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The Downfall of Sam Bankman-Fried’s FTX: The Industry Reacts

The rise and fall of Sam Bankman-Fried’s FTX exchange has already had a profound impact on the industry. Bankman-Fried is among the most influential political dealers in crypto, and so regulators and politicians will likely notice that the exchange he built has collapsed.

That FTX may (or may not) be bought by Binance, its largest rival and earliest backer, is significant. While Binance has made serious steps towards transparency in recent years, it is also a stand-in for crypto’s seeming intransigence.

No one knows, for instance, where Binance is officially located or how wealthy is its founder, Changpeng Zhao. If Binance acquires FTX – preventing a bank run that it helped foment – questions will be raised. Regulators are already hyper-sensitive to monopolistic behavior in tech, and wasn’t crypto supposed to provide an alternative model?

If there is one lesson from this ongoing crisis, it’s the need for transparency. The irony that Bankman-Fried has advocated for reducing financial privacy and abstruse licensing models for crypto should not be lost – SBF’s Alameda Research and FTX were tied up in dangerous, unsustainable ways the world is only beginning to understand.

See also: The Story of Sam Bankman-Fried's Backroom Deal With Binance

This is a “dynamic situation,” to steal Zhao’s phrase, and can change by the hour. CoinDesk reached out to a number of regulatory, financial and technological experts for their take on what it all means. In short, whatever happens, the effects will be wide-reaching.

The Blockchain Association’s Kristin Smith discusses conversations likely happening on Capitol Hill while former New York State Department of Financial Services regulator Matt Homer breaks down the challenges of global enforcement. Others examine using zero-knowledge proofs to show exchanges are solvent, while some others discuss buying opportunities.

Foreign buyoutsThe ultimate meltdown of the internet market [around] 2001 demonstrated a lot of the interconnections that you might not have predicted, which may be at play here in the possible merger. … Whenever there's a question of Chinese investment in a technologically innovative business, a lot of antennas go up. On the one hand, there's no question the Biden administration has been much more aggressive about antitrust enforcement than we've seen. We saw this with the rejection of Penguin Simon Schuster publishing deal.

[Crypto] is such an immature market that I don't know what the conversations might be inside the FTC [Federal Trading Commission] or inside the Department of Justice. I don’t know how traditional antitrust actors would think about a market that is this volatile [and] that is changing this rapidly.

– U.S. Rep. Jim Himes (D-Conn.), on CoinDesk TV

The Congress conversationIt's important to remember that Binance.US and FTX.US are not part of this deal. So U.S. retail customers should not at least, at this stage, be caught up in the deal that is being negotiated.

That being said, lawmakers are very much paying attention to this because Sam [Bankman-Fried] has spent a lot of time in Washington, D.C., and does personally know a lot of the policymakers. And so it’s going to invite a lot of scrutiny into how centralized exchanges should be regulated. It’s interesting, because what happened with FTX may not be able to be addressed by U.S. regulation.

Congress is very interested, as we've seen this past year, in finding a way to regulate the spot markets and exchanges registered with the CFTC [Commodity Futures Trading Commission] and potentially the SEC [Securities and Exchange Commission]. Part of that could mean having some sort of proof of reserves and guidelines around what you're supposed to do with customer deposits.

There’s an expectation with crypto customers when they're keeping their crypto on exchanges that it’s not being taken and lent out and doing something else, like it would be with a bank. This is going to open up a more robust debate around exchange regulation.

– Kristin Smith, executive director of Blockchain Association, on CoinDesk TV

Regulatory questionsWhile the FTX story is still unfolding, one of the most important lessons we might eventually take from it is that prudential regulation and supervision matters. Let’s break that down. Regulation means rules and requirements. Supervision means ongoing oversight through means such as examinations and reporting. And prudential means safety and soundness, or financial condition.

In contrast to conduct regulators, who care primarily about how you conduct yourself in the marketplace (Are you providing appropriate disclosures? Are you treating customers fairly? etc.), prudential regulators are concerned with the financial health of your company (Are you solvent? Do you have sufficient capital reserves? How susceptible are you to market contagion?).

This type of regulation is especially needed for opaque market actors. And if there’s one thing we’ve learned several times over this year it’s that the centralized crypto players are a pretty opaque bunch. And they’re global, making the web of lines connecting them to each other difficult to determine.

See also: Does the US Government Have a Monopoly on Trust? | Matt Homer

It turns out that for these types of centralized actors having a regulator examine their books and set capital requirements that are commensurate with the risks posed is pretty important. While there’s a lot of talk over which conduct regulator in Washington, D.C., should rule the roost, it seems we’ve forgotten about a more foundational element of regulation and supervision: ensuring a company is financially sound.

