FTX Offers a Master Class in Crypto's Flaws

In one sense, investors and regulators should be grateful to Sam Bankman-Fried, the erstwhile head of the FTX cryptocurrency exchange. The spectacular flameout of his virtual empire has evolved from a cautionary tale into a master class on everything that’s wrong with crypto markets.

As customers and creditors sort through what remains of the failed exchange’s holdings, and as the repercussions spread throughout the crypto realm, here are four lessons that stand out:

• Beware of assets denominated in crypto. FTX was vulnerable not only because it was leveraged, but also because its assets weren’t really assets. Judging from the balance sheet that the company reportedly sent potential rescuers, they consisted largely of notional digital tokens. Unlike stocks, bonds or commodities, they had no associated cash flows or practical uses. At best, they represented fee income from trading other similarly made-up tokens. The same applies to just about all digital tokens, the primary “assets” of the exchanges and other intermediaries through which most people interact with crypto. They’re pure speculative instruments. Something like them might someday prove useful as representations of traditional assets, or as assets in virtual worlds, but that’s a distant prospect. As things stand, they’re fundamentally worthless.
• Market capitalization is not value. If a company has 100 beads and sells one for $1 million — maybe to itself, maybe to someone to whom it loaned the money, maybe to a true bead believer — it can say the beads have a market capitalization of $100 million. This is roughly how Bankman-Fried came up with an estimate of more than $10 billion for FTX’s holdings of digital tokens including FTT, Serum and Solana. It also helps explain how the entire crypto market at one point achieved a supposed capitalization of about $3 trillion. Clearly, those beads aren’t worth $100 million. Attempting to sell them all might yield nothing. Anyone who accepted them as collateral might end up with nothing, too.
• Accounting matters. Cryptocurrencies on public blockchains are highly transparent: Everyone can see what belongs to whom at any time. Not so crypto intermediaries. They don’t publish financial statements audited to generally accepted standards (with the exception of Coinbase, a public company). Before FTX’s demise, investors and customers had little idea of what was going on beyond some not-so-reassuring tweets from Bankman-Fried, such as “assets are fine.” Now they’re puzzling over a balance sheet with entries such as “hidden, poorly internally labelled ‘fiat@’ account” and “TRUMPLOSE.” Some intermediaries have promised better disclosures in the wake of the FTX fiasco. But given the lack of standardized rules, there’s little to ensure their accuracy. What’s really backing the stablecoin Tether remains uncertain, despite the issuer’s regular reports. Customers have no reliable way of knowing how leveraged big exchanges such as Binance might be, executives’ assurances notwithstanding.
• Consumer protections are essential. Billions of dollars in FTX customers’ funds have effectively gone missing, lost to a tangle of entities and at least one apparent hack. This was possible in part because FTX — with the exception of its US derivatives-trading subsidiary — operated in a regulatory vacuum, with none of the requirements governing capital, liquidity, segregation of funds, cybersecurity or conflicts of interest that traditional intermediaries must meet. The same is true of just about every intermediary in the crypto world. Sometimes authorities take one-off actions, as the Commodity Futures Trading Commission and the Securities and Exchange Commission have done in relation to false reporting, “wash” transactions and insider trading at Coinbase. But there’s no “cop on the beat” making rules and enforcing compliance.

Whatever the potential benefits of crypto, the surrounding speculative frenzy has little to do with them. On the contrary, it primarily serves to lure people in and separate them from their money, as FTX has now demonstrated. Proper regulation might help nudge crypto in a more useful direction, and is needed to ensure it doesn’t present a threat to the broader financial system. Meanwhile, the message for investors and traditional finance remains simple: Stay away.