The second largest Virtual Digital Asset (VDA) trading platform in the world, FTX, its sister company Alameda Research, and 134 affiliated corporate entities filed for Chapter 11 voluntary bankruptcy, following a catastrophic solvency crisis on November 11th. Despite the fact that it is a company valued at approx. $32 billion, at the forefront of the payments and finance revolution, its demise was rooted in the kind of mismanagement and shortsightedness that has long existed in the financial world.
As new evidence pours in, it appears that FTX misused client funds to cover losses in Alameda by extending a loan, which was backed by self-created tokens (FTT) as collateral. Once this information was revealed to the public, a bank-driven and ultimately death spiral ensued resulting in the bankruptcy of both companies and their subsidiaries.
Also, nearly $1 billion worth of tokens were “hacked” in the same period. Now an estimated $10 billion in client funds are missing, with the full impact of the contagion yet to be felt.
For those not affected by the crash, there are some silver linings. Exchanges such as Binance, Zebpay and Bybit, for example, will soon implement Proof of Reserves via Merkle Trees – a method where each user can verify that his/her funds are backed up in real time – providing a level of transparency not seen anywhere else. other market.
However, a crucial part of the FTX saga is that periodic revisions of reserves will not be sufficient to prevent a similar collapse, as they only represent assets and not liabilities. A framework for a stronger ‘Proof of Solvency’ protocol for platforms could help remedy this, but like any business it remains vulnerable to fictitious accounting.
The collapse of FTX is not exceptional as the company’s history is full of similar financial disasters.
What is peculiar to the VDA industry is the ability to create tokens similar to shares, which provide little or no rights or guaranteed value to the holders. This can be abused in the way FTX used such tokens instead of security. Indeed, exchange tokens are an analogue of initial coin offerings (ICOs), and the current crisis makes a strong case that they should be similarly regulated.
Regardless of similarities to the past, one of the biggest consequences of FTX’s spectacular collapse is the loss of confidence that is likely to occur among larger, institutional investors. It is essential that investors are provided with the same level of protection and assurances found in comparable industries. For example, most countries require banks to pay for deposit insurance and submit to regulatory oversight. VDA trading platforms, which often act as lenders and brokers rather than just simple trading venues, lack such railings.
However, appropriate regulation of centralized international platforms has so far proved elusive due to the ability to arbitrate jurisdictions. In this case, FTX US was forced to shut down, with a class-action lawsuit already in the works – for international customers, such as those from India, there is little legal recourse or potential for reimbursement.
Regardless of best practice, or local licensing arrangements and regulations, regulatory arbitrage from centralized platforms will lead to poor compliance, risk management and subsequent losses. Undoubtedly, a cross-border solution to engage with and (as needed) rein in opaque mega-platforms like FTX is a crucial question; the ability to enforce regulation at a global or national level will be important here.
Speaking of difficulties in regulating international organizations, as a result of the FTX debacle, crypto traders are increasingly turning to decentralized finance protocols (DeFi) – as Ethereum tokens flow from large centralized crypto exchanges such as Binance and OKX. In fact, DeFi protocols have seen double-digit growth in the past week according to data analytics firm Nansen.
About $3.7 billion in BTC and $2.5 billion in ETH were withdrawn from centralized platforms, further indicating a significant and sudden loss of trust in centralized platforms. While decentralized platforms offer a greater degree of transparency, and are more in line with the libertarian ethos of VDAs, they are not without risks for users – millions of dollars have been hacked from poorly coded DeFi platforms, while the proliferation of decentralized finance potentially would deter the government’s ability to track transactions.
An immediate solution available to policymakers is to reduce risks arising from regulatory arbitrage.
Centralized exchanges, especially those operating in low-regulated jurisdictions, will always be prone to such issues of mistrust. So transparency, accountability, regulation and protection for investors are indispensable for VDA trading.
Otherwise, the system is bound to be abused by bad actors. FTX was not the first high-profile international exchange to fail, and it will not be the last – the purpose of choosing such jurisdictions is to offer increasingly exotic products that would not be allowed elsewhere.
The author is a former IAS officer