Cryptocurrency trading platforms like FTX have acquired a sheen of legitimacy in recent years by billing themselves as exchanges — creating an association with staid and trusted financial institutions like the New York Stock Exchange and Nasdaq.
But the implosion of FTX shows just how different crypto exchanges are from their more well known, and highly regulated, counterparts. The latter must abide by strict rules about what they can and cannot do. Crypto exchanges face few such hurdles, especially if they are outside the United States — and most are. They don’t have to disclose how customer money is handled, either to investors or to a regulatory body. Internal financial controls can be scant.
The absence of oversight contributed to what prosecutors said was a yearslong, widespread fraud at FTX, once the crypto world’s second largest exchange. Founded by Sam Bankman-Fried in 2019, FTX used customer funds to finance political donations, buy real estate and invest in other companies, U.S. authorities said this week. FTX filed for bankruptcy in November after being unable to meet about $8 billion in customer withdrawal requests.
By contrast, LedgerX, a crypto derivatives exchange owned by FTX, was based in the United States and was more strictly regulated. It is still standing.
FTX did not respond to requests for comment.
“Where is the industry exposed? It’s still exposed on exchange,” said Nicola White, the chief executive of B2C2, a cryptocurrency trading firm. Ms. White said that B2C2 had limited the assets it held on FTX, but still had a small amount trapped on the defunct exchange.
“We need proof of where exchanges hold our money and how,” she said. “It’s really important.”
The traditional financial industry became a highly regulated one over decades of scandal, fraud and other costly lapses that led to steep losses for customers and wider market contagion. The 2008 financial crisis alone prompted reams of new regulation designed to protect investor assets and limit risk-taking by banks and other firms.
The cryptocurrency industry grew outside of the traditional financial system. It built its market structure from scratch, creating new rules meant to make business more efficient by combining a lot of jobs that are typically separated in more regulated exchanges — such as trading, custody of client assets and trade settlement.
Customers trading on FTX’s main exchange, which was based in the Bahamas, had to send cash or cryptocurrency to the platform before they could trade. Cryptocurrency deposits were sent from a customer’s personal wallet to the customer’s FTX account. If a customer sent funds in cash, the money was converted into “e-money,” according to FTX’s terms of service, which was then used to buy cryptocurrency.
FTX’s terms of service made no mention of how, or where, client assets would be stored. Instead, there was a brief line saying that the legal title of any digital assets passed to FTX remained the property of the customer.
What to Know About the Collapse of FTX
What is FTX? FTX is a now bankrupt company that was one of the world’s largest cryptocurrency exchanges. It enabled customers to trade digital currencies for other digital currencies or traditional money; it also had a native cryptocurrency known as FTT. The company, based in the Bahamas, built its business on risky trading options that are not legal in the United States.
“None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading,” said the terms of service. There was no similar declaration for cash assets.
FTX’s alleged use of customer assets to fund its activities would be highly unlikely at U.S. stock exchanges, which don’t touch any customer money. Instead, stock market investors send their money to a broker who is a member of the exchange and can act on behalf of their clients. Larger institutional investors typically hold money with a custodian bank like State Street or BNY Mellon, sending trade details via their brokers to the exchange. Custodian banks are responsible for protecting investors’ assets, with strict rules on what they can do with them.
The exchange simply acts as a meeting place for buyers and sellers, collecting transaction and other fees for providing the service. Every trade conducted on an exchange contains instructions about what should happen next to ensure that money ends up in the correct accounts and that the ownership of whatever stock is being bought or sold transfers to the buyer.
Most banks are also brokers, catering mainly to professional and high net worth investors. Robinhood, Charles Schwab and other brokerages target retail investors. Exchanges are prohibited from owning brokerages, other than for sending trades to other exchanges if there is a better price for a stock elsewhere. And brokerages can own, at most, 20 percent of an exchange.
The rules are meant to prevent any conflicts of interest that can arise if a brokerage shares ownership with the exchange where the trades happen, and where the broker or its client stand to make and lose money on trades.
