We’ve marked the first year since the fall of FTX that shook the industry in 2022. Billions in depositors funds were lost and a scandal unfolded over the subsequent twelve months regarding how poorly the business was managed. Fast forward, Sam Bankman-Fried (SBF) was found guilty on all accounts in a New York courtroom last month. 18 months earlier, he sat in the US congress testifying as a subject matter expert on blockchain technology. He faces up to 110 years in prison.
What happened to FTX?
FTX was a leading centralized cryptocurrency exchange battling Binance for the top position among traders and institutional clients in the world. In September 2022, Coindesk released an article raising concerns on Almeda Research’s balance sheet (FTX hedge fund sister company, 90% owned by SBF), highlighting the $6 billion in equity value was essentially made up of FTT token (FTX’s publicly listed token). This was an issue because FTT trading volume ranged between $5 and $40 million in daily trading volume, rendering it close to impossible to unwind $6 billion in the market. The result: Almeda is essentially insolvent and the relationship between the two is precarious, at best.
The community started to question the intertwined relationship – why did Almeda carry all of this FTT token? Because of their close relationship, users started to begin to fear the worst. One week later, CZ, the founder and former CEO of Binance announced they were selling all of their FTT tokens in the market. If the Condesk article was a shot at FTX, then CZ’s Tweet was a nuclear bomb. Users quickly began offloading their FTT positions; the price started to crash, and so did FTX.
What proceeded next was a classic bank run scenario: users started to process withdrawals until FTX couldn’t cover the funds, and within 36 hours they became insolvent. Binance audited the company in an attempt to try and save it, but quickly reported it was too messy to save. The rumors of commingling customs funds and using it for personal spending quickly became true. After the company filed for Bankruptcy, John Jay Ray, a specialist in high profile liquidations assumed control and started reporting it was even worse than Enron (2001).
Ultimately, FTX and Almeda engaged in price fixing strategies to bolster the price of FTT token, then used it as collateral so FTX could lend real customer funds and placed big bets with Almeada Research. Additional funds were used for the executive team’s posh lifestyle in the Bahamas and to influence many politicians in Washington in order to advance their agenda. $16 Billion in customer funds were frozen, the calculated losses were roughly $8 billion. Thankfully, to date around $6 billion has been recovered, only leaving roughly $2 billion in losses.
SBF’s fate is in the hands of a New York Judge
SBF was found guilty on all seven accounts in a New York courtroom last month. The top executives of FTX and Almeda all gut plea deals. Their assets are being wiped to help cover customer deposits. The sentence could vary, but early estimates suggest he will be behind bars for at least 15 years before a chance of parole.
Financial fraud crimes are not taken lightly in the United States, especially when customers’ funds are lost. The US prides itself on its economy and financial markets. When companies disobey the public’s trust, the SEC (Securities and Exchange Commission) and DOJ (Department of Justice) will step in with thorough evaluation and heavy penalties.
What does this mean for centralized exchanges?
Centralized exchanges (CEX) are the heart of the industry because they develop the on and off ramps into the sector, connecting traditional finance with digital finance. CEXs run centralized order books with deep liquidity, oftentimes connected to institutional Market Makers who represent specific tokens in order to provide deep liquidity to the CEXs who are listing said tokens. The web of liquidity is similar to traditional finance, where larger Market Makers and CEXs can extend liquidity to smaller operations. This is what ultimately produces the highest level of trading volumes and the most efficient way for users to bank, buy, sell, trade, and swap their digital assets. When many fail, it’s a scary sign in the crypto economy, because it puts that web of liquidity in jeopardy.
Since FTX, a greater focus has been on showing proof-of-reserves within CEXs, adding greater transparency to their holdings and their ability to keep their users’ funds 100% available. Since the crypto winter began, there has been a shift of focus to DeFi products or wallets with self-custody. However, the model of CEXs will be a pillar in the industry for the years to come and their user base isn’t migrating anywhere anytime soon.
New technologies are starting to emerge that blend the advantages of DeFi with CeFi, starting with improved self-custody signatures. In the traditional model, CEXs manage the signing keys that authenticate the release of funds from a wallet. The confirmation from the user to release those funds are done through double confirmation via an order plus email confirmation or authentication code, similar to the traditional bank model.
Private markets evolve fast in their infancy stages, and two unique models are starting to emerge. Although they have yet to pick up serious traction, they are challenging the current model.
1. Self custody-centralized liquidity: Users will manage their own keys like a traditional DeFi wallet but will still have to complete a thorough KYC process in order to gain access to the centralized liquidity with tight spreads and low fees.
2. Shared keys: Funds are stored centrally, but the user stores one signing key and the CEX stores the other signing key to authenticate wallet transfers.
Self-Regulating Design
What both models have in common is it prevents the CEX from lending users deposits, as does a trandation bank, in order to generate more interest arbitrage revenue. User funds have increased protection from business and fraud risk. Had FTX adopted one of these models, they still would be competing for the top spot.
Read the full article written by Alex Cavallero, COO of Kii Global, on the Forbes website.
