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John Martin 23 Aug 2023 ◦ 11 min read

Consequences of the FTX Fall for Crypto World: Bailouts, Regulations and Structural Change

Consequences of the FTX Fall for Crypto World: Bailouts, Regulations and Structural Change

The story of the collapse of FTX took a central place in all crypto media, and the chronology and reasons were discussed on various sides, including the details of the personal life of the participants. At the same time, it seems more important to reflect on what is happening and take measures that in the future will prevent or reduce the likelihood of bankruptcy, and therefore customer losses.

Recent scandals in the market have almost destroyed the idea of crypto as a safe haven in turbulent times. But none of these events — from the collapse of TerraUSD to the bankruptcy of Celsius — was as devastating as the news that even FTX, which until recently was considered one of the most successful companies on the market, was unreliable.

In this material, we will try to analyze the potential consequences that may come in the future, both near and relatively far. As part of the discussion, we will look at the problem from three sides: users, market players, and regulators.

Consequences on the Part of Users

FTX, possessing liquidity and capabilities, bought up and invested in various crypto projects it did this with borrowed money. As a collateral for such transactions, FTX used its token. The change in its rate led to the fact that the exchange began to have problems with liquidity. As you can now conclude, in general, the company did not really monitor reserves on its site. When users suddenly began withdrawing funds at the time the token fell, the exchange simply did not have enough liquidity.

As a result of the bankruptcy of FTX, a large number of users suffered — the exact number is currently being established. Radically different categories of customers will probably be represented among the victims: large and medium-sized institutions, retail investors, private traders, miners, arbitrators, other crypto exchanges, crypto projects, and others. All of them lost not only their funds but also their confidence in counterparties. It can be assumed that the change in user behavior will be expressed in the following:

1. Outflow of Funds from Centralized Platforms to Personal Wallets

Logic suggests that after the bankruptcy of FTX, users will be more cautious about choosing where to store their digital assets. Previously, many believed that storage on large crypto exchanges is an adequate alternative to storage on their wallets, as it meets the criteria of reliability, convenience, and recoverability. Now, many will probably reconsider their views on the reliability of exchanges as storage places. This is already leading to the outflow of client funds from crypto platforms. We believe that the process will continue. In turn, a large outflow of client funds, if it reaches the appropriate scale, can become another stress test for industry players, and, perhaps, we will find new holes in their balances.

2. Increase in the Use of DeFi Tools Where Possible

The concept of decentralized finance is based on a progressive idea aimed at consolidating two vectors at once. The first one is the creation of a new financial industry that will replace the traditional market areas: banking, insurance, credit, and many others. Secondly, everyone will have the right to independently control their money without regulators and intermediaries.

Technically, DeFi is needed for maximum democratization of the asset management structure, as well as the creation of new financial trading, investing, lending, depositing, and many other services. Thanks to the blockchain, they will become completely seamless. The vast majority of DeFi applications are based on Ethereum. Although, as technology develops, competitive alternatives appear, for example, Binance Smart Chain.

Because users will move assets from exchanges to their wallets, they will have the question of the subsequent placement of funds. On the one hand, it will be tempting to use liquidity pools to earn passive income, and on the other hand, the choice of a site for conducting exchange operations will not be limited to the place where tokens are stored, but there is also a choice between a centralized and decentralized cryptocurrency or centralized and decentralized site. At the same time, DeFi will win in speed and, sometimes, in price and commissions.

3. Reduced Interest in Exchange Tokens

This consequence is a logical continuation of the two above. The loss of confidence in exchanges will lead to a decrease in interest in their tokens, which, according to the law of supply and demand, should lead to a decrease in the value of exchange coins, which in turn will lead to adverse consequences for those who hold long positions on such tokens or use them as collateral. FTX was not the only exchange that used its tokens as collateral, so if the price of some exchange token changes significantly, this could lead to another collapse of a particular platform.

Market Player Implications

1. Domino Effect

The most obvious consequence is that other market participants started having problems. It is known that FTX had a large number of institutional customers who used the exchange as a purse, hedge fund, or liquidity provider. Accordingly, those companies that kept substantial funds for themselves in FTX can eventually follow the path of the recently collapsed crypto exchange. If these companies stored not only their own but also client funds, then this can lead to rather high-profile crises of solvency in the industry with subsequent bank runs, successful and not. This thesis is confirmed by several announcements that have already occurred about difficulties of varying severity in companies such as Gemini, Genesis, BlockFi.

2. Transparency Efforts

To avoid negative consequences for themselves, market players can begin to form self-regulation practices aimed at convincing users that working with a particular site is safe. This can be achieved by increasing the transparency of the state of assets and liabilities of companies. After the bankruptcy of FTX, Changpeng Zhao devoted several tweets to the need for crypto exchanges to use the concept of "Proof of Reserves," which allows users to disclose information about the balances of the crypto exchange itself, as well as the volume of their obligations to customers. From the discussions in the relevant branches, it can be concluded that it is planned to implement this concept using Merkle trees and evidence with zero disclosure. Without waiting for the development of a ready-made solution, many exchanges published the addresses of their wallets and balances on them.

At the same time, the publication of information on the adequacy of assets for the fulfillment of obligations is likely to be not the only step towards improving the transparency of exchanges. Surely, large players will go further and will disclose other information, for example: the structure and bodies of business management, annual (or other periodic) reports, audit reports, and other important information.

