As FTX implodes, the crypto exchange model is under scrutiny

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The revelation this week that up to a million investors could be harmed by the collapse of the FTX cryptocurrency exchange exposes what critics say is a fundamental flaw in the fundamentals of the $850 billion digital currency market.

As the implosion of the Bahamas-based company continued to cause turmoil in crypto markets on Wednesday, experts said the concern is less with crypto itself than with the lightly regulated firms serving crypto investors.

For investors, FTX has been a gateway to the crypto world, an exciting marketplace where celebrity ambassadors like quarterback Tom Brady invited them to open accounts and trade digital currencies like bitcoin and ether. FTX, in turn, functioned in many ways like the banks and brokers of traditional finance, servicing customer accounts, exchanging currency, and making loans and investments with customer assets.

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But like other crypto exchanges, FTX operated outside of the traditional banking system, and this came with huge risks. While they behave like banks and brokers, crypto exchanges are typically not subject to the same kind of regulation, insurance, and disclosure rules that protect customers of traditional banks.

“On some level, the fall of FTX is not a crypto story at all,” said Adam Levitin, a professor of law at Georgetown University and a director at Gordian Crypto Advisors, a crypto bankruptcy advisory firm. “People invested billions in an unregulated financial institution on a Caribbean island. How can this end well?”

What the FTX case shows on a grand scale is that companies that hold crypto for clients can make investment decisions that end in disaster, and if they do, there is no clear guarantee that clients will get their assets back.

At least $1 billion in customer funds have disappeared from FTX, one of the industry’s largest exchanges, in circumstances under investigation by the Justice Department and the Securities and Exchange Commission, according to Reuters. In bankruptcy filings, FTX revealed that the money could be owed to more than a million people and organizations.

The collapse has drawn attention because FTX is one of the largest crypto exchanges and its founder, 30-year-old Sam Bankman-Fried, has been widely hailed as a crypto prodigy and the top Democratic donor. But in the past year, as the total value of the crypto market plummeted from a peak of over $3 trillion, other crypto companies have also run into financial trouble.

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Crypto lenders Celsius Network and Voyager Digital filed for bankruptcy earlier this year after they failed to meet customer demands for withdrawals. Last week, another lender, BlockFi, announced it was “unable to continue as usual” and was “pausing customer withdrawals” in the wake of FTX’s collapse. This week, crypto exchange AAX announced it had ended withdrawals, citing technical issues with a third-party partner. And on Wednesday, cryptocurrency lender Genesis said it was temporarily suspending redemptions and new loans.

The House Financial Services Committee has scheduled a hearing next month to investigate FTX’s collapse, Rep. Maxine Waters (D-Calif.), the panel leader, on Wednesday.

The company’s troubles have spooked investors, leading executives at other major crypto exchanges – including Coinbase, Crypto.com and Binance – to reassure customers that their balance sheets are strong. Some have portrayed the FTX’s collapse as an anomaly in an otherwise safe industry.

“This is the direct result of a rogue actor violating every basic rule of fiscal responsibility,” Patrick Hillmann, chief strategy officer at Binance, the largest of the crypto exchanges, said in a statement to The Washington Post, citing Bankman-Fried . “While the rest of the industry operates under extreme scrutiny, the cult of personality that enveloped FTX gave them a dangerous level of privilege they didn’t deserve.”

But the lack of regulation creates risks for crypto investors, experts say. In the United States, the financial condition of a traditional bank is subject to regulation and official scrutiny. If FTX had been subjected to the same scrutiny, the weaknesses in its financial condition might have come to light sooner. In addition, customer deposits with traditional banks are insured up to $250,000 by the FDIC. Such protections will not help those who have lost money at FTX.

FTX is one of several major crypto exchanges that have played a vital role in popularizing cryptocurrencies, including paying for Super Bowl ads to reach a large audience. According to a Pew Research Center survey, 16 percent of American adults say they have invested or traded in cryptocurrency at some point.

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Some “companies have been allowed to get really big despite their clear disregard for the rules imposed on traditional financial institutions,” said Tyler Gellasch, president of the Healthy Markets Association, a group focused on increasing transparency and reducing conflicts of interest in the capital markets. .

“The banking and securities rules are designed to ensure that if the bank or broker fails, you can still get your assets back,” Gellasch said. “The crypto exchanges don’t seem to match any of them.”

Since FTX filed for bankruptcy last week, several major exchanges have attempted to become more transparent. Last week, Binance published a brief account of its cryptocurrency holdings, but not its liabilities.

