What went wrong with FTX and what’s next for Crypto?

[ad_1]

FTX, the third largest of the centralized exchanges where people go to trade all kinds of cryptocurrencies, recently filed for bankruptcy. The fallout should be widespread.

Kellogg Insight sat down with Sarit Markovich, clinical professor of strategy and fintech expert, to discuss what happened, what we can learn from it, and where the industry could go.

This conversation has been edited for length and clarity.

Kellogg INSIGHT: Can you explain to us why the collapse of FTX is so destabilizing in the Crypto space?

Sarit MARKOVICH: When you think of FTX, they were really the darlings of the crypto space in the sense that they were considered some of the safest and they were pushing for regulation. And Sam Bankman-Fried donated to so many different charities and politicians. FTX was definitely seen as a very stable point in a very volatile world. Crashing them or carrying out fraudulent activities is what really shocks a lot of people and has a huge negative effect on the whole crypto world.

The other thing to understand is that FTX is a centralized exchange. FTX is like the New York Stock Exchange, but instead of letting you buy and sell shares of large organizations, it lets you buy and sell cryptos. They are a custodian, which means they hold your money. And that’s where a lot of the problems come from.

In a decentralized project, everything is transparent. Some projects do not contain your money, your information, your data. You have your own wallet where you keep everything you want to keep. And then if you want to make any type of transaction, you authorize it and no one else has access to it. Someone would need your password and keys to access your wallet. Whoever is holding your money is completely transparent, so if there is any fraudulent activity, anyone can see it and know who did it.

So there are also decentralized crypto exchanges Uniswap, SushiSwap which have no problems in terms of fraud. There may be hacking, but they do not perform any fraudulent activity. And that’s because they’re not gatekeepers; they don’t hold your money. You simply use them to trade different cryptocurrencies. But they can’t take your money and use it for something else because it’s a decentralized exchange.

So, in a way, we have here a breakdown of a centralized system that should be regulated. There is no doubt that it should be regulated. However, as regulators are still trying to figure out how to regulate crypto, it is unregulated. This allowed FTX to do what they did.

INSIGHT: So just to clarify, FTX is an exchange, but it also had its own token?

MARKOVICH: Yes, called FTT. And if you held their token, you would get a discount on some of their fees. Because it was considered such a successful company, there was a lot of demand for this token, so its value increased. People were trading FTT like you would typically trade any type of stock or crypto.

FTX therefore has an investment arm, a sister company called Alameda. And in early November, crypto publication CoinDesk realized that Alamedas assets are mostly in FTT. They own a very large share of all FTT tokens. So if they sell FTT, its price would crash, which means that overall their balance sheet is worth less than they claim. This is not in itself a fraud, but it has raised suspicions that something is wrong.

Once CoinDesk announced that Alameda did not hold enough relief funds, Binance, which held a lot of FTT, said: We were going to sell our FTT. And then it was clear that it would have a huge effect on the price of FTT and that’s when it all started to fall apart.

We then learned that Alameda also invested in companies, but required those companies to keep their money in FTX, which was then loaned to Alameda to invest in other projects. And on top of that, FTX made loans to Alameda that were actually their clients’ money. It’s really Bear Stern: it’s really fraud what they did.

And that is exactly what we know today. There may be more going on.

INSIGHT: So obviously it doesn’t happen completely in isolation. Many cryptocurrencies have collapsed over the past year. I was wondering if you could contextualize that for us. How do investors even feel about crypto? Is it an existential crisis if you can’t trust currencies? If Terra LUNA loses more than 90% of its value and the exchanges are fraudulent, does crypto have a future?

MARKOVICH: I truly believe there is a future for crypto. In a way, these events are going to benefit the crypto world because there is a need for regulation and trying to get it as soon as possible will help. It would also push the market more towards DeFi, towards fully transparent decentralized projects.

It is true that now the regulations are probably going to be stricter than they would have been otherwise. But regulation that helps stop fraudulent activity and Ponzi schemes benefits the entire industry.

INSIGHT: So it’s partly about these purely speculative cryptos. Like, Hey, I got this new token! His name is TOKEN. Now enter the ground floor where you can get it for a low price.

MARKOVICH: Exactly. It’s like Dogecoin, there’s nothing behind it. But then you have a token like Ethereum, which is used to perform different activities on the Ethereum network. The Ethereum network does a lot of cool things by enabling different types of trades and transactions that create value.

The problem is that many retail or hobby investors are simply looking for quick returns. They often don’t know how to distinguish between decentralized and centralized projects, and they don’t do their due diligence to understand what’s behind the coins. They cannot respond to the value of a specific token or whether they believe it will create and sustain some kind of value.

The sad thing is that even many VCs don’t have a good understanding of this whole industry and get it wrong.

Now FTX was something completely different. If FTX has not performed fraudulent activities, then in general a centralized exchange could be a great investment and a great project. So you can’t really blame the market here. There was no way of knowing that FTX was lending money to its investors at Alameda. This is where a regulator will have to step in, otherwise the transparency that comes with decentralization would be of great value.

INSIGHT: It seems like the community is kind of split right now: some companies are very strongly asking for regulation and others are saying we just need better crypto workarounds.

MARKOVICH: Yes, exactly, there are those who are trying to build a decentralized and unregulated parallel ecosystem and those who think regulation is going to allow crypto to go mainstream.

The thought of these is that once it becomes mainstream, you will be able to do much more than what you are doing now, because you will have more funding and more customers. There will be a much larger ecosystem.

But a lot of decentralized projects felt this was going to hurt them, because when you think of crypto trading, for example, there are a lot of high-frequency traders. So there are a lot of high-profile activities that will be illegal if the market is regulated. Regulation would remove much of the opportunity that exists.

INSIGHT: Taking a step back, how do you see the FTX implosion affecting the future of crypto? How does this change the trajectory of the industry?

MARKOVICH: We’ve had meltdowns over the past year, but many felt it was because the projects just weren’t legit. If you wanted to learn more about Luna, you could read their publicly available whitepaper and do the analysis. Then you could have figured out that when the market is high they are going to do well, but when the market is down they are not. With FTX, you couldn’t really see what they were doing with the funds. This is the difference between centralized and decentralized projects and most recent meltdowns like Celsius, Three Arrow Capital or BlockFi are centralized projects. Since many do not realize this difference, they consider them to be cryptographic failures. This will therefore slow down demand. Investors will not be as likely to invest.

It also means that regulation will come sooner rather than later and it will be stricter.

My concern is whether regulators will understand that regulating centralized and decentralized projects should be different. You don’t want to just regulate the market and think of crypto as crypto. There are different types of projects that need to be regulated in different ways. Rules that are too strict will not allow the DeFi world to be so innovative.

INSIGHT: If I think I don’t care about crypto at all, can you give me an example of one of these projects that you think is really interesting and actually has the potential to make a cool impact about the physical world, what do you think DeFi is making possible?

MARKOVICH: Decentralized exchanges like Uniswap and SushiSwap are really cool. If you think of crypto as a stock, the fact that I can buy a stock from you without going through a broker and paying high fees makes everything more liquid. I think that’s great.

Another project that I think is awesome is MakerDAO. They provide loans that are secured but do not require any type of AML KYC [anti-money laundering and know your customer checks]which means you don’t need to prove that you have a lot of money or who you are. If you need money, MakerDAO will lend it to you if you provide the necessary collateral.

There are ways it’s played and there are attempts to limit the type of game that’s going on, but as a concept, using DeFi to help people who are struggling to borrow money is interesting.

Cross-border payments are another problem, with their high fees, which crypto can do so easily.

[ad_2]