Bloomberg described it as ‘the worst of its kind‘: a financial bubble that lacks even the faintest of silver linings.
But if FTX’s collapse in November 2022 was undoubtedly the worst possible end to what was already proving to be an extremely difficult year for digital assets, we’d argue this assessment isn’t entirely fair.
While it’s true that FTX’s collapse will cause untold misery to millions of investors, it’s also an opportunity for the digital asset space to re-assess, re-evaluate, and come back stronger.
In our latest 4×4 salon, we discussed the lessons learned in the aftermath of FTX’s collapse, and what the way forward could look like for digital assets in 2023 and beyond.
Rethinking custody
John Ray III, the veteran insolvency practitioner entrusted with overseeing FTX’s liquidation, has blamed the company’s collapse squarely on poor corporate governance.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,” he said in the company’s chapter 11 bankruptcy filing.
This from the man who handled the liquidation of Enron: the poster child for corporate fraud and mismanagement.
Unacceptable practices at FTX, he elaborated, included:
‘…the absence of daily reconciliation of positions on the blockchain, the use of software to conceal the misuse of customer funds, the secret exemption of Alameda [a key trading partner which FTX CEO Sam Brinkman-Fried was also CEO of] from certain aspects of FTX.com’s auto-liquidation protocol, and the absence of independent governance.‘
Inevitably, these findings have raised important questions about the future of digital asset custody.
Where, prior to FTX, self-custody was common practice, Zodia Custody CEO Julian Sawyer observes that ‘we’re now seeing much more segregation… And I think you’re going to get some of the traditional custodians coming into the market.‘
But does this mean self-custody is going to become a rare exception?
Not necessarily, thinks Sawyer.
‘I think what’s happening,’ he explains, ‘is that people are asking the right questions [about custody]: What are the controls? Who owns you? How do you work? What markets are you regulated in?‘
Metaco Chief Growth Officer Seamus Donoghue agrees: ‘… the market is becoming a bit more nuanced,’ he explains. ‘It’s clear not everybody should be doing self-custody. But that doesn’t mean self-custody is never a valid option.’
‘It really boils down to the type of investor,’ concludes Sardine‘s Head of Strategy and Content Simon Taylor. ‘Investors who don’t use their assets for leverage need solid, reliable custodians.‘
Leveraged investors, on the other hand, ‘typically gain leverage by pledging and transferring the title of their assets.’
And in this case, Taylor argues, the counterparty’s creditworthiness is more important than the custodian.
Regulating the right way
If FTX’s collapse has encouraged investors to think more carefully about custody arrangements, it has also provoked strong responses from regulators.
In February 2023, the UK government launched a consultation aimed at strengthening the regulatory regime for digital assets.
Meanwhile, the EU has argued there’s no chance an FTX-style crash could happen in the bloc once its flagship regulatory framework for digital assets — the Markets in Crypto Assets Directive — comes into force in 2024.
But while regulation has the potential to be a positive development for the industry — by creating greater trust and legitimacy, and curbing the scope for abuse — there’s also a risk it could backfire if it isn’t grounded in an understanding of how the digital assets and the blockchain work.
‘Extending existing rules to this new technology… is actually harmful to risk prevention,’ argues Simon Taylor. ‘You have to recognise that this new technology presents both new risks and also new opportunities to be more effective at compliance.‘
For this reason, Seamus Donoghue argues that engaging with regulators is going to be make or break.
‘I think there are some very basic questions that still need to be answered,’ he explains. ‘How are you addressing the risk that keys might be compromised?… Are there any single points of failure in your control processes, and what are they? Is there a risk that administrators could collude to create catastrophic losses?…
‘And then once you’ve identified those new risks, you need to also make sure that this new asset class is integrated into existing controls and governance programmes… not managed as an exception…‘
Equally, though, if regulatory frameworks are to help the industry flourish, they need to lean into its strengths.
‘Decentralised exchanges have definite automation benefits,’ says Simon Taylor.
‘…natively [they’re] a golden source of records of transactions. Everybody has reconciled by default. There are no reconciliation errors. There are no issues of trying to find that piece of paper that happened somewhere in a filing cabinet because it’s all digital… ‘
Leaning into these strengths could actually help make compliance easier even in more traditional areas of financial services, by increasing transparency, providing a clearer audit trail, and reducing or eliminating a lot of manual work.
Out of adversity comes opportunity
In the immediate aftermath of the FTX debacle, enthusiasm for digital assets cooled significantly. Bitcoin, for instance, was down 63% over 2021 in December 2022. And many institutional investors, including historically crypto-friendly ones, took steps to limit their exposure.
And with the ripple effects of the FTX demise still affecting the industry today – such as Signature Bank and Silvergate’s bankruptcies removing a big part of USD crypto on-ramps, increased U.S. regulators crackdown – there is no denying we’re in the deepest, coldest depths, of a crypto winter, the potential of digital assets remains as compelling as ever.
‘Tokenization, for instance,’ says Julian Sawyer, ‘could transform any number of broken industries — cross-border payments, remittances for consumers, supply chain finance… ‘
Similarly, says Seamus Donoghue, ‘there are a lot of applications for many corporate clients… If you have a global cash-intensive business with lots of internal transfers, for instance, using a system like JP Morgan’s JPM Coin could create a lot of treasury efficiencies.‘
So what needs to happen for digital assets to finally fulfil their promise?
‘We need to build institutional-grade infrastructure,’ says Hidden Road‘s Global Head of Business Development Mike Higgins.
‘Anonymity is something that’s attractive, but doesn’t really work for institutions, because it falls foul of AML and KYC requirements… So, going forward, I think we’re gonna see a bifurcation…
‘On the retail side, there’ll be these fully anonymous pools that are really cost effective and efficient… And on the institutional side, I think we’ll see permission pools, where we’ll have an independent auditor come in and stamp wallets to approve them… achieving efficiencies without creating AML or KYC issues.‘
More importantly, concludes Donoghue, it’s time to start building for the long term.
‘Agility is important. But security and compliance — and scaling in a secure, compliant way — should be number one. You want to ensure all processes are fully distributed… that the organisation has the kind of risk frameworks that can manage these assets safely.‘
Want to learn more about the future of digital assets in a post-FTX world?
