“The good news is, we're not bankrupt. The bad news is, we're close.” – Richard J. Codey
In the early fall of 2011, financial broker-dealer MF Global was teetering on the brink of disaster. Led by former US Senator and Governor of New Jersey Jon Corzine, the company was making large bets with its own money on, among other things, the future direction of the European bond market. Although MF Global’s primary business was acting as a custodian for its clients’ funds and facilitating their trades, it was the company’s proprietary trading activities that put it in a jam.
Corzine entered this crisis with a well-earned reputation for dubious decision-making. In 1998, while serving as chair and CEO of Goldman Sachs, he directed the firm to replicate trading strategies being used by Long-Term Capital Management (LTCM). Months later, LTCM blew up, nearly taking Goldman with it. That ill-fated decision led to Corzine’s ouster from Goldman, after which he began a career in politics (naturally). Years later in early 2010, having lost his gubernatorial reelection bid to the charismatic Chris Christie in the fall of 2009, Corzine returned to finance and took over the reins at MF Global. Less than 2 years after that, the unthinkable happened.
When its reckless bets on European bonds turned sour, MF Global was hit with margin calls that it could not meet. Simply put, the firm was insolvent. Rather than filing for bankruptcy or working out a deal with its creditors, MF Global met those margin calls by stealing client money. The fraud was discovered during a frantic weekend of due diligence by Interactive Brokers (a potential white knight MF Global was courting) and the company collapsed into bankruptcy on Monday, October 31, 2011. As an anonymous banker, quoted in the Financial Times a few days later, put it: “This is the only financial bankruptcy in the US with a deficiency of client funds. It just doesn’t happen.”
It would turn out that a total of $1.6 billion of client money was misappropriated, and while customers were eventually made whole, the process involved years of legal wrangling. Bankruptcy proceedings are costly and messy affairs, and a reasonably good outcome such as the one achieved here was far from certain.
You would be forgiven for assuming that shocking acts of fraud like this would land a few people in jail. In fact, not a single person in the entire MF Global affair was even charged with a crime, let alone convicted of one. It seems impossible that, through a shocking abuse of fiduciary duty, $1.6 billion could be pilfered without somebody having committed a single act of wire fraud. And yet, the case was closed with no charges. How could this be? The answer is as simple as it is disheartening. Jon Corzine is a member of a certain class of politically connected individuals for whom “equal protection under the law” means something different than it does for the rest of us: as long as we protect each other equally, we have no reason to fear the law.
The MF Global scandal sharpens the point on something individual investors regularly overlook: the counterparty risk presented by the custodians of their assets. Layer on a general disregard for regulatory reprisal and you have a recipe for absolute value annihilation.
At its core, the crypto community should have an inherent appreciation for counterparty risk, with its well-worn “not your keys, not your coins” ethos. That familiar phrase was borne out of the infamous collapse of the Mt. Gox Bitcoin exchange in February of 2014, and victims of that fraud are still waiting for partial restitution more than eight years after the event. Like the MF Global scandal that preceded it, the Mt. Gox matter highlights how the failure of a custodian can turn its clients into mere unsecured creditors of a bankruptcy proceeding, economically crushing many in the process.
In recent weeks, the counterparty risk monster has been raising its ugly head again in the crypto universe, this time on a scale that makes Mt. Gox more hill than mountain, and with enough haughty disregard for regulatory authority to make Corzine blush. The remarkable events unfolding at Coinbase, one of the premier cryptocurrency exchanges in the world, illustrate what a giant risk many investors are taking when they custody their digital assets on exchanges. We find ourselves in literal awe at the behavior of Brian Armstrong, Coinbase’s CEO, as he confronts legitimate investor concerns on this topic. He either has shockingly little knowledge of or even less regard for his obligations as an officer of a publicly traded company, and we would be stunned if the Securities and Exchange Commission (SEC) doesn’t have a few pointed questions for him.
Before proceeding further, we should state clearly and definitively that we are writing about counterparty risk at Coinbase by way of comparison to MF Global and Mt. Gox. We are not making comparative accusations of fraud. But when counterparty risk and disdain for regulatory oversight collide, we can’t help but pay close attention.
Let’s dig in.
[Disclosure: No member of the Doomberg team has any position in Coinbase, nor do we intend to open one in the coming weeks.]