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As FTX implodes, the crypto exchange model draws scrutiny

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The revelation this week that up to a million investors could be harmed by the collapse of the FTX cryptocurrency exchange exposes what critics say is a fundamental flaw in the foundations of the $850 billion digital currency market.

As the collapse of the Bahamas-based company on Wednesday continued to fuel turmoil in crypto markets, experts said the concern lies less in crypto itself than in light of regulated companies serving crypto investors.

For investors, FTX was a gateway to the crypto world, an exciting market where celebrity ambassadors like quarterback Tom Brady invited them to open accounts and trade digital currencies like bitcoin and ether. FTX, in turn, functioned in many ways as the banks and brokers of traditional finance, maintaining customer accounts, exchanging currencies and making loans and investments with customer assets.

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But like other crypto exchanges, FTX operated outside the traditional banking system, and this created enormous risks. Although they act like banks and brokerages, crypto exchanges are typically not subject to the same types of regulations, insurance, and disclosure rules that protect customers of traditional banks.

“At some level, the fall of FTX is not a crypto story at all,” said Adam Levitin, a law professor at Georgetown University and a principal at Gordian Crypto Advisors, a firm that provides advice on crypto- bankruptcies, said. “People invested billions in an unregulated financial institution based on a Caribbean island. How could it end well?”

What the FTX case shows on a large scale is that companies that hold crypto for clients can make investment decisions that end in disaster, and when they do, there is no clear guarantee that clients will get their assets back.

According to Reuters, at least $1 billion in client funds disappeared from FTX, one of the industry’s largest exchanges, under circumstances being investigated by the Justice Department and the Securities and Exchange Commission. In bankruptcy filings, FTX revealed that it may owe money to more than a million people and organizations.

The crash drew attention because FTX is one of the largest crypto exchanges, and its founder, 30-year-old Sam Bankman-Fried, was widely regarded as a crypto prodigy and top Democratic donor. But over the past year, as the overall value of the crypto market has fallen from a peak of more than $3 trillion, other crypto firms have also experienced financial difficulties.

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Crypto lenders Celsius Network and Voyager Digital filed for bankruptcy earlier this year after being unable to meet customer demands for withdrawals. Last week, another lender, BlockFi, announced it was “unable to conduct business as usual” and “suspended customer withdrawals” in the wake of the FTX collapse. This week, crypto exchange AAX announced that it has stopped withdrawals, citing technical issues with a third-party partner. And on Wednesday, cryptocurrency lender Genesis said it was temporarily suspending redemptions and new loans.

These problems have spooked investors, prompting executives at other major crypto exchanges — including Coinbase, Crypto.com and Binance — to reassure customers that their balance sheets are strong. Some have portrayed the FTX crash as an anomaly in an otherwise safe industry.

“This is the direct result of a rogue actor breaking every single basic rule of fiscal responsibility,” Patrick Hillmann, chief strategy officer at Binance, the largest of the crypto exchanges, said in a statement to The Washington Post, citing to Bankman-Fried . “While the rest of the industry operates under an extreme degree of scrutiny, the cult of personality that has enveloped FTX has given them a dangerous level of privilege that is undeserved.”

But the lack of regulation creates risks for crypto investors, experts said. In the United States, the financial condition of a traditional bank is subject to regulations and official scrutiny. Had FTX been subjected to the same scrutiny, the weaknesses in its financial condition might have come to light earlier. In addition, customer deposits at traditional banks up to $250,000 are insured by the FDIC. No such protection will help those who have lost money at FTX.

FTX is one of several major crypto exchanges that have played a critical role in popularizing cryptocurrencies, including by paying for Super Bowl ads to reach large audiences. According to a survey by Pew Research Center, 16 percent of American adults say they have invested or traded in cryptocurrency at some point.

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Some “companies have been allowed to become very large despite their blatant disregard for the rules imposed on traditional financial institutions,” said Tyler Gellasch, president of the Healthy Markets Association, a group focused on increasing transparency and conflicting regulations. reduce interests in the capital markets. .

“The banking and securities rules are set up to ensure that if the bank or broker fails, you can still get your assets back,” Gellasch said. “The crypto exchanges don’t seem to comply with any of them.”

Since FTX filed for bankruptcy last week, several major exchanges have tried to become more transparent. Last week, Binance published a brief account of its cryptocurrency holdings, but not its liabilities.

