The end of 2022 has not been kind to the crypto space. The melting of the FTX exchange, along with the high-profile collapses of many currencies, have caused many investors to think twice about their positions in the sphere.
Kellogg Insight caught up Sarit Markovicclinical professor of strategy and fintech expert, to discuss what happened, what we can learn from it and where the industry can go next.
This conversation has been edited for length and clarity.
Kellogg INSIGHT: Can you give us some background on why the FTX crash is so destabilizing in the Crypto space?
Sarit Markovic: When we think of FTX, it was really the darling of the crypto space in the sense that it was considered one of the most secure and lobbied for regulation. And Sam Bankman-Fried donated to so many different charities and politicians. FTX was definitely considered a very stable spot in a very volatile world. For them to crash — or do fraudulent activity — is what really shocks a lot of people and has a huge negative effect on the entire crypto world.
The other thing to understand is that FTX is a centralized exchange. FTX is like the New York Stock Exchange, except instead of allowing you to buy and sell stocks of large organizations, it allows you to buy and sell crypto. They are a custodian, meaning they keep your money. And that’s where a lot of issues come from.
In a decentralized project everything is transparent. Some projects don’t keep your money, your information, your data. You have your own wallet where you keep everything you want to keep. And then if you want to perform any kind of transaction, you are the one who authorizes it and no one else has access to it. Someone would need your password—your keys—to access your wallet. Who owns your money is fully transparent, so if there is any fraudulent activity, everyone can see it and know who did it.
So there are also decentralized crypto exchanges – Uniswap, SushiSwap – which have no problems in terms of fraud. There may be hacking but they are not performing any kind of fraudulent activity. And that’s because he’s not a custodian. they don’t keep your money. You just use them to trade different cryptocurrencies. But they can’t take your money and use it for something else because it’s a decentralized exchange.
In a way, we have here a breakdown of a centralized system that needs to be fixed. There is no doubt that it needs to be regulated. However, because regulators are still trying to figure out how to regulate encryption, it is not regulated. This allowed FTX to do what it did.
INSIGHT: So to clarify, FTX is an exchange — but did it have its own token?
Markowitz: Yes, it’s called FTT. And if you kept their coupon, you would get a discount on some of their fees. Because it was considered such a successful company, there was a lot of demand for this token, so its value increased. People traded FTT like you would normally trade any kind of stock or crypto.
So FTX has an investment arm, a sister company called Alameda. And in early November, crypto publication CoinDesk realized that Alameda’s assets are mostly in FTT. They hold a very large share of the total FTT tokens. So if they sell FTT, then its price would crash, and that means overall their balance sheet is worth less than they claim. This in itself is not a scam, but it raised suspicions that something was amiss.
Once CoinDesk After the news that Alameda did not hold enough reserve funds, Binance, which held a lot of FTT, said: “We will sell our FTT.” And then it was clear that it was going to have a huge effect on the FTT price—and that’s when it all started to fall apart.
We later learned that Alameda also invested in ventures, but required those businesses to keep their money in FTX, which was then loaned back to Alameda to invest in other projects. And furthermore, FTX gave Alameda loans that were actually their customers’ money. It’s really Bear Stern: it’s really a scam what they did.
And that’s exactly what we know today. There may be more going on.
INSIGHT: So obviously this doesn’t happen entirely in isolation. Many cryptocurrencies have crashed in the past year. I was wondering if you could approach this for us. How do investors feel about crypto? Is it an existential crisis if you can’t trust coins? If you have Terra LUNA lose more than 90 percent of its value and you have exchanges that are fraudulent, does crypto have a future?
Markowitz: I definitely think there is a future for crypto. In a way, these events are going to benefit the crypto world because there is a need for regulation and trying to get it as quickly as possible will be helpful. It would also push the market more towards DeFi, towards decentralized projects that are fully transparent.
It is true that now regulation will probably be tighter than it would otherwise be. But regulation that helps stop fraudulent activity and Ponzi schemes benefits the entire industry.