In contrast, Alameda Trading, one of the biggest trading firms on FTX that was at the center of its collapse, was also co-founded by Mr. Bankman-Fried. FTX has been accused of using customer money to prop up Alameda’s trading activity. Given the bankruptcy, it’s likely that FTX customers will never get all of their money back.
If a regulated stock exchange were to suffer the same fate as FTX, the separation of duty at different links in the trading chain means that customer money would be less likely to get caught up in the bankruptcy.
“Investor protections, such as the segregation of roles between trading venues, market makers and asset custodians, are a hallmark of regulated exchanges like the N.Y.S.E.,” said Michael Blaugrund, the chief operating officer of the New York Stock Exchange.
The Aftermath of FTX’s Downfall
The sudden collapse of the crypto exchange has left the industry stunned.
- A Spectacular Rise and Fall: Who is Sam Bankman-Fried and how did he become the face of crypto? The Daily charted the spectacular rise and fall of the man behind FTX.
- Market Manipulation Inquiry: Federal prosecutors are said to be investigating whether Mr. Bankman-Fried manipulated the market for two cryptocurrencies, leading to their collapse.
- Parental Bonds: Mr. Bankman-Fried’s mother and father, who teach at Stanford Law School, are under scrutiny for their connections to their son’s crypto business.
- Frantic Exchanges: Texts from a group chat that included crypto leaders from rival companies showed the chief executive of Binance, another crypto exchange, accusing Mr. Bankman-Fried of orchestrating trades to destabilize the industry.
Even tracking customer assets on FTX could prove tricky, because of the limited books and records. John J. Ray III, the chief executive of FTX, told lawmakers this week that he was dealing with a “literal paperless bankruptcy.”
Trading on FTX also differed from traditional exchanges in that not all trades were publicly recorded. While crypto currency transactions are meant to be recorded on the blockchain, a public digital “ledger,” any trading that happened using those crypto holdings within the FTX platform did not get publicly recorded — only customer deposits or withdrawals hit the blockchain. On a U.S. stock exchange, every individual trade is accounted for.
In prepared remarks to U.S. lawmakers in February, Mr. Bankman-Fried said that at FTX, a “key investor-protection principle is making sure there is adequate bookkeeping (and related records) to track the customer’s assets, combined with appropriate disclosure and reporting.”
This was done, he said, “to ensure that whoever is in control of a customer’s assets is not mis-allocating or misusing those assets, particularly in furtherance to their own purposes at the expense of the customer’s best interests.”
The comments, undermined by the now known facts, highlight that written statements are worth little without oversight and enforcement.
FTX’s U.S. derivatives exchange, LedgerX, is subject to more stringent rules surrounding derivatives trading that were introduced after the global financial crisis. Those rules are overseen and enforced by multiple regulators, primarily the Commodity Futures Trading Commission — and abiding by them is arguably what kept LedgerX out of bankruptcy.
Yet FTX had plans to export elements of its trading model to LedgerX. In December 2021, it sought approval from U.S. regulators to use customer money for LedgerX’s own “temporary” needs. The changes weren’t approved before FTX’s collapse.
Other crypto exchanges have since sought to soothe investors’ concerns over how their assets are treated. But it remains a far cry from the assurance, evidence and oversight in more regulated markets.
“What’s the lesson learned?” asked Chris Perkins, president of Coinfund, a crypto investment firm. “The regulated part of the business worked. The other stuff was fast and loose. But even if the regulation is perfect, fraud is fraud. The key is transparency.”
Get Your Free "No Credit Card Needed" Access to GrooveFunnels Here https://obboom.com/traffic
By: Joe Rennison
Title: A Traditional Exchange? FTX Was Anything But.
Sourced From: www.nytimes.com/2022/12/16/business/ftx-exchange.html
Published Date: Fri, 16 Dec 2022 08:00:09 +0000
Did you miss our previous article…