The level of transparency in cryptocurrency exchanges remains incomparably lower than in the classical world of finance.
The University of Cambridge is investigating the phenomenon of cryptocurrencies through its Center for Alternative Finance. Cryptocurrencies and the classical world of finance – they go hand in hand, with the story of FTX.com’s collapse raising the question: Why is the level of transparency in crypto-exchanges still incommensurably lower than in the classical world of finance? And why do most cryptocurrency traders trust just what crypto exchanges say in social media, in the absence in most cases of public financial statements that would get an opinion from one of the Big 4 companies – Ernst & Young (EY), KPMG, PricewaterhouseCoopers (PwC) or Deloitte?
The FTX.com crypto exchange story shows how vulnerable the third largest cryptocurrency trading platform in the world has been in the absence of regular public financial reporting with an audit opinion from the Big-4.
Indeed, the whole story of the tragedy began on November 2, when an English-language media outlet published an article claiming that the publication had managed to see a “private document” – a sheet showing the balance sheet of FTX.com’s trading arm, Alameda, as of June 30.
This statement itself begs the question: why should investors take the word of this “private document”? Even if this balance sheet had been published (it is not given in any form in the publication), the question would still arise as to whether it is an engineered one?
Any attempt to explain the absence of the sheet itself by the fact that it is a “private document” does not make the information reported allegedly from this “document” unconditionally credible.
All these questions are crucial in the history of FTX.com, since it is from the appearance of this publication that we can count the beginning of the collapse of this crypto-exchange.
Trust – the key point
The situation itself could not have arisen in principle if FTX.com had adhered to the standards generally accepted in the classical world of finance, compared to which some participants in the blockchain industry have positioned it as a more innovative field.
In the November CBR report, “Digital Asset Market Development in the Russian Federation,” submitted for public comment, highlightedthat:
“The application of distributed ledger technology, including blockchain, allows financial market participants to obtain the following positive effects and benefits:
Reducing the role of intermediaries and therefore increasing the speed and reducing the cost of financial services by:
– The possibility of direct user access to the system;
– the possibility of carrying out P2P-transactions without recourse to an intermediary;
– The possibility of using smart contracts, which enable the automation of services, multilateral interaction between members of the same network, as well as the use of individual DeFi tools”.
At the same time, as a result of the analysis of international regulatory experience, the Bank of Russia came to the following conclusions:
Due to the similarity of economic and legal constructions in the framework of the first approach, regulation related to securities (EU, USA, Switzerland, Brazil) is most often applied to digital financial assets.
Stablecoins are generally subject to regulatory requirements similar to those for deposits, money market funds and securities. Requirements for disclosure, financial stability, collateralization, as well as safeguarding reserve assets and independent auditing must be met (US, EU, Switzerland).
E-money tokens and their issuers are planned to be regulated by rules approximating the activities of e-money operators – credit and other e-money organizations (EU).
Another November CBR report, “Decentralized Finance,” addresses attention the following point:
“Often noted in studies, users’ lack of necessary initial knowledge, understanding of DeFi mechanisms and volatility of crypto-assets, and mental willingness to use DeFi may further reduce consumers’ interest in learning more about the decentralized services sphere and lead to unconscious ignorance (underestimation) of risks by consumers, which may also entail loss of a significant portion of invested funds.
These risks are also exacerbated by the average consumer of financial services lacking the ability to independently audit the smart contract code, and the lack of mandatory external audit of smart contracts and requirements for insurance of their performance”.
What was the basis for users’ confidence in FTX.com?
The findings and observations presented by the Central Bank may provide an answer to the question: what was the basis for users’ trust in FTX.com? The crypto-exchange belonged to centralized structures in finance (CeFi), not DeFi, that is, it was an intermediary between buyers and sellers of cryptocurrencies.
Note that even with DeFi, there is still a risk of losing funds because, in the absence of an intermediary, the role is de facto a smart contract whose code must undergo an independent technology audit – this reduces the risk of a smart contract being compromised, but it does not reduce it to zero.
Speaking about CeFi and crypto-exchange FTX.com, its lack of regular public audited financial statements opened the door for some in the cryptosphere to be willing to believe a single publication with alleged information about the numbers that might have been in such statements in the absence of such data.
Among those who did believe was Binance’s management, which concluded on Nov. 6 that they should gradually, over several months, “so as not to harm the stability of the cryptosphere,” sell FTX.com’s native tokens, FTT. One can speculate what other information might have been available to make this decision, but what definitely wasn’t was the stated audited Big-4 public financial statements of FTX.com.
The announced Binance decision itself could not have had less impact on the market than even the sale of FTT tokens: most traders “counted” the signal, and it is not surprising that within hours after the announcement of such decision FTT began to lose value. Once again, it is important to emphasize that the speed at which Binance decided to sell them did not play a crucial role in this change in FTT.
After the decision was announced with the publication of FTX.com’s “private document”, the market reacted in a logical way: the FTT sell-off became significant, which caused the cryptocurrency market as a whole to decline – this happened on November 7-9.
That the trigger for this decline in the cryptocurrency market was the FTX.com factor was shown by the fact that all three major Wall Street indices (Nasdaq Composite, Dow Jones and S&P 500) were showing growth on the same three days. In other words, investors were in a generally good mood and there was no correlation with Wall Street this time.
On November 8 FTX.com stopped processing withdrawals and Binance signed a “non-binding” memorandum of understanding with FTX.com about a possible purchase of the crypto exchange, but on November 9 it was reported that the possibility of such a purchase was declining sharply, all accompanied by assurances from Binance that the crypto exchange was in support of the crypto-sphere as a whole.
