Regulation + "Decentralization"
One doesn't cancel out the other
“The insanity of Theranos, the speed of Lehman, and the scale of Enron.” -Matt Ballensweig, Former Genesis Executive
A better one-line summary of crypto’s current state of affairs than I could ever offer. Over the past 48 hours the collapse of FTX and the undoing of Sam Bankman-Fried (SBF) just keeps getting… weirder. Netflix docudrama writers lack the talent to write a script this rich. SBF and other executives are reportedly trying to flee to Dubai, so we’re at the chase scene.
The Latest
It turns out the darling of the crypto industry was a company without a board operated out of a mansion in the Bahamas by 10 romantically-involved coders running a prop-trading desk. The company was audited by Prager Metis, the so-called “First CPA Firm in the Metaverse.” I’m not making any of this up.
Some notable updates…
Executives at the direction of Mr. Bankman-Fried reportedly built a secret backdoor to the FTX platform so that billions could be moved in and out without flagging the transactions internally or externally, per CNBC. Presumably, this is how $10 billion of client funds landed with Alameda Research for speculative trading. The justification for this backdoor is currently unknown.
Last night, Coindesk reported that FTX and FTX US wallets appeared to have been hacked, with over $600 million leaving the exchange. FTX told users not to install any new updates and to delete all FTX apps. Theories are circulating but it remains unclear who is behind the hack.
According to a Financial Times report, FTX held just $900 million in liquid assets against $9 billion in liabilities as of their bankruptcy filing on Friday. That figure only represents the liabilities of FTX and its subsidiaries. When factoring in leverage across the entire global ecosystem of firms with exposure to FTX, the notional value of liabilities is likely far higher. For example, FTX’s largest holding was $2.2 billion of a token called Serum (that SBF himself founded). Serum’s entire market capitalization is only $84 million. The $2.2 billion was never realizable as Serum was a completely made up currency. It’s easy to imagine this same scenario affecting dozens of other firms.
In the last day, crypto lender BlockFi has paused activity on their platform and is reportedly at risk of collapse. Reports are surfacing that Crypto.com is in dire straits as well. Expect more shoes to drop as businesses assess their exposure to contagion risk. All companies have lost the benefit of the doubt.
We have gone from an apparent liquidity crisis caused by poor corporate governance to outright fraud bringing an industry to its knees.
DeFi Defenders: “Hey, Don’t Blame Us”
In the wake of the FTX disaster, I’ve seen many people – mostly hard-liners – defending crypto and decentralization writ-large. The argument sounds something like: “The government will rush to regulate this space when they should do just the opposite. This shows why we need decentralization now more than ever.”
My question for these folks: What exactly is meant by decentralization?
If by decentralization, they’re referencing the concept of peer-to-peer (P2P) financial transactions, I agree there is value. P2P in this context refers to the ability of two parties to conduct a transaction without an intermediary. In the traditional banking system, completing wire and ACH transactions takes anywhere from a few hours to several days. P2P capability, on the other hand, allows holders of stablecoins like US-dollar backed USDC to send and receive funds nearly instantaneously—think Venmo but without the bank intermediary.
Or perhaps they’re referring to truly decentralized exchanges like Uniswap. Uniswap uses a decentralized finance protocol to facilitate the exchange of cryptocurrencies and tokens. The service operates on a blockchain network built atop open-source software. In contrast to centralized exchanges run by companies like FTX, Uniswap uses liquidity pools rather than serving as a market maker. If all that sounds like gibberish, just remember this one key distinction: centralized exchanges like FTX provide liquidity at the firm-level, whereas truly decentralized exchanges rely on user participation.
Amid the current mayhem, decentralized protocols relied upon by firms like Uniswap are intact and operating as intended. Centralized exchanges, on the other hand, are facing insolvency.
Requiring companies to 1) ensure clients’ access to funds on demand, 2) maintain proper collateral and debt-to-asset ratios, and 3) demonstrate adequate corporate governance is not radical. Basic consumer protection measures would not have impacted FTX’s ability to do business in any way. What’s radical is allowing a 30-year-old crypto king and his friends to mishandle billions of dollars in client funds and operate a global company with no board.
Arguments in support of decentralization as a concept make sense if we are clear on the definition of decentralization. What these anarchic crypto bros are arguing instead is that traditional finance is so bad, so unredeemable, that we must move towards a world of unregulated “decentralized” finance because banks and the government have failed. I don’t buy it.
I trust Chase to hold my cash, TD Ameritrade to hold my investments, and that I can access those funds when needed. For all the ways in which one could improve the traditional banking user experience, I never question whether my assets are safe. Why? Because there are laws in the US that require banks to ensure this is the case. As a caveat, the consumer protection environment does change drastically when swapping the United States for an authoritarian or developing country. But promising digital asset use cases exist, most recently evidenced by Lebanese citizens using stablecoins to navigate a broken banking system and hyperinflation in the national currency.
The cynic will point to the various banking crises over the years as evidence of my naivete, but perhaps I should link to the Glass-Steagall Act (1933) which separated commercial and investment banking, or the Sarbanes-Oxley Act (2002) that mandated corporate financial record keeping and reporting. Or how about Dodd-Frank and the Volcker Rule (2010), which prevents banks from making speculative investments that do not benefit clients. Decades of regulation has strengthened the global banking industry, and with a new 2008 moment every few months for the crypto industry, it’s laughable to argue that traditional finance hurdles towards obsolescence.
Any company worth your business should welcome common-sense regulation rather than shun it. For the industry to thrive, order must be established.
It's Both-And, Not Either-Or
A future we might expect—and even welcome—is one where traditional finance and decentralized finance become integrated. Imagine a world where you can access your checking accounts and USDC stablecoins on one mobile app, giving you access to the digital asset markets and the ability to conduct global P2P transactions. The adoption curve of digital assets like cryptocurrencies will never end in a total migration away from traditional banking. For the good of consumers and the stability of the global financial system, TradFi and DeFi should be compliments to one another, not substitutes.
The FTX fiasco might well have catalyzed an overdue cleansing of the crypto space, albeit at the expense of investors’ savings and livelihoods. As the tide recedes, FTX won’t be the only company caught swimming naked. I’ll leave you with this—in an industry brimming with scams and murky business models, perform your own due diligence. Sequoia Capital, Tom Brady, and Kevin O’Leary aka “Mr. Wonderful” won’t do it for you.
“Big advocate for Sam, because he has two parents who are compliance lawyers. If there’s ever a place I can be that I’m not going to get in trouble, it’s going to be at FTX.” -Kevin O’Leary
Cheers,
Ryan