DeFi has not failed, CeFi has failed… and will TradFi respond?
The last few weeks featured an incredible string of events that left the crypto markets stunned, driven by the FTX bankruptcy. Let’s review what exactly happened, the common denominator across this year’s numerous collapses, and what the future might hold as the industry learns from these failures.
What happened, and how did we get to this point of failure so suddenly?
In summary, FTX, a leading cryptocurrency exchange, was viewed as a market leader along with its founder and CEO, Sam Bankman-Fried (SBF). Until November and its recent Chapter 11 bankruptcy filing, FTX was the third largest cryptocurrency exchange and valued at $32 billion.
On November 2, CoinDesk published a private document containing balance sheet information for Alameda Research, SBF’s trading firm, showing that it was heavily invested in the FTT token from the FTX exchange which he also owns. There was significant concern that Alameda’s balance sheet was on a foundation of a coin created by its sister company rather than an independent traditional or digital asset. FTX and Alameda apparently have had extremely close ties from their inception. There is a high likelihood that with the increase in FTX and its valuation of its native token, it heavily collateralized itself against these assets which caused significant issues during the recent market volatility and crypto winter.
On November 6, Changpeng Zhao (“CZ”), the CEO of Binance, subsequently made an announcement to liquidate the remaining holdings of the FTT token held by the exchange.
On November 8, the FTT token price fell below $22 and Binance announced a letter of intent to buy FTX. However, after only 24 hours of due diligence, Binance withdrew itself from the process.
On November 11, FTX filed for bankruptcy (along with 134 related entities) and even more wild events ensued, including stolen assets from the exchange without certainty of whether this occurred internally or from a hack. Not only have all 134 related entities been impacted, but it is estimated that between 100 and 150 crypto hedge funds are also believed to have at least some direct exposure to FTX Group or its native token.
On November 15, CoinDesk observed that cryptocurrencies were trading in sync after the FTX collapse... just not with with the stock market. The analysis shows how correlations have increased on various sectors of the 162-asset CoinDesk Market Index (CMI) amid widespread crypto distress following the collapse of Sam Bankman-Fried's FTX exchange. U.S. stocks, meanwhile, look unfazed by it all:
Targeted for November 30, SBF is still shockingly slated to speak at the New York Times DealBook Summit with Aaron Sorkin. There has been a lack of immediate action against SBF, and some interesting intersections with US politics as well, as SBF is well known to have contributed more than $70 million to election campaigns in less than 18 months. Eight US Congressional representatives tried to stop the SEC's inquiry into FTX back in March, of which five received donations from SBF and FTX. A US Senate committee has scheduled FTX hearings for December 1, with the head of the CFTC to testify.
On December 12, SBF was arrested in the Bahamas after U.S. files criminal charges. The ex-CEO of bankrupted FTX was arrested in the Bahamas after the U.S. Attorney for the SDNY shared a sealed indictment with the Bahamian government. The SEC, CFTC, and SDNY attorney's office charged SBF with defrauding investors.
On December 13, SBF was denied bail by a judge in the Bahamas. The chief magistrate said Mr. Bankman-Fried’s access to financial resources made his risk of fleeing “so great” that he had to remain behind bars.
Also on the same day, The U.S. House Financial Services Committee held a hearing focused on FTX’s collapse, mere hours after the crypto exchange’s former CEO, Sam Bankman-Fried, was arrested in the Bahamas. Highlights can be found here on TechCrunch’s overview.
On December 19, SBF agreed to be extradited to the United States, one of his lawyers said on Monday, after a chaotic morning of legal maneuvering in which Mr. Bankman-Fried was shuttled back and forth between court and prison in the Bahamas.
On December 20, FTX announced that it is seeking to claw back donations to politicians and charities. FTX had a reputation for corporate philanthropy to tune of hundreds of millions of dollars
On December 21, Alameda's Caroline Ellison and FTX's Gary Wang plead guilty to DOJ 'fraud' charges, and also settled with the SEC and CFTC.
