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The Crypto Industry Struggles for a Way Forward After FTX Collapse

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Not long after several Wall Street banks collapsed in 2008, a nine-page document circulated on an obscure mailing list, proposing a new kind of financial system that would not rely on any “trusted third party.”

The paper was the basis for what became the cryptocurrency industry. Using far-reaching, idealistic language, its adherents promised to conduct business in a transparent and egalitarian manner, rejecting the high-risk practices of a small number of powerful financial firms that caused the Great Recession.

But last month, the actions of a single crypto firm — the $32 billion exchange FTX — plunged the emerging industry into its own version of a 2008-style crisis. Once considered a safe marketplace for people to trade virtual currencies, FTX filed for bankruptcy after the crypto equivalent of a bank run, forcing industry executives, investors and enthusiasts to grapple with how a technology intended to correct the shortcomings of traditional finance, ended up repeating it. .

Executives who only a year ago reveled amid crypto’s seemingly unstoppable growth are now scrambling to prove they can learn from mistakes and reclaim the industry’s early ideals. Binance, the world’s largest exchange, announced last month that it would release more information about its finances and hire independent auditors to review those disclosures. Coinbase, the largest US crypto exchange, proclaim that it is committed to a “decentralized system where you don’t have to trust us.”

Many crypto advocates are pushing for more drastic reforms, urging investors not to store their digital holdings with big companies and instead turn to more experimental platforms run only by code.

But despite all the promises of change, FTX’s collapse shows how far crypto remains from achieving its original goals and gaining widespread adoption. Consumer distrust has risen this year amid heavy financial losses, criminal investigations and an increasingly skeptical regulatory climate in Washington. At a conference last month, Binance CEO Changpeng Zhao said that FTX’s collapse would set the industry back by years.

The stock market’s demise compounded months of losses in the virtual currency market, brought on by a devastating spring crash that unfolded amid a broader retreat from risky assets. The upheaval sent some prominent crypto firms into bankruptcy. Bitcoin, the original and most popular cryptocurrency, is trading at less than $17,000, down about 75 percent from its peak of nearly $70,000 almost exactly a year ago.

“You start going through these problems, and they pile on top of each other,” said John Reed Stark, a former Securities and Exchange Commission official turned outspoken crypto critic. “More and more people are seeing it for the scam it is.”

The crypto industry bounced back after previous crashes, attracting big-name investors who poured even more money into experimental companies. But FTX’s collapse has been widely described as the worst moment in the industry’s short history.

The origins of crypto date back to 2008, when a mysterious figure known as Satoshi Nakamoto published a white paper on Bitcoin, which laid out a detailed vision for what cryptocurrencies would become. The paper outlined Bitcoin’s technological foundation, which was a publicly visible ledger called a blockchain where transactions would be recorded for all to see.

Early enthusiasts thought Bitcoin could become the foundation of a more transparent, egalitarian financial system. Many of the paper’s backers were libertarians who had become disillusioned with traditional finance, particularly the concentration of power among a small number of companies.

Initially, crypto’s primary use was criminal. Thieves and drug dealers have used Bitcoin to transfer large sums of money without relying on a bank or other intermediary to process transactions.

But over the years, law enforcement has gotten better at detecting cryptocrime, and the technology has evolved to enable more sophisticated financial applications, such as loans and lending. People who started their careers on Wall Street — including FTX’s founder, Sam Bankman-Fried, who worked at the trading firm Jane Street — have become involved in the burgeoning industry, looking to profit from the technology.

As the industry grew, it began to take on some of the same characteristics as the Wall Street institutions it was designed to replace. Crypto trading has become increasingly centralized, with a large portion of transactions taking place on a handful of major exchanges, including Binance, FTX and Coinbase. In the months leading up to the collapse of FTX, cryptocurrency trading volume on Binance alone was greater than the combined totals of its seven closest competitors, according to an industry data tracker.

The original vision of crypto “was an attempt to rewrite the rules of finance on a global basis,” says Charley Cooper, managing director at blockchain company R3. “And here we are again — we’re in an even more centralized industry than we’d see in banking.”

Cryptocurrencies rose in value last year and in 2022 – until May. This was when a popular cryptocurrency called Luna crashed, sending the crypto economy into free fall. Two major lending companies, Celsius Network and Voyager Digital, have filed for bankruptcy. Enthusiasts have lamented the start of a “crypto winter” of depressed prices and waning enthusiasm.

In the midst of the crisis, FTX was seen as a relatively reliable force. Based in the Bahamas, the company served as a marketplace for people to buy and sell cryptocurrencies, offering high-risk but popular trading options that are illegal in the United States. Mr. Bankman-Fried, 30, who built FTX into a $32 billion company, has bailed out struggling firms and built a reputation as a benevolent figure willing to extend a lifeline to colleagues.

Last month, a run on deposits exposed an $8 billion hole in FTX’s accounts. The company filed for bankruptcy within a week. The Securities and Exchange Commission and the Department of Justice have opened investigations focused on whether FTX illegally loaned its users’ funds to Alameda Research, a crypto hedge fund that Mr. Bankman-Fried also founded and owned.

The implosion has been described as a “Lehman moment” for crypto, a reference to the investment bank whose implosion helped trigger the 2008 financial crisis. Other companies with ties to FTX began to falter. Last Monday, crypto lender BlockFi, one of the companies that backed FTX in the spring, filed for bankruptcy, citing its entanglement with Mr. Bankman Fried.

Some prominent figures in crypto have tried to spin FTX’s demise as a positive development, arguing that it will redirect energy into finding practical uses for the technology.

“For us, it’s actually a great moment,” said Jeremy Allaire, the CEO of crypto-payments company Circle. “We are delivering real value, and the people who have focused on building giant speculative trading casinos are not so happy.”

Binance essentially runs the same type of business as FTX, but Mr. Zhao, the CEO, has recently been careful to distance himself from Mr. distinguishing Bankman-Fried, calling his one-time rival a liar and criticizing FTX’s most dangerous practices. On Nov. 25, Binance announced a new “proof of reserves system,” promising to keep users informed of the amount of cryptocurrency in its accounts and allaying fears that it could be vulnerable to the type run on deposits that destroyed FTX. (But Binance’s plans were heavy criticized for lack of key information.)

Coinbase also tried to allay fears of a crash, publishing a blog post that said it always held the same amount of money as customers deposited. “There cannot be a ‘run on the bank’ at Coinbase,” the post said.

Still, the mere existence of big companies like Binance, Coinbase and FTX is antithetical to the ideals of crypto, some industry experts say. Since FTX’s collapse, some crypto enthusiasts have flowed to smaller firms in the experimental field of decentralized finance, which enables merchants to borrow, lend and execute transactions without banks or brokers, relying instead on a publicly visible system governed by code.

But DeFi has its own problems, including vulnerability to hackers, which have drained billions of dollars from the experimental projects this year.

“They based it on clumsy technology that is very inefficient,” said Hilary Allen, a financial expert at American University. “They are operationally very fragile.”

Scrutiny in Washington has also intensified. SEC Chairman Gary Gensler has vowed to prosecute crypto companies for securities law violations. The House Financial Services Committee is scheduled to hold a hearing on December 13 investigating FTX’s collapse.

Mr. Bankman Fried was asked to testify. In interviews with The New York Times, he sometimes seemed anguished over FTX’s bankruptcy — and at other times he was conspicuously flippant.

“You know,” he said in one interview, “the crypto winter has officially been extended.”

Wasn’t that a bit of an understatement? “Yep,” he replied. “Ouch.”

Audio produced by Parin Behrooz.

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