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Adolescence to Adulthood
It's time for the crypto industry to mature
FTX, the second largest Crypto Exchange, filed for Bankruptcy last week. Their irresponsible actions (and fraud) have yet again tarnished the crypto industry. While we wait for official confirmation, $1 billion worth of consumer wealth evaporated. Additionally, there is $8 Billion dollar balance sheet gap!
The collapse of FTX is the latest in a series of events and bankruptcies this year. Celsius, Terra Luna, Voyager, 3AC, Alameda Research (subsidiary of FTX) to name a few, all went bankrupt.
In our educated opinion there are two primary reasons for this:
The larger macro-economic conditions
Lack of discipline to manage risk
Point #2 is the more significant reason for this fiasco.
In this post we will break down and synthesize the key mistakes these crypto companies made. We are using publicly available information and our knowledge of traditional finance.
Note: This is not financial advice. Do your own due diligence.
#1 Ring fence the “Retail” and “Wholesale” business activities
Retail activities include custody of retail accounts, deposits, loans to retail customers. Wholesale activities include sales and trading on equities, derivatives, futures, corporate lending and borrowing, issuance of equities and debt etc.
Wholesale activities carry an enormous amount of risk.
In TradFi, financial institutions have a clear segregation between retail and wholesale activities/businesses. Using retail funds into wholesale investment banking activity is a violation and calls for stringent legal actions.
In Celsius’s case, retail depositors were lured with greater than 12% APYs’ and were lent to 3AC, a hedge fund in return for a higher market return. 3AC indulged in high-risk derivatives trading. When 3AC collapsed due to economic contraction (Luna / Terra crash), it defaulted on Celsius’s payments. As a result, millions of consumers' deposits vaporized.
This is a violation.
#2 Diversification of assets and liabilities
Loans lent or borrowed must be diversified to avoid concentration risk. Today no diversification practice exists in lending and borrowing with crypto currencies. The below FSOC diagram shows the lending and borrowing that happened between crypto participants when Three Arrows Capital (3AC) defaulted. As 3AC collapsed defaulted on loans, Voyager went under and so did Celsius.
Concentration of risks is a recipe for contagion.
#3 Conflict of Interest
FTX is an exchange - a marketplace for trading digital assets. FTX also functioned like a bank, where they issued (printed) their own FTT tokens. FTX marketed FTT to consumers and traders as a utility token to avail benefits on their platform. This included discounts on trading fees, leverage trading, rewards, and settlements. FTX used FTT tokens as collateral to borrow loans via Alameda research.
These tokens inherently have no value but were priced on FTX’s exchange due to trading activity. The reason there was any value attached to FTT was due to backing from FTX and branded by SBF. This is a flawed valuation. When the news got out about FTXs’ liquidity issues, these tokens went under.
An exchange indulging in banking activities is a conflict of interest.
#4 Proprietary trading from clients' capital is a violation
Financial institutions can perform proprietary trading activities with their own capital. They cannot do this using consumer funds. Utilizing capital of consumers, retail or corporate, is prohibited. TradeFi has strict regulations towards carrying out such activities.
FTX, the exchange was hand in glove with Alameda research. Alameda research was indulging in proprietary trading activities and are now under SEC investigation.
Consumer depositor funds cannot be used for risky trading activities.
The issues of the Crypto industry are no different to TradFi. Lehman's collapse in the US, Bernie Madoff’s Ponzi scheme, JP Morgans’ London Whale, SocGen’s Rogue Trader,LTGM etc, are examples of TradFi's bank runs and ponzi schemes.
What this also means is that Risk management and governance have evolved over years. Risk management gets calibrated every time there is disaster. The 2007/8 crash set us up for harmonization of risk governance and oversight on financial institutions.
There isn't a perfect risk mitigation technique to avoid a catastrophic collapse. But not having a perfect solution is not an excuse for organizations that deal with financial data. There is enough literature and history from TradFi that are applicable immediately. Crypto companies must take a rational and balanced approach in identifying and mitigating organization-wide risk metrics.
Crypto companies, unlike TradFi, have no Uncle Sam (governments) or central bankers to save them. While this is a main draw to the world of DeFi, the implications of not managing risks leave the retail user holding the bag. These companies need to start gauging and quantifying the financial risks. TradFi has come a long way in establishing a resilient risk management framework. A mindless rebellion against an established financial framework is irresponsible and arrogant. Instead, crypto companies should work with existing policy frameworks until The Network state comes true.
It's about time that the entire Crypto industry wakes from its adolescence and grows towards a responsible ecosystem driving efficient financial innovation.
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