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FTX: One step back for crypto, two steps forward for blockchain

FTX's downfall means that even those strongly against the need for crypto regulation may now realise its importance if we really want a trusted safer crypto market

Jonathan Raa/NurPhoto
Insurers are reluctant to underwrite asset and directors and officers protection policies for crypto companies

In 1998, when FTX founder Sam Bankman-Fried was only six years old, Long Term Capital Management (LTCM) was bailed out by a group of 14 banks in a deal put together by the US Federal Reserve. 

The brainchild of infamous Salomon Brothers bond trader John Meriwether, LTCM had been established in 1994, bringing together heavyweights from academia and trading and leading economists including Myron Scholes and Robert Merton.

LTCM attracted over $1.3 billion at inception and a $3.4 billion bailout just four years later.

So, what went wrong? Answer: A liquidity crisis.

I recall during my time at JP Morgan working on the structuring of the LTCM bailout. Our focus was the potential market disruption and the related market implications.

The parallels are clear to the sudden meltdown of FTX. 

In the absence of regulation, the crypto world should have adopted a higher operational threshold and financial discipline. The crypto market is embryonic and lacks strong institutions that could step in and prevent a wider market impact.

At the start of the year FTX raised $400 million, setting a new peak valuation of $32 billion. In the beginning of November, rumours suggested it may be undercapitalised. This drove over $650 million in withdrawals, after which FTX closed its doors, further confirming it was in a liquidity crisis.

This shattered the price of FTT (the token issued by FTX) by over 90 percent and in turn impacted the price of all other crypto currencies. 

Could this have been avoided? Yes. 

And what’s ironic is that FTX was sitting on the technology that could have made it transparent and resilient: Blockchain.

Before we start it’s important to separate crypto, which is a single application of blockchain technology, and the role of a crypto trader, which was FTX’s model. Crypto is to blockchain what email is to the internet – it’s one of many possible applications.

While the curtain is being drawn back on the true operations of FTX, it is clear that the true assets of FTX were unknown and lacked transparency, and therefore trust.

This compares with the traditional banking and financial sector, which rely on regulators to set the threshold for transparency through reporting and independent auditors and apply standard assessment rules. 

The challenge with a lack of transparency is that the value you can apply to your assets is capped, particularly when the market for those assets is very small. This is why we have external audits to independently ascertain the true picture.

Consider, FTX, whose balance sheet was reported to consist of large holdings of the digital token FTT. As the value of FTT fell, so did FTX’s capitalisation. I can now see why transparency could be an impediment. 

Remember the Neil Woodford (a celebrated London ‘superstar’ fund manager) scandal in 2019?

A £10 billion-plus fund collapsing overnight because the assets it claimed to have included large investments in unlisted and illiquid stocks whose value was self-determined rather than externally validated.   

Ultimately trust (which leads to confidence) requires transparency to validate integrity.

Had blockchain been used to underpin the accounting framework of FTX, it is likely that false entries would never have been approved by the distributed ledger technology.

The time-stamped links of blocks could reveal alterations or tampering to the recorded transactions, as well as providing an immediate insight into the performance of the company at any given time.

And if investors had been fully aware of the hyped assets of FTX, would they have trusted the platform? 

Adopting technologies such as blockchain into the reporting and audit framework of a fund could provide a fresh approach so that investors can avoid being caught out. More validated, immutable information will generate trust in the crypto market and audit industry as a whole. 

There is a clear argument for an automated blockchain that can act as a single source of truth for the benefit of investors, on whose trust the share price of listed entities partially depends. 

At the time of writing, incoming FTX CEO John Ray (appointed to manage the bankruptcy, having previously performed the same role at the $23 billion winddown of Enron) said he had never seen such a “complete failure of corporate controls and trustworthy financial information”.

FTX had a unique opportunity to establish itself as the gold standard underpinning the crypto markets, but this required a different mindset at the start – not just to praise the virtues of blockchain technology, but to also use it to build a transparent, trustworthy platform for all. 

It’s ironic that the very technology that enabled crypto could have addressed FTX’s transparency and custody challenges. 

The blow-up will undoubtedly set back crypto progression, but it should not affect Blockchain’s advancement.

The contagion has started as other crypto exchanges are restricting or suspending withdrawals and unfortunately, many will be caught in the tsunami.

The silver lining is that even the hardened protagonists against the need for regulation may now recognise its importance. This, along with greater transparency, could support the growth of a trusted safer crypto market. 

Unfortunately, given the current lack of regulation and self-certification in this embryonic market, I fear this will not be the last crypto blow-up (even with an alleged fraud).

This market quickly needs more and better regulation, and supervision, to prevent this and to start to r-build trust.  

Blockchain can play a crucial part in this. And if it does not happen, then as the philosopher George Santayana put it: “Those who fail to learn the lessons of history are doomed to repeat it.” 

Nish Kotecha is a serial tech entrepreneur and board professional. He is the chair and co-founder of Finboot

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