8d9c6426 3150 427a B3f5 59a1e3cf4c20

The crypto world must be made safer for investors and users

The author is an independent financial commentator

The sudden collapse of the crypto exchange FTX raises serious questions about the state of the crypto ecosystem. Without serious changes in the way it works, it is hard to see how it could even become part of the existing mainstream financial system, let alone replace it as some would like to see.

The crisis at FTX, and before it crypto lender Celsius, Voyager, hedge fund Three Arrows Capital and digital tokens terraUSD and luna, has little to do with cryptocurrency as a technology. Rather, it exposes what financial systems look like when there are insufficient checks and balances. Crypto people rail against central banks and regulators, but they exist for good reasons.

Exactly what went wrong at FTX is still unclear. Its CEO, Sam Bankman-Fried, insisted it was just a liquidity failure. But Binance, which initially agreed to buy FTX to bolster liquidity, pulled out of the deal after looking at its books. There are reports that FTX has a balance sheet hole of about $8 billion. Unless someone is willing to commit a lot of capital, FTX will eventually file for bankruptcy. Investors are bracing for the worst: Sequoia Capital has already written down its investment to zero.

More worryingly, it appears that client funds are being compromised. Indeed, it is hard to see how a balance sheet hole of such size could have developed unless the exchange clients lent out funds.

Reuters reported that FTX lent customer funds to Alameda Research after it was hit hard by the failures of Three Arrows Capital and Voyager in May this year. And the U.S. Department of Justice and U.S. regulators are now investigating relationships between FTX and Alameda, including whether client funds may have been misappropriated.

If customer funds were lent, customers of FTX’s international exchange would apparently lose a significant portion of their funds unless Bankman-Fried manages to find a buyer who will pay close to the full price (which seems a tall order). Some — perhaps many, because FTX lured retail traders and encouraged ordinary people to deposit their wages into its accounts — will suffer as a result.

FTX is far from the first crypto company to fall amid token crashes, bank runs and allegations about the use of client funds. The recent failures of Celsius, Voyager and in 2021 the crypto lender Cred show similar characteristics. Underlying these failures are four major weaknesses in the crypto ecosystem:

• Interconnection between companies in the form of opaque cross-holdings and circular lending practices such as re-hypothecation. Rival crypto exchange Binance had a significant holding of FTX’s native token, FTT. When he announced that he would be selling his stake, it sent people scrambling to sell FTT themselves and pull their funds from FTX.

• Too much reliance on personalities. Crypto was supposed to eliminate the need for trust between people. “Don’t trust, verify” was the mantra. But the whole system now seems to depend on a few big personalities, who are trusted by thousands. Bankman-Fried is one. He built up a large empire in a short period of time and gave a lot of money to good causes. He seemed like an all-around good guy. So people trusted him with their money. Investors in particular have shown a remarkable willingness to back his ventures without the usual financial due diligence.

• Concentration. There aren’t many big crypto exchanges and banks, and those who run them all know each other and invest in each other’s companies. When they go on, all is well; but when they fall out, they can cause tremendous damage. It should not be possible for a tweet from Binance’s CEO to spur a run that drops its biggest rival; but that’s what happened.

• Transparency. Crypto was supposed to improve the transparency of financial transactions. But crypto companies like FTX reveal very little about their financial status – far less than what is expected of a conventional bank. The opacity of Bankman-Fried’s companies, FTX and Alameda, was compounded by a complex corporate structure, intercompany transfers and the reported use of owning a native token to boost the balance sheet.

These problems will be painfully familiar to anyone who has studied the history of financial panics and banking crises. They seem to be endemic to financial systems. Crypto has shown it is no different.

If crypto is to have a future as a mainstream financial product, it must now accept the regulation and controls that make financial systems safe for investors, creditors and depositors.

Related Posts