DECIL Insights - Issue #2, FTX, blockchain regulation, future outlook and more (Nov. 2022)

FTX special report, Blockchain future outlook, Blockchain regulation, more FTX coverage from DECIL friends, the FIFA World Cup 2022 & Web3, other Blockchain mainstream adoption, SustainaDAO Non-Fungib

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Jan 04, 2023

Four of the six largest meltdowns in crypto have happened this year, and FTX is the largest one among them. U.S. Congressman Tom Emmer said FTX’s collapse was not a crypto failure but of “centralized Finance, business ethics, and government oversight.” It is a company fraud sitting between trusting retail and immutable protocols.

FTX was the third largest exchange in terms of perpetual trading, doing an average of $9.5 billion of volume per day. FTX’s founder, SBF (Sam Bankman-Fried), has spent time in DC promoting crypto regulation and marketed FTX as ‘the safe and regulated way to buy crypto.’ FTX put their name on the Miami Heat arena, buddied up with Tom Brady, and persuaded Larry David to do his first-ever commercial.

A few days before the FTX collapse, there was a public spat between SBF and CZ, the CEO of Binance, on Twitter. CZ accused SBF of throwing Binance under the bus with regard to some political efforts in DC. Then CZ said their team saw an article in Coindesk about FTX potentially having a problem and decided to sell their stake in FTT, which they disclosed to the public, and the cascade of calamity began.

Binance was an early investor in FTX International and exited the position last year. As part of that exit, Binance received $2.1B of FTT and USD. The threat, and possible act, of selling that much FTT created an overhang on the asset, causing investors to sell off FTT and pushing the price down rapidly. This in turn, put pressure on Alameda, which used FTT as collateral for Alameda’s loans. Due to this, traders and investors who had assets pledged as collateral on FTX withdrew them, sparking a classic bank run. Over the course of about 48 hours, this became a self-perpetuating downward spiral, where as much as $5B quickly left the exchange, revealing the holes in FTX’s balance sheet where customer deposits should be.

With 134 companies declaring bankruptcy and billions of dollars locked on the bankrupt exchange, the FTX collapse has left many customers in limbo. And contagion has been spreading to firms including BlockFi and Genesis. According to this news, FTX owes its 50 biggest creditors nearly $3.1B. However, retail customers are the ones get impacted the most.

Coinfessions @coinfessions

Please let this be a dream. If not for us, for my daughter.

Coinfessions @coinfessions

I lost everything today. I don’t know what I’m going to do now.

“Where did user funds go?” It’s possible that funds were used to pump up FTT’s price starting in early 2022 when it outperformed several other similar tokens. FTT was FTX’s largest position, and it is central to both Alameda and FTX’s survival. SBF wrote a four-page letter to FTX employees about the collapse. Still, it didn’t once directly mention the actual problem: giving customer deposits to a risky trading fund (Alameda) in exchange for its self-minted FTT token collateral.

The Web3 community sees FTX’s collapse as another showcase of people interacting directly with the protocols. They believe DeFi is a remedy to the problems that have haunted the crypto sector over the past year, following the collapse of large centralized organizations like crypto lender Celsius and hedge fund Three Arrows Capital.

(You can learn more about the Luna/Terra crash via our paper: How to build a true stable coin: lessons from Luna/TerraUSD, traditional currencies and US banking history. )

As Brian Quintenz, former CFTC commissioner pointed out: “The evil financial trinity of centralization, leverage (collateral), and opacity keep finding ways to blow things up. Until now, regulation was the only solution. DeFi presents a new one. ”

Brian Quintenz @BrianQuintenz

The evil financial trinity of centralization, leverage (collateral), and opacity keep finding ways to blow things up. Until now, regulation was the only solution. DeFi presents a new one.

According to Hayden Adams, founder of UniSwap, the world’s largest DEX, this is “a good learning moment for the industry.” Decentralized exchanges differ from their centralized counterparts (like FTX, Binance, Coinbase, and others) in a few important ways. Most notably, instead of relying on an intermediary to match buyers with sellers, DEXs let users transact on a peer-to-peer basis—and keep custody of their own funds. The old system of “trust us because we’re a big brand and sponsor arenas” is moving aside to a new system of “trust us because we have live visible public proof of reserves.”