– Matt Homer, venture capitalist, crypto adviser and former NYDFS regulator

Discount what SBF has saidIt's incredible how quickly these things can spiral out of control. FTX was the crypto giant offering to acquire the assets of bankrupt crypto platforms (like Voyager Digital) and signing loans to other entities (BlockFi) not that long ago, and now they're sinking.

It was hard not to notice how [Binance CEO] CZ really seemed to be hedging things in his tweets:

"we signed a non-binding LOI, intending to fully acquire FTX."

"we will be conducting a full DD in the coming days."

"This is a highly dynamic situation, and we are assessing the situation in real time. Binance has the discretion to pull out from the deal at any time."

I'm giving it decent odds that the deal doesn't go through, or that Binance threatens to pull out if they're not given very friendly terms. It's remarkable, again and again, how crypto personalities like SBF will claim that everything is fine up until the very second they have to admit it isn't. I think it's because so much of crypto is dependent on the belief that things are going well – as evidenced by the fact that FTX was floating along for quite some time with this overinflated balance sheet until it suddenly became apparent to the public that things were not OK behind the scenes.

Sam's last tweet before the acquisition deal announcement was him saying "A competitor [Binance] is trying to go after us with false rumors. FTX is fine. Assets are fine." It's all very reminiscent of Do Kwon's tweets as Terra was collapsing all around him. "So, is this $UST depeg in the room with us right now?" "Deploying more capital - steady lads"

I'm curious what will happen to Alameda, which as far as I can tell is not included in the Binance deal. They are almost certainly in trouble, and the cascading effects from [the hedge fund’s] insolvency could be massive. I am also curious what effect this will have on crypto legislation. SBF has spent a lot of time in D.C. schmoozing with lawmakers and giving recommendations on possible crypto regulation, acting as the "adult in the room" and the liaison from the crypto industry.

If I was those legislators, I would be questioning a lot of his suggestions after seeing what was happening behind the scenes at FTX that whole time, and it would be another blow to my trust of the crypto industry to see a prominent member of it that I potentially trusted had been on such shaky ground.

– Molly White, crypto skeptic, founder of Web3 Is Going Just Great

Crypto cronyismPerhaps it’s time we take seriously the blatant and obvious conflicts of interest that dominate the cryptocurrency industry.

– Bennett Tomlin, co-host of the “Crypto Critics' Corner” podcast

Privacy-preserving proof of reservesExchanges not adequately safeguarding customer’s deposits has been a recurring theme within crypto. From the early days of Mt. Gox to the recent troubles of FTX (and innumerable events in between), hacks and thefts have occurred leaving consumers holding empty bags.

Transparency and openness have always been the key to operating an exchange. While many exchanges have started the process of providing on-chain proof of reserves, such proofs alone cannot completely solve the problem as exchanges may not necessarily disclose to the public the balances of all their clients.

Even if exchanges redacted private customer information and displayed account balances publicly or, better yet, used secure computing techniques to conceal their clients’ data but proved the sum of the balances, the skeptic could rightfully say an exchange may not be including all information. This scenario reflects the adage of “garbage-in, garbage-out.”

– Matthew Niemerg, co-founder at Aleph Zero

On self-custodyCases like this further emphasize the need for self custody and infrastructure that is built to support decentralization. The near-collapse of FTX also highlights the urgency to hold centralized entities, like [centralized exchanges], accountable for any damage done in such instances.That’s because they’re failing to deliver under its promise to safeguard users' funds. In [decentralized finance] this problem is solved by code. We have self-custody to make sure users aren’t vulnerable when those in charge are being reckless.

– Paulina Jóśków, head of business development at Ramp

Don’t conflate DeFi with CeFiOne of the main reasons we have regulation is to prevent people from being defrauded before it happens. Without regulation, we’d have to rely solely on deterrence by after-the-fact civil and criminal litigation. One inherent problem with this prevention approach, though, is that it’s an enormous amount of work! In the extreme, it’s obviously impossible for an agency to check everything and everyone.

The people most likely to mislead the public are also the most likely to mislead regulators, so a dynamic is created wherein do-gooders bear an increasing regulatory burden while the actual targets of regulation simply lie about adhering to the same regulations.

No doubt, FTX is going to increase regulatory scrutiny of crypto. That’s sad, because the best form of prevention is transparency to the public. Crowdsourcing audits is inherently more scalable than a centralized review, and thus decentralized finance (DeFi) is a long-term answer to this core problem of regulation.

Hopefully, regulators will avoid conflating DeFi crypto with CeFi crypto so they don’t hamstring the solution to the very problem they are trying to solve.

– Mark Lurie, CEO of Shipyard Software

Never use your own token for collateralThe last year has taught the crypto industry, and those investing in it, some harsh lessons about the future of digital currencies – FTX’s troubles only underline them further.

