the lesson for everyone in the collapse of FTX

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Anthony* (a friend) called a few weeks ago, deeply worried.

Deputy principal at a high school in Queensland, he spent hundreds of thousands of dollars buying cryptocurrencies last year, borrowing money using his house as capital.

But now all of his assets, valued at A$600,000, were locked in an account he couldn’t access.

Hed purchased through FTX, the world’s third-largest cryptocurrency exchange, endorsed by celebrities such as Seinfeld co-creator Larry David, basketball champions Steph Curry and Shaquille ONeal, and tennis ace Naomi Osaka.

Tennis player Naomi Osaka advertises for FTX as she plays at the Miami Open tennis tournament in April 2022 in Florida. Wilfredo Lee/AP

With FTX’s dramatic collapse, it now awaits the outcome of the liquidation process which is likely to see it, another 30,000 Australians and more than 1.2 million customers worldwide lose everything.

I thought those trades were safe, Anthony said.

He was wrong.

Not like scholarships

Cryptocurrency exchanges are sometimes described as being like stock exchanges. But they are very different from the stock exchanges in London or New York, institutions that have gone through multiple financial crises.

Stock exchanges are both highly regulated and help regulate stock trading. Cryptocurrency exchanges, on the other hand, are largely unregulated and have no regulatory function.

They are just private companies making money from helping mum and dad investors get into crypto trading, profiting from the commission taken from each trade.

Indeed, crypto exchanges that have grown to dominate the market such as Binance, Coinbase, and FTX arguably undermine the entire vision that led to the creation of Bitcoin and blockchains because they centralize control in a system intended to decentralize and liberate finance from the power of governments. , banks and other intermediaries.

These centralized exchanges are not necessary for trading cryptocurrencies and are pretty much the least secure way to buy and hold crypto assets.

Negotiate before trades

In Bitcoin’s early days (since 2008), the only way to acquire it was to mine it to earn new coins by performing the complex calculations needed to verify and record transactions on a digital ledger (called a blockchain).

The coins would be stored in a digital wallet, an application similar to a private bank account, accessible only by a password or private key.

A wallet can be virtual or physical, on a small portable device similar in appearance to a thumb drive or a small phone. Physical wallets are the most secure because they can be disconnected from the internet when not in use, minimizing the risk of hacking.

A physical digital wallet is the most secure way to store your cryptocurrency. Shutterstock

Before the emergence of exchanges, trading involved owners selling directly to buyers through online forums, transferring coins from one wallet to another like any electronic funds transfer.

Decentralized vs Centralized

All of this, however, required some technical knowledge.

Cryptocurrency exchanges have reduced the need for such knowledge. They have made it easier for less tech-savvy investors to enter the market, in the same way that web browsers have made browsing the Internet easier.

Two types of exchanges have emerged: decentralized (DEX) and centralized (CEX).

Decentralized exchanges are essentially online platforms for connecting orders from buyers and sellers of cryptocurrencies. They are just there to facilitate communication. You should always keep cryptocurrencies in your own wallet (known as self-custody).

Centralized exchanges go much further, eliminating wallets by offering a one-stop-shop service. They are not just an intermediary between buyers and sellers. Rather than self-custodial, they act as a custodian, holding cryptocurrency on behalf of clients.

Stock exchange, broker, bank

Centralized exchanges have proven to be the most popular. Seven of the ten largest crypto exchanges in the world by trading volume are centralized.

But what customers gain in simplicity, they lose in control.

You don’t give your money to a stock exchange, for example. You trade through a broker, who uses your trading account when you buy and deposits money into your account when you sell.

A CEX, on the other hand, acts as an exchange, a brokerage (taking customers’ fiat money and converting it to crypto or vice versa) and a bank (holding customers’ crypto assets as depositary).

This is why FTX held cash and crypto assets worth US$10 billion to US$50 billion. It also acted like a bank by borrowing and lending cryptocurrencies, but without customers’ knowledge or consent, and without any of the regulatory responsibilities imposed on banks.

Holding both wallets and keys, founder and owner Sam Bankman-Fried borrowed funds from his clients to support his other businesses. Customers realized too late that they had little control. When it encountered problems, FTX simply stopped letting clients withdraw their assets.

The power of marketing

Like stockbrokers, crypto exchanges make their money by charging a commission on every trade. They are therefore motivated to increase trading volumes.

FTX did this primarily through celebrity and sports marketing. Since its inception in 2019, it has spent approximately US$375 million on advertising and endorsements, including buying the naming rights to the stadium used by the Miami Heat basketball team.

FTX Arena in Miami. Lynne Sladky/AP

Such marketing helped create the illusion that FTX and other exchanges were as safe as traditional institutions. Without such marketing, it is arguable that the value of the cryptocurrency market would have grown from US$10 billion in 2014 to US$876 billion in 2022.

Read more: Why sports sponsorship is unlikely to save cryptocurrency businesses from ‘crypto winter’

Not your key, not your coins

There’s a saying among crypto investors: Not your key, not your coins, it’s as simple as that.

This means that your crypto is not safe unless you have self-custody, storing your own coins in your own wallet whose private key you alone control.

The bottom line: Crypto exchanges aren’t like exchanges, and CEXs aren’t safe. If the worst happens, be it an exchange crash or a cyberattack, you stand to lose everything.

All investments involve risk, and the unregulated crypto market carries more risk than most. So follow three golden rules.

First, do some homework. Understand the crypto trading process. Learn how to use a self-service wallet. Until governments regulate crypto markets, especially exchanges, you are largely on your own.

Second, if you are going to use an exchange, a DEX is safer. There is no evidence to date that a DEX has been hacked.

Finally, in this world of volatility, only risk what you can afford to lose.

Read more: Crypto: What could more regulation mean for the future of digital currencies?

*Name has been changed.

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