FTX’s Downfall Means More Regulation and a Push for DeFi

• FTX, the crypto exchange once worth $32 billion, filed for Chapter 11 bankruptcy on Nov 11.
• The firm’s liquidity crisis and alleged misuse of client funds leaves a dent on the industry.
• Insider asked 5 VCs about their takeaways from the collapse of Sam Bankman-Fried’s crypto empire. 

Crypto has endured its fair share of blows this year, with the wipeout of algorithmic stablecoin TerraUSD, along with the downfall of the now-defunct and overleveraged hedge fund Three Arrows Capital.

The Federal Reserve’s attempts to combat inflation – leaving investors wary of risky bets – is not doing the space any favors either. Crypto’s market capitalization is down 72% from its record high last November, according to data from Messari on Monday.

This month, however, has presented a new slew of problems for the industry. A crypto empire, started by the once-beloved industry wunderkind Sam Bankman-Fried, collapsed. 

FTX, the crypto exchange reportedly worth $32 billion in February, filed for Chapter 11 bankruptcy on Nov. 11. FTX subsidiary FTX.US, proprietary trading firm, Alameda Research, and around 130 others were listed in the proceedings. In an emergency court filing on Thursday, however, FTX alleged that Bankman-Fried transferred assets to the Bahamian government after the company filed for bankruptcy protection.

How did we get here? Well, Alameda and FTX had unusually close ties for two separate entities.

FTX’s token, dubbed “FTT,” was issued by the exchange as a perk for holders who wanted lower trading fees on the platform. But the token made up an uncomfortably large part of Alameda’s balance sheet, Coindesk first reported on Nov. 2., which ultimately triggered a “run on the bank” for FTX. (Investors were freaking out and withdrew a ton of funds all at once.)

This FTT token was used to precariously prop up Alameda, while the firm misused and traded customer deposits, CNBC reported. Many users of the once second-largest crypto exchange can’t access their funds, causing a devastating impact on the industry.

“I fucked up, and should have done better,” Bankman-Fried tweeted a day before he resigned as CEO of the company he started. 

The quixotic founder stepped down and was replaced with John Ray III, the exec who oversaw Enron’s bankruptcy process. “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,” Ray said in a court document. 

Last election cycle, Bankman-Fried was also the Democratic party’s second-largest donor, according to data from OpenSecrets, spending around $37 million to support various candidates. He held several meetings with top regulators and even attended a congressional retreat. 

“Sam was so popular among institutional investors and even regulators that the news about the FTX’s collapse is known to absolutely everyone in the market,” Vadim Krekotin, a founding partner at venture firm Cryptomeria Capital, said.

A regulatory crackdown and the bull case for DeFi

Insider asked five venture investors about their biggest takeaways from the fallout. The consensus was that a regulatory crackdown is imminent and DeFi, or decentralized finance, could have prevented this.

Prominent government officials quickly spoke out against FTX following the crash, demanding more regulatory oversight in the nascent space.

“It is clear that there are major consequences when cryptocurrency entities operate without robust federal oversight and protections for customers,” Rep. Maxine Waters, the chair of the House Financial Services Committee, said in a statement.

The Securities and Exchange Commission (SEC) and Department of Justice (DOJ) are both investigating FTX for potential civil and criminal violations of securities laws, according to a Wall Street Journal report. “Investors need better protection in this space,” Gary Gensler, the chair of the SEC, said during an interview on CNBC on Nov. 10.

“Regulators will take the opportunity to tighten their grip on the industry, although some were ironically collaborating with Sam Bankman-Fried on a bill to squash DeFi,” Marc Weinstein, a partner at crypto venture firm Mechanism Capital, said.

Many say that moments like this – the fallout of major centralized firms like FTX Group –  only further secure the bull case for DeFi as well. Over the past year, centralized companies such as lender Celsius and digital asset brokerage Voyager Digital both filed for bankruptcy, one for insolvency and the other for restructuring. FTX was the next shoe to drop.

“First, the crypto market is being de-leveraged, which paves the way for the next upturn. Secondly, most poorly managed companies are eliminated, making room for there financially/operationally sound peers to thrive,” Roland Sun, general counsel of blockchain-focused venture firm Fenbushi Capital, said. 

DeFi remains a bright spot in crypto markets as the FTX crisis continues to unfold. 

Using decentralized exchanges like Uniswap and SushiSwap could have prevented the FTX catastrophe because their protocols are on-chain i.e. users can see the way their funds are being used. DeFi lending platforms like Aave operate based on supply and demand so a liquidity crisis would be much more difficult. If Aave, for example, were to have difficulties, its founder couldn’t solely decide the project’s future because it’s a DAO, or decentralized autonomous organization. Token holders vote on Aave’s roadmap instead, mitigating risk for one person to siphon funds from a project.

Yida Gao, a general partner at venture firm Shima Capital, said that the situation shows the “need for non-custodial DeFi even more.” In the chance that the firm goes under, if users custody their funds in a cold wallet, instead of a centralized platform, this could prevent losses as well.

“In addition, DeFi continues to function well as we’re seeing significant trading volume moving to decentralized exchanges like dYdX,” Weinstein said. “Finally, more users have learned the importance of crypto self-custody and new businesses will arise to improve the user experience (UX) around this.”

How could FTX have been avoided? VCs moving forward

Venture investors advise more caution in the next market cycle. Weinstein says to avoid rapid, so-called hot rounds. Venture giants like Softbank notched losses at $100 million to FTX, while Sequoia Capital lost $210 million from its investment in the company.

Gao added that “proper risk management is very important” as well. Risks of FTX’s downfall could have been mitigated with a “hands on approach” by venture investors.

“Frequent check-in with portfolio companies could help avoid some errors in operations,” Gao said. “Always focus on longer term vision when evaluating an investment. Transparency is needed both internally and externally.”

Venture investors, however, say that the carnage is not over yet. Crypto’s market cap will further plummet and many institutions will be wiped out, according to Sun.

“I think it set us back a year. The turbulence and ripple effect of the FTX collapse will continue for at least a few more months — until February-March 2023,” Krekotin said. “We need to be extremely careful and very selective in investing both in new projects and in old projects and tokens. There are a lot of pitfalls that we most likely do not know about yet. And not every participant in the market is ready to admit that they are currently experiencing difficulties openly.”

But once crypto finally hits a market bottom, the industry could come out even stronger. 

“As news continues to roll out, it becomes more clear how bad of an actor FTX/Alameda was. This feels like chemotherapy, killing the cancer, and if the industry doesn’t die with it, then we will only come out stronger,” Weinstein said, adding that soon valuations for companies will also go down.

“It is healthy for the markets to shake out players with poor fundamentals. This will likely continue for several more cycles as the market learns what products work long term and which don’t,” Mason Borda, the founder and CEO of crypto platform TokenSoft, said.