A number of major crypto companies did not look at audited financial statements prior to investing or loaning FTX and Alameda Research billions of dollars. This won’t help the industry’s case in Washington or on Wall Street.

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It’s raining unaudited financials

The narrative

Paradigm, BlockFi, Genesis and other companies did not have access to audited financial statements prior to investing or loaning billions to FTX, FTX.US. and Alameda Research, according to testimonies given in the trial of Sam Bankman-Fried. Rather, these investors and lenders looked at unaudited financial statements and spoke with the executives at these companies to determine critical pieces of information like FTX's cash flow, its liabilities, its current assets and net asset value.

Why it matters

Everyone, including regulators, is paying renewed attention to the FTX and Alameda Research collapse. The amateur-hour practices coming out in that courtroom are unlikely to impress anyone in traditional finance or in policy, underscoring the distance crypto still has to cover to be taken seriously by the TradFi world.

Breaking it down

Last week, BlockFi CEO Zac Prince testified that most cryptocurrency companies had trouble getting audits, so his team mostly looked at unaudited financials or "effectively any and all financial information that the potential borrower was willing to share with us."

His testimony came days after former Alameda Research CEO Caroline Ellison testified that she had doctored internal balance sheets that she then sent to companies including Genesis (a subsidiary of Digital Currency Group, CoinDesk’s parent), which, like BlockFi, had also loaned funds to Alameda.

While the crypto industry's struggles with auditing aren't new, relying on unaudited financials prepared by stressed out twenty-somethings who unbeknownst to you were trying to hide a multibillion dollar hole on their balance sheets is just an insane way to handle billions of dollars.

For an industry that loves to express the motto "don't trust, verify," it is entirely unsurprising that the opposite of that motto sank so many companies – including BlockFi and Genesis, which filed for bankruptcy protection between November 2022 and January 2023, respectively.

FTX in particular seems to be an excellent example of just how toxic the hype cycle can be, though. It looked like a good company – Paradigm's Matt Huang previously testified that its rapid growth was a factor in his firm investing $278 million in the FTX empire – and drew attention from so, so many people.

It's a sharp contrast with SEC-regulated companies, one auditor told CoinDesk. Public companies receive regularly audited financials.

"It is very unusual to just accept unaudited financial sheets … [if anything] you'd expect that to be anchored to an audit once a year," said the auditor, who did not want to be identified.

At a minimum, executives from the lenders might be expected to discuss the unaudited financial results in excruciatingly comprehensive detail with executives from borrowers – in this case Alameda Research – more than we’ve heard discussed from testimony so far.

The lenders would need to understand the competency of the executives at the borrower and what kind of financial controls are in place, as well as how the borrowers came up with the evaluation for the collateral being put up to secure the loans.

"These guys couldn't possibly be more of a mess," the auditor said of FTX and Alameda.

The scale of the collapse also calls into question just what kind of due diligence may be needed to evaluate crypto companies' financial health in future.

Prince testified that BlockFi had conducted due diligence on the FTX and Alameda teams prior to making the initial loans, though mainly BlockFi's legal team handled this, he said.

Genesis's press email did not respond to a request for comment about its own due diligence process during the time that it was lending funds to Alameda, though the company has shut down operations since filing for bankruptcy earlier this year.

Tying this back to regulators, it's very likely that FTX’s collapse and the way it took down several other crypto companies is going to continue to reverberate through the halls of Washington, D.C. and other national capitals.

And again it's well known that crypto companies have difficulty securing auditors for a number of reasons. But the industry will likely need to find ways of solving these issues if it wants to be taken seriously.

Stories you may have missed

• California 'BitLicense' Bill Signed by Gov. Newsom: California has a new crypto licensing law, directing the Department of Financial Protection and Innovation (DFPI) to develop a regulatory framework for the digital asset sector.
• Australia Proposes New Licensing Regime for Crypto Exchanges, Aims for Draft Legislation by 2024: Australia plans to publish draft legislation for crypto licensing and custody by next year, giving exchanges a year after that to comply.
• U.S. House Speaker Drama Could Threaten to Unravel Crypto's 2023 Chances: The U.S. House Speaker role remains in limbo.
• U.S. State Regulators Intervene in Coinbase’s Unregistered Securities Case: Amicus briefs filed by the North American Securities Administrators Association and other groups argue that the U.S. Securities and Exchange Commission’s lawsuit against Coinbase does not raise any major questions doctrine issues.
• SEC Won’t Appeal Loss in Grayscale Case, Boosting the Odds GBTC Can Become a Bitcoin ETF: Next set of deadlines are coming up soon so we’ll see.

This week

Monday

• Singapore-based crypto company Hodlnaut (no relation to Hodlonaut) had a bankruptcy hearing on Monday.

Thursday

• 17:00 UTC (1:00 p.m. EDT) BlockFi has a bankruptcy hearing.

Elsewhere:

• (Bloomberg) A London-based distributor of airplane engine components sold a huge number of parts with fake documentation. Aircraft part forgery has had tragic consequences before.

If you’ve got thoughts or questions on what I should discuss next week or any other feedback you’d like to share, feel free to email me at nik@coindesk.com or find me on Twitter @nikhileshde.

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See ya’ll next week!