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Mark Twain is alleged to have said: “History never repeats itself, but it does often rhyme.”
The recent events surrounding FTX show that the crypto world is susceptible to the same risks as in traditional finance, but with the difference of not having any regulation in place to protect investors.
Financial commentator Frances Copolla explained how there can be a run on a crypto exchange.
She wrote: “The young, dynamic, ambitious owner of a crypto hedge fund – let’s call him “Joe” – sets up a crypto exchange. To start with, this just enables his hedge fund to trade without having to pay margin or exchange fees.”
However, he can earn more money by transferring customer assets on the exchange to the hedge fund and replacing them with a token issued by the exchange. This works while the token holds its value and is liquid but stops working if the token falls in price and customers want to withdraw their assets from the exchange en masse.
“For a big exchange, the gap between assets and liabilities can easily amount to billions of dollars,” Coppola added. “There is no way of recovering from it. Injections of funds will merely delay the inevitable. It is a crisis of solvency, not liquidity.”
Vetle Lunde, an analyst at Arcane Research, said this is a defining structural shift in the crypto market.
He wrote: “I admired FTX and Sam, a group of quants finding gold in a BTC-related FX arb with the yen, using the fortune to launch an exchange behemoth. I am sorry for not being able to expose their vulnerable model and not pointing fingers at the iffy structure between Alameda and FTX.”
Lunde continued that Sam Bankman-Fried, founder of FTX, has also been the institutional darling of the industry
“FTX’s series B featured BlackRock, Tiger Global, Temasek, Sequoia, VanEck, and the Ontario Teachers Pension Plan to name a few,” he added. “Not finding crypto investments worth the risks would be a natural reaction from TradFi giants providing capital to FTX, who likely was deemed as the most trustworthy character in the space up until recently.”
Traditional exchanges are also likely to benefit from the latest meltdown of a crypto-native marketplace as they did after the 2008 global financial crisis. Regulators then pushed standardized derivatives to move from over-the-counter markets to being centrally cleared and traded on exchanges.
Since the issues with FTX, Cboe Digital Assets has published a letter highlighting its customer protection policies, the benefits of regulatory oversight and the value of including intermediaries in its marketplace.
CME has been experiencing record trading volumes and open interest in its suite of crypto derivatives despite the crash in crypto values. When CME launched options on ether futures in September this year Rob Strebel, head of relationship management for DRW, said the market maker was happy to provide liquidity on day one because the exchange has proven trading and clearing infrastructure.
Nasdaq is building a digital asset custody for institutions, which is aiming to launch next year, subject to regulatory approval. Ira Auerbach, head of digital assets at Nasdaq, has said custody is foundational to providing a trusted institutional platform.
In addition, in 2021 FTX purchased LedgerX, which has been rebranded FTX US Derivatives, and gained a CFTC-regulated designated contract market, swap execution facility and derivatives clearing organization. FTX US had applied to CFTC to offer central clearing of margin products directly to retail customers and replace the traditional distributed risk clearing model involving fixtures clearing merchants (FCMs) with an automated and centralized process that does not use intermediation. This has been opposed by derivatives exchanges and clearinghouses as too risky, and they have been proved right in doubting FTX’s risk management capabilities.
After this crypto financial crisis, it seems likely that institutions will only trust financial market infrastructure providers with long, proven track records of resilience and safety. History is set to repeat itself.
