What does crypto look like after FTX?

Not only has the collapse of FTX and its sister company Alameda Research created a cascade of crypto entity collapses and suspension of withdrawals but has initiated an intense debate about the future of the crypto ecosystem. How would the crypto ecosystem be changed following the collapse of FTX?

As we argued previously the collapse of FTX is likely to increase investor and regulatory pressure on crypto entities to disclose more information about their balance sheets, to safeguard client assets, to limit asset concentration and will induce more diligent risk management including management of counterparty risk among crypto market participants. FTX in particular had been preferred over Binance by institutional clients such as hedge funds, so the past weeks events will likely change the way institutional investors interact with exchanges to ensure their assets are protected. Here are the main changes we envisage post FTX:

A) Existing regulatory initiatives already underway are likely to be brought forward. The European Union’s Markets in Crypto Assets (MiCA) bill which has passed most of the EU’s legislative processes except the final approval by the European Parliament. This final approval is likely to take place before year end. After that there would transitional period of up to 18 months before the regulation takes effect at some point in 2024. In our opinion the past week’s events could if anything lead to pressure to reduce this transitional period. As a reminder to our readers MiCA brings crypto assets and markets under the supervision of ESMA and the European Banking Authority and introduces important rules for the crypto industry: marketing guidelines for crypto companies issuing crypto requiring them to provide detailed information about their project, it regulates mining companies by requirement them to disclose energy consumption, it mandates stablecoin issuers to maintain ample liquidity in the form of deposits to prevent crashes like that of Terra USD, it imports rules from existing equity market regulations on market manipulation and investor protection including AML rules that require crypto transfers to include data on the payer and the payee. It also restricts stablecoin issuers on how many tokens they can issue if they are not denominated in euros or other EU currencies and introduces a transaction value cap of 200m euros per day for non-euro stablecoins. This cap is likely to have important implications as most of the biggest stablecoins such as Tether and USDC are already exceeding the proposed cap. Under MiCA, cryptocurrencies are divided into four categories: crypto-assets, utility tokens, asset-referenced tokens and electronic money tokens (e-money); these will be regulated in accordance with their classification. NFTs which serve as financial instruments such as tokenized bonds or equities will be regulated as securities under existing securities law while those such as digital art and collectibles would not fall under MiCA. It is worth mentioning that crypto-assets that are already regulated by existing EU financial services regulations will not be covered under MiCA and will remain under the existing framework.

The US has lagged Europe in terms of regulatory initiatives and has yet to introduce similarly comprehensive rules. To some extent this reflects fragmentation and disagreements among US regulators. Having said that there have been several regulatory initiatives in the US Congress (i.e. the Responsible Financial Innovation Act, the Digital Commodity Exchange Act, the Digital Commodities Consumer Protection Act, the Stablecoin Innovation and Protection Act, the House Financial Services Committee stablecoin bill) not necessarily consistent with each other. US regulatory initiatives attracted more interest following Terra’s collapse as there was perceived need for increased oversight and consumer protections. Our guess is that there would be even more urgency following the FTX collapse. A key debate among US regulators centers around the classification of cryptocurrencies as either securities or commodities. The SEC Chair has been resisting the need for special rules for the crypto industry as he argues that most cryptocurrencies should be classified as securities and should thus be regulated under existing securities laws. Crypto intermediaries such as exchanges, brokers-dealers and custodians should be under the SEC purview and should be registered accordingly. Stablecoins could also be classified as securities depending on how they are pegged. The SEC chair has also suggested that the oversight of cryptocurrencies (and their intermediaries) such as bitcoin that are not classified as securities but rather as commodities could fall under CFTC. Instead the CFTC Chair, which regulates the U.S. derivatives markets, had previously argued that at least Bitcoin and Ethereum should be classified as cryptocurrency commodities and that the CFTC should be assigned with spot market authority over cryptocurrency commodities. Following the FTX collapse these differences are likely to be bridged with perhaps bitcoin classified as commodity and the vast majority of the other cryptocurrencies classified as securities. Irrespective of the classification mix, the CFTC will have a prominent role in the cryptocurrency space as the regulator of cryptocurrency derivatives markets. Regarding stablecoins, the most recent initiatives and momentum points to Federal Reserve rather than OCC oversight over stablecoin issuers with new reserve requirements to protect customers in the event of insolvency.

B) New regulatory initiatives are likely to emerge focusing on custody and protection of customers’ digital assets as in the traditional financial system. In the meantime, until these regulations come into place, both retail and institutional investors are already taking steps to protect their digital assets. The FTX collapse has already sparked an increase in crypto self-custody with hardware wallet providers such as Ledger and Trezor seen an exponential increase in sales in recent weeks. But the main beneficiaries post FTX collapse are institutional crypto custodians with large balance sheets and established reputation. Over time these trusted custodians will likely dominate over relatively smaller crypto-native custodians or crypto exchanges.

