Don't Throw the Baby out with the Bathwater
FTX Postmortem; where do we go from here?
Amidst the mind-numbing collapse of FTX, I’ve seen an overwhelming amount of negative sentiment aimed at the crypto industry. It’s understandable given the magnitude of the fraud. What makes this episode especially disheartening is that the fraudulent actor, Sam Bankman-Fried (SBF), was perceived to be not only playing by the rules, but actively shaping them in tandem with regulators.
But let’s not conflate select assets with the nefarious actors that leech on them. Fraud is rampant across industries and asset classes, an unfortunate byproduct of the greed and hubris that plague human nature (as my friend Tom White puts it eloquently).
Lest we forget the fraud that tainted and toppled the real estate market: the mortgage lenders that preyed on unwitting Americans; the banks that securitized those sub-prime mortgages into toxic products for their clients to buy; and the ratings agencies that signed off on those toxic products. All parties supposedly monitored by the all-seeing eye of regulators. It wasn’t the real estate. It was the humans.
Lest we forget the opportunists that hastily shopped shell companies during the dot-com bubble. It wasn’t the internet. It was the humans.
It’s not the assets or the industries. It’s the humans.
This is yet another example that reinforces the need for truly decentralized technologies. There is value, I believe, in an asset whose monetary policy is transparent, predictable, immutable, objectively enforced by code, and, most importantly, separate from any reactive measures of any central government.
There is value, I believe, in an asset that enables verifiable ownership of digital property.
There is value, I believe, in an asset that’s provably pegged 1:1 to the dollar and can be exchanged expeditiously across borders without fees or friction.
Crypto has a major PR problem right now. But there is innovation here at a fundamental level that shouldn’t be neglected or tarnished.
A painful cleansing is in process. So, what happens next?
Regulation is Coming…
…but the wrong target might be in the crosshairs: decentralized finance.
Less than a month ago, SBF authored a document, Possible Digital Asset Industry Standards, articulating his viewpoints on how effective regulation could address several facets of the industry (DeFi, stablecoins, asset listings etc.). His core mission was to ‘create clarity and protect consumers,’ laughable now. Several quotes really stand out when reading the document postmortem:
Hacks: ‘Customers must be protected above all else.’
DeFi: ‘[my proposals] ultimately create a layer for regulators to enforce consumer protection and market integrity.’
Customer Protections & Proposals: ‘Centralized, regulated digital asset venues–like FTX–are going to end up under various disclosure/transparency regimes, potentially including suitability checks in some cases.’
Asset Listings (What is a Security): ‘We remain excited to work constructively with regulators to develop and act within a regulatory framework for tokens that are securities.’
The words ‘protect’ and ‘protection’ are mentioned 15 times in the proposal. If you loudly feign concern for increased customer protections and proactively invite regulation then you’re definitely NOT operating a fraud under the hood, right? This behavior is confounding at first blush, but then you remember that Bernie Madoff was Chairman of the largest securities regulator in the US - FINRA (formerly known as NASDR) - while perpetrating a $64B ponzi.
SBF’s lobbying efforts in DC culminated in the drafting of the Digital Commodities Consumer Protection Act (DCCPA), colloquially known on Capitol Hill as the ‘FTX Bill.’ Following the collapse, co-authoring Senators Debbie Stabenow (D-Mich.) and John Boozman (R-Ariz.) issued a statement expressing an even greater need for federal oversight of the industry. They reaffirmed their commitment to advancing a final version of the bill after ‘taking a top down look to ensure the bill establishes the necessary safeguards.’ Reassuringly, the current draft explicitly prohibits the exact type of malfeasance that led to FTX’s implosion:
What the current draft does not provide, however, is a clear delineation between centralized and decentralized parties; decentralized protocols are subject to the same registration and reporting requirements as their centralized counterparts. Beyond the cost and reporting burden, it becomes a question of whether it’s feasible for decentralized protocols in their current state - objective code - to comply.
In the coming months, I’ll be watching out for DCCPA amendments added in direct response to FTX (e.g., frequency of disclosures, liquidity thresholds, asset reserve specifications). I’ll also be watching for amendments that provide a clear acknowledgment and understanding of DeFi, and concrete, feasible asks of the protocols.