3. Establishment of Stabilization Funds

Stabilization funds may appear soon as a market reaction to the domino effect mentioned above. No one in the industry benefits from a further cascade of bankruptcy or liquidity crises, which requires the development of a systemic solution to support bona fide colleagues who suffered directly or indirectly due to problems with unscrupulous companies. In other words, such funds will most likely be used just to counter the unfolding of the domino effect described in the two paragraphs above and are unlikely to finance projects that have formed a hole in the balance as a result of their incorrect actions.

4. Development of More Advanced Tools: For Storage, Exchange, Trading, and Transactions

Given the expected change in user behavior, developers will probably try to create more friendly, understandable, and convenient products that can replace existing ones. In the same way as Youtube, other streaming services, and high-speed Internet have changed the user experience regarding video viewing, new solutions are quite capable of changing the process of communication between the user and the blockchain in the future. It is difficult to predict what will change, but we would highlight the following promising points of application: key management, interaction with protocols directly from wallets, and transfer of functions of centralized finance to a decentralized world.

5. Strengthening the Role of Security and Technical Audit in Projects

New projects, especially those launching or making changes shortly, will face, at a minimum, skepticism about the fault tolerance and safety of their decisions. If earlier many project founders neglected the need to undergo serious inspections, then in the future teams with serious intentions will seek conclusions from reputable companies or representatives of the community.

Regulatory Implications

The general consequence can be expressed in two words tightening of regulation. It is likely to be more like banking, as the most advanced and closest in spirit, and can be expressed in the following requirements:

1. Tightening of Financial Requirements

The first thing that any regulator will pay attention to in companies operating with customers' cash is their financial condition. As an increase in the threshold for entering and cutting off potentially risky projects, the requirements for the statutory fund of the established exchanges and other centralized projects may increase. This is natural since it is impractical to allow companies with an authorized fund of a few thousand dollars to the market. In addition to the requirements for initial capital, there will probably be requirements for its maintenance, which, most likely, will be expressed in the appearance of equity standards and limiting the loss-making of crypto business participants.

It is naive to believe that financial requirements will concern only absolute indicators. Other standards and restrictions may also apply or start being monitored, such as:

  • a ratio of the volume of owned and raised funds;
  • liquidity ratios;
  • limits of risk (assets) per client, groups of interconnected customers, insiders, and affiliates;
  • the obligation to create and store reserves on accounts and addresses controlled by the regulator and others.

2. Creating/Expanding a List of Reporting and Quality Requirements

This point is a logical continuation of the previous one since it is not enough to develop and implement financial standards — it is necessary to monitor and control the compliance of all market participants with them. In this regard, the regulator will use the familiar practice of obliging market participants to provide prudential reporting. However, obtaining reports for regulators will probably not be enough, since the risk of forgery and deception is high, and it is almost impossible to double-check every report. Therefore, we should expect an increase in the requirements for the quality of reporting by monitoring the adequacy of various indicators, as well as by involving external auditors (auditors) periodically to verify the compliance of companies with their requirements.

3. Establishing the Best Practices of Corporate Governance

In addition to financial regulations, regulators are likely to concern themselves with the quality of cryptographic exchange management and try to introduce best practices from the corporate sector, among which may be the following:

  • presentation of qualification and reputational requirements to owners of crypto projects;
  • presentation of qualification requirements to the top management of exchanges;
  • the establishment of collegial management bodies, both at the operational (Management Board, internal committees) and the above-operational level (Supervisory Board and its committees);
  • mandatory disclosure of certain information, including the facts about the company's managers, business structure, and key financial indicators;
  • implementation of risk management and internal control procedures.

4. Combating the Practice of Multiple Legal Persons

It is no secret that today crypto exchanges actively use the practice of sharing the same platform with different legal entities located in different jurisdictions. On the one hand, this is due to the need to comply with regulatory requirements, and on the other, the construction of customer-friendly financial logistics. It is very difficult to imagine a similar situation in other financial sectors, for example, in banking or insurance in them the regulator, as a rule, requires a separate legal entity operating in the relevant territory. In this regard, a similar attitude can spread to the crypto business, operating the funds of customers.

5. Strengthening the Role of Oversight

With the growth of standards, reporting, and other requirements, the regulator will need to monitor their implementation, so the strengthening of the role of supervision over the activities of crypto projects is inevitable. The essence of the supervision will be to conduct control measures aimed at checking the reliability of the information provided to the regulator, as well as monitoring the key types of risks inherent in the activities of crypto companies. Unlike audits, supervision is usually carried out directly by the regulator (its employees) and is aimed at a comprehensive or thematic study of the company's work. This means that regulators will need to create competent teams that carry out inspections. Quality and number of supervisory measures performed by them will depend on how successfully the regulators cope with this task.

Let's Summarize

The likelihood of certain consequences will depend, among other things, on the further development of events. As for the industry as a whole, the priority at the moment is to overcome the collapse of FTX with minimal losses for all market participants and, first of all, for customers. It is the dissatisfaction of the latter that can push the authorities to apply tough regulatory measures against the remaining crypto companies. However, such companies may begin to engage in self-regulation, creating rules of behavior for themselves, to thus increase user confidence in themselves. In our opinion, one thing is obvious what happened with FTX will not leave the state of affairs in the "as is" position and will become a trigger for changes that, hopefully, will bring the industry into a better state than now.

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