Firstly, never use a token you created as collateral, as FTX, Celsius Network and [Terra] all did. If you create a token, you have to have the cash available behind it for withdrawals. Tether is continually being asked about the assets backing [its stablecoin]. Relatively recently, USDT had 17% of its token redeemed – the cash has to be there instantly.

Secondly, we heard a lot in the run-up to these events about “using capital efficiently.” The liquidity pressures that ultimately led to the situations at these brokers and lenders means all crypto businesses should have large reserves to draw on and certainly shouldn’t rely on borrowing to fund themselves.

Binance’s acquisition of FTX marks a fulcrum for the digital asset industry. This acquisition may have prevented a black swan event, but will it help the industry in the long term? Consolidation of exchanges may be necessary but, as ever, fewer players means less competition.

See also: Why Is Crypto Tanking: The FTX-Binance Drama Explained

Markets have obviously dropped significantly on the back of the news about FTX, but that was to be expected. You wouldn’t rule out further bad news to come. Subsequently, I expect there to be further falls in the value of BTC and ETH, as there will be massive losses from this latest debacle.

– Temple Melville, CEO of Scotcoin

Another great financial crisisI’ll be very happy to see Binance help individual customers avoid losing out from the hubris and bad decisions made by another centralized exchange that positioned itself as a sensible and trustworthy operator.

However, this, like the financial crisis of 2008, demonstrates the need for transparency to ensure that participants in the financial system can make decisions with their eyes open, and for self-custody to ensure that no person or company has to place their assets at risk in order to access financial products and services.

That is the promise and benefit of DeFi, and the reason that DeFi will succeed over the long term.

– Barney Mannerings, co-founder of Vega Protocol

When ‘off-chain activity’ becomes publicThe FTX/Binance situation highlights the risks of poor disclosure. When “off-chain activities” unexpectedly become public, market participants will be shocked. In other financial markets, intermediaries entrusted with client assets are required to regularly file statements of financial condition, which clarify to customers and counterparties the risks they are assuming when transacting with that party.

In DeFi protocols, these requirements are primarily satisfied by the protocols' in-built transparency. Potential users of these protocols can compare protocol transparency and make informed choices. We believe that eventually, intermediaries such as exchanges, brokers and over-the-counter trading providers will use visibility into their financial condition as a competitive differentiator, independent of any regulatory action or requirement.

– Dan Hoover, director at Castle Funds

The deal is not a win for BinanceIt's highly unlikely that Binance will eventually succeed in acquiring FTX. It looks like CZ had a complete victory, but Binance will eventually pay the price for damaging the long-term interests of the industry. The joint statement tells us one fact: FTX has serious liquidity problems or even insolvency, so serious that it can no longer find people willing to save it, and can only turn to the opponents who started this war.

Why would Binance spend money to acquire it? FTX doesn't have a U.S. license (so it's nonsense to acquire FTX to get a regulatory advantage). Acquiring its users or the tech system? Huh. FTX is dead, and its users will naturally choose to go to Binance regardless.

Acquiring FTX isn't a valuable trade, and CZ's goal is already achieved. Even if Binance buys FTX, it's damaging to the industry and a humiliation to decentralization. For Binance, it might be a short term victory written into a case study, but will backfire Binance in the long term.

– Gracy Chen, managing director of Bitget

How to ensure long-term stabilityLiquidity and access to capital is the foundation of a financial ecosystem. Every investor and every innovator who is banking on cryptocurrencies needs to feel secure that there are trustworthy on and off-ramps. We are encouraged by this preemptive move by two titans in the industry to ensure ongoing stability for further, stable innovation.

– Anna Becker, CEO of EndoTech

Another point for BitcoinFTX’s overnight implosion and subsequent forced acquisition by Binance highlights the danger of highly centralized, opaque operations that continue to govern the crypto ecosystem.

Crypto has the potential to change the world in a positive way but will only be able to unlock its full potential to give everyone in the world access to secure digital money once crypto companies start to consistently uphold strong, transparent business practices. Centralized companies like FTX that have tied their fortunes to coins without proven value will ultimately only wrong their consumers and disadvantage themselves.

Bitcoin was created to serve as a secure, independent store of value that is not reliant on any one centralized power. Bitcoin thereby solves the problems that countless companies like FTX continue to encounter by relying on their own tokens. We will continue to see this effect in crypto until companies recognize that they cannot secure their or their clients’ wealth in centralized assets that are ultimately baseless stores of value.

– Alex Adelman, CEO of Lolli

The competitive effectA deal between Binance and FTX may strengthen the monopoly of certain trading platforms. At the same time, the importance of checking exchange reserves is also clearly being emphasized – this will be a top-of-mind topic at least in the nearest month. As a result, weaker players will leave the competition.

– Serhii Zhdanov, CEO of EXMO.com
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