FTX caps off painful but necessary industry purge
“Destruction leads to a very rough road but it also breeds creation”
- Red Hot Chili Peppers
Last week the crypto world was turned upside down when one of the largest global exchanges, FTX, announced it was insolvent. The news was a shock to the industry, as FTX's founder, Sam Bankman-Fried (SBF), had seemingly become the industry's white knight following the LUNA/UST collapse and subsequent contagion, as well as a leader (for better or worse) in US crypto policy discussions. Initial reports suggest FTX, along with its sister company Alameda Research (a quant trading firm), surreptitiously and unlawfully took on excessive risk with FTX user deposits (among other fraudulent activity) and ultimately could not pay them back. Its been estimated the firm owes creditors around $10B.
FTX recently filed for Chapter 11 bankruptcy, but given its complex corporate structure and massive VC portfolio, the case will likely take years to resolve. FTX joins a long list of blow-ups this year (BlockFi, Celsius, Voyager, 3AC, Babel Finance, CoinFLEX, Vauld, Zipmex, and Hodlnaut) which all failed to establish basic risk management controls, and likely many of them committed fraud. So, where does crypto go from here?
Most of the focus today is on the near/medium-term risks from the recent FTX fallout:
Further contagion
Overly harsh regulatory response
Tarnished industry credibility
Pause in institutional adoption/onboarding
These fears are warranted — but I see things differently.
Many of the shady business practices that were hidden, ignored, or even just tolerated during the bull run are finally coming to a head at once. The fall of FTX could finally be the catalyst needed for profound change in an industry with great potential but very few “adults in the room”.
Although this year has been painful, the industry unfortunately needed a deep cleanse from toxic actors and behavior. Those who remain strongly believe in a decentralized future and are in it for the long haul. Now its time to rebuild.
Areas where reform is needed:
Regulation
Despite the popular crypto-native narrative — regulation is not inherently a bad thing! It (knock on wood) protects depositors of US exchanges against principal token loss — contrary to offshore peers. However, regulators have dragged their feet for 10+ years on creating useful crypto-specific legislation. We still have little clarity on which tokens are securities vs. commodities, how mining/airdrops/staking/DeFi lending/etc. will be taxed, legal implications of DAO participation, and if web3 companies will be treated as broker dealers, money transmitters, or something entirely different. Without clarity, crypto cannot thrive in the US and activity will continue to move offshore where US consumers repeatedly get burned by unregulated entities.
Post-FTX collapse, industry leaders have opined on the ineffective US regulatory environment:
Brian Armstrong, Founder & CEO of Coinbase:
Jesse Powell, Co-Founder of Kraken:
Antonio Juliano, Founder & CEO of dYdX:
Finger pointing will not move the industry forward, but I do think its important to understand the implications of crypto “policy” to-date. I’m optimistic this meltdown can illuminate the shortcomings of US market dynamics and finally motivate policy makers to enact real change. There absolutely exists regulatory middle ground that can both protect consumers and promote healthy industry growth and technological innovation. In fact, without clear and constructive regulations in the US, I don’t believe crypto will ever reach its full potential. Even TradFi stalwart JP Morgan agrees this may finally be the catalyst the industry needs to reach its next phase of adoption:
Centralized DeFi (CeDeFi): lenders, market makers (MM), centralized exchanges (CEX)
Rather than argue the ideological merits and benefits of DeFi vs. CeDeFi, its important to acknowledge DeFi UI/UX isn’t good enough yet, so CeDeFi will have to do for now. With this in mind, we must fix this disastrous segment of the market. Since the US cannot regulate the rest of the world, the following should become industry standards demanded by users:
Full counterparty financial transparency: on-chain, real-time, easy to audit proof-of-reserves and liabilities (the latter is admittedly a bit more complicated). We need to practice more of what we preach, on-chain financial transparency should be ubiquitous. Unless financial information is easily verifiable on-chain, it should be assumed to be inaccurate.
Complete separation of MMs and exchanges — seemingly obvious, but had to be said because of Alameda/FTX.
Separation of exchanges and their VC funds to avoid a variety of conflicts of interest.
More scrutiny & transparency in loan collateral. Too many lenders became insolvent due to absurd “mark-to-market” valuations for illiquid collateralized assets, or “liquid” tokens with tiny float-to-FDV ratios. All tokens used as collateral should be stress tested for ~90% drawdowns.
More transparency on where lending yield comes from and what specific risks are involved. Fine print is not enough, it should made be abundantly clear.
Early-stage project fundraising
The private-to-public crypto market in the US is broken. In an effort to “protect” retail, the SEC only allows accredited investors to participate in early stage, private token fundraising rounds. The unintended consequence of which is that retail misses a lot of the upside, and instead ends up supplying VCs with exit liquidity when tokens finally gets listed. I believe this was one of the primary reasons for the crypto market’s violent boom-and-bust cycle over the past two years.
This environment was so profitable for VCs that many (not all) poured money into projects with little-to-no diligence, knowing they could always dump on retail. Anecdotally, I spoke to a fund manager this bull run who told me crypto VC was much safer than liquid token investing. Uh what? Early stage investing should always be riskier than later stage. The manager said worst case scenario is a 1-5x ROI, but even bad projects usually return at least 10x. The SEC inadvertently created a toxic funding system which eventually suffered a vicious collapsed at the expense of retail investors.
Though this is more of a regulatory issue, we can still demand better industry standards. Before listing publicly on an exchange, projects should disclose a detailed token supply schedule, including all terms, unlocks, emissions, ownership, etc. The industry can’t prevent VCs from seeking liquidity, but it can at least demand full transparency.
I believe the events of this year are unfortunately natural for a newly created industry with unclear rules & regulations. Human nature doesn’t change — we’ve seen similar behavior many times in the past and will undoubtedly see it again in the future. It is not specific to crypto and should not discourage the vision of web3 and decentralization. Many industry flaws have recently come to light — and that’s ok — we just need to address them, come up with solutions, and keep moving forward.
Photo cred: The Purge, USA Network