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Vellir #24 → The FTX fallout

What are the implications of the FTX meltdown?
Vellir #24 → The FTX fallout

We’ve succumbed. We couldn’t help ourselves but add our two pennies worth on the latest turmoil in crypto. The FTX and Sam Bankman-Fried (SBF) implosion this week is another blow for a sector that has already had its fair share of crises this year.

The tl;dr is that FTX – an exchange that allows users to buy and sell crypto – was shown not to be backing user assets 1:1. In effect, FTX lent billions of dollars worth of customer assets to fund bets by its affiliated hedge fund, Alameda Research. And these loans were collateralised by a token created by FTX called FTT. Obviously bad. After some of this leaked, there was a classic bank run with users trying to get their assets out, which put FTX at risk of insolvency. Binance, another exchange, thought about stepping in to save FTX having played a role in triggering the run, but backed out. The FTX Group has now filed for bankruptcy.

This has left FTX customers (both retail investors and corporates) out of pocket, with assets tied up on the exchange they can’t get out. It’s hard to know exactly where the fallout will end, and there are already questions about who else might have exposure to FTX and could still be in trouble. Crypto prices have certainly taken a hit. And venture firms with exposure are scrambling to explain their approach. Sequoia has marked their investment down to zero: you can see their letter to LPs here. And Multicoin has written to LPs in a similar fashion.

We won’t rehash the event – for a good overview of what happened, we’d recommend this article from Bankless or this from Coindesk. There are some excellent podcast discussions on the subject too – Crypto Critics Corner from Wednesday is excellent.

SBF apologised on twitter: the lawsuits will presumably follow.

There are a few responses to the events that are worth reading.

Jeremy Allaire (Circle) and Brian Armstrong (Coinbase) were quick out of the blocks to highlight the need for better regulation, which would prevent such companies operating in an untransparent manner offshore.

Noah Smith asked what would happen if crypto just died? He makes the case that institutional money will be put off until there’s regulation (we agree). And for crypto to see a real revival, it needs to start financing real assets, which will break the endogenous cycle of crypto financing crypto that inevitably leads to these sort of big blow outs when confidence shatters.

Like Smith, Gillian Tett of the FT also pointed out that it would be wrong to think this signals the end of crypto altogether, though suggested some of the reason for this was that there would always be people looking to use a system like crypto to avoid government control or oversight. Her view is that this could lead to a split between a wild west crypto, and one that is tightly regulated in the form of CBDCs. That seems a bit too binary: there is a large middle in between.

So what are our takeaways from this saga?

  1. Regulation matters

As we’ve said before (see Vellir #13), it is clear that crypto needs to be regulated appropriately to protect consumers and investors. The vote on the EU’s MiCa regulation has been delayed until February 2023, and there will no doubt be pressure for changes on the back of the FTX fallout. And it’s likely that the US will follow suit in the next Congress, however the final results shake out. Rishi Sunak, the UK’s new Prime Minister, has historically been bullish on the technology, and there is an opportunity for the UK to lead the way on sensible regulation (as per Vellir #13).

SBF had been the poster boy in the US leading the charge for regulation (in ways not everyone agreed with and by making huge political donations), which is why some are so angry about how FTX went down. But there will be no shortage of players to pick up the mantle. For instance, Paradigm – a major US crypto focussed venture firm – has just launched a new crypto policy council to help shepherd regulation in a sensible direction.

2. DeFi vs CeFi

Since the Terra/Luna, Three Arrows Capital (3AC) and Celsuis meltdowns earlier in the year, which we discussed in Vellir #5, many have pointed out that it is centralised finance (CeFi) exchanges which are custodians of user funds that are the major risk, not decentralised finance (DeFi) protocols that execute entirely using code.

The FTX experience adds credence to this idea – another round of dodgy risk practices, loaning customer funds to linked trading companies and using self created tokens as collateral – none of which should be possible under a transparent DeFi protocol.

This is true, but it’s hard to think that DeFi will avoid regulatory action altogether. Miles Jennings, Legal Counsel at a16z, has been trying to take rear-guard action over the last few months, with an interesting take on regulating crypto apps not protocols. This is an approach which is worth deeper consideration (and we may come back to in a future post).

3.  The search for use cases

In truth, and as Noah Smith pointed out in his piece, it all really comes down to whether crypto can be used to solve real world problems and finance non-crypto related assets.

We’ve written before about some of the ways that we think blockchain technology could be used in novel ways to support real world activity, including last month in Vellir #23 about Provenance and programmable trust. And there are good reasons to think these ideas could still succeed: the fundamentals of the technology are still the same. In many areas, there are interesting companies being built leveraging crypto. To take two examples…

  • We’ve been playing around on Farcaster in the wake of the Musk Twitter takeover, based around its notion of being ‘sufficiently decentralised’.
  • Spexigon is a drone imagery marketplace powered by crypto – it incentives anyone with a drone to take images in response to demand signals and be paid for it.

There’s no question that this has been another major confidence blow to the crypto industry. But with serious regulation and a focus on how crypto can provide genuine utility, not just speculation, it may yet rebound.

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