FTX fiasco offers masterclass on everything that’s wrong with crypto markets

FTX was vulnerable not only because it was leveraged, but also because its assets were not really assets. PHOTO: REUTERS

NEW YORK – In one sense, investors and regulators should be grateful to Mr Sam Bankman-Fried, the erstwhile head of the FTX cryptocurrency exchange. The spectacular flameout of his virtual empire has evolved from a cautionary tale into a masterclass on everything that is wrong with crypto markets.

As customers and creditors sort through what remains of the failed exchange’s holdings, and as the repercussions spread throughout the crypto realm, here are four lessons that stand out:

Beware of assets denominated in crypto

FTX was vulnerable not only because it was leveraged, but also because its assets were not really assets. Judging from the balance sheet that the company reportedly sent to potential rescuers, they consisted largely of notional digital tokens.

Unlike stocks, bonds or commodities, they had no associated cash flows or practical uses. At best, they represented fee income from trading other similarly made-up tokens.

The same applies to just about all digital tokens, the primary “assets” of the exchanges and other intermediaries through which most people interact with crypto. They are pure speculative instruments.

Something like them might someday prove useful as representations of traditional assets, or as assets in virtual worlds, but that is a distant prospect.

As things stand, they are fundamentally worthless.

Market capitalisation is not value

If a company has 100 beads and sells one for US$1 million (S$1.37 million) – maybe to itself, maybe to someone to whom it lent the money, maybe to a true bead believer – it can say the beads have a market capitalisation of US$100 million. This is roughly how Mr Bankman-Fried came up with an estimate of more than US$10 billion for FTX’s holdings of digital tokens, including FTT, Serum and Solana.

It also helps explain how the entire crypto market, at one point, achieved a supposed capitalisation of about US$3 trillion.

Clearly, those beads are not worth US$100 million. Attempting to sell them all might yield nothing. Anyone who accepted them as collateral might end up with nothing too.

Accounting matters

Cryptocurrencies on public blockchains are highly transparent: Everyone can see what belongs to whom at any time.

Not so crypto intermediaries. They do not publish financial statements audited to generally accepted standards, with the exception of Coinbase, a public company.

Before FTX’s demise, investors and customers had little idea of what was going on beyond some not-so-reassuring tweets from Mr Bankman-Fried, such as “assets are fine”.

Now, they are puzzling over a balance sheet with entries such as “hidden, poorly internally labelled ‘fiat@’ account” and “TRUMPLOSE”.

Some intermediaries have promised better disclosures in the wake of the FTX fiasco. But given the lack of standardised rules, there is little to ensure their accuracy.

What is really backing the stablecoin Tether remains uncertain, despite the issuer’s regular reports.

Customers have no reliable way of knowing how leveraged big exchanges such as Binance might be, executives’ assurances notwithstanding.

Consumer protections are essential

Billions of dollars in FTX customers’ funds have effectively gone missing, lost to a tangle of entities and at least one apparent hack.

This was possible in part because FTX – with the exception of its US derivatives-trading subsidiary – operated in a regulatory vacuum, with none of the requirements governing capital, liquidity, segregation of funds, cyber security or conflicts of interest that traditional intermediaries must meet.

The same is true of just about every intermediary in the crypto world.

Sometimes, the authorities take one-off actions, as the Commodity Futures Trading Commission and the Securities and Exchange Commission have done in relation to false reporting, “wash” transactions and insider trading at Coinbase. But there is no “cop on the beat” making rules and enforcing compliance.

Whatever the potential benefits of crypto, the surrounding speculative frenzy has little to do with them. On the contrary, it primarily serves to lure people in and separate them from their money, as FTX has now demonstrated. Proper regulation might help nudge crypto in a more useful direction, and is needed to ensure it does not present a threat to the broader financial system.

Meanwhile, the message for investors and traditional finance remains simple: Stay away. BLOOMBERG

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