Crypto VC David Pakman on FTX: ‘A completely avoidable tragedy’

If you want to better understand the size of the deal that the FTX crypto exchange exploded, you could do worse than talk to David Bachman, an entrepreneur turned venture capitalist. After being logged in for 14 years with investment firm Venrock, Bachman — who spearheaded Venrock’s investment in digital collectibles firm Dapper Labs and even mining bitcoin in his home years ago — has bowed to his passion for digital assets and last year joined Seven Years Now. Old crypto venture company CoinFund.

Its timing was either too good or too bad, depending on your view of the market. In fact, in part because CoinFund was an early investor in the collapsed cryptocurrency exchange FTX, we asked Pakman to jump on the phone with us today to talk about this very wild week, a week that began with FTX flying high on the ropes, and that ended with the filing of bankruptcy and the resignation of the FTX founder, Sam Bankman-Fred, as CEO. Following are excerpts from that conversation, edited slightly for length and clarity. You can hear our long talk here.

TC: The last time we talked, about two years ago, the NFT wave was in the making. Now, we are talking about a day when one of the largest cryptocurrency exchanges in the world declared bankruptcy. In fact, 130 additional subsidiaries have declared bankruptcy. What do you think of this development?

DP: I think it’s pretty horrific on a number of levels. First, it was a tragedy that could have been completely avoided. This failure of the company resulted from a combination of flawed human decisions, not from failed business. The core business is doing well. Actually it is [was] Very profitable and growing, even in a bear market. It is one of the most widely used cryptocurrency exchanges not located in the US and has a large derivatives business. He has written a lot of really good software. It doesn’t look like he’s running out of capital or a victim of the macro environment. But its leadership, with seemingly no oversight, made a bunch of terrible decisions and did things that were really wrong. So the tragedy is how much can be avoided, how many victims there are, including employees, shareholders and hundreds or even thousands of customers who will be affected [by this bankruptcy].

There’s also reputational damage to the entire crypto industry, which is already plagued by questions like, “Isn’t this a scam place with scam people?” This kind of Enron-esque collapse of one of the most valuable and most successful companies in the space is really bad, and it’s going to take a long time to explore. But there are also pluses.

Positives?

Well, the positive thing is that the technology has not failed; Blockchain did not fail. Smart contracts are not hacked. Everything we know about the technology behind cryptocurrencies continues to work brilliantly. So it would be different if this crash was due to flawed software design, the blockchain not scaling, or major hacks that infected people. The long-term promise of software and technology architecture around cryptocurrencies is intact. People are constantly making mistakes. We’ve made two or three big man-made mistakes this year.

There are a lot of news stories outlining what happened in broad strokes. How do you explain that?

I have no direct knowledge of what they did or did not do. But apparently FTX and [the trading desk also owned and run by Sam Bankman-Fried] Alameda Research has a relationship that may not have been known to all shareholders, employees or clients. Apparently FTX acquired FTT, their token that Alameda held in large quantities, and they pledged it as collateral and took out large loans for it. So they took a highly volatile asset, and pledged it as collateral.

One could imagine that if a corporate board of directors or investors found out, someone would say, ‘Wait. What happens if the FTT drops by 50%? It happens in high-frequency cryptocurrencies, right? So, for example, why would we pledge these highly volatile assets? Incidentally, the assets of half a billion dollars are owned by our biggest competitor [Binance]. What happens if they throw it in the market?

So simply borrowing against it was unwise. And the and then It looks like they’ve also taken the proceeds from that borrowing, investing it in very illiquid assets, like maybe to bail out BlockFi or all those other private companies that FTX recently bought. But it’s not like they can sell those quickly if they need to return their borrowing proceeds. They also appear to have been using and lending clients’ money or perhaps lending it to their trading arm. So all of these things are just things that I think the board of directors, if they found out about, would be like, “No, no, these are just unofficial items, we’re not doing any of those things, it’s a very high risk.”

But there was no real board of directors, which is amazing, given that enterprising investors have poured $2 billion into this company. Your company is among those companies.

I joined CoinFund a little over a year ago, so the investment the company made in FTX was a long time ago, before my time, a minuscule amount. We are barely on the cover table. We do not hold any FTT tokens.

But I will touch on your big question, which I think has to do with the management of this company. I come from a traditional tech investing background, where perhaps 99% of the time, there’s just a standard set of governance that every entrepreneur agrees to when they take on venture capital, which is: there will be a board of directors; The Board of Directors consists of investors, employees and possibly outside experts; There will be a bunch of controls. Controls usually say things like, “You have to disclose any related party transactions so you don’t switch coconuts between a company and something else we don’t know about.” The board also has to approve things, so you can’t issue new shares without [the board] knowing about it.

The fact that there isn’t any of that here is mind-boggling. And I hope this moment like this one in crypto is that whatever loose standards about not giving that level of oversight and governance as part of investing, it just goes away.

Everything is very interconnected. The crypto investor Digital Currency Group is said to be offering $140 million in equity to a derivatives company in its portfolio called Genesis Global Trading because Genesis has about $175 million locked into its FTX account. How bad would this get? What percentage of your investment portfolio is affected here by the FTX failure?

How impressed are we at CoinFund? It’s negligible because we have had such a small investment in this company from one of our funds and have never had any of our assets in FTX*, either in the US or international business. [As for broader implications]I don’t think any of us know the full long-term impact of what’s going on here because there’s like some contagion, right? Like, how many other funds when companies and investors have assets in FTX and how long will it take to get those funds back? One has to assume that the whole thing goes into massive bankruptcy proceedings that take months or years to clear up. Thus there will be uncertainty, not only about when the refund will be made but also about how much you will get.

The vast majority of the startups we invest in are not trading on FTX and therefore were not clients. But FTX was very helpful in providing a launch pad for the tokens to become liquid, and then creating a market for those tokens or at least providing a place for them to trade and provide liquidity. A large part of cryptocurrency today is not just about raising capital but creating tokens and using tokens as an incentive mechanism, and this requires at some point that these tokens become liquid and traded on exchanges, and FTX was one of the biggest places where the tokens traded. And now you lose it.

How does this affect your day-to-day business of making investments? You’ve seen the news that CoinFund is looking to raise $250 million in new funding, and that it filed for SEC papers on November 1 after closing the $300 million fund three months earlier. Are you going to have to put a pin in that now? I’m sure this disaster made LPs nervous.

We’ve talked to a lot of LPS in the last 48 hours. I think most people are treated. They ask, as you ask, “What happened here?”

I think the late stage capital will freeze a bit here. Dust really needs cleaning. It is unlikely that capital would be drawn into such a tragedy.

There is a more immediate impact on startup ratings. Evaluating startups is an imperfect process that investors do in illiquid markets, and one way of this is to look at comparisons. And FTX was one of the brightest stars that everyone pointed out in crypto. If the value of FTX is $40 billion, we value X. So you take the crypto company backed by the most valuable projects, and their value ranges from $40 billion to zero, so who is the new cap on crypto value? It immediately affects late stage assessments.

*After our interview with Bachmann, he learned that he was wrong when he said that CoinFund has no assets on the exchange. It had a small amount of exchange assets on FTX International that was in the process of transacting.

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