Word of mouth
The actions of FTX.com’s founder, Sam Bankman-Fried, are difficult to discuss, as the lack of the above reporting led to his words on November 7 about having the necessary liquid assets not being fully understood by the market either.
It turns out that the words from the publication in the media the market believed more than again the words of FTX.com: in terms of the standards of the classical world of finance, they have the same weight and can not be seen as the final basis for an investor to trust or not trust their money to FTX.com. How did this happen?
In terms of the sustainability of any organization in the financial services industry, trust is key. In FTX.com’s case, the fact that the first information (in the publication) was negative played a role in its downfall, but what was also important was that it was said, albeit gradually, about the realization in the FTT token market by a major player in the cryptosphere and cryptocurrency trading. Together, these two events easily outweighed the positivity that the founder of FTX.com wanted to instill.
Again, the question is not what kind of liquid assets FTX.com actually had, but rather that quite a few crypto exchanges can end up in the same story as FTX.com if they have an Achilles heel in the form of a lack of public financial statements, with an audit report from the Big-4 that would make the company’s net worth calculation available to all and eliminate the possibility of any negative impact of any news blurb about a “private document” with an asset balance sheet – no one would simply believe it given the numbers already confirmed. And no words from the founders or management of crypto-exchanges would have been needed in such a case.
At present, it is impossible to claim that FTX.com collapse was provoked in the interests of specific participants of the cryptosphere, but it is not difficult to foresee that the vulnerability of any companies in the cryptosphere opened to all without reporting will be used in the future in the interests of some investors.
Both in the classical world of finance and in the cryptosphere, many participants of these markets have most of their funds working, i.e. in circulation, invested. That is why in the classical world of finance there is a developed reporting practice which makes it impossible to manipulate investors with messages about allegedly these or those figures of assets and what they consist of – all investors get this information anyway by going to the corporate website of this or that legal entity.
In the cryptosphere, the FTX.com story showed how important it is for crypto exchanges to adhere to the same standards of transparency as in the classic world of finance. The movement in this direction has begun, but it’s not enough. For example, Crypto.com announced that it is starting to publish information about its reserves, and Tether Inc. presented another audit report.
In the case of Crypto.com, there is no audit report at all, and in the case of Tether Inc. for some reason the company again decided not to use Big-4 services, although auditing companies from that group have been providing a wide range of auditing services for cryptosphere participants for years.
Why is the issue of Big-4 audits important? The fact is that they collectively account for about 90% of the global market for audit services, so seeking an audit opinion from them is very logical, especially given their strong brands.
As a number of crypto-exchanges reported their reserves, some experts began to pay attention to the fact that literally immediately after the publication of their data, large amounts of cryptocurrencies began to move from them to other crypto-exchanges.
Some analysts began to conclude that this is how some crypto-exchanges can appease customers by leasing digital assets from other cryptosphere participants, with their consent, to show excellent reserve data, referring to blockchain, and then return them.
However, such an issue in the classical world of finance has long been discussed and a solution has been found. Indeed, any financial statement is a “snapshot” of the financial condition on a certain date, and the next day the composition of assets can change dramatically.
In addition to such reporting with audit, institutional investors have both obligatory and voluntary insurance of clients’ risks, which is not a trend in case of crypto-exchanges yet. In addition, in the case of the financial stability of, for example, banks, this is monitored on a daily basis by the regulator – the central bank, which also determines the reserve requirements and adapts them depending on the external circumstances.
What happened after the FTT token crash?
On Nov. 12, it was reported that FTX.com, which had already filed for bankruptcy and temporary protection from creditors in the United States under Section 11, had been compromised and up to $1 billion in funds had been withdrawn from it by an attacker.
This came even after the Bahamas Securities Commission (SCB), where FTX.com is registered, ordered a “freeze” on the crypto exchange’s assets, as well as the appointment of a bankruptcy trustee. At the same time SCB. statedHowever, SCB did not refuse to impose a “freeze” on the accounts of residents of the Bahamas, and attempts to withdraw assets, it considers as bearing legal risks.
On November 13, Binance announced about delisting a number of FTT-based financial instruments starting November 14.
There are conflicting reports about the whereabouts of FTX.com and Alameda’s founder and management. It has appeared message of interest in FTX.com from the U.S. Securities and Exchange Commission (SEC). The Wall Street Journal discusses in connection with this, what could be happening to the crypto-exchange’s customer accounts.
Potentially, the crypto-exchange could be saved by an infusion of additional funding into it – the total amount of money needed is estimated by some analysts to be as much as $11 billion. It is reported that the founder of the cryptocurrency project Tron, Justin Sun considering about backing FTX.com with “billions of dollars.”
The amount of money required to bail out FTX.com is difficult to estimate, in part because dozens of companies associated with the crypto exchange have turned out to be, and these companies in the FTX.com ecosystem may also testing difficulties with corporate financial stability.
Until recently, FTX.com raised funds from investors. Thus, in the summer of 2022 in another round of funding, which in addition to venture capital funds took the largest regulated cryptocurrency exchange in the U.S. Coinbase represented by the venture arm of Coinbase Ventures, FTX.com has raised more than $ 900 million at a business valuation of not less than $ 18 billion.
Of particular interest in the FTX.com situation was publication Fortune that the crypto-exchange was one of the donors to the U.S. Democratic Party.
What’s happening could be a good scenario for a new Netflix series, but it’s already clear that the FTX.com story has provided additional arguments for cryptocurrency critics, as well as provided more scrutiny of the cryptosphere by regulators in the United States, the Bahamas and other jurisdictions.