What is Happening In Crypto, What Happened to FTX and What Does It Mean for Web3? An upheaval of "crypto giants" have ultimately failed to protect consumers, breaking trust in the developing world of Web3. Why is this happening and what is next?
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FTX today. Celsius and BlockFi yesterday. A seemingly unending upheaval of "crypto giants" who have ultimately failed to protect consumers, breaking trust in the developing world of Web3. Why does this keep happening, and will there be more?
First, the "why?" and then "who's next?" (the short answer is 'yes' there will be more).
Why do these cryptocurrency giants keep falling apart? The answer is a combination of greed and incompetence on the part of crypto exchanges and lenders combined with improper (or lack of) regulation. It all comes down to "balance sheet assets."
Why balance sheet assets matter
In the US, we see crypto exchanges and others obtaining simple money-transmitter licenses and holding investor assets (cash, crypto, securities, NFTs, etc.) on their balance sheets. Offshore, these entities have either no licenses or money-transmitter-type licenses that permit them to hold customer assets on the balance sheet. This means those assets are the exchange's property (or lender's) property.
The customer's assets become unsecured liabilities on that balance sheet. Now, since these are company assets, the company can use those for its benefit. They can lend them, invest them and do other things to juice corporate returns, which can go down in flames. And if a company goes out of business, others may have a superior claim on those assets over investors, including the government (taxes, fines), debt holders, and secured vendors. Customers get whatever might be left — if anything.
Balance sheets and FTX
In the case of FTX, they are short $10 billion, which means that they made investments with the assets on the balance sheet to try and make money for the company (not the customers.) Then those investments went south, and there aren't enough assets to cover investor accounts (unsecured liabilities on the balance sheet).
The CEO said, "I'm sorry, I f***'d up," which is true to the tune of $10 billion but never should have been permitted by regulation in the first place.
Regulated entities that hold customer assets
There are three types of "qualified" custodians — or firms that are regulated and required to take care of their customers:
- Trust companies
- Clearing brokers
Trust companies and clearing brokers can NOT hold customer assets on their balance sheets. They must keep them "FBO" (for the benefit of) customers. This means they can not comingle customer cash or other assets with company cash or assets. They have to be segregated. They can not be used or misused. And no third-party creditors have any claim on them.
If a trust company or clearing broker fails, their regulator ensures an orderly transfer of assets to another financial institution. 100% of assets.
Banks can hold customer assets on their balance sheet and invest them in making profits. This includes lending, stocks, bonds, life insurance pre-funds, credit card advances, letters of credit, etc., all using customer assets. If a bank makes terrible investments and fails, then, in this case, the FDIC steps in and makes up the difference between assets on the bank's balance sheet vs. customer liabilities (up to $250,000).
This is why the FDIC has onerous regulations on what banks can and cannot invest in and how much of their balance sheet they can invest into any particular thing, no matter how good it seems. It is tightly restricted, controlled and regulated.
Regulated entities and non-traditional assets
Clearing brokers generally don't hold private securities or tokenized assets (including cryptocurrency). There are a variety of deliberate and nuanced regulations that make it impractical for them to do this. Banks can not hold tokenized assets on their balance sheets, only in their trusts. While very few of those have the common forms of cryptocurrency (Bitcoin, Ethereum), none hold the vast array of cryptocurrency, private securities, real estate interests or tokens representing rewards programs, health care records, event tickets, collectibles, etc. That leaves trust companies as the only qualified custodian.
Money transmitters — a risky regulatory loophole
There is currently a regulatory loophole resulting in billions of dollars in consumer losses. A money transmitter is a state-by-state licensed entity originally intended for firms moving small amounts of cash point-to-point between people (which might temporarily land in the money transmitter's account).
Money transmitters carry these customer assets on their balance sheet instead of trust companies and clearing brokers who do not. Thus, the crypto industry has leveraged this loophole to get "licenses," enabling them to hold assets on their balance sheets, and they can do stupid things with other people's money. The regulation allows for this behavior.
So, who is next?
Ah, the multi-billion dollar question. There will be others. FTX is a giant shoe, as were Celsius and BlockFi. Brace yourself for more. By way of example, let's talk about Coinbase.
Coinbase issued a statement saying, "a note to the financial statements explains that as of June 2022, Coinbase has taken all customer assets onto its own balance sheet... it still has $12bn of its own and customers' cash (both on its balance sheet)."
The first thing that hit me when I read that was, "why the heck would they do that?!" They own a trust company, so why wouldn't they keep all customer cash and crypto at their trust company to ensure it's safeguarded and protected? Why would they put all those assets on the exchange, which only has money-transmitter licenses?
I can only imagine that they can't use other people's money and crypto for their benefit if it's at the trust company, but only if it's at the exchange. Maybe there is something else, but I don't see it. So the natural question is, "what exactly are they doing with those customer assets?" Possibly no different than what FTX was doing, maybe not. Without proper regulation, we can't know for sure.
They might claim the assets are protected under UCC Article 8. Still, my understanding is that the protection is meant to apply to securities and, even then, attempts to put customer balance sheet liabilities ahead of other creditors on available assets in the event of company failure. It does not prevent the company from using customer cash and assets for its own interests and potentially losing those (like FTX.) So Article 8 wouldn't matter much even if it is held to be applicable in a disaster scenario.
Yes, any firm operating as a simple money transmitter, what I call a pseudo-custodian, is capable of doing these things — which is all crypto exchanges that don't use a trust company, whether their own or independent, all crypto lenders, etc.
I respect the teams at Coinbase, Binance.us, Zero Hash, Bittrex, and other such money transmitters. I have no idea if they've used or misused customer assets or done anything intentionally ignorant or wrong. Maybe they are being as safe as they know how. But when you are permitted by lax regulation to use customer assets for your benefit, greed almost always prevails.
Protect yourself and your customers
How? Easy. If you have cash, crypto, NFTs, or other assets at any of these pseudo-custodians who operate with money-transmitter licenses, get it out of there. Now. Right now. Move it to a qualified custodian or self-custody. If you are a business working to bring crypto, digital assets, or other Web3 initiatives to your customers: only partner with a qualified custodian.
Next steps for the industry
Regulation is (finally) coming. Legislation is coming. We, as an industry, don't want another Dodd-Frank or Sarbanes-Oxley knee-jerk reaction that overcorrects a problem. The CEO of Fortress Trust, Albert Forkner is going out to work with members of Congress, including Senators Lummis and Gillibrand and Representatives McHenry and Waters, as they craft legislation. They will also work with the SEC, CFTC, CFPB and other government agencies on sensible regulation.
In the meantime, we're advocating for the states to modify their money-transmitter regulations to immediately retract and cancel licenses from any out-of-state entity other than trust companies, banks and clearing brokers.
Regulation leads to the blue ocean for Web3
Not in the slightest. The tokenization of rewards programs, real estate, healthcare records, insurance receivables, securities, event tickets, estate records, music, film, sports, photography, books, art and everything else electronic in the world is continuing without delay. These things — tokenized — so the blockchain acts as the ledger of record, are not cryptocurrency. Every company has Web3 initiatives, which will utterly transform the world as the internet did beforehand. Blue ocean continues for those in this space working to build for scale.