In the last weeks of 2022, a high-profile fraud case rocked the world of cryptocurrency and cast doubt on the future of a system lauded by many as the future of finance. What does the collapse of the crypto exchange FTX mean for the future of this emerging industry? Cal Poly Orfalea College of Business finance professor Ziemowit Bednarek explains.
How are cryptocurrencies different from other currencies?
Cryptocurrencies are digital assets, unlike traditional currencies. Transactions in cryptocurrencies are recorded on a digital ledger called the blockchain, which is meant to eliminate the intermediaries. What makes the blockchain different from a regular ledger is that it’s virtually impossible to make any alterations to an already-recorded transaction, and the ledger is public knowledge.
The idea was to enable peer-to-peer transactions, which didn’t necessarily require people to trust one another in order to transact. Unlike a regular transaction, you don’t need to trust someone else’s credit rating or accounting practices — all you have to do is trust the cryptography underlying the blockchain.
What is FTX?
The initial idea behind cryptocurrencies was that it was just peer-to-peer — which eliminated transaction costs. Nevertheless, people ended up gravitating towards some sort of entity to facilitate these transactions.
FTX was one of these places where you deposited your cryptocurrency. Your crypto funds went from your personal wallet to your account with FTX, where you were able to exchange it for fiat currencies (e.g., USD), or other cryptos. FTX also played a role of a custodian. Just like with any other bank or financial institution, the cryptocurrency remains the property of its owner.
Of course, fees are charged for transactions, although usually substantially lower than in traditional banking.
What did FTX allegedly do wrong?
Allegedly, FTX’s CEO, Sam Bankman-Fried, was misusing customer funds, to say the least. He bought property. He made political donations with money that was not his. He also propped up a company called Alameda Research, which was owned by FTX.
This came to light recently when the CEO of Binance, another major cryptocurrency exchange, sold his stake in FTX and made some remarks about both FTX’s financial stability and possible mismanagement of funds. Since he presumably had more information than an average investor, FTX’s customers panicked, feeling that there was something fishy going on here.
Customers essentially ran to FTX to get their money, but the company didn’t have it. And because they couldn’t meet their financial obligations of several billion dollars in customer withdrawals, they filed for bankruptcy. There’s going to be a host of lawsuits, both class-action and from individual investors, and I’m guessing that they will either not see a penny, or they’ll see pennies on the dollar at best. And with something that big affecting that many customers, usually federal agencies will get interested.
So, it all goes back to defrauding investors. Whether it’s cryptos or non-digital assets, it’s a tale as old as the world. You have a bunch of investors who were misled after investing their money with a seemingly trusted institution.
What does this case mean for cryptocurrency? Is this the end?
What’s unique in this case, compared to similar scandals in more traditional financial institutions, is the lack of transparency and lack of some sort of a unifying framework of regulations.
Cryptocurrencies are somewhat regulated by a bunch of different federal agencies, and this means that various jurisdictions may have different regulations. Because the industry is so new, bad actors may try to find loopholes where the framework is not well established.
Don’t get me wrong, the traditional banking and investment markets and institutions have suffered a lot of scandals and fraud cases. But when those happen, they eventually tended to lead to new regulations addressing what people did wrong in those cases. As an example, think of Enron and its fallout in 2002. As a result, Sarbanes-Oxley Act was passed the same year. That’s one example of why we have strong regulations in the financial sector. There are limits on what banks can or cannot do with the money, or how much cash banks need to hold on hand, among other requirements.
There have been calls from some people to ban cryptos, but I don’t think that’s going to happen. What I do think will happen will be increased scrutiny and a host of new regulations.
How will this case shape how customers approach cryptocurrency in the future?
There’s a big fallout that we’re going to see play out over the next year or two. It’s going to be televised and we’re going to all be better for it. People will learn more about crypto. Five years ago, few people had even heard of blockchain or cryptos or NFTs. Now people at least are hearing about it.
Crypto-related scams have become a major form of financial fraud in these past few years. Over time, everyone will have heard of FTX and these fraud cases. If more people gain an understanding of how scams like this work, that’s a huge educational benefit to society coming from these events.
Education and scrutiny are only beneficial to financial markets. Financial markets rely and function based on trust. Blockchain-related transactions in cryptos are not entirely trustless, even though that was the initial idea. We’re not there yet.