How can one of the world’s most respected cryptocurrency exchanges go from a US$32 billion (NZ$52b) valuation to bankruptcy in the space of a week?
That’s what over one million investors who had assets tied up in FTX are asking themselves as they become creditors lining up in a drawn-out fight to claw back money and digital tokens held by the Bahamas-based exchange founded by MIT graduate and hedge fund trader Sam Bankman-Fried, or SBF as he is known.
Where FTX really appears to have come unstuck is in creating its own cryptocurrency – FTT – which retail and institutional investors use to buy and sell cryptocurrency, stocks, futures, options and non-fungible tokens (NFTs).
Because FTX offered discounted trading fees for using FTT, as opposed to other cryptocurrencies, users were incentivised to build up large holdings of FTT.
But it appears that the enigmatic SBF used US$10b of its customers’ assets to funnel funds to FTX’s sister company, hedge fund Alameda Research.
As the shaky status of FTX’s finances became industry knowledge, crypto holders started withdrawing their assets, leading to last week’s run on the exchange and the implosion of FTX as it finally owned up to the dire state of its books.
It could turn out to be one of the biggest frauds in history and caps off a terrible year for crypto, following the collapse of the Terra stablecoin and the bankruptcy of crypto lender Celsius.
Guarding the coins
New Zealand investors may well be among the victims of FTX.
I’ve seen a few pained posts on social media forums from individuals lamenting their losses. But it doesn’t appear that institutional investors and start-ups here have much exposure.
NZ’s largest cryptocurrency exchange, Easy Crypto, is a non-custodial exchange, meaning it doesn’t hold digital assets on behalf of its customers.
It doesn’t make Easy Crypto a target for hackers trying to steal users’ coins, unlike Cryptopia, a popular Christchurch-based custodial exchange that collapsed in 2019 after a major hacking attack saw $24 million worth of assets stolen.
It also means that Easy Crypto can’t be subject to the cyber equivalent of a bank run, where everyone tries to get their deposits out at once.
It doesn’t hold the coins, which typically reside in the digital wallets of Easy Crypto users or on offline storage devices. I’ve bought Bitcoin and Ethereum via Easy Crypto, but I’m solely responsible for holding them securely.
Most people aren’t willing to shoulder the risk and hassle of doing so.
“I think there does need to be a place for custodial options, as not all of those who engage with crypto will want to (or be able to) secure their own assets,” Easy Crypto CEO Janine Grainger told me yesterday from Indonesia, where she is attending the V20 Summit of virtual asset service providers, which was being held in parallel with the G20 leaders’ summit.
“Custodial services should be provided within a framework that provides the right checks and requirements around probity and governance, market stability and integrity, customer protection and insurance – similar to what a consumer would expect from a custodian in the traditional financial sector,” added Grainger.
The problem is that, in most countries, crypto investors don’t enjoy the same protections as customers do in the traditional finance sector.
Banks have to meet reserve and liquidity requirements. The new government-backed depositors’ compensation scheme will also see bank account holders paid out to the tune of $100,000 if a bank fails.
There is no such safety net in the world of crypto.
Proof of reserves a must
The FTX collapse plays into the hands of regulators who want to tidy up the sector.
Crypto enthusiasts hate the idea of regulation, but given what has transpired this year, would-be digital asset investors could be forgiven for never wanting to go anywhere near a crypto exchange again.
How financially solid are Coinbase, Kraken, Bitfinex and the biggest exchange of all, Binance? It’s very hard for the individual investor to know.
One solution is for the exchanges to publish independently audited proof of their reserves so asset holders know how secure their investments are on an exchange.
In the crypto world, everything is recorded on the blockchain, which makes it relatively easy to track the state of assets at any time.
“One of the huge benefits of our industry is the in-built transparency, and while we do make great use of blockchain analytics to see what’s happening on chain, we don’t have enough transparency over the assets (and liabilities) of custodial providers,” Grainger said.
“The tricky part is matching the assets with the outstanding liabilities,” wrote CoinDesk columnist Nic Carter who is also a partner at blockchain-focused Castle Island Ventures.
“To achieve that, an exchange adds up all user balances, anonymises them and publishes the data in Merkelized format. From there, depositors can verify that they are included in the liability set. If enough do this, they can have strong confidence that the exchange isn’t cheating by omitting liabilities.
“And if the process happens under the eye of an auditor, users can gain additional assurance that no liabilities are being excluded.”
At the very minimum, that’s what any self-respecting crypto exchange will need to do to shake off the credibility blow FTX has served the sector.
What mystified many is the extent to which SBF, with his goofy hair and penchant for wearing shorts and a t-shirt to business meetings, managed to lure in big-name investors who should have known better.
“I am curious to know how the high-profile [venture capital firms] that invested in FTX weren’t across this,” Grainger said.
“Given the profile and trust of those names (Sequoia, Blackrock, Insight Partners etc) their investment lent credibility to FTX, but it seems that either due diligence was not done, and/or governance was missing.”
If the crypto world is to emerge from the extended winter it is experiencing, people need to have trust in the infrastructure that’s integral to a healthy crypto market – the exchanges.
The FTX debacle shows that no assumptions can be made over the financial integrity of an exchange.
Providing independently verified proof of reserves is the bare minimum they can do to rebuild shattered confidence.
Originally published on BusinessDesk.co.nz.
PETER GRIFFIN 