“Crypto exchanges that have grown to dominate the market – such as Binance, Coinbase and FTX – arguably undermine the whole vision that drove the creation of Bitcoin and blockchains – because they centralize control in a system meant to decentralize and liberate finance from the power of governments, banks and other intermediaries.”— https://theconversation.com/i-thought-crypto-exchanges-were-safe-the-lesson-in-ftxs-collapse-195800
The recent collapse of FTX, as well as the ongoing ripple effects, has casted world wide skepticism on the cryptocurrency industry. While this is expected, it does not mean that the entire block-chain based industry should be avoided. Instead these collapses should reinforce the importance of the basic principles of which blockchain based transactions were founded on: fast global settlement, no need for central authority, trust minimization of 3rd parties, open source code, and the ability to independently verify transactions and balances via publicly auditable ledgers.
While the most recent meltdown in the crypto industry can be attributed to several factors, the primary cause is the same thing we have seen over and over in this nascent industry: irrational exuberance of investors paired with a near complete disregard for risk analysis and mitigation.
Why did FTX and others fail?
The final collapse of FTX, Celsius, BlockFi, Terra and others was because they suddenly and quickly became public knowledge that the company simply didn’t have sufficient assets in reserve to meet customer demand. How could this have happened? The formula seems simple: customers deposit fiat and cryptocurrency, make various trades, and withdraw their funds when the trades are complete. The company takes their cut along the way, and everyone is happy.
In the case of FTX, the creation of their own exchange token, FTT, was supposed to provide an incentive for users to trade on the FTX platform. The more FTT a user held, the larger the discount they received. However, the basic foundational principles of cryptocurrency were ignored. Trust was created not from open source cryptography and independent verification but through celebrity endorsements and the promise of easy money. Additionally, the lack of proper (if any) due diligence of FTX by its investors and partner companies was also a major oversight. Moreover, the value of FTT tokens were not based on scarcity but instead its quantity was controlled by the founder or central authority. More and more tokens were printed and added to the balance sheet creating heightened exuberance in the market and giving it an unreasonably high valuation.
The case for more due diligence, not more regulation
Predictably, there was a knee-jerk reaction to hastily push more legislation through congress via the Warren-Marshall Digital Asset Anti-Money Laundering Act, which “would attack money laundering by attempting to bring the digital asset ecosystem into compliance with the existing system of anti-money laundering in the worldwide financial system.”
The reality is that FTX had a US entity, FTX.us, that was already regulated as a Money Services Business, so this new legislation would do nothing to prevent something like this from happening in the future. FTX wasn’t laundering money, they were simply stealing money from customers without any attempt to run a legitimate business with common sense internal controls. There are many cryptocurrency exchanges across the globe, some regulated and some not, that have operated without a major liquidity issue for many years. Even Binance, one of the longest running and most successful unregulated exchanges, suffered a liquidity crisis shortly after FTX, but emerged rather quickly, seemingly proving it actually held customer assets rather than lending or spending them.
Bad behavior of actors participating in nascent industries often results in bad regulations by those who are not fully aware of the inner machinations of the industry. Ultimately, new regulation won’t prevent future disasters like FTX from occurring, only proper due diligence by investors, partners and investors can do that.
Third parties should be minimized if not avoided
This is one of the primary purposes of cryptocurrency, right? To be your own bank, hold your own keys, not trust 3rd parties any more than you have to? What we are seeing in the industry is customers being more than happy to give control of their crypto to 3rd parties, whether it’s giant exchanges like FTX, or to other custodial services promising too-good-to-be-true yield on their crypto like Celsius network or BlockFi (both now defunct as well). This is a learned behavior from our traditional banking system but unfortunately, this learned thought process often leads to mistrust in flawed systems like we have seen in the FTX example.
Ultimately, it is not a crime to trust your assets with a 3rd party. We all do it every day with the traditional banking system. What IS a crime, is when these 3rd parties at best do not take this responsibility seriously, and at worst commit outright fraud by using customer assets to fund their own lavish lifestyles and/or make enormous political donations in the attempt to swing regulatory favor their way.
The cryptocurrency industry that has sprouted as an after effect re-introduced a great deal of trust in these third parties, without even the basic amount of due diligence or proper understanding of risk. If crypto is to survive then everyone participating must revert to the principles of decentralization and minimization of third parties, while also performing enhanced due diligence of any and all counterparties.
Crypto should not be trusted, and that is the point
There are a lot of great things promised by crypto: fair and transparent financial services for all, more efficient and less costly transactions, and a publicly verifiable ledger are just a start. However, gambling on the future value of tokens that have been printed out of thin air to solve a problem that was likely created by the token maker is the opposite of fair and transparent.
The recent actions of a handful of bad actors should not scare future participants away. Instead of following the hype of tokens, we need to reframe the use of the technology and look for ways the blockchain technology can improve some areas of traditional financing. Most importantly, it is up to each participant to do their own due diligence and educate themselves on why foundational principles are so important to the success of this market.
Jeff Kern is the Chief Compliance Officer at AlmondFinTech.
Almond FinTech is a blockchain-based funds transfer network connecting financial institutions globally. Almond’s infrastructure is built for speed, security, and accessibility, enabling users worldwide to send money across borders using their existing financial institutions. Additionally, Almond uses a combination of psychometric and financial data to provide fast, low-risk, ethical loans to communities with unconventional or limited credit histories.