Top 5 Lessons to Learn From FTX Exchange Collapse
- By Bilal Hafeez and Dalvir Mandara
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- 3 min read
News around the FTX collapse has been dizzying. There will clearly be a movie, but beneath all the drama are important lessons to learn. Here are the five I learned:
1. Crypto Does Not Change Human Nature
For all the talk of uprooting the establishment, crypto has re-affirmed the human desire to make a quick buck through whatever means necessary. FTX is just the latest in a long line of crypto scandals from Mount Gox to Terra/Luna to Three Arrows. These in turn share parallels with other debacles like Lehman’s, Enron and the South Sea Company – all the way back in the 1700s. The FTX details may differ, but it shares common ingredients for human-driven scandals like inflating the value of balance sheets, tactics to boost the value of shares/tokens and clever marketing.
2. Centralisation Scales Fast, Decentralisation Does Not
One of the biggest selling points of crypto is that is decentralised, trustless and permissionless. This was meant to provide an alternative to existing financial institutions. Yet, the crypto industry has quickly centralised while still marketing itself as decentralised. FTX was a centralised exchange, much like the other big ones like Binance and Coinbase. Over 90% of crypto transactions are done through centralised exchanges.
But why this move to centralisation? The answer is simple. It is easier to scale centralised entities than decentralised ones. Decentralised exchanges are clunky, slow and have high transaction costs. In the Wild West of crypto, centralised exchanges have been able to increase demand for crypto and transaction activity (and hence fees) much more than de-centralised exchanges. All the VC money has therefore gone to centralisation, which has a clearer route to monetisation.
3. Decentralisation Illusion
But even the concept of decentralisation is a matter of degree than a binary. After all, FTX also had a decentralised exchange (DEX) called Serum. The DEX had seen over $30bn in trades this year, but DeFi protocols have started to withdraw from Serum. Why? It seems the private keys to Serum were held by FTX, and investors lost confidence in Serum. It now appears that other developers have created a new version (fork) of Serum with better governance.
But outside the centralised governance of many decentralised protocols, we also find a significant proportion of decentralised finance is underpinned by stablecoins. Most of these coins, like Tether and USD coin, are actually centralised coins. Then there is the reliance of protocols on tech infrastructure. When Amazon Web Services (AWS) – a centralised entity – saw an outage in December 2021, decentralised exchanges like dYdX went down too.
4. From Trustless to Trusted – Regulation or Reputation
In the absence of a trustless decentralised protocol, centralised crypto entities must build trust. One path is through getting regulated – the path taken by Coinbase, which is based in the US. The other is to rely on reputation – the path taken by FTX, which is based in the Bahamas. FTX founder Sam Bankman-Fried (SBF) built that reputation through a combination of sponsoring sports events, political lobbying, being associated with political and tech leaders and smart marketing. This was all helped by the meteoric rise in the valuation of FTX. Offshore crypto companies that rely on reputation will therefore attract more scrutiny than ever before.
5. More ‘Proof-Of(s)’
There is a long-established infrastructure of auditors, lawyers and compliance officers that verify the balance sheets of financial entities. But crypto, being crypto, is re-inventing the wheel with its own version. The latest is ‘proof-of-reserves’ where exchanges publicly attest to which reserves they hold. Recently Kraken and BitMex have done this. But that are ways of gaming this by borrowing reserves. We are likely to hear of ‘proof-of-reserves’, ‘proof-of-identity’ (aka KYC) and so on. A simpler route would be to use the existing infrastructure of auditors.
For our latest investment views on crypto, read our overviews on ethereum and bitcoin or explore our more in-depth trading views here.
Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.