The crypto industry lost a lot in 2022, but there’s plenty of optimism it will rebound stronger and better in the years to come.
“When prices were always going up, it became pretty easy for people in general to kind of ignore risk management,” said Schwenk. “With the collapse of Terra/Luna, FTX, Three Arrows Capital, Celsius Network, BlockFi, we've seen a lot of refocus in the industry on risk management.”
For most of the past five years, DAR has preached the need for advisors and investors to vet their counterparties within the digital assets space.
As a free service, DAR offers a monthly general vetting of exchanges. January’s Crypto Exchange Vetting evaluated over 450 exchanges, clearing 18 with a “Vetted” status: Binance.US, bitbank, Bitfinex, bitFlyer, Bitso, Bitstamp, Bittrex, BTC Markets, CEX.IO, Coinbase, Coincheck, CrossTower, Gemini, itBit, Kraken, LMAX, Okcoin and Zaif.
DAR’s big business is working with institutional investors to conduct detailed due diligence on opportunities within the digital assets space.
Today, more of those investors are buying exchange vetting and counterparty diligence services from DAR, according to Schwenk. Instead of vetting one or two counterparties at a time, they are often looking at lists of 10 or more, implying that more investors are considering diversifying around counterparty risk by using multiple exchanges.
“I think this is an opportunity to really raise the bar as an industry, because we’ve had a couple of challenges,” said Schwenk. “A big one is just the immaturity of many of these counterparties. As centralized exchanges grow up, many of them are stubbing their toes along the way. Things are not as buttoned up and put-together as we would like them to be.”
There are also plenty of bad actors in the digital assets industry, according to Schwenk. But differentiating immature actors from bad actors is often only possible in hindsight, after the money’s gone.
The path towards more maturity and trust in digital assets will be paved by transparency. After 2022’s failures, investor and consumer expectations for transparency are going up.
“We’re working on developing and defining what the expectations of transparency should be that are reasonable for the industry to meet at this stage of its maturity, and necessary for those who are taking risk,” Schwenk said. “We’re going to see a lot of solutions to some of these problems being worked out and built out, whether it’s the ability to trade on Binance while your assets are in custody in a separate entity and in theory segregated client funds, or net settlements solutions.”
One of the biggest failed exchanges in 2022, FTX, was not on DAR’s vetted exchange list ahead of its collapse.
“FTX was not on our vetted list, but we definitely had some things that worked, and some things that we could have done better with or that we just missed,” said Schwenk. “We had some immediate fails in our diligence based on public information on FTX, one being the lack of robust [know your customer] and [anti-money laundering] controls – you could actually trade on FTX.com without providing proof of identity, and that opens up the opportunity for wash trading and market manipulation as well as money laundering concerns.”
The opaque relationship with crypto hedge fund Alameda Research was another red flag, according to Schwenk. Attempts to get FTX to clarify its relationship with Alameda were dismissed.
Eventually, Sam Bankman-Fried stepped down from Alameda Research to focus on FTX and the nature of his continued involvement in both firms was obfuscated.
“They were just not very forthcoming,” said Schwenk. “One of the things we got right was in recognizing that there was no clarity into how they were managing those conflicts. You could jump to conclusions and suspect that there was a possibility Alameda was front-running clients or has fast-track access to the exchange – we didn’t know exactly what it meant, of course, but without a policy governing or for managing those conflicts, the suspicions were warranted. You need to have questions about why they weren’t offering to address the issue.”
Other concerns included the likelihood that FTX’s native FTT token was actually a security, and that FTX was potentially running afoul of securities laws.
Read more: The FTX Downfall: Full Coverage
DAR was engaged by a large hedge fund to conduct institutional due diligence on FTX – and when the analysts requested more transparency from the doomed exchange, they were met with resistance.
“We came in with a request for more transparency around the number of what would be deemed confidential materials,” said Schwenk. “This is something we’ve done successfully with CoinBase, Genesis, Hidden Road, Falcon X and a number of more mature centralized counterparties. The response of FTX was that ‘we are not willing to engage in diligence at all, especially given the questions we think you are going to ask.’”
So Schwenk and DAR tried to leverage personal relationships they had with people behind the scenes at FTX, but were “boxed out” of any amount of diligence they tried to conduct.
To see a digital assets exchange interested in courting large clients but unwilling to participate in modest due diligence “screamed red flags,” according to Schwenk.
“When you make those kinds of overtures, the tone and manner of the response, there’s valuable information in that,” Schwenk said. “It lets you know that they’re either immature, or that bad things are happening – and it turns out that it was both at FTX, based on the information we have now.
“I lived through the financial crisis as COO of a $1 billion hedge fund, we did diligence on Morgan Stanley, Goldman Sachs, BNY Mellon, Lehman Brothers, and we stayed out of Lehman because of the inherent risks and didn’t get caught in the bankruptcy,” he said. “Crypto people need to apply the same thinking in times of stress.”