The Lehman Brothers moment of the crypto market
Introduction
It is November 10, 2022, and we are experiencing the Lehman Brothers moment of the crypto industry. Not only this is a black swan event that has a huge impact on the crypto market, but it is also very likely that this will end the era of centralized exchanges as we know them.
Although already facing an increasingly more regulatory environment as the market develops, centralized exchanges are still operating under models that are not fully transparent. The collapse of something as big as FTX resembles the Lehman Brothers moment, which had a significant impact on the financial markets and led to subsequent regulations for the banks.
These moments, which affect institutions that are ‘too big to fail’ and involve customers’ funds, are expected to shift the attention of regulators and the market itself. What is clear is that exchanges and protocols that deal with customers’ funds need to show complete transparency. So what happened?
The FTX saga
FTX, one of the World’s largest crypto exchanges, run by famous Sam-Bankman Fried, is about to collapse. At the time of writing, the FTX crypto exchange told investors that it needs $8 bn in emergency funding to survive. We are yet to see what will unravel, but what is clear is that this black swan event is of huge significance, notwithstanding that this comes after Celsius, Terra Luna, and 3AC collapse earlier this year.
For FTX, it all started with the Coindesk story, which shed light on the balance sheet of Alameda- Sam Bankman’s other vehicle, which operates as a trading hedge fund and also provides liquidity to FTX. The report showed that Alameda holds a lot of FTX’s own token FTT on its balance sheet, $5.8 bn out of $14.6bn, to be precise. Moreover, other balance sheet items were $3.37bn Solana blockchain’s native token SOL, a project that is closely tied to Sam Bankman Fried, and other assets that are doubtful to support the strength of the balance sheet.
This led to questioning Alameda’s and FTX’s liquidity. Binance, which is one of the largest holders of FTT, has decided to sell its $2.5 bn worth FTT position, citing that it has learned its lessons from Terra Luna collapse. The concerns in the market led to a ‘bank run’ on FTX with $6bn of funds withdrawals. FTX, halted the withdrawals from the exchange, while the value of FTT token is down 80%. FTX is on the brink of collapse.
Sam Bankman Fried, reportedly called Binance’s head and asked for a bailout. The market has been expecting Binance, the behemoth of crypto trading, to swallow FTX. But, here comes a twist to the story- Binance is not taking in FTX anymore:
Time will show how this saga will unravel, but what is clear is that it sheds light and attention on the operations of the crypto exchanges and how customers’ assets are being managed.
The crypto markets are already under the loop of regulators, with MiCA coming into effect in Europe, and discussions are underway in the U.S. on how to regulate DeFi. Crypto exchanges, in general, are already regulated vehicles. In order to access markets and users, crypto exchanges must comply with specific regulatory and compliance requirements. These are entities that operate the crypto exchanges on their servers and provide trading and other services to users who often also hold funds on these exchanges. Centralized crypto exchanges also act as on-ramps to crypto and DeFi- they bring in new users as they usually include a crypto wallet for buying crypto with a fiat currency.
What has been unclear until now, it appears, on how the crypto exchanges manage their customers’ funds. It is alleged that FTX has been using users’ funds to trade on Alameda. If Alameda loses money, what happens to users’ funds? How well are they protected? How much money does FTX, Alameda have to cover the losses? These are regular questions that come to the mind of a user that trades on the FTX exchange and holds funds in his account.
It is always possible to prove the amount of funds stored in various crypto wallets that belong to an exchange. Blockchain is the vehicle for transparency, which provides insight into all transactions that have taken place, and how much each wallet address holds. In all the sagas that have unraveled so far this year in crypto- Celsius, Terra Luna- the investigations and insights of wallet contents were being revealed real time. That makes the crypto markets more transparent than the financial markets, as we never got to see the books of the financial institutions and banks that collapsed while managing customers’ funds.
Blockchain, by its essence, provides real-time insights and is operating in a self-regulatory environment. Decentralized Exchanges (DEXs), contrary, to centralized exchanges, operate on blockchain: the transactions are conducted and recorded on various layers of blockchain, ready to be verified. Users always retain full custody of their funds and operate on a DEX from their own wallet, interacting with smart contracts that are programmed on the blockchain. All transactions are visible on the blockchain, while the smart contract codes the rules under which wallet addresses are able to operate the transactions.
History lessons
So what to expect now for centralized exchanges? If you want to know the future, look at history. What happened after the Lehman Brothers collapse? In order to protect the investors and customers, the regulators had to act and make changes, and they did.
Firstly, the Volcker rule was introduced. Volcker rule means that banks can not use customer deposits for their own profit- they can not own, invest in, sponsor hedge funds, private equity funds, or other trading operations for their one use. That also means that under Volcker rule, banks can no longer trade securities, derivatives, commodities future, and options for their own account- conduct proprietary trading. For the customers, that means that their deposits are safer because banks can’t use them for high-risk investments.
Another requirement that was introduced after the Lehman Brothers was the bank capital requirement- they were told to strengthen their business with more shareholder capital and less debt. Regulations came in place regarding how much capital banks need to hold, how to their fund their business, structure of short-term and long-term debt. This is again to protect the customers so that in case of sudden customer funds withdrawals, the bank would be able to return their funds.
What now?
Right now, we will have to take a back seat and watch the saga unravel. Customers are losing funds, and both investors and retail users are being cautioned again about putting funds into highly speculative entities. The domino effect is already hitting the market, with users and many major funds such as Sequoia Capital, Black Rock, SoftBank, and others being affected.
It is very likely that the regulators will pay much closer attention to the oversight of crypto exchanges and those crypto providers that deal with customers’ funds after the collapses of Celsius, Terra Luna, and now FTX saga. Long gone will be the days of wild centralized exchanges that keep their books under the hood.
The whole market will demand transparency, accountability, and tools to monitor the actions and transactions. Growing financial inclusion needs updated systems on how to monitor transparency in the ecosystem, and blockchain technology can provide exact tools to enable that.
Stay safe, and learn self-custody!
