an “entirely avoidable tragedy” • TechCrunch

If you want to better understand exactly how big a deal it is that the FTX cryptocurrency exchange just imploded, you could do worse than talk to David Pakman, an entrepreneur turned venture capitalist. After logging 14 years with the investment firm Venrock, Pakman – who led Venrock’s investment in the digital collection company. Dapper Labs even mined bitcoin in his own house years ago – leaned on his passion for digital assets and last year joined the now seven-year-old crypto venture firm CoinFund.

It’s a very good or very bad time, depending on your view of the market. Indeed, partly 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, one that began with FTX flying high on the ropes, and which ended with bankruptcy filings and resignations of FTX founder, Sam Bankman-Fried, as CEO. Excerpts from that conversation follow, lightly edited for length and clarity. You can hear our long conversation Here you go.

TC: The last time we talked, almost two years ago, the NFT wave was just is underway. Now, we’re talking about a day where one of the biggest cryptocurrency exchanges in the world has just declared bankruptcy. Actually, it declared bankruptcy for 130 additional affiliated companies. What do you make of this development?

DP: I think it’s terrible on a bunch of levels. First, it is a completely avoidable tragedy. The failure of this company was caused by a set of flawed human decisions, not by a failed business. core business is doing great. In fact, it is [was] very profitable and growing, even in a bear market. This is one of the most used non-US crypto exchanges with large derivatives businesses. It writes a lot of good software. It’s not like it’s out of capital or a victim of the macro environment. But his leadership, with almost no oversight it seems, made a bunch of terrible decisions and did the wrong things. So the tragedy is how it could have been avoided, and how many victims, including employees and shareholders and hundreds or even thousands of customers will be affected. [by this bankruptcy].

There is also reputation damage for the entire crypto industry, which has had questions like, ‘Isn’t this a scammy place with scammy people?’ This sort of Enron-esque meltdown of one of the highest priced and arguably the most successful companies in the space is just really bad, and it will take a long time to dig out of it. But there are also positives.

Positive?

Well, the positive is that technology has not failed; blockchains do not fail. The smart contract is not hacked. Everything we know about the technology behind crypto continues to work well. So it would be different if this was a problem due to flawed software design, or the blockchain didn’t scale, or massive hacks that got people hurt. The long-term promise of software and technology architecture regarding crypto is non-existent. It’s people who keep making mistakes. We’ve had two or three man-made errors this year.

There are plenty of news stories out there outlining what happened in broad strokes. How do you explain it?

I have no direct knowledge of what they do or don’t do. But it turned out to be FTX [the trading desk also owned and run by Sam Bankman-Fried] Alameda Research has relationships that may not be known to all shareholders, employees, or customers. And it sounds like FTX took FTT, which is their token that was held in great amount by Alameda, and they pledged as collateral and took a large loan in fiat against it. So they take unstable assets, and they pledge them as collateral.

One can imagine if the company’s executive board or investors knew about it, someone would say, ‘Wait. What happens if FTT drops by 50%? That happens in crypto with high frequency, right? So, like, why are we pledging this super volatile asset? And by the way, half a billion dollars of that asset is held by our biggest competitor [Binance]. What if they throw it on the market?’

So only borrowing action against it is not recommended. and then It sounds like they also took the proceeds from that loan, and they invested that in highly illiquid assets, like maybe to save BlockFi or all other private companies that FTX recently bought. But it’s not like they can sell it quickly if they need to return their loan proceeds. It also appears to be using customer funds and lending them or may even lend them to its trading arm. So all this stuff is stuff that I think the board, if they knew about it, would be like, ‘No, no, this is a total nonstarter, we’re not doing any of that stuff, it’s too high risk.’

But there is no real board, which is scary, considering that VC poured $2 billion into this company. Your company is among those companies.

I joined CoinFund a little more than a year ago, so the firm investment was made in FTX a long time ago, before my time, and it was a small, small amount. We’re barely at the stamp table. We don’t have any FTT tokens.

But I will answer your big question, which I think about the governance of this company. I come from a traditional tech investment background, where maybe 99% of the time, there is only one standard set of governance that every entrepreneur agrees when they take venture capital, that is: there will be a board; the board will be made up of investors and employees and maybe outside experts; there will be a set of controls; control usually says something like, ‘You must disclose all related party transactions so you don’t shuffle coconuts between one company and something else that we don’t know about.’ The board also has to approve things, so whenever you want to pledge assets as collateral for a loan, you can’t issue new shares without [the board] know about it.

The fact that no one is here is terrifying. And I hope that what happens in a moment like Enron in crypto is that any norms that do not exist about not providing a level of oversight and governance as part of an investment are immediately removed.

Everything is so highly correlated. Crypto investor Digital Currency Group reportedly gave one $140 million equity infusion to a derivative business in his portfolio called Genesis Global Trading because Genesis has about $175 million dollars locked in his FTX account. How bad is this going to be? What percentage of your own investment portfolio was affected here due to the FTX failure?

How many people at CoinFund are affected? This is ignored because we have a small investment in this company from one of our funds and we do not hold our assets in FTX*, either US or international business. [As for broader implications], I don’t think any of us know the full, long-term impact of what is happening here because there is like some contagion, right? Like, how much other funds when companies and investors have assets in FTX and how long will it take to return those funds? We have to assume that everything goes into a massive bankruptcy process that takes several months or years to unwind. So there’s going to be this uncertainty, not just when you get your money back but how much you get.

Most of the startups we invest in do not trade on FTX and therefore are not customers. But FTX is very useful to provide a launching pad for tokens to become liquid, then either create a market for their tokens or at least provide a place for them to trade and provide liquidity. A big part of crypto today is not just raising equity capital but creating tokens and using tokens as an incentive mechanism, and that requires at some point for these tokens to become liquid and trade in the exchange, and FTX is one of the biggest places where those tokens are traded. And now you lost it.

How does that affect your day to day business of investing? I saw the news that CoinFund is looking to raise a new $250 million fund, that it filed an SEC document on November 1 after closing a $300 million fund three months ago. Should you put that pin down now? I believe this debacle has LPs feeling nervous.

We have talked to many of our LPS in the last 48 hours. I think most people process it. They ask, like you ask, ‘What’s going on here?’

I think late-stage capital will freeze up for a little bit here. The dust really needs to be cleaned up. And it seems that capital is attracted by tragedies like this.

A more immediate impact is on startup valuations. Valuing startups is an imperfect process that investors do in non-liquid markets, and one way to do that is to look at comparisons. And one of the brightest star comps that just about everyone in crypto points to is FTX. If FTX is worth $40 billion, we are worth X. So you take the most valuable venture-backed crypto company, and it goes from $40 billion to zero, then who is the new ceiling of crypto value? It directly affects the final stage valuation.

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

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