Binance chief Changpeng Zhao said the company would publish a fuller account of its financials within weeks once a third-party auditor can complete its work. Zhao did not identify the auditor but said the same firm also worked for FTX.

“Nothing is risk free, right? Crypto exchanges are inherently pretty risky businesses,” Zhao said in a Twitter Spaces chat on Monday. “You have to manage them well. You have to do security well. You have to do a number of things well.”

Unlike FTX, Zhao said Binance does not carry debt. “We’re a very clean, very simple business,” he said. “We’re not trying to be a pawn shop or hedge fund shop.”

At Crypto.com, CEO Kris Marszalek held a video livestream Monday amid online rumors that the company had stopped processing withdrawals. Marszalek acknowledged that the number of withdrawals rose temporarily after the company mishandled a transaction worth about $400 million that he said was accidentally sent to the company’s account on a rival exchange.

But he called rumors of a break “absolutely not true,” adding, “We’re back to business as usual.”

In what Marszalek touted as an effort to restore depositor confidence, Crypto.com published a partial breakdown of its cryptocurrency holdings, revealing that as of Nov. 14, the company had at least $2.3 billion in held cryptocurrency reserves. But the company’s outstanding liabilities are not publicly known and were not included in the initial report the company released after the collapse of FTX.

On Monday, Marszalek downplayed Crypto.com’s exposure to FTX, assuring investors that the company’s balance sheet is “extremely robust.” He said a “third-party audit” of the exchange’s customer reserves would be released in the coming weeks.

Based in Singapore, Crypto.com plowed a fortune into flashy marketing campaigns, hired actor Matt Damon as a brand ambassador and acquired the naming rights for the Los Angeles Staples Center in a deal worth an estimated $700 million. However, this year the price of its native token, cronos, has fallen. In the past week, cronos has lost more than 50 percent of its value, fueling questions about the exchange’s solvency.

Marszalek said the upcoming audit will prove his position remains strong.

“We don’t run a hedge fund. We do not trade clients’ assets,” he said during the live stream. “In a few months, all these guys are going to look really, really bad for throwing around claims that have absolutely no substance.”

Coinbase, the largest of the publicly traded crypto exchanges, is based in the United States and subject to more disclosure rules than most other major exchanges, a point its executives emphasize. The company said it has sought and obtained licenses in every jurisdiction in which the company needs it to operate in the United States.

“We follow the laws and regulations in these jurisdictions, which include a variety of obligations such as capital requirements,” the company said in a statement.

Alesia Haas, the company’s chief financial officer, wrote in a blog post last week that the company’s “public, audited financial statements confirm that we do not have a liquidity problem.”

Still, regulators urge caution. In a speech last month, Michael J. Hsu, acting head of the Office of the Comptroller of the Currency, warned crypto exchanges about what he saw as their dangerous attempts to “disguise” themselves as banks.

“The crypto industry arose out of a desire to … disrupt the traditional financial system,” Hsu said. “Yet crypto imitated [traditional finance] concepts to market itself and grow… Using the familiar to introduce something new can reduce or mask the risks involved and establish false expectations. Over time, people get hurt.”

The visionaries who laid the groundwork for bitcoin and other digital currencies have also raised questions about exchanges. Crypto was supposed to eliminate the need for banks, brokers, and other so-called “financial intermediaries,” and many early advocates were critics of a financial system they saw as predatory and opaque. The seminal white paper that launched bitcoin envisioned cutting out the banks because it would “allow online payments to be sent directly from one party to another without going through a financial institution.”

When centralized crypto exchanges emerged to take on the role of banks and brokers, critics say, they distorted the original ideals of crypto.

“It’s really hard to square centralized crypto exchanges with the core premise of cryptocurrencies,” said Finn Brunton, a professor of science and technology studies at the University of California at Davis and the author of “Digital Cash: The Unknown History of the Anarchists, Technologists and Utopians who created cryptocurrency.” Centralized crypto exchanges essentially recreates the same risks and lack of transparency that existed in other financial institutions, but with even less regulation and oversight.”

In their bankruptcy filings, Celsius and Voyager described their failures in a way that makes clear their similarity to traditional banks. Both explained how a surge of customers demanded to withdraw their assets. Neither firm had the resources to return their clients’ money, forcing them to file for bankruptcy protection.

In court documents, both firms used the same phrase to describe their problems. They were hit, according to the filings, by “a run on the bank.”

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