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Digital Assets

Crisis of Confidence

By:

Richard Barnett, CFA

Crisis of Confidence

Last week saw the shocking and rapid disintegration of FTX and Alameda Research, the two vehicles controlled by Sam Bankman-Fried.  FTX was one of the largest cryptocurrency brokers in the world, and Alameda was a prolific trading, market making, and VC investment vehicle.  Now we are finding out that Alameda was using FTX customer funds to prop up losses in their trading activities and fill holes in their balance sheet.  

To quote a recent Bloomberg article “If there was ever a full-blown crisis of confidence across the crypto industry, judging by the $200 billion of losses in the digital-asset market over the past week, that time is now.”

We thought we would examine what it will take to mitigate the damage and restore confidence in the Cryptocurrency space following the failure of a major player.

  • Proof of reserves: As a first step, brokers are rushing to publish proof of their reserves. Proof of reserves employs a “Merkle tree”, which allows for reserves to be seen on their respective blockchains, and are supervised by an auditing or blockchain analytics firm.  However, they do not provide a snapshot of liabilities.  The big exchanges including Binance, OKX, Crypto.com, Kucoin, and Bybit have or will publish proof of reserves in the near future.
  • “Not your keys, not your crypto'': While things shake out, investors have been rushing to move crypto assets off exchanges and into their personal wallets, where they control the private keys.  This makes them safe from undercapitalized exchanges and bank runs, but heightens the need to manage their own wallet security. Assets will have to be moved back to exchanges when it's time to sell.
  • Sensible regulation: It goes without saying that moving customer funds into risky investments is already fraud, but future regulation will have to address strict capital requirements, auditing requirements, and firewalls between related entities.
  • Decentralized Exchanges:  The failure of a major centralized exchange may strengthen the case for decentralized exchanges (DEXs), where the flow of funds is controlled by the code and not by the exchange.  Decentralized exchanges can reduce counterparty and hacking risk when used with non-custodial wallets to hold their funds when not trading on the exchange.  

Why this matters to you:

The failure of FTX is a big setback for digital assets, and it will shape regulation, investor due diligence, and investor behavior.  The events of last week will surely speed up digital asset regulation, which was coming anyway. However, we don’t think it's game over. Just as traditional finance survived the fall of Bear Stearns, Lehman Brothers, and MF Global, the digital space has a chance to learn from its mistakes and evolve regulatory and risk management practices to harness the potential of digital money.

Sources:

Centralized exchanges are scrambling in attempts to prove their reserves, The Block, November 11, 2022.
Sam Bankman-Fried’s Magic Money Box Enriched Vast Crypto Network, Bloomberg, November 14, 2022
What are decentralized exchanges, and how do DEXs work, Cointelegraph, undated.

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