Although the DEX model suffers from a steeper learning curve for new users, it eliminates the need to store coins with an exchange, which allowed FTX to divert customer funds to its sister company, Alameda Research, in the first place. Customers can never be completely sure what’s happening to their assets inside a centralized exchange. But with a DEX, “how funds are being used is fully transparent” because everything is hosted on a public blockchain.

There are many innovations in the self-custodial space. For example, MPCValut built the most advanced and secure self-custodial infrastructure using multi-party computation (MPC) and Intel Enclave technology, eliminating any single point of vulnerability. Now, you can build applications, run hedge funds, and manage the team’s assets without worrying about security. (Welcome to contact us if you want to be on the whitelist of this product.)

Admittedly, a limiting factor for DeFi’s ceiling remains expensive transactions and slow block times of decentralized derivatives. Scaling solutions are still in their infancy. Therefore, more time is needed to build out dedicated infrastructure.

The FTX fiasco is keeping lawyers plenty busy, too. “We are here on an unprecedented matter,” said James Bromley, a partner at law firm Sullivan & Cromwell who is representing FTX. A “substantial amount of assets have either been stolen or are missing” from FTX, Bromley told the court, and FTX employees under its new CEO, John J. Ray III, were working “day and night” to locate them. The exchange has also been facing cyber attacks and is working to protect the assets it does have, Bromley said. “What we have here is a worldwide, international organization but which was run as a personal fiefdom of Sam Bankman-Fried,” Bromley said.

Celebrities who endorsed FTX also got into trouble. An FTX customer filed a lawsuit against the reigning NBA champion Golden State Warriors, alleging they fraudulently promoted the exchange. Golden State Warriors named FTX an “official crypto platform” late last year, marking its entry into the crypto space. Mr. Lam lost $750K and accused the defendants of falsely representing FTX as “a viable and safe way to invest in crypto” and is now suing on behalf of millions of customers.

It does feel like FTX’s fiasco is a black eye for Sand Hill Road. Sequoia writes down $214m FTX investment to zero. “I can’t point to other brand-name institutional firms that have delivered this amount of money to one company with this lack of governance and level of this disaster, but it’s possible there are others,” NFX general partner Pete Flint commented about Sequoia’s FTX investment.

Source: WSJ

It has been estimated that 25-40% of crypto funds had some level of exposure to FTX exchange or their exchange token (FTT). As investors in this space, even if we are not directly affected, we will all have to socialize the reputational loss as an industry.

Here are what we can take away from the FTX debacle:

Use caution while using leverage, and limit your net exposure to no more than 100%.
Be very disciplined with counterparty risk management.
Support initiatives that give priority to technological or product solutions to real problems.
Support projects focused on organic growth via product-market fit.
Encourage initiatives that place a strong emphasis on cash conservation and financial transparency.

A good article about FTX’s fiasco:

Don't Worry About the Vase

Sadly, FTX

It has been quite a past two weeks, with different spheres in deeply divided narratives. In addition to the liberation of Kherson City, the midterm elections that of course took forever to resolve and the ongoing hijinks of Elon Musk taking over Twitter, there was the complete implosion of Sam Bankman-Fried (hereafter ‘SBF’), his crypto exchange FTX and…

3 years ago · 56 likes · 40 comments · Zvi Mowshowitz

A good Infographic on FTX’s balance sheet:

https://www.visualcapitalist.com/ftx-leaked-balance-sheet-visualized/

Future of Blockchain:

In the short term, the contagion will likely cause a series of events in the blockchain industry. The market is poised to get worse before it rebounds. That’s because there are more collapses ahead that will result from the sudden failure of FTX and sister hedge fund Alameda Research, which were both owned by Sam Bankman-Fried. With contagion fallout, many trading firms will be wiped out and shut down, putting pressure on liquidity and volume throughout the crypto ecosystem.

