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What Happened to FTX, Why is Crypto Tanking and What is The Future of Web3?

by lacygibson
November 15, 2022
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What Happened to FTX, Why is Crypto Tanking and What is The Future of Web3?
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expressed opinion entrepreneur Contributors are their own.

FTX today. Celsius and BlockFi yesterday. The seemingly endless upheaval of “crypto titans” ultimately failed to protect consumers, undermining trust in the developing world of Web3. Why does this keep happening and will there be more?

First, “Why?” then “Who’s next?” (the short answer is ‘yes’ there will be more).

Why do these crypto giants keep falling apart? The answer is the greed and incompetence of cryptocurrency exchanges and lenders combined with improper (or lack of) regulation. It all boils down to “balance sheet assets”.

RELATED: “Sorry. This is the biggest thing. Sam Bankman-Fried and Cryptoworld lose big in FTX Meltdown, company files for bankruptcy.

Why Balance Sheet Assets Matter

In the US, we are seeing cryptocurrency exchanges and other companies obtain simple remittance licenses and hold investor assets (cash, cryptocurrencies, securities, NFTs, etc.) on their balance sheets. Offshore, these entities either do not have a license or a remittance type license that allows them to hold client assets on their balance sheets. This means that these assets are the property of the exchange (or the lender).

The client’s assets become unsecured liabilities on that balance sheet. Now, since these are corporate assets, companies can use these assets for profit. They can lend to them, invest in them, and do other things to increase business returns that could burn to ashes. If a company fails, others may have higher demands on these assets than investors, including governments (taxes, penalties), debt holders, and secured suppliers. The client gets whatever may be left – if there is one.

RELATED: Celsius network files bankruptcy, customers unlikely to get their money back

Balance Sheet and FTX

In the case of FTX, they are $10 billion short, which means they invest their balance sheet assets in an attempt to make money for the company (not the customer). These investments then head south, with insufficient assets to cover investor accounts (unsecured liabilities on the balance sheet).

This CEO says“Sorry I screwed up”, which is true at $10 billion, but shouldn’t have been allowed by regulation in the first place.

Regulated Entity Holding Client Assets

There are three types of “qualified” custodians – or companies that are regulated and need to look after their clients:

  1. trust company
  2. bank
  3. clearing broker

Trust Companies and Clearing Brokers Client assets cannot be held on the balance sheet. They have to make them “FBO” (for the benefit of the client). This means they cannot conflate customer cash or other assets with company cash or assets. They must be quarantined. They cannot be used or misused. And no third-party creditors have any claims against them.

If a trust company or clearing broker fails, their regulators ensure an orderly transfer of assets to another financial institution. 100% of the assets.

bank Client assets can be held on the balance sheet and invested for profit. This includes loans, stocks, bonds, life insurance advances, credit card advances, letters of credit, etc., all using client assets. If a bank makes a bad investment and fails, in that case the FDIC steps in and makes up the difference (up to $250,000) between the bank’s balance sheet assets and customer liabilities.

That’s why the FDIC has onerous rules on what banks can and cannot invest and how much of their balance sheets they can invest in any given thing (no matter how good it looks). It is strictly restricted, controlled and regulated.

Related: 6 Things You Should Consider Before Investing in Crypto, Good and Bad

Regulated entities and non-traditional assets

Clearing brokers typically do not hold private securities or tokenized assets (including cryptocurrencies). There are all kinds of well thought out and nuanced regulations that keep them from doing this. Banks cannot hold tokenized assets on their balance sheets, only in their trusts. While few of them are cryptocurrencies in common form (bitcoin, ethereum), none have a large collection of cryptocurrencies, private securities, real estate interests or tokens representing rewards programs, healthcare records, event tickets, collectibles, etc. . The rest is the trust company as the only qualified custodian.

Senders – a dangerous regulatory loophole

There is currently a regulatory loophole that is costing consumers billions of dollars. A money transmitter is a state-by-state licensed entity originally designed for companies to transfer small amounts of cash (possibly temporarily into the money transmitter’s account) peer-to-peer between people.

