That’s the nightmarish trifecta that engulfed the crypto industry last week.
Unless you’ve been living under a rock, you’ll know that popular cryptocurrency exchange FTX has collapsed spectacularly.
You’ll also know the reason for the collapse…
Its founder and CEO, Sam Bankman-Fried (known as SBF), stole customer funds from FTX to prop up his crypto hedge fund, Alameda Research.
This triggered a bank run on FTX. It couldn’t make good on its promise to make its customers whole. And FTX and Alameda are now seeking bankruptcy.
It wasn’t supposed to be this way for crypto.
Its original mission was to eliminate the need to trust centralized financial institutions such as FTX… and protect its users from the SBFs of this world.
Make no mistake: It’s a crucible moment for crypto.
Large parts of the industry have abandoned decentralization. And that’s what made crypto so revolutionary in the first place.
But the FTX collapse is refocusing minds on that core mission. And although it’s hard to see now, that’s long-term bullish for crypto.
Nakamoto is the pseudonymous developer who created bitcoin in 2008.
On October 31 that year, Nakamoto published a white paper. It outlined bitcoin’s mission.
This from the introduction (my emphasis added)…
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. […] A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
I’m sure the irony isn’t lost on you.
Some cryptocurrency exchanges are decentralized. Uniswap is one of the most popular.
They run on blockchains and work peer-to-peer. So transacting parties don’t need to trust a middleman to validate transactions or store their crypto.
If I’m transacting with you across a decentralized exchange (or “DEX”), it’s done directly via our digital wallets.
These are apps for storing and transferring crypto assets.
When you use a digital wallet, only you can access your crypto. The only way you can authorize a transfer is to use a personal cryptographic “key.”
But FTX wasn’t decentralized. It wasn’t governed by code. It was Bahamas-based. And SBF – the biggest fraudster since Bernie Maddoff – had full control.
Turns out SBF’s FTX empire didn’t even have a chief financial officer or a proper board of directors.
Bloomberg reports that FTX Trading International held just $900 million in liquid assets the day before it filed for Chapter 11 bankruptcy.
That’s against $9 billion of liabilities.
Daily Cut regulars know Teeka well. But for newer readers, he’s a former Wall Street insider and hedge fund manager.
He’s also the longest-standing member of the Legacy Research team.
And in April 2016, he started recommending crypto to readers of our Palm Beach Letter and Palm Beach Confidential advisories.
This was back when crypto was still a fringe asset class. Sure, some computer geeks, libertarians, and pioneering investors were interested.
But this was long before there were Super Bowl ads about it. (Those Tom Brady and Larry David ads last year were for FTX). And it was before we named sports stadiums after crypto exchanges.
And from the start, Teeka has stressed how important it is to self-custody your crypto on a wallet instead of trusting an exchange to store it for you.
As he put it in a crypto FAQ he published for Palm Beach Confidential in October 2017…
An exchange is where you can buy and sell cryptocurrencies. A wallet is where you store your cryptocurrencies.
For security reasons, we recommend you hold most of your cryptocurrencies in a wallet rather than an exchange. You should only keep the amount of money you plan to use to purchase other cryptocurrencies on an exchange.
There’s still a lack of regulation of centralized exchanges in the U.S.
That’s why many of them – including Binance, OKX, and KuCoin – are registered offshore like FTX was. This removes many of the protections customers of U.S. banks and other financial institutions have.
It’s kind of like the early years of the U.S. stock market.
Until the 1930s, there was no Securities and Exchange Commission (“SEC”) to regulate the stock market. And there were no rules for brokers about safeguarding customer assets.
So you’d regularly see brokerage firms rise up and go out of business. And you’d see lots of runs on brokers, too.
And due to today’s SEC dragging its feet over crypto regulation, we’re back to a similar situation in the U.S. today.
That leaves customers of these offshore centralized crypto exchanges vulnerable. Teeka…
Centralized holders of my capital? One of the reasons I got into crypto is to escape that risk. I lived through 2008 and 2009 like many of us did. And like many others, I saw how centralized players in Wall Street that had begged us for our trust went on to absolutely abuse it.
That’s the reason why I have so much of my money in bitcoin. It’s decentralized. So I don’t have to rely on trust. It’s also why I’ve spent so much time writing about decentralized finance – or DeFi. It takes the need to trust another human out of the equation.
That could lead to problems with other centralized exchanges… which may or may not be as liquid as they claim.
It’s also going to ricochet through crypto markets.
In the aftermath of FTX’s collapse, bitcoin reached a two-year low when it briefly dipped below $16,000 last week. The CMC Crypto 200 Index, a basket of the largest cryptos, is also trading at levels we haven’t seen since 2020.
We’ll see no end to articles in the press… and posts on social media… about crypto going the way of the dodo.
If you’re invested in crypto – as I know many Daily Cut readers are – this will be an extremely challenging time.
But it’s not all bad news… provided you keep a long-term view. Back to Teeka…
All the attention today is on centralized exchanges and the problems there. But the DeFi market is growing.
Yes, there have been problems there. But those protocols are designed so the problems don’t get out of control.
You can’t borrow more than whatever the smart contract says. It also makes sure all loans are collateralized. So you don’t have these death spirals that end up with these huge debts… and customers paying the price.
I’ll have more for you later this week on why the FTX collapse will trigger a boom in DeFi… and how that will finally bring crypto back in line with its original mission of trusting code, not human middlemen.
Today, if you’re invested in crypto, just know that your crypto assets are safer on a digital wallet than a centralized exchange.
You can find out more about how to do that from the one-page guide Teeka and his team put together for you.
And if you find the prospect of self-custodying your crypto too daunting, Teeka says U.S. exchange Coinbase has the best seal of approval.
It’s publicly listed. So it has extra scrutiny from regulators. And unlike privately held exchanges, it has to publish audited financial statements.
Regards,
Chris Lowe
Editor, The Daily Cut