C) New regulatory initiatives are likely to emerge focusing on unbundling of broker/trading/lending/clearing/custody activities as in the traditional financial system. This unbundling will have most implications for exchanges which like FTX combined all these activities raising issues about customers’ asset protection, market manipulation and conflicts of interest. The above regulatory pressures on exchanges are unlikely to leave offshore exchanges like Binance, the world’s biggest crypto exchange, unaffected. In other words, the pressure to bring important crypto players under some regulatory oversight will pose a bigger challenge for offshore exchanges such as Binance which are largely unregulated.

D) New regulatory initiatives are likely to emerge focusing on transparency mandating regular reporting/auditing of reserves, assets and liabilities across major crypto entities including exchanges, brokers, lenders, custodians, stablecoin issuers etc. Again these regulations are likely to be imported from the traditional financial system, thus causing convergence of the crypto ecosystem towards the traditional financial system. Some crypto exchanges and firms have begun to publish their proof of reserves, while some exchanges have taken one step further to publish reserves to liability ratio (R2L ratio) to gain further trust of the customers when there is mass withdrawals of assets from the exchanges.

E) Crypto derivative markets will likely see a shift into regulated venues with CME emerging as a winner. With several institutional investors such as hedge funds getting trapped via their derivative positions at FTX, there is likely to be greater shift towards regulated venues such as CME for both futures and options. Such shift would naturally increase the role of CFTC in crypto markets given US derivatives markets are regulated by the CFTC.

F) We are skeptical of a structural shift away from centralized exchanges (CEX) into decentralized exchanges (DEX). An argument put forward for DEX was that the bundling of trading/clearing/settlement that centralized exchanges like FTX try to achieve, is more efficiently integrated into smart contracts in a non-custodial (i.e. a user remains in control of their private keys), permissionless and trustless way. This argument may face greater scrutiny given the likely regulatory initiatives noted in C above focusing on unbundling of these activities. And while there has been some increase in the share of DEX in overall crypto trading activity in recent weeks (Figure 12) this is more likely to reflect the collapse in crypto prices and the deleveraging/automatic liquidations that followed the FTX collapse. For larger institutions, DEXs typically would not suffice for their larger orders due to slower transaction speed or their trading strategies and order size to be traceable on the blockchain. As we mentioned previously in our publications until DeFi becomes mainstream it faces several hurdles:

— 1) Most of the price discovery in crypto markets has been taken places on exchanges, with DeFi protocols relying on oracles to supply price data to smart contracts. In turn these price data come mostly from exchanges. In other words DeFi protocols rely heavily on centralized exchanges to be able to function and it would likely take a long time until the center of the price discovery process in crypto market shifts from centralized exchanges to DeFi.

— 2) Smart contract risk such as hacking and protocol attacks, smart contract governance failures and controversies. Platform risk, platform vulnerability to attacks, platform governance failures and controversies, high gas fees and platform bottlenecks. Chainalysis estimates $3bn lost due to hacks across DeFi platforms this year.

— 3) The management, governance and auditing of DeFi protocols without compromising too much on security and centralization is thus a big challenge

— 4) Systemic risks could arise from a potential cascade of automated liquidations that materialize if the collateral provided drops below certain levels. We saw signs of that after the collapse of Terra as well as after the collapse of FTX.

— 5) Over-collateralization puts DeFi at a disadvantage relative to traditional finance although some new innovations have been emerging in DeFi lending space such as flash loans (typically used for quick arbitrage trading) which allow for unsecured lending with the capital borrowed and repaid in one almost instant transaction

— 6) Front running in DEXs (when some participant ,usually a miner, seeing an upcoming trading transaction puts his own transaction ahead by playing with a transaction fee) puts them at a disadvantage relative to centralized exchanges

— 7) Absence of limit order/stop loss functionality also puts DEXs at a disadvantage relative to centralized exchanges although new generation DEX platforms are currently emerging trying to incorporate this functionality

— 8) Risk/return tradeoff more difficult to assess in DeFi given the use of different tokens in terms of assets borrowed or lent/collateral posted/received interest payments and given the general absence of limit order/stop loss functionality

— 9) Pooling of assets into liquidity pools inherent in DeFi might make institutional investors uncomfortable.

As a result we believe that centralized exchanges will continue to play a big role in the crypto ecosystem in the foreseeable future, in particular for larger institutional investors, despite the FTX collapse.