However, in the long run, despite the unavoidable cyclical cycle of the financial industry, blockchain technology, and crypto brings unprecedented opportunities for addressing some of the most pressing world issues, like financial inclusivity, transparency, and equality.

Global inequality leaves 1.7bn people, especially women, people of color, and underprivileged communities, without bank accounts. Blockchain eliminates traditional barriers such as prohibitive fees and proximity to physical banks. Reaching $589bn, remittances are a major driver of economic growth for developing countries. The G20 roadmap recognizes crypto’s immense potential to bring down costs from the current global average of 7%, closer to the UN’s sustainable development goal of 3%. Small- and medium-sized enterprises account for 90% of businesses and 50% of jobs globally. Decentralized finance solutions can bridge the $8.9tn gap in SME finance.

Just like effective altruism, we can not discredit the whole theory because of some bad players and historical setbacks. Following the learning path of traditional finance, the blockchain industry is learning from trial and error and pacing toward maturity. The FTX incident provides blockchain entrepreneurs a reminder to reevaluate their risk exposure and follow more sustainable business models.

NYC Mayor Eric Adams doubles down on cryptocurrency despite industry implosion. Adams has converted some of his salaries into BTC and ETH, demonstrating his commitment to new technology. “These industries are not going to go away because they reached a low point,” he said Tuesday during an unrelated press conference. “This is an industry that we must embrace.” Responding to recent events, the mayor argued that all industries have bad actors and “ups and downs.” He pointed to losses he has suffered in the stock market. “I’m afraid to even look at it nowadays,” he said.

Blockchain Regulation:

Countries across the world are taking regulatory action in an attempt to solve these pressing blockchain issues. The lack of regulatory certainty has become a major concern for crypto investors and adopters, also driving some major industry players out of the US. In the United States, the lack of regulatory clarity threatens to slow down not just the mainstream adoption of new technologies but also innovation in digital payment options, potentially cutting off consumers and businesses nationwide from sought-after conveniences.

While regulators are trying to balance two priorities: law enforcement and innovation, balancing the invisible market hand and more structured regulations is not blockchain industry-specific but part of a more century-long social economics debate. FTX's downfall heated the discussion, and more calls for immediate blockchain regulation have been heard.

Before the collapse of FTX, Bankman-Fried and his lobbyists centered on promoting the Digital Commodity Consumer Protection Act of 2022 (DCCPA), which addresses a gap in U.S. law that leaves financial regulators unsure over who has priority when it comes to overseeing crypto spot markets. However, the legislation, as written, currently requires decentralized finance (DeFi) platforms to submit to regulations with which they argue that due to their technological design, they would not be able to comply.

U.S. Sen. Sherrod Brown (D-Ohio), the chairman of the Senate Banking Committee, sent a letter this week to U.S. Treasury Secretary Janet Yellen for the first time outlining his willingness to work on legislation and the broad strokes of what that legislation should look like – including that the approach must be comprehensive and rope in all the relevant financial agencies. “Single regulatory agencies currently generally do not have a comprehensive view of crypto asset entities’ activities,” Brown argued in his letter, which highlighted the findings of a report from the Financial Stability Oversight Council led by Yellen, including its recommendation for legislation that would “create authorities for regulators to have visibility into, and otherwise supervise, the activities of the affiliates and subsidiaries of crypto-asset entities.” He said he wants to “work on such legislation”, especially in light of the collapse of the crypto exchange FTX that destroyed many Americans’ investments.

Successful, comprehensive regulations address six elements: legal certainty, effective risk monitoring, financial stability, consumer protection, market integrity, and cross-border cooperation. Effective blockchain regulation is likely to be not only a cross-regulatory agency effort in the US but a global cooperation effort.

We also urge the regulators to listen to the blockchain industry while refining the blockchain legislation, as traditional regulations may worsen financial risk in the crypto industry. Read more about why.

The lesson of these recent events for policymakers should not be that web3 is bad and must be constrained. It should be that pushing innovation offshore creates greater uncertainty. We need trusted and well-regulated centralized entities to survive and thrive and we also need decentralized web3 protocols to flourish and provide a path to a fully decentralized web. Creating a healthy web3 sector in the US with clearly defined sustainable regulations can protect US consumers from risky/ shady offshore entities.

