VC-crypto: A new way forward?

In November 2022, the crypto industry suffered arguably its biggest shock of the year, when the Bahamas-based cryptocurrency exchange FTX collapsed following the major mismanagement of funds.

In the wake of the collapse, nearly a dozen other crypto firms have either folded or are struggling to stay afloat, including BlockFi, Genesis Trading, Voyager Digital and Galois Capital.

In a recent episode of The Chopping Block on Laura Shin’s Unchained podcast, Dragonfly’s Haseeb Qureshi and Tom Schmidt analyzed the recent FTX fiasco and its impact on the way VCs operate in crypto.

One of the biggest disasters in Crypto VC history

The collapse of FTX underscores a clear lack of due diligence even at the highest levels of both crypto and traditional venture capital.

Backed by industry heavyweights such as Paradigm, Sequoia Capital and Blackrock, as well as the massive Singapore sovereign wealth fund Temasek, FTX managed to raise more than $1.5 billion at a valuation of $32 billion by January 2022.

Although it is now clear that FTX was operating on borrowed time and had an $8 billion hole in its balance sheet, it managed to fly under the radar for months before a wave of mass withdrawals exposed its insolvency.

And just months before the collapse, it was reported that the stock exchange was still looking to raise another $1 billion for acquisitions and industry rescue. .

For example, Sequoia Capital has already written off its $210 million investment in the company. What has gone wrong that would cause investors to be blindsided by this exchange? Were there no red flags?

Despite being backed by dozens of the most prominent funds in the world, none required a seat on the board, or financials audited by a reputable firm. Chamath Palihapitiya of Social Capital stated in a podcast that prior to a potential investment in FTX, he made several reasonable suggestions about creating a board with outside advisors, but was told by Sam to “f*ck yourself.”

A lesson learned by investors

Part of this boils down to the aura that Sam Bankman-Fried had developed over the past year – fueled in large part by crypto media painting him as a savant. Many things that would be considered weird/red flags would be lionized as part of his genius. This was underlined by the horde of glowing profiles that appeared in the mainstream media about SBF.

Unfortunately, this allowed him and FTX to evade investors who asked too many questions. As the media constantly inflated SBF’s ego, a mythology formed around him. This has displaced the proper due diligence process that should have been carried out.

This was not helped by the fact that VC firms in both the crypto and tech industries are now starting to launch their own publications to enhance the marketing/PR efforts of their portfolio companies.

This includes the likes of Sequoia Capital, which published a nasty piece about Sam. Some believe this may have led to other less diligent investors being caught up in the failure.

Despite the disaster of the FTX collapse, there is a silver lining. Both traditional and crypto VCs are now painfully aware that deception can occur at even the highest levels of venture funding, and that even the largest institutional investors can be blindsided by it.

The way forward

After FTX, due diligence standards will almost certainly increase in the industry. We will likely see more VCs demanding board seats and other corporate controls when investing in CeFi companies.

On the demand side, most institutional traders now require Proof of Reserves (PoR), a cryptographic method by which exchanges can prove that their assets match their liabilities.

Many exchanges have started to offer this already, and it is likely that this will become standard industry practice going forward.

And eventually, we’ll likely see more splitting of the exchange stack. Today, stock exchanges function as managers, brokerage houses, lenders and stock exchanges, all in the same package.

Going forward, we are likely to see these different functions break out among different entities, as they do in traditional finance; this makes it much more difficult for an exchange to steal a customer’s funds (since they don’t have access, the custodian does). In other words, eventually you won’t need to store your funds with Binance to trade on their exchange.

Taken together, these changes should help reduce the likelihood of the next FTX happening on our watch. Although crypto is often chaotic, the learning is always public and it is ultimately up to the users of these platforms (and their investors) to demand these changes.