Unpacking the endless FTX nightmare

Seriously, things can’t get any worse, right? ...right?
Nov 12, 20226 min read

Dear Bankless Nation,

Here’s a recap of the biggest crypto news in the second week of November.

Goodbye FTX

What a week.

If you haven’t followed the events around FTX at all, I recapped a play-by-play in The Shocking Collapse of the FTX Empire this past Wednesday on how the chaos has transpired. But crypto moves at the speed of sound, and this week has been moving at Star-Wars-level lightspeed, so there have been plenty of updates since.

A tldr: A CoinDesk article on November 2nd alleged that FTX’s sister hedge fund Alameda Research over-levered in holding way too much of FTX’s illiquid FTT token, and people got scared. Binance CEO CZ subsequently announced he was selling $2.1B FTT, so people got more scared and things escalated to a full-blown panic over the weekend with record withdrawals of ~$8.6B from FTX since the 10th. (See Bankless’s previous article for insight into how users and institutions rushed for the exit.)

If you’d like a more visual recap in the language of The Office:

Where does that leave us?

Binance has pulled out of a potential purchase of FTX, citing reasons of “mishandled customer funds”. SBF confirmed that he lent ~$10B of funds (out of $16B) to sister hedge fund Alameda Research with the use of customer deposits, despite previous claims in a now-deleted tweet that “FTX has enough to cover all client holdings. We don’t invest client assets.”

SBF filed for chapter 11 bankruptcy and resigned as FTX CEO yesterday, but not before apologizing profusely for fucking up.

In response to law enforcement, Tether has frozen $46.2 million USDT on an FTX account.

Justin Sun is offering a 1:1 redemption for all Tron-based assets on FTX (and no, he’s not seriously bailing out FTX).

Due to regulatory pressure, FTX is also resuming withdrawals for users in the Bahamas where it’s based. Because trading on FTX hasn’t been halted, this has produced a million-dollar opportunity for users to indirectly cash out of FTX by “buying” an NFT on FTX’s NFT marketplace with their stuck funds from a KYC’d Bahamas user, which they can then off-ramp from FTX.

Looks like NFTs are finally getting some of the “utility” that users were clamoring for.

Regulatory backlash

Regulators already don’t love crypto, and this week’s events didn’t help much.

The regulatory hawks of the SEC and CFTC are already circling the fresh carcass of FTX, as reported by Bloomberg.

Contrary to initial expectations, American regulators are still unfortunately committed to pushing forth the SBF-championed Digital Commodities Consumer Protection Act (DCCPA) bill.

Washington’s resident anti-crypto senator, Elizabeth Warren, tried to capitalize politically on FTX and got shut down by Brian Armstrong.

The problem of course with Warren’s line of thinking is that the entire fiasco demonstrates more of a failure with the mechanics of traditional finance, rather than crypto. FTX had a giant hole in their balance sheets for as long as they did because their balance sheets were precisely that: a balance sheet that didn’t exist on a publicly verifiable blockchain.

When SEC chair Gary Gensler was asked in a CNBC interview about why they had focused crypto enforcement efforts on smaller targets like Kim Kardashian and small DAOs rather than big players like FTX, he responded, “Building the evidence, building the facts, often takes time.”

I guess Gensler is free to take all the time he needs now.

Tom Emmer also alleges that Gensler was “helping SBF and FTX work on legal loopholes to obtain a regulatory monopoly”.

Wen Proof of Reserves? (right now)

The downfall of FTX is opening a productive conversation around how the industry can improve transparency around centralized exchanges through Proof of Reserves (PoR) audits. PoR lets users verify that centralized crypto custodians actually do hold the funds they claim to hold by matching them to on-chain records, and are solvent.

Here’s how PoR work:

  1. A CEX claims to hold $1B in assets
  2. The CEX lets a third-party auditor take a snapshot of these funds
  3. The auditor aggregates this snapshot into an anonymized Merkle tree
  4. This Merkle tree is untamperable, cryptographic proof that all the funds audited at that time of the audit matches up to on-chain data.
  5. Any user can independently verify that their funds were included in the PoR audit

PoR is an industry standard that has been embraced by exchanges like Kraken, BitMex and Nexo. Many exchanges are late to the game, but the FTX blowup is prompting almost all the major players like Binance, KuCoin, OKX, Poloniex and Huobi into action.

Don’t be misled into thinking PoR is a perfect solution however. It still requires trust in the third-party auditor. Even if auditors can be trusted, it’s also only a routine update depending on how often auditors conduct that audit. User funds that were deposited post-audit won’t be immediately updated and transparent like an on-chain transaction would be on a public blockchain.

Moreover, a centralized exchange can prove that they hold all of the user's funds, but lie on the liabilities side of their balance sheet. An exchange can technically hold all of their reserves 1:1 to customer’s deposits (as it should be in theory), but their liabilities might far exceed those assets, and aren’t solvent.

It’s why it’s called “Proof of Reserves”, not “Proof of Solvency”, even though the point of PoR is to try and prove solvency.

The silver lining is that PoR is a huge step up from the status quo of zero transparency.

If you want to eliminate all risk, move your funds to a hardware wallet. At the risk of sounding like a boomer: not your keys, not your crypto.

Some unimportant Ethereum stuff

Ethereum is officially deflationary as of November 9, which means ETH is being burned at a faster rate than what is being minted.

Bankless livestreamed this amidst the week’s chaos. ETH Goes Ultra Sound | ETH Staker Livestream

Vitalik announces an updated Ethereum roadmap.

Other news:

Opensea launches tools to enforce on-chain royalties

Not financial or tax advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. This newsletter is not tax advice. Talk to your accountant. Do your own research.

Disclosure. From time-to-time I may add links in this newsletter to products I use. I may receive commission if you make a purchase through one of these links. Additionally, the Bankless writers hold crypto assets. See our investment disclosures here.

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