The crypto world needs to be made safer for investors and users

The author is an independent financial commentator

The sudden collapse of crypto exchange FTX raises serious questions about the state of the crypto ecosystem. Without serious changes to the way it works, it’s hard to see how it could even become part of the existing mainstream financial system, let alone replace it as anyone would like to see.

The crisis at FTX, and before it crypto lender Celsius, Voyager, hedge fund Three Arrows Capital and digital tokens terraUSD and luna, has little to do with cryptocurrency as a technology. Rather, it reveals what financial systems look like when there are insufficient checks and balances. Crypto people rail against central banks and regulators, but they exist for good reasons.

Exactly what went wrong at FTX is still unclear. Its chief executive, Sam Bankman-Fried, insisted it was just a liquidity crunch. But Binance, which originally agreed to buy FTX to boost liquidity, pulled out of the deal after looking at the books. There are reports that FTX has a balance sheet gap of around $8 billion. Unless someone is willing to commit a lot of capital, FTX will eventually file for bankruptcy. Investors brace for the worst: Sequoia Capital has already written down the investment to zero.

More worryingly, customer funds appear to have been compromised. It is actually difficult to see how a balance sheet gap of such a size could have developed unless the stock exchange had lent customer funds.

Reuters reported that FTX lent client funds to Alameda Research after it was hit hard by the failures of Three Arrows Capital and Voyager in May this year. And the US Department of Justice and US regulators are now investigating the relationship between FTX and Alameda, including whether customer funds may have been misused.

If customer funds have been lent, then unless Bankman-Fried succeeds in finding a buyer willing to pay nearly full price (which appears to be a tall order), it appears that customers of FTX’s international exchange will lose a significant part of their funds. Some – perhaps many, because FTX attracted retail traders and encouraged ordinary people to deposit their wages into their accounts – will suffer hardship as a result.

FTX is far from the first crypto company to fall amid token collapses, bank runs and allegations of using customer funds. The recent failures of Celsius, Voyager and in 2021 the crypto lender Cred show similar characteristics. Behind these errors lie four major weaknesses in the crypto ecosystem:

• Interconnection between companies in the form of non-transparent cross-holdings and circular lending practices such as rehypothecation. Rival crypto exchange Binance had a significant holding of FTX’s original token, FTT. When it announced it would sell its stake, it sent people rushing to sell FTT itself and get their money from FTX.

• Too much dependence on personalities. Crypto was supposed to eliminate the need for trust between people. “Don’t trust, verify” was the mantra. But the whole system now seems to depend on a few big personalities, trusted by thousands. Bankman-Fried is one. He built up a huge empire in a short time and has given a lot of money to good causes. He seemed like an all-around good guy. So people trusted him with their money. Investors in particular have shown a remarkable willingness to back his ventures without the usual financial due diligence.

• Concentration. There are not many large crypto exchanges and banks, and the people who run them all know each other and invest in each other’s companies. When they get on, all is well; but when they fall out, they can do enormous damage. It shouldn’t be possible for one chirping from Binance’s CEO to spurring a race to take down its biggest rival; but that’s what happened.

• Opacity. Crypto was meant to improve the transparency of financial transactions. But crypto companies like FTX reveal very little about their financial status – much less than would be expected of a conventional bank. The opacity of Bankman-Fried’s companies, FTX and Alameda, was exacerbated by a complex corporate structure, transfers between companies and the reported use of holdings of a natural token to boost balance sheets.

These problems will be painfully familiar to anyone who has studied the history of financial panics and banking crises. They appear to be endemic to financial systems. Crypto has shown that it is no different.

If crypto is to have a future as a mainstream financial product, it must now accept the regulation and controls that make financial systems safe for investors, creditors and depositors.