Binance chief Changpeng Zhao said the company would release a fuller account of its finances in a few weeks, once an outside auditor can complete its work. Zhao did not identify the auditor, but said the same company had also worked for FTX.

“Nothing is risk-free, right? Crypto exchanges are inherently quite risky businesses,” Zhao said in a Twitter Spaces chat Monday. “You have to manage them well. You have to do security well. You have to do a number of things right.”

Unlike FTX, Zhao said Binance has no debt. “We’re a very clean, very simple company,” he said. “We’re not trying to be a pawn shop or a hedge fund shop.”

On Crypto.com, CEO Kris Marszalek held a video livestream Monday amid online rumors that the company had stopped processing withdrawals. Marszalek acknowledged that withdrawals temporarily spiked after the company mishandled a transaction worth about $400 million, which he says was accidentally sent to the company’s account on a competitor’s exchange.

But he called rumors of a break “absolutely untrue”, adding: “We are back to work as usual.”

In what Marszalek touted as an effort to restore depositor confidence, Crypto.com released a partial breakdown of its cryptocurrency holdings showing that the company had at least $2.3 billion in cryptocurrency reserves as of Nov. 14 . But the company’s outstanding liabilities are not publicly known and were not included in the company’s initial report following the collapse of FTX.

Marszalek downplayed Crypto.com’s exposure to FTX on Monday, assuring investors that the company’s balance sheet is “tremendously robust.” He said a “third-party audit” of the exchange’s customer reserves will be released in the coming weeks.

Singapore-based Crypto.com has poured a fortune into flashy marketing campaigns, hiring actor Matt Damon as a brand ambassador and acquiring the naming rights for the Los Angeles Staples Center in a deal worth an estimated $700 million. This year, however, the price of its native token, cronos, has fallen. Cronos lost more than 50 percent of its value in the past week, raising questions about the exchange’s solvency.

Marszalek said the upcoming audit will prove his position remains strong.

“We don’t have a hedge fund. We do not trade client assets,” he said during the livestream. “In a few months, all these guys will look really, really bad for making accusations that make absolutely no sense.”

Coinbase, the largest of the publicly traded crypto exchanges, is based in the United States and is subject to more disclosure rules than most other major exchanges, a point its executives emphasize. The company said it has sought and obtained licenses in every jurisdiction in which the company needs them to operate in the United States.

“We follow the laws and regulations in these jurisdictions, which include a variety of obligations, such as capital requirements,” the company said in a statement.

Alesia Haas, the company’s chief financial officer, wrote in a blog post last week that the company’s “public, audited financials confirm that we do not have a liquidity problem.”

Still, regulators urge caution. In a speech last month, Acting Chief of the Office of the Comptroller of the Currency, Michael J. Hsu, warned crypto exchanges about what he sees as their dangerous attempts to “disguise” themselves as banks.

“The crypto industry was born out of a desire to disrupt the traditional financial system,” Hsu said. “Still, crypto has mimicked [traditional finance] concepts to market themselves and grow… Using the known to introduce something new can downplay or mask the risks and raise false expectations. Over time, people get hurt.”

The visionaries who laid the foundations for bitcoin and other digital currencies have also raised questions about exchanges. Crypto was supposed to eliminate the need for banks, brokers, and other so-called “financial intermediaries,” and many early proponents were critics of a financial system they viewed as predatory and opaque. The groundbreaking white paper that launched bitcoin aimed to shut down the banks because it “would allow online payments to be sent directly from one party to another without going through a financial institution.”

When centralized crypto exchanges emerged to take on the role of banks and brokers, critics said, they twisted the original ideals of crypto.

“It’s really hard to reconcile centralized crypto exchanges with the core principles of cryptocurrencies,” said Finn Brunton, a professor of science and technology studies at the University of California at Davis and the author of “Digital Cash: The Unknown History of the Anarchists, Technologists and utopians who created cryptocurrency.” Centralized crypto exchanges essentially create the same risks and lack of transparency that existed at other financial institutions, but with even less regulation and oversight.”

In their bankruptcy filings, Celsius and Voyager described their failures in a way that shows their similarity to traditional banks. Both explained how a wave of clients had demanded to withdraw their assets. Neither firm had the resources to return their clients’ money, forcing them to file for bankruptcy protection.

In court documents, both companies used the same phrase to describe their problems. They were hit, the documents say, by “a run on the bank.”

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