On December 22, SBF was released on a record breaking $250 Million bond with restrictive terms. The disgraced cryptocurrency executive appeared in court in Manhattan after his extradition from the Bahamas the night prior. He was granted bail and will live with his parents in California. It was also reported that during his house arrest, “Moneyball” writer Michael Lewis spent several hours inside the residence just hours after Bankman-Fried had landed Friday, presumably talking about the latest twist in his crypto-downfall. Supposedly this collaboration had been ongoing for six months, long before financial irregularities were spotted.
On December 23, Caroline Ellison apologized for misconduct in the FTX collapse, telling a judge that she and others conspired to steal billions of dollars from customers of the doomed crypto exchange while misleading investors and lenders. Both agreed to cooperate with the government’s investigation in exchange for the prospect of lighter sentences.
On December 28, it was discovered that FTX diverted $200 million of customer money for two venture deals that caught the SEC’s attention. FTX and former CEO Sam Bankman-Fried made two $100 million venture investments using customer funds through an FTX subsidiary, the SEC said in a pair of complaints. The only disclosed $100 million investments by FTX Ventures were in Mysten Labs and fintech company Dave. These deals raise questions about potential clawbacks or conveyance issues for FTX bankruptcy attorneys and for individual clients.
On December 29, it was reported that SBF had agreed to entering a plea deal on January 3, 2023, on the same criminal charges alleging wire fraud, money laundering and campaign finance violations.
On January 3, SBF returned to New York to appear in Federal District Court and pled not guilty to fraud and other charges. According to NY Times, the eight-count indictment charges him with a multiyear scheme that defrauded customers and lenders, and that he had conspired to violate federal campaign finance laws.
On January 6, it was reported that SBF was seeking to keep his grasp on $450 million in Robinhood shares. The FTX founder, who stated he needs the money to pay his legal fees, is fighting rival claims to the stake by his former company and crypto lender BlockFi.
On January 9, the Robinhood shares worth nearly $500M were seized in the FTX Case. The stock was owned – via a holding company – by Sam Bankman-Fried and his FTX co-founder Gary Wang.
On January 12, SBF launched a blog on Substack detailing an FTX "pre-mortem overview", which many are observing that this is simply a reiteration of many of the previous evasions if not outright lies about what has transpired with the FTX collapse.
On January 19, Mr. Ray noted that there was a possibility that the exchange could restart. Earlier in the week, FTX debtors had identified $1.7 billion of cash and $3.5 billion of crypto assets and $3 million of securities, according to a company statement. This totals about $5.5 billion in liquid assets, which Ray referred to as a “herculean” effort to assess the firm’s financial position.
On January 26, a complete list of the creditors owed money by the bankrupt cryptocurrency exchange FTX was released, revealing a wide range of companies and government entities. The names of nearly 9.7 million (9,693,985) FTX customers with funds stuck on the exchange were however redacted from the document. Notable crypto and Web3-related companies appeared, including Coinbase, Galaxy Digital, Circle, Chainalysis, Messari and entities of Binance.
Big Tech players Apple, Netflix, Amazon, Meta, Google, LinkedIn, Microsoft and Twitter were also included. The New York Times, The Wall Street Journal and CoinDesk were among the media outlets mentioned, according to Cointelegraph.
On March 28, farther down the line and post charges, US prosecutors charged SBF again, stating that in 2021, Mr. Bankman-Fried instructed Alameda employees to pay a $40 million bribe to one or more unnamed Chinese officials to restore access to trading accounts maintained by Alameda that held about $1 billion in cryptocurrency.
This article from CoinDesk further maps out the full timeline of events for the FTX collapse. The coverage has also been so outrageous as to include a Vox journalist publishing private and disturbing correspondence from SBF and emerging facts suggesting that SBF may have even outright stolen funds on top of misusing them.
… since these events, veteran bankruptcy professional John J. Ray III, was then appointed FTX CEO, and is well known to have covered the Enron bankruptcy in the early 2000’s.
The bankruptcy filing has some incredible quotes from Mr. Ray, especially given his past experiences, including:
“I have over 40 years of legal and restructuring experience. I have been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance (Enron).”
