The crypto world needs to be made safer for investors and users

The author is an independent financial commentator

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

The crisis at FTX, and before that, Celsius crypto lender Voyager, hedge fund Three Arrows Capital, and digital tokens terraUSD and luna, had little to do with cryptocurrency as a technology. Rather, it exposes what financial systems look like when there are not enough checks and balances. Cryptocurrencies attack central banks and regulators, but they exist for good reasons.

Exactly what was wrong with FTX is still unclear. Its chief executive, Sam Bankman-Fried, insisted it was just a lack of cash. But Binance, which initially agreed to buy FTX to bolster its liquidity, pulled out of the deal after reviewing its books. There are reports that FTX has a hole in the balance sheet of around $8 billion. Unless someone is willing to commit a lot of capital, FTX will eventually file for bankruptcy. Investors are preparing for the worst: Sequoia Capital has already reduced its investment to zero.

More worryingly, it appears that customer funds are in jeopardy. Indeed, it is difficult to see how a balance sheet hole of such size could have developed if the exchange had not lent client funds.

Reuters reported that FTX loaned funds to clients at Alameda Research after being hit hard by the failures of Three Arrows Capital and Voyager in May this year. And the US Department of Justice and US regulators are currently investigating FTX’s relationship with Alameda, including whether customer funds may have been misused.

If client funds have been loaned out, unless Bankman-Fried can find a buyer who will pay almost full price (which seems like a tall order), clients on FTX’s international exchange seem ready to lose a substantial portion of their funds. Some – perhaps many, because FTX has attracted retail traders and encouraged ordinary people to deposit their paychecks into its accounts – will suffer as a result.

FTX is far from the first crypto firm to fall amid token meltdowns, bank runs, and allegations about the use of client funds. The recent failures of Celsius, Voyager and in 2021 of crypto lender Cred exhibit similar characteristics. Behind these failures lie four major weaknesses in the crypto ecosystem:

• Interdependence between firms in the form of opaque cross-shareholdings and circular lending practices such as rehypothecation. Rival crypto exchange Binance held a substantial share of FTX’s native token, FTT. When she announced she would be selling her stake, she sent people rushing to sell FTT themselves and withdraw their funds from FTX.

• Too much confidence in 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, trusted by thousands of people. Bankman-Fried is one. He built a huge empire in a short time and donated a lot of money to good causes. He seemed like a good guy all around. So people trusted him with their money. Investors, in particular, have shown a remarkable willingness to back his ventures without the usual financial diligence.

• Focus. There aren’t many major crypto exchanges and banks, and those who run them all know each other and invest in each other’s businesses. When they get along, everything is fine; but when they fall, they can do immense damage. It should not be possible for a Tweeter from Binance’s chief executive to spur a run that brings down its biggest rival; but that’s what happened.

• Opacity. The crypto was supposed to improve the transparency of financial transactions. But crypto companies such as FTX reveal very little about their financial situation – much less than you would expect from a conventional bank. The opacity of the companies of Bankman-Fried, FTX and Alameda, was aggravated by a complex corporate structure, intercompany transfers and reported use of native token holdings to boost the balance sheet.

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

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

#crypto #world #safer #investors #users #Crypto

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