Author

Miroslav Đurić, LL.M.

Associate

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Author

Miroslav Đurić, LL.M.

Associate

Read More

28 November 2022

November 2022/2 – 3 of 3 Insights

FTX Collapse: (non)safeguarding of client assets & the lessons learned

  • Briefing

Introduction

The last couple of weeks can be described as everything but as steady when it comes to crypto-markets. One after another, news articles were popping up outlining the reasons and explanations for one of the greatest scandals that crypto-industry has seen so far, the collapse of one of the largest crypto-exchanges in the world, FTX.

The collapse of an entire crypto-empire built around FTX, that occurred almost overnight, sent the shockwaves through the crypto-industry, drove prices of major crypto-currencies to the new lows, alarmed regulators around the world and left the entire world asking one simple question – what in God’s name just happened?

Sand Empire

Founded in 2019 by Sam Bankman-Fried, FTX rapidly became one of the most popular crypto-derivative exchanges in the world operating under the slogan “built by traders for traders”. Two years before, he founded another company Alameda Research, which engaged in trading in crypto-currencies by earning profits on price differences of major crypto-currencies like BitCoin in different jurisdictions (i.e. buying them at lower price in one and selling at higher price in another jurisdiction). Ever since its founding, FTX was primarily operating from the tiny island country of the Bahamas, which was one of the first jurisdictions that openly showed readiness to position itself as a crypto-hub back in 2018 by announcing its plans to launch first central bank digital currency, “Sand Dollar”. 

Through a series of eye-catching acquisitions and by applying aggressive marketing strategy, which included celebrity endorsements, the company quickly rose to international prominence and attracted attention of venture capital investors that started lining up to pour almost $2 billion of fresh capital into the company. 

Same as many other crypto-exchanges, FTX also issued its native token, FTT, whose main functionality was to serve as a utility token by offering certain benefits to token holders such as discount on trading fees on the platform. That being said, FTT was not designed as a stablecoin or a token that was offering its holders other incentives (e.g. interest payment, governance rights) in a similar way like a debt or equity instrument. However, since the token was listed on several major exchanges, and as the popularity of FTX was rising, many investors ran into buying it without proper understanding of its main functionality which led to its rapid increase in price over the course of last two years. 

The initial trigger for the crisis was an article published on CoinDesk on November the 2nd that revealed that Alameda Research held a great amount of FTT tokens which effectively represented a substantial proportion of its balance sheet. Following the CoinDesk release, key person of the world’s largest crypto-exchange Binance announced his intention to sell FTT tokens worth over $500 million on the open market, which immediately triggered a massive selloff of FTT tokens and sparked withdrawals of customers’ funds from FTX exchange at an unexpected scale. As the price of FTT was tumbling and as the customers were trying to get into possession of their crypto-assets, FTX started running into liquidity problems and suddenly halted withdrawals of customers’ assets from the exchange. 

(Non)safeguarding of client assets and regulatory (un)certainty

From the allegations that FTX and key people at the company are currently facing, it appears that FTX was misusing customers’ assets by transferring them to its sister company Alameda Research which was subsequently using them as a collateral to borrow funds from institutional counterparties on the other side. Once the price of FTT started to tumble, Alameda Research started receiving margin calls that it could not meet any longer without the injection of fresh capital that was nowhere to be found at such a short notice. 

Following brief and unsuccessful takeover negotiations with Binance, without being able to find another way of getting out of this unpleasant situation, on November 11th FTX leadership decided to file for Chapter 11 bankruptcy in the United States. In addition to FTX Trading LTD, approximately 130 affiliated companies have become part of the bankruptcy proceedings, including Alameda Research, and FTX.us, the company’s U.S. subsidiary. Shocking estimations about the magnitude of the downfall of one of the largest crypto-exchanges in the world indicating billions of dollars’ worth of missing customers’ crypto-assets accompanied by a wave of allegations about fraudulent activities that have allegedly occurred at the company followed.

Unlike some other crypto-asset service providers whose business model was openly built on the use of customer’s assets in accordance with the applicable terms of service (like for instance Celsius who ran into liquidity problems earlier this year), FTX’s terms of service did not grant the exchange the right to use customer’s assets held in its custody. 

In the ocean of contradictory theories about FTX collapse, many have tried to identify absence of clear regulation of the crypto-industry in key jurisdictions as the main reason for recent events. However, despite the undisputed absence of clear regulatory guidance and long ongoing power struggle between the regulatory agencies in the United States, where a great number of FTX’s customers is located, one must have in mind that the Bahamas, where FTX was primarily operating from, was one of the first jurisdictions that has introduced designated regulatory framework applicable to crypto-asset service providers back in 2020.

