Updated Nov 11, 2022.
Hey Fintech Friends,
What! Is! Happening!
"Crypto exchange FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm, Alameda Research, setting the stage for the exchange’s implosion, a person familiar with the matter said.
FTX Chief Executive Sam Bankman-Fried told an investor this week that Alameda owes FTX about $10 billion, the person said. FTX extended loans to Alameda using money that customers had deposited on the exchange for trading purposes, a decision that Mr. Bankman-Fried described as a poor judgment call, according to the person." - The Wall Street Journal
Remember when FTX stepped in to bail out crypto platform BlockFi over the summer? The same FTX that then made a bid to buy Voyager and was hailed for altruistically using its fortress balance sheet to save the crypto industry from potential collapse? FTX, the company that built a reputation for regulatory compliance and was taking shots at Binance on Twitter for its alleged lack thereof?
There’s a lot of chaos to unpack amid the recent spate of crypto exchanges going insolvent, sassy tweets, and investigations into potential fraud. There’s also a lot of wisdom for the crypto industry and its regulators to take away from this.
FTX's collapse– and its recent antecedents– are underscoring the need for crypto to live up to its ethos of transparency and exposing cracks that platforms are already moving quickly to address. The crypto ecosystem will emerge better-off for it.
Before getting into lessons learned, let's have a quick refresher on the journey that got us here.
Dumb collateral
If you're leveraging a trade, you’ll ask a broker to lend you funds covering some percentage of the order. Putting less of your own money down means that your gains will be multiplied when the trade is a success, and losses multiplied when the trade isn’t. You’ll typically need to show the broker that you have enough money to cover their downside in a margin call if the underlying security drops in value and the trade starts going south.
Apparently, this is not the case if you’re Three Arrows Capital.
Three Arrows Capital (3AC) grew to become the world's largest crypto hedge fund by making leveraged bets on early-stage crypto projects, borrowing billions of dollars from brokers to amass what reached $10 billion in assets at the fund's peak. It turns out that 3AC's founders were borrowing from brokers that they had friendly relationships with, but didn't tend to disclose their financials to in the process, likely because the financials would’ve shown that 3AC didn’t actually have enough money to collateralize their souped-up over-leveraged crypto positions.
This became a problem when algorithmic stablecoin TerraUSD de-pegged from the dollar in May, destroying $60 billion in token value and bringing 3AC's $560 million position in TerraUSD’s sister coin, Luna, down with it.
When 3AC's brokers initiated margin calls on their failing bets, it came to light that 3AC didn't actually have the cash to meet their margin requirements. 3AC's founders fled during bankruptcy proceedings, sticking brokers with a $3.5 billion tab that eventually drove Voyager into bankruptcy, BlockFi to take a $250 million bail-out from FTX, and Blockchain.com to lay off 25% off its staff.
We still don’t know the whereabouts of 3AC’s co-founders. Their liquidators are trying to serve them subpoenas over Twitter. The founder of Terraform Labs (company that launched TerraUSD & Luna), Do Kwon, is also dodging prosecutors from an undisclosed location.
FTX and its founder, Sam Bankman-Fried (SBF), got a lot of good press at this point for stepping in to keep some of these competitors afloat. The tide changed last week when Coindesk reported that Alameda Research, a trading firm that was founded by SBF, had billions of dollars of FTT– FTX’s native exchange token– on its own balance sheet. Alameda and FTX were ostensibly run as separate companies, so this raised questions around the relationship and prompted Binance to announce it was selling off its FTT.
"I fucked up"
If you run an investment platform, a basic principle to adhere to is that you shouldn't use customers' deposits to fund your own business activities.
It's coming to light that FTX lent over half of its customers' $16 billion in deposits to Alameda, which took a major hit in the Three Arrows collapse. SBF allegedly built a “back door” to siphon funds from FTX to Alameda without raising flags to FTX employees. As of right now, FTX doesn't have the funds to let customers get their deposits back. SBF says this was the result of him misunderstanding FTX's actual leverage and liquidity levels. And that he is really sorry.
The takeaways
This isn't a story of some failure inherent to crypto. Crypto is a nascent concept, and with that comes a lot of experimentation to validate new concepts, high-profile blow-ups when certain concepts fail, and a collective effort to create regulatory guardrails protecting participants from "fuck-ups" going forward.
These events are reinforcing the argument for crypto’s ethos of transparency and are already catalyzing change in the right direction from centralized exchanges, where 99% of transactions take place today, and the regulators who oversee them.
A few key lessons here:
Crypto exchanges will be increasingly expected to show proof of reserves
It hasn't been a norm for crypto exchanges to show proof that investors' assets are backed by reserves, but exchanges are now rushing to reassure customers this is, indeed, the case. Many are touting that they'll publish audited financials, which is good, but not completely satisfying as audits only give a snapshot of exchanges' liquidity positions at the time of the assessment and point-in-time attestations can easily be manipulated.
To be fully transparent, exchanges could let customers cryptographically validate that their assets are accounted for using Merkle Tree Proof of Reserves.
Lenders and brokers will increasingly demand on-chain proof of collateral
This one is kind of a "Duh", but a lesson learned for lenders and brokers is to maybe not lend billions of dollars to risk-friendly investors making degen crypto bets, even if they are your friends.
(This is the big one) Crypto needs a better regulatory framework
This episode has renewed calls for US regulators to establish clearer rules for the crypto industry:
This is music to the regulators’ ears.
As we’ve discussed, the SEC, CFPB, and US Treasury have been in a stalemate over who gets to regulate crypto, with each making the argument that some subset of crypto is most akin to the financial instruments that they currently regulate. These regulators did not miss a beat, joining the crypto community to pressure Congress into delegating oversight and enabling a more forward-looking approach to regulation.
We surely haven't seen the last of the dominoes fall, but this one feels like a turning point. The urgency for crypto to achieve a fully transparent and decentralized end state seems clearer now than ever. All that's left is for crypto players to accelerate its delivery.
