There are many lessons to draw from the collapse of FTX, but above all, the first rule of crypto holds: “Not your keys, not your coins.”
In other words, if you have crypto, self-custody it: Own the private key that identifies you as the valid owner of the funds. Without a private key, essentially, the money isn’t yours because the way crypto works, you’re entrusting your digital assets to the exchange.
In that same vein, if you’re dealing in decentralized finance, ensure there aren’t security bugs or flawed logic in a smart contract that would allow somebody to redirect funds to a wallet or drain a wallet. Because in crypto, when cash disappears, there’s little recourse to get it back, and there’s no FDIC equivalent to protect your money. If you get anything back, you’re lucky.
Compounding the risk is the thinness of the crypto markets, which are minuscule compared to traditional markets, contributing to increased volatility. This, coupled with an exchange that used the money for purposes other than intended, decreases trust and cools the entire sector. FTX, for instance, had its hands in many other crypto projects and companies, increasing the magnitude of the knock-on effect and the crash.
All eyes are on FTX and its CEO, Sam Bankman-Fried. While crypto is still relatively nascent, I expect there will be closer scrutiny and more of a code of conduct for how crypto firms use customers’ funds.
Coming up with a framework for investor protection won’t be easy and won’t be quick. The biggest challenge from the U.S. point of view is that different government agencies view the asset class differently. The Committees and Futures Trading Commission sees it as a commodity. The IRS considers it as property. The Fed and others view it as a potential value store, not a currency. They all have different regulatory mandates and perimeters.
So you have several different regulators – and that’s just from the U.S. perspective – engaged in the conversation. And they have to look in their toolboxes to see what applies to that asset. If they don’t have the right tools, regulators might need Congressional action to expand their regulatory powers. And then you’ll have different categories of regulation applying, and things might be more disjointed if everybody does it independently.
Regulatory harmonization takes time, meaning the space will be fragmented from a regulatory perspective for quite a while. Consumers must educate themselves, and crypto organizations must improve self-governance and transparency.
In the near term, volatility will continue, but clearly, more transparency – perhaps voluntary transparency — is required of exchanges. In the aftermath of the FTX meltdown, some other exchanges released data about themselves to indicate their stability and avoid being dragged down by the domino effect.
FTX’s demise is a setback for the crypto industry, but the magnitude of the setback is hard to gauge. There are two ways to look at it. The good actors will emerge stronger, but it’s still a setback because it suddenly paints the whole industry with a broad brush.
I firmly believe the asset class is here to stay. Bitcoin and Ethereum have demonstrated that you can have a true digital asset class where you can do things that, in the longer term, can help bank the unbanked, speed up cross-border payments and increase other categories of digital assets, like the tokenization of physical assets. It will allow trade execution and currency exchange to happen much faster.
As with cash transactions, crypto comes with the concept of finality: If the cash disappears, there’s little one can do. FTX and other failures have been a setback for the industry. We can expect greater scrutiny, transparency, and regulation. The firms that successfully navigate this will emerge stronger and, hopefully, be the new foundation of this sector.