The collapse of FTX is because we let TradFi practices infiltrate crypto
IMHO the FTX collapse isn’t a failure of crypto/blockchain/web3, it’s crypto failing to shake off the practices of TradFi.
So what TradFi things did FTX do?
They failed to ring fence client deposits and instead siphoned them off to proprietary (prop) trade with but ended up doing it very badly and so not having sufficient liquid (or even illiquid it seems) assets to cover their liabilities.
Let’s break this down…
In the UK the concept of ring fencing for banks was introduced in Jan 2019 and required the banks to separate core retail banking services (less risky) from their investment and international banking activities (more risky). This was brought in after the 2008/9 global financial crisis which was caused by poor risk management and the creation of systemically risky financial assets by the banks. This ended up bringing down several banks, seeing 10m US citizens lose their homes, a doubling of the unemployment rate and financial impacts to hundreds of millions of people across the globe for years to come.
If FTX, and centralised crypto exchanges generally, were required to ring fence client assets from their own assets this could help to reduce the risk of the CEX’s investment activity impacting the funds of every day users. It’s also worth noting that decentralised exchanges (DEXs) don’t trade either on their own behalf or their users — they simply provide a mechanism for the market to trade transparently and effectively. An important reminder that DeFi =/= CeFi, and that the risks in TradFi and CeFi are very different, and should be treated differently from DeFi.
FTX secretly siphoning off funds to it’s sister firm Alameda and introducing software backdoors to hide this from external auditors is likely criminal behaviour. This isn’t a crypto-related activity, this is just shady behaviour which could happen in any industry. I’m sure we’ll see actions taken about this specifically.
Prop trading is where a firm will use its own funds, rather than client funds when acting on behalf of a client, to trade stocks, bonds, currencies, commodities, or other financial instruments. It brought in billions of dollars in revenue for banks but was a risky activity for them with Lehman losing more than $32billion from prop trading in the year before the crisis and Morgan Stanley posting a $4billion loss from it in Q4 of 2007. Many commentators saw it as a driving factor behind the global financial crisis. There was also risks around insider trading and the use of material non-public information with Merrill Lynch ordered to pay a $10m fine in 2011 due to misusing customer order information for its own prop trading profits.
However, since the Volcker Rule was introduced within the Dodd-Frank Wall Act of 2010 banks are generally prohibited from engaging in prop trading. The aim of this was to clean up the space and further help to mitigate risky activity by banks which could lead to systemic risk impacting client’s funds.
If CEX’s and firms like Alameda have regulatory clarity around prop trading and disclosure of trading activities, perhaps this will help limit some of the risky trading activity and ensure transparency for those firms which have failed to create appropriately managed financial positions. It’s also worth noting here that with DeFi being on chain such activity to be visible to all and any large/risky/loss making positions could not be hidden.
Another financial crisis driven piece of regulation from TradFi is Basel III which looked to introduce stability and mitigate customer impact from risky activity by banks. A key part of this was mandating capital requirements for banks. Simply put this is the amount of liquid assets that the bank must have on hand to sustain operating while still honouring withdrawals. Basel III mandates that banks must have 7% of capital reserves and in the USA it’s just 4.5%. (FTX is reported to have had ~$900m of liquid assets to ~$9billion of liabilities. That’s a capital reserve of 10% so would ironically be well over this threshold!) What the capital requirements of TradFi importantly show is that a run on any bank e.g where customers look to all withdraw their funds, couldn’t be covered. The banks would need to halt withdrawals. We saw this in 2007 with the run on UK bank Northern Rock where queues of customers looked to take their funds out via ATMs but these quickly ran dry and the bank ended up being bailed out and nationalised using taxpayers’ funds. Also when looking back around the time of the global financial crisis we can see how the investment activity of the banks mirrored some of the over levered activity within CeFi crypto — by Q1 2008 Golman had liabilities 27.9x their assets, Merrill Lynch was 28.5x and Morgan Stanley sat at 32.8x.
I therefore think it’s worth reflecting on this as we (fairly) scrutinise crypto exchanges and question whether they could survive a bank run — because is anyone asking whether the institutions which hold their fiat could?
We are now seeing proof of reserves from CEXs to try to shore up consumer confidence that sufficient capital reserves are being held and many are reporting 100% capital reserves — head and shoulders above the requirement in TradFi. However, without full transparency on liabilities, it’s still hard to understand whether there would be sufficient liquidity to cover a run of customer withdrawals. It will therefore be interesting to see if self-regulation can further take off or if enforced capital requirements come down from regulators. However, it’s likely that we’ll see a huge disparity between the capital requirements for TradFi vs crypto. Then taking a moment to look at DeFi, all DEXs have transparent liquidity pools where you can see the total locked in value and all trades adding or removing assets from them. This radical transparency means that asset and liability amounts are on chain, they can’t be hidden or manipulated by nefarious or misguided actors.
I think it’s important to now state that I’m not advocating that crypto and DeFi is some kind of panacea from financial bad practice. I’m instead looking to highlight that much of what has come to light in the last few days was done by a centralised exchange, holding funds on behalf of customers and utilising bad practices which were pioneered and honed in TradFi and which weren’t outlawed until they had brought down the entire global economy. DeFi in its purest form, as highlighted above, doesn’t have many of these same tripwires and pitfalls because it’s designed fundamentally differently. If we therefore want to create a safer and more successful crypto economy we have to lean into the actual crypto and DeFi aspects of it, and stop allowing the bad practices from TradFi to infiltrate. Yes I’m sure some regulation could help to protect consumers and prevent some actions like this from happening again, as we saw with the regulation noted above which came in post the crisis, but we must be careful and thoughtful to ensure we are creating proportional, technically applicable and innovation-protecting regulation which is clear to follow and possible to enforce. Otherwise we risk copy and pasting regulation from TradFi which doesn’t work and will harm the industry more than it protects it as well as copy and pasting bad practice from TradFi like we’ve seen revealed over the last few days.
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The opinions expressed here are solely my own and do not express the views or opinions of my current employer, previous employers or any potential future employers.
Originally published at https://www.linkedin.com.