More FTX coverage from DECIL friends:

Tommaso Di Bartolo, the co-founder of Phygtl Inc., talks about afterthoughts on FTX chaos and lessons to learn. Please find SustainaDAO Non-Fungible Podcast interview with Tommaso through the link.

Tommaso Di Bartolo: The FTX chaos is probably the worst in crypto history. On the bright side, we’ll come out stronger. We have seen two major contagions in the web3 space. Two giants fell and sent a massive shockwave to the whole crypto space. Terra went on a death spiral because of their algo stablecoin, and FTX borrowed against and leveraged their own token. In the aftermath, tens of thousands of people lost their investments. There is no argument that these are extreme examples of irresponsibility and incompetence in web3. And we can’t have such events and still aim for mass market adoptions. But on the bright side, Terra, FTX, and hundreds of other companies are setting examples of what not to do in the web3 space. And as brutal as the ramifications are, like every emerging industry, it’s a trial and error method to find the right way. Next time when a new Luna or a new FTX comes up, people will be able to spot them instantly. For the people who are actually building something game-changing every day, I want to say- keep building. Real builders are going to create a real difference in the world.

Felix Hartmann, GP of Hartmann Capital, talks about the FTX collapse and what is next for Crypto on Felix O. Hartmann's Youtube Channel.

We will publish SustainaDAO non-fungible talk podcast interview with Felix and dive deep into FTX failure on Dec. 7th. through the link.

Felix Hartmann: Ultimately, the events with FTX have proven that transparency in on-chain finance is essential. And so, this was a wake-up call for the industry to realize that, hey, it is now more important than ever that we have Decentralized Exchanges that can handle institutional throughput and Decentralized Lending Platforms that can handle billions of dollars of lending volume.
The problem in bull markets, a lot of times, is that we make concessions in the wrong places. We accept blockchains with faster speed and higher throughput. But in exchange, give up decentralization. If we give up decentralization, there's no point in using a blockchain in the first place. And so, if we go back to the roots of blockchain, focusing on decentralized chains that enable self-custody, we can go a very long way.

Stevie Cline and Ian Kar, co-GP of Vol1 Venture, talk about what led to the collapse of FTX and its impact on the whole crypto field from the regulation perspective and why it is so critical to set up the company’s legal strategies correctly from Day One. Please find the SustainaDAO podcast with Stevie Cline and Ian Kar through the link.

Stevie Cline and Ian Kar: So, speaking of the regulation of crypto, The legislation area hasn't changed much since during the past decade. This week people have been talking about the not-so-good news about FTX. I think that partially reflects the volatile nature of the crypto market. But I think another part, it's like it's probably like shows as a consequence of lack of regulation.
We work with companies with whom we try to be the first check-in. What that means is we wanna be there from the start to make sure you are making a good legal start…We really wanna make sure we're saving people time, money, and effort. Getting tripped up on these things can set you back years.

Jason Li, the founder of MPCVault, talks about cyber security and how to prevent the FTX situation from happening again. We will publish SustainaDAO non-fungible talk podcast interview with Jason on Dec. 14th and talk about DeFi security.

Jason Li: The recent blowup of FTX serves as a reminder of the corruption that can exist within centralized entities. This is why there are strong regulations in traditional financial systems - to prevent these kinds of incidents from happening repeatedly.
Centralized exchanges have the ability to manipulate prices, engage in insider trading, and misappropriate user funds, which goes against the fundamental principles of blockchain technology such as decentralization and transparency.
How can we prevent similar cases in the future?
To avoid similar situations in the future, it is essential that we prioritize the adoption of decentralized finance (DeFi) such as decentralized exchanges (DEXes) and lending protocols. DeFi offers on-chain transparency, allowing for greater accountability and visibility. Additionally, it lowers the barrier of entry and encourages continuous innovation for the benefit of all users.

The FIFA World Cup 2022 & Web3: