The sudden implosion of FTX was a dark moment for crypto. But it’s also an opportunity to shine a light on some of the crypto industry’s worst practices. What we know about Sam Bankman-Fried’s crypto trading empire is startling, and the situation gets bleaker with every new disclosure.
FTX is likely an outlier in terms of mismanagement and apparent fraud within the industry. But the exchange, once a paragon of trust in this industry, is also emblematic of what can go wrong when crypto strays too far from its founding principles. Its downfall is thus an act of creative destruction – and a path forward is becoming clear.
Shlomit Azgad-Tromer and renowned cryptographer Matthew D. Green are co-founders of Sealance, a blockchain-based trust platform for cryptocurrencies. This opinion piece is part of CoinDesk’s Crypto 2023 outlook.
Crypto’s untamed reputation has limited its ability to grow (perhaps seen by the fact that this year’s contagion event didn't affect the wider financial system). For better or worse, the collapse of some of crypto’s most august institutions make it all but inevitable that new consumer protection and financial stability legislation will soon be coming down the pipeline.
Rather than waiting for regulators to write rules that may not be effective, the industry should harness existing cryptographic tools to enforce compliance and demonstrate good faith. These technologies can ensure that users and regulators can continuously audit the health of various financial entities to prevent trouble before it manifests.
Were controls like these adopted earlier, as they were in many decentralized-finance (DeFi) protocols, the recent plague of illiquidity among centralized cryptocurrency firms could have been avoided.
Just look at FTX. At the most basic level, the company collapsed because of a mismatch between its assets and liabilities. The assets it had were mostly the FTT tokens it created. Blockchain technology could be configured to impose limits on such self-dealing by enforcing and maintaining programmable policies that prevent the overreliance on any one token. Yet instead of using the tools already in their toolbox, industry participants were allowed to cut backroom deals, rehypothecate funds and hide worrying information from their balance sheets.
Blockchains, being fully auditable, can offer a window into a company's or project’s economic health. But this alone is not enough. Perhaps attempting to allay investor concerns, several exchanges have published so-called "proof-of-reserves." This is a step in the right direction, but also a false sense of security. Unfortunately, asset transparency offers no information about liabilities, thus falling short of true financial stability enforcement. And that doesn’t even get into the security concerns revealing information like this may present.
Blockchain-based technology could solve this, too, by mathematically ensuring that appropriate funds are locked up and that asset/debt ratios remain within acceptable limits. Zero-knowledge proofs, a tried-and-true method by which one individual can prove to a counterparty that a given statement is true without relaying unnecessary information, completes the picture. Privacy-preserving audits can enable outsiders to monitor exchange assets and their resilience in the face of adverse scenarios.
There is urgency for the industry to get this right and do so quickly. After all, using blockchain technology for financial compliance would be more efficient and much less costly than comparable compliance costs in banks. JPMorgan Chase (JPM), for one, has reported in the past that one in six of its employees works on regulatory compliance.
Regulation isn't only costly and potentially harmful for innovation, but also limited in its effectiveness. For example, in 2017, we learned that over the course of 15 years, thousands of Wells Fargo (WFC) employees had falsified bank records, forged customer signatures and illegally transferred depositor funds. Yet during this period, Wells Fargo was subject to an increasingly intense regulatory regime.
While what regulation looks like is ultimately up to policymakers, they could consider using blockchain technology to create a certification standard that meets these lawmakers’ criteria. Crypto firms in compliance with this tech-forward standard would be able to declare and prove it to their users and investors. Those entities that ignore this standard would also be known, and their users would be aware of their heightened risk.
Crypto’s recent crises are disappointing, but they were also avoidable. We can use blockchain technology to prevent similar issues down the road, while at the same time enforcing compliance and inspiring market confidence. But without a course correction, the next domino to fall could be the one that cements perceptions and keeps crypto from fulfilling its promise of creating a more just, resilient and accountable economic system.