INSIGHT: So part of it is these purely speculative cryptos. Like, “Hey, I’ve got this new token! It’s called TOKEN. Now get in on the ground floor where you can get it cheap.”
Markowitz: Exactly. This is like Dogecoin – there is nothing behind it. But then you have a token like Ethereum, which is used to perform different activities on the Ethereum network. The Ethereum network does a lot of cool things in terms of enabling different types of transactions and transactions that create value.
The problem is that many small investors or amateur investors are just looking for quick returns. They often don’t know how to distinguish between decentralized and centralized projects and don’t do their due diligence to understand what’s behind the coins. They cannot answer what a particular token is worth or if they believe it is going to create and sustain any kind of value.
The regulation will likely be stricter than it would otherwise be. But regulation that helps stop fraudulent activity and Ponzi schemes benefits the entire industry.
— Sarit Markovic
The sad part is that even many VCs don’t have a good understanding of the entire industry and get it wrong.
Now FTX was something completely different. If FTX wasn’t doing fraudulent activities, then overall a centralized exchange could be a great investment and a great project. So you can’t really blame the market here. There was no way of knowing that FTX was loaning its investors’ money to Alameda. This is where a regulator would have to come in, otherwise the transparency that comes with decentralization would be of great value.
INSIGHT: It sounds like the community is divided right now: you have some companies pushing for regulation very strongly, and others saying we just need better ways to deal with encryption.
Markowitz: Yes, exactly, there are those who are trying to build a parallel ecosystem that is decentralized and unregulated and those who believe that regulation will allow cryptocurrencies to become mainstream.
The latter’s thinking is that once it goes mainstream, you’ll be able to do a lot more than what you’re doing now, because you’ll have more funding and more customers. There will be a much larger ecosystem.
But many of the decentralized projects felt that this would hurt them, because when you think about trading in crypto, for example, there are a lot of high-frequency traders. So there are many cutting edge actions that will be illegal if the market is regulated. Regulation would take away many of the opportunities that are out there.
INSIGHT: Taking a step back, how do you think the collapse of FTX will affect the future of crypto? How does this change the trajectory of the industry?
Markowitz: We’ve had meltdowns in the last year, but many felt that was because the projects just weren’t legal. If you wanted to know more about Luna, you could read their white paper which is available for everyone and do the analysis. Then you could have understood that when the market is high, they will do well, but when the market is down, they are not. With FTX, you couldn’t really see what they were doing with the funds. This is the difference between centralized and decentralized projects — and most of the recent crashes like Celsius, Three Arrow Capital or BlockFi are centralized projects. Since many don’t realize this difference, they consider them as encryption failures. So this will slow demand. Investors will not be as likely to invest.
It also means that regulation will come sooner rather than later — and it will be stricter.
My concern is whether regulators will understand that regulation for centralized and decentralized projects should be different. You don’t want to just set the market and think of crypto as crypto. There are different types of projects that need to be set up in different ways. Too strict rules are not going to allow the DeFi world to be as innovative.
INSIGHT: If I don’t think I care about crypto at all, can you give me an example of one of those projects that you think is really neat and has the potential to have an amazing impact on the physical world that you think DeFi is enabling?
Markowitz: Decentralized exchanges like Uniswap and SushiSwap are very good. If you think of crypto as a stock, the fact that I can buy a stock from you without going through a broker and without paying high fees makes everything more liquid. I think this is great.
Another project that I think is great is MakerDAO. They give loans that are secured but do not require any kind of AML KYC [anti-money laundering and know your customer checks]—which means you don’t have to prove that you have a lot of money or who you are. If you need the money, then MakerDAO is going to lend it to you if you put up the necessary collateral.
There are ways in which it is played – and there are efforts to limit the type of gaming that occurs – but as an idea, using DeFi to help people who are struggling to borrow money is interesting.
Cross-border payments are another issue, with their high fees, which crypto can make so easy.