“Nearly every situation in which I have been involved has been characterized by defects of some sort in internal controls, regulatory compliance, human resources and systems integrity. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”
You can further go on to read key excerpts from the bankruptcy filing here, as well as the full affidavit.
There are also a significant number of articles and blog posts with excellent coverage and analysis of what transpired, to include: Nansen’s Blockchain Analysis, CoinDesk’s initial reveal that triggered this course of events, CoinDesk’s timeline of the FTX collapse, Tweets from well known DeFi thought leaders (and here as well), coverage by Market Sentiment, and former employee commentary.
What do each of these recent failures and liquidity crises have in common?
Look at most of the most recent bankruptcies, liquidity events, and other failures in this recent crypto winter.
Celsius. Terra (LUNA). 3 Arrows Capital (3AC). Voyager. BlockFi … and now FTX.
What do they all have in common?
CeFi.
The vast majority of the crypto winter’s meltdowns, loss of customer funds, and unethical or illegal activities have come from trust-based CeFi organizations that do not have to abide by the same regulatory guidelines as TradFi, and also are not completely trustless and transparent as most DeFi protocols and projects. There are solutions detailed below for how each of TradFi, CeFi, and DeFi can learn and evolve from this, but also consider this article from Bankless suggesting that we need more DeFi, not less, as the solution. Bankless also submits a hypothesis that this could be the crypto bottom.
A great way to frame this actually comes from US Representative Tom Emmer:
““Public blockchains allowed the crypto community to reveal Sam Bankman-Fried’s fraud in the on-chain public record…FTX is a failure of centralization, a failure of business ethics, and a crime, not a failure of technology”.”
How can this be fixed going forward for the industry?
Let’s take a look at each of TradFi, CeFi, and DeFi, especially given the hybrid hypothesis for the future of finance technology.
Solution 1: TradFi - Acceleration of regulatory policy and becoming the “trusted CeFi”.
Increased regulatory oversight, policy and overall clarity from the US Federal Government is critical at this juncture.
FTX’s failure is already sparking a massive regulatory response, as the DOJ and SEC have already launched investigations into the company as well as bipartisan calls to action from the US Congress.
More broadly speaking, this article from Bloomberg suggests that the future of crypto lies within the TradFi ecosystem to solve many of these problems and enable mainstream adoption. Will TradFi embrace digital assets custody, trading and even exchange and liquidity services in a bigger way combined with a mature regulatory and compliance ecosystem to provide stability to retail and institutional customers?
Solution 2: CeFi - Proof of solvency and proof of reserves.
This has already left many CeFi’s sweating. CeFi exchanges and platforms have already scrambled to reinforce its sound practices to its retail and institutional customers, including these announcements from Coinbase, Gemini, and Grayscale. Most of these announcements state regulatory compliance, holding assets 1:1 for its customers, and claiming limited exposure to FTX. In contrast, some articles are suggesting that no one is safe regardless of its exposure to FTX.
In the near term, these CeFi’s need to establish the right mechanisms to continuously show transparency to its customers and the industry as part of standard operating procedures.
Proof of solvency is expressed by proving an exchange has the funds required to pay back all of its depositors. This is done by validating that all customers deposits equals “X” (“proof of liabilities”), and proving ownership of the private keys of those digital assets (“proof of assets”).
Read more here from Vitalik Buterin on proof of solvency and reserves.
Solution 3: DeFi - Increasing mainstream adoption and regulatory compliance.
Decentralized Exchanges (DEX) feature the transparent, on-chain transactions, the concept of trustlessness via smart contracts and oracles, non-custodial services, and other mechanisms that are novel to DeFi ensure that bad actors cannot act in a “CeFi” fashion. However, this comes with a number of downsides and tradeoffs that many TradFi institutions still are not fully willing to embrace or have a solution to navigate (e.g. compliance requirements). The concepts and tech in DeFi need to be leveraged in a way that combats CeFi and other trust based issues, while also providing a means for both mainstream adoption as well as complaint platforms and protocols.