Remitters keep these client assets on their balance sheets, not trust companies and clearing brokers. So the crypto industry exploited this loophole to get a “license” that allowed them to hold assets on their balance sheets and do silly things with other people’s money. Regulations allow this behavior.

So, who’s next?

Ah, the multi-billion dollar question. There will be others. FTX is a huge shoe, as are Celsius and BlockFi. Get ready for more. For example, let’s talk about Coinbase.

Coinbase issue a statement Said, “The notes to the financial statements explain that, as of June 2022, Coinbase has brought all client assets into its balance sheet…it still has $12 billion in cash for itself and clients (both in assets) on the balance sheet).”

When I read this, my first thought was, “Why would they do that?!” They own a trust company, so why don’t they keep all customer cash and cryptocurrency in their trust company to ensure their protected? Why would they put all these assets on exchanges that only have money transfer licenses?

I can only imagine that if in a trust company, they can’t use other people’s money and cryptocurrencies for profit, but only if it is on an exchange. Maybe there is something else, but I don’t see it. So the natural question is, “What the hell are they doing with these client assets?” Probably not that different from what FTX is doing, maybe not. Without proper regulation, we cannot be sure.

Related: U.S. government monitors crypto market as FTX saga continues

They may claim assets are protected UCC Article 8. Nonetheless, my understanding is that this protection is intended to apply to securities, and even then, in the event of a company failure, attempts to place the liabilities of the client’s balance sheet above the available assets of other creditors. It does not prevent companies from using customer cash and assets for their own benefit and potentially losing these (like FTX). Therefore, even if Article 8 is considered applicable in a disaster situation, it does not matter much.

and others?

Yes, any company that operates as a simple money transmitter, what I call a pseudo-custodian, is capable of doing these things – all cryptocurrency exchanges that don’t use trust companies, whether their own or independent, all cryptocurrency lenders, and more

I respect the team at Coinbase, Binance.us, Zero Hash, Bittrex and other such currency senders. I don’t know if they are using or misusing customer assets or doing anything knowingly or wrongly. Maybe they know how to be safe. But when lax regulation allows you to use client assets for your own benefit, greed almost always prevails.

Related: White House on Crypto: More Oversight Needed to Avoid ‘Hurts’ Americans

Protect yourself and your customers

how? simple. If you have cash, cryptocurrencies, NFTs, or other assets in these pseudo-custodians operating under a money transfer license, take them out of there. Now. immediately. Move it to a qualified custodian or self-host. If you are a business dedicated to offering your clients crypto, digital assets or other Web3 initiatives: only work with qualified custodians.

Related: Solana Feels Ripple Effect of FTX Crash, Crypto.com Stops Solana, USDC, and USDT Withdrawals and Deposits

Next steps for the industry

Regulation (eventually) is coming. Legislation is coming. As an industry, we don’t want another Dodd-Frank or Sarbanes-Oxley overcorrection problem. Fortress Trust CEO Albert Forkner will work with members of Congress, including Senators Lummis and Gillibrand and Representatives McHenry and Waters, as they develop legislation. They will also work with the SEC, CFTC, CFPB and other government agencies for smart regulation.

At the same time, we advocate for states to amend their money transfer regulations to immediately withdraw and revoke the licenses of any out-of-state entities other than trust companies, banks, and clearing brokers.

Regulatory blue oceans leading to Web3

Not at all. Tokenization of rewards programs, real estate, medical records, insurance receivables, securities, event tickets, estate records, music, movies, sports, photography, books, art and every other electronic product in the world is continuing without delay conduct. These things – tokenization – so the blockchain acts as a ledger of record, not a cryptocurrency. Every company has plans for Web3 that will revolutionize the world just like the Internet did before. For those struggling to scale in this space, the blue ocean continues.

Tags: business newsCoinbaseCryptocryptocurrencyCryptocurrency Crashencrypted conversationFTXFTX goes bankruptFutureHappenedinnovationSam Bankman-FriedTankingtechnologyWeb3
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