Renewed Emphasis on Self-Custody
This one is obvious. Following the collapse, my mom texted me asking if her funds were safe on Coinbase. Fair question. The reality is no crypto exchange is FDIC-insured. Coinbase may hold all deposits 1:1 and avoid opaque lending practices, but custody risk still implicitly exists.
The best analogy for a crypto exchange that I’ve heard comes from Bitcoin educator Andreas Antonopolous: “Crypto exchanges are like public bathrooms. Get in, do your business, and get out. Don’t hang out.” The age-old mantra in crypto has been “not your keys, not your crypto.” In other words, cold storage through a hardware wallet is the only sure-fire way to exercise complete dominion over one’s assets. But this dominion invites what can be viewed as a daunting level of personal responsibility, or liability.
Is it realistic to expect generations that have trusted centralized financial institutions to change their behavior in this way? I think the future of crypto hinges to some extent on more widespread education and awareness of self-custody, like this excellent piece by Laura Holmes. But I also think trustworthy CeFi organizations, aided in part by crystal clear regulation, are required to scale this industry beyond its current user base.
I’ll be watching the movement of coins on and off exchanges closely these next few months to see if a trend line emerges.
Institutional Investor Capital Allocation
This is certainly not the first time the industry has been tainted by the failure of a centralized intermediary. The Mt. Gox hack in 2014 resulted in ~$500mm in losses; FTX is estimated to be 20x the size.
Beyond the increased magnitude, FTX also had an air of legitimacy - despite being an unregulated and offshore exchange - that Mt. Gox (short for ‘Magic: The Gathering Online eXchange’) never did. The latter exchange serviced predominantly retail investors while the industry was still very much in its infancy. FTX was an exchange juggernaut with a diversity of products that catered to even the most sophisticated institutions in a much more mature industry. Many crypto hedge funds that traded on FTX were burned.
The FTX equity investors are the who’s who of Silicon Valley and Wall Street: Sequoia, Tiger Global, Softbank, Blackstone, NEA, Lightspeed, Thoma Bravo, Paradigm, Temasek among others. The implosion makes the ‘smart money’ look not so smart, and has invited a barrage of vitriol due to the apparent lack of collective due diligence. I find that criticism to be unfair as details continue to emerge on SBF’s fraudulent obfuscations. Matt Levine’s analysis of the balance sheet SBF sent around while shopping for emergency funds is a must-read.
I am curious to see how this affects future capital allocation to crypto funds and, subsequently, how that capital flows between DeFi and Cefi opportunities. It might be a long winter before the music starts again. But there is still a lot of powder that needs to be deployed.
Advertising & Ambassadors
Crypto appeared to finally permeate the mainstream during Super Bowl LVI in February. FTX had no shortage of celebrity ambassadors. It poured millions into a Super Bowl commercial with Larry David. It acquired the naming rights to the Miami Heat’s NBA Arena in a 19-year $135mm deal. Tom Brady was an outspoken investor in the exchange; Shark Tank’s Kevin O’Leary as well. Relatedly, Matt Damon caught flak for his ill-timed partnership with Crypto.com ahead of the selloff.
With such high profile celebrities eating crow in the form of a class action lawsuit from their FTX affiliation, it might make others think twice about aligning with the industry regardless of check size. As the Heat scramble to collect new naming rights bids, will they and other more traditional brands be reticent to take advertising dollars from the industry?
I’ll be watching to see if potential regulatory clarity from the DCCPA reignites these types of relationships. Not holding my breath in the near term.
Sources (of inspiration)
How SBF’s Crypto Empire Collapsed by New York Times
SBF’s Collapsed Crypto Empire Creates Regulatory Chaos in Washington by Forbes
Possible Digital Asset Industry Standards by FTX/SBF
A Response to SBF and Principled Crypto Regulation by Erik Vorhees
How to Custody Crypto by Laura Holmes
Armageddon in Retrospect: FTX and SBF by Tom White (White Noise)
Great take on an interesting topic. Thanks for sharing your thoughts and ideas.