That being said, lack of written rules applicable to FTX as a crypto-exchange in the Bahamas can be hardly identified as the sole reason for the collapse that happened. Whether the applicable rules and regulations in the Bahamas were followed by proper enforcement and supervision by competent authorities is another topic that does not appear to be that clear as the question of whether there was any regulation in place at all. Nevertheless, one may argue that the lack of regulatory clarity in jurisdictions where major customer base of FTX was located may have incentivized FTX and similar crypto-asset service providers in recent years to go offshore in the first place, to jurisdictions where one may expect lighter regulatory and supervisory touch.

Future EU regulatory framework as a safe harbour

On the policy front, the FTX saga drew attention of the regulators around the globe in a major way. Whereas in the United States it still remains unclear whether a necessary bipartisan approach to the regulation of the crypto-industry will be taken anytime soon, the situation in the European Union appears to be much clearer. For almost two years now, EU lawmakers have been working on a harmonized regulatory framework on crypto-assets (the Markets in Crypto-Assets Regulation, better known as “MiCA”), that shall create a single set of rules applicable to crypto-asset service providers and issuers of crypto-assets. 

One of the main regulatory safeguards anchored in MiCA is clear set of regulatory requirements on custody and management of customer’s assets that all crypto-asset service providers operating in the EU will need to comply with. To that end, prospective providers of crypto asset related services in the EU will need to hold their customer’s assets operationally and legally segregated from their own estate so that they remain properly protected from providers’ creditors in the case of insolvency.

New regime introduces rather strict rules on the issuers of stablecoins as well, that apply to crypto-assets whose value is being referenced to the value of one fiat currency (the so-called e-money tokens) or several different underlying assets (the so-called asset-referenced tokens). The new rules are aimed at ensuring rue “stability” of stablecoins by requiring their issuers to hold at all times certain amount of reserve assets that are backing their value. Depending on the type of a stablecoin, the issuers will be either completely prohibited from using reserve assets for investment purposes or strictly limited to investing them in highly liquid assets only.

With the new regime, the EU appears to be leading the way of regulation of the crypto-industry by coming up with the first comprehensive regulatory framework that shall provide higher level of regulatory certainty in one of the world’s wealthiest single markets. In the light of recent events, it is highly likely that once MiCA becomes operational, many crypto-asset service providers may seek authorization in the EU with the aim of gaining more trust of their customers regardless of their place of residence. 

A chance for the new rise of DeFi and self-custody?

In pursuit for solutions that may prevent similar events from happening in the future, many see wider adoption of decentralized finance (DeFi) protocols (like Uniswap) as a safer alternative to centralized trading venues that can be easily manipulated by persons running them. The argumentation of the people advocating for DeFi appears to be quite logical – one can trust the code more than a living person with free decision-making power, at least when it comes to unplanned events (i.e. excluding the errors in the code itself). In the same vein, by following now already well-known mantra “not your keys not your coins” many argue that self-custody (e.g. cold storage on a private piece of hardware) is a better and safer alternative to custody of private cryptographic keys with centralized exchanges.

Whereas both DeFi and self-custody have their benefits compared to the use of centralized exchanges, we must not lose out of sight the fact that many investors that have already entered or are yet planning to enter into the space are not crypto-natives and may still tend to choose centralized venues as a matter of pure convenience. This is not surprising given that the situation in other industries does not seem to be different at all (e.g. travel industry, traditional finance etc.) - many people simply prefer having a central counterparty they can refer when necessary.

Conclusion

Against the backdrop of everything mentioned, it is clear that neither the underlying technology nor the industry as such is to be seen as a driver, let alone the reason, for FTX collapse. Provided that the current allegations prove to be accurate, the reason is going to appear to be quite simple – misconduct (at a massive scale) of a group of individuals running the company that apparently managed to break almost every single rule and regulation that they were ought to comply with when providing services to their customers. Having said that, reactions coming from people from the traditional finance saying that “crypto cannot be trusted” and that something like this was inevitable, shall be considered as rather malicious and inaccurate, if one bears in mind all the “hick ups” that the financial services industry has experienced in recent decades, starting with the downfall of Lehman Brothers all the way up to countless scandals that the investment bank giants of this world always managed to play a major role in. 

While DeFi and self-custody may be suitable safe harbour for certain groups of investors, in order for the industry to achieve mass adoption it needs to gain more trust of the general public. For this to happen, people need to see more good examples of trustworthy centralized venues that are able to manage customer’s assets in accordance with the promised terms of service and applicable laws and regulations. It goes without saying that clearer regulatory landscape in key jurisdictions that provides for adequate regulatory requirements on safeguarding and management of customer’s assets, accompanied by proper regulatory enforcement and supervision of obliged entities, can play an essential role in this process.

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