the tracing exercise. These experts must be well versed in the investigation side and the legal aspects of tracing back how the transactions have taken place.

That is why you would put in place cyber security experts. In sum, one would first seek out the value of the assets and then see the most efficient approach to recover them.

HÉCTOR SBERT, Ph.D., Partner at Law firm, ECIJA, Member of ICC FraudNet for Spain

Legal Assets Tracing & Recovery Tools

It is interesting to compare the asset tracing tools in different parts of the world, especially comparing the common and civil law approaches.

In the common law approach, asset tracing and recovery are based on civil actions, especially in cross-border insolvencies like the one we see with FTX. Spain is a civil law jurisdiction country and a member of the EU, and we normally use criminal proceedings to deal with this kind of fraud.

Criminal proceedings in continental jurisdictions have a much wider scope than in common law jurisdictions and civil law jurisdictions. Victims of fraud have legal standings to start private prosecutions in criminal cases against fraudsters.

That is generally not the case in civil law jurisdictions where victims of fraud do not have this kind of legal standing. But this is one of the basic distinctions in the criminal fraud case against Sam Bankman-Fried in the United States; it has not been initiated by the victims but by the Department of Justice.

The FTX case is very complex; one does not know if it’s a simple Ponzi scheme or the cause of fraudulent mismanagement.

One sees many Ponzi schemes/pyramid schemes on the internet, inviting people to invest in cryptocurrency. Some bitcoins promise an amazing return, so people start with small investments and receive monthly recurring payments. The word spreads, and it attracts a lot of investors.

However, there are actually no returns behind these schemes; it’s just that customers are paid with the money the new investors coming into the platform are providing. This has been seen with some crypto assets, specifically utility tokens linked to Ethereum-based blockchains.

One specific case is called the Quailian case; the Quailian platform allowed customers to invest in the master node of an Ethereum- based blockchain. A node is a computer that is locked into an Ethereum-based blockchain, and a master node is a supercomputer that provides services to the rest of the nodes, basically validating transactions over that blockchain.

Think of a supercomputer that provides services and gets paid for the services. The trick is that since it’s an Ethereum blockchain, it follows the proof of stake standard.

To become a master node, you have to prove that you have enough stake in the platform, meaning that you have bought an enormous amount of Ethereum-based tokens with which this blockchain runs. So the trick here is to get a pool of investors to invest in this master node.

With thousands of people investing thousands of dollars, the scheme can become a master node controlling mini-nodes in the blockchain. In the case of the Quailian Scam, many investors put their money till, all of a sudden, they stopped receiving payments.

The funny part is that the defendant of the scheme said that this was not a scam but an investment that went wrong- there were just not enough nodes! Mr Bankman-Fried of FTX is also saying the same thing in his defence.

This is uncharted territory; the kind of legal arguments defending the scheme is new. Sam Bankman Fried has become a blogger; while under criminal prosecution, he has the right to remain silent, but he has chosen to start a blog.

And in this blog, he is trying to convince everyone that everything is perfect and fantastic; I am sorry you lost your money, and I am sorry I was a bad manager, but there is no fraud here. Just a case of bad luck!

In terms of asset tracing tools, the same tools are used in a criminal proceeding in continental European jurisdiction- disclosure orders or freezing orders that we see in common law civil proceedings. So, a huge array of tools are at your disposal, including the support of the police.

In most continental jurisdictions, police departments are opening specialised sections devoted to prosecuting technology-based crimes. In Spain, such sections are efficient and competent, and there is great support from the police hierarchy to trace the assets.

Another challenge is the cross-border nature of these frauds. In the EU, there is very strong cooperation between courts, criminal courts, police departments etc.

Once we move out of the EU, like in this case of crypto scams, you never know how much to rely on mutual legal assistance treaties that may or may not exist with the jurisdiction of interest. Judicial cooperation may not be easy.

The possibility of obtaining actual results is quite a challenge regarding asset tracing and recovery. It is rare in continental jurisdictions to have insolvency proceedings opened against this kind of exchange or platforms because we follow the EU law, which gives jurisdiction to insolvency only when the platform, the crypto platform, has its centre of main interest in the local jurisdiction.