Quick Recap FTX, once the second-largest cryptocurrency trading platform, filed for bankruptcy and the CEO and founder, SBF, has been arrested for allegedly mismanaging customer funds, and more. The collapse of the platform came after a surge in customer withdrawals sparked by a tweet from Binance CEO Changpeng Zhao. In the tweet Changping announced Binance's decision to sell FTX's token FTT, worth approximately $580 million, due to ""recent revelations."" It was later revealed that $10 billion of customer funds from FTX were allegedly transferred to SBF's trading company Alameda as a loan, and at least $1 billion of FTX customer funds have disappeared without a trace.
As an exchange, FTX had a legal obligation to hold customer funds in custody. The question of SBF's intentional or unintentional illegal actions remains and is being investigated. Considering that he only had a bachelor’s degree in physics, some wonder if the collapse was simply an issue of incompetence. Now, this is obviously no news and just the tip of the iceberg.
The cryptocurrency markets are going nowhere. The growth rate of the global blockchain technology market is estimated to be 85.9% between 2022 and 2030, and within this market are crypto start-ups introducing innovative ways of investing and transacting year on year. Bitcoin adoption alone has grown at an average of 113% yearly, since its launch in 2009. There’s capital from web 3 investors all around the world, who believe in this market and are determined to see it through its stormy days.
However, millions of people continue to lose their money in this volatile market, and one failed company always seems to have a ripple effect across the market. How can we zoom into the case of FTX and derive some lessons from it?
Regulatory shortfalls
The new CEO of FTX, John Ray, discovered significant regulatory shortcomings at the cryptocurrency trading platform, which ultimately led to its bankruptcy. Amongst other things, he found that most FTX entities did not have board meetings and that there was a lack of implementation of controls such as the audit and risk management controls. Moreover, the newly elected CEO also found that the address of FTX’s auditors exists in the Metaverse. Additionally, there appeared to be no policies governing decision-making, exposing FTX and its customers and creditors to increased risk. In the FTX bankruptcy filing, John Ray stated that the situation was ""unprecedented,"" citing compromised systems integrity, faulty regulatory oversight abroad, and concentration of control in the hands of inexperienced and unsophisticated individuals who may have been compromised. These findings highlight the crucial role that effective regulation plays in ensuring the safety and security of customers and the integrity of the cryptocurrency markets as a financial system.
How do we regulate this industry to protect the user, while maintaining the freedom of trade cryptocurrencies offer?
At the moment, blockchain-based financial institutions implement Know Your Customer (KYC) protocols to corroborate their customer identity and assess the level of risk associated with a customer. In addition, some centralised crypto exchanges get independently audited to produce what is called proof of reserves, which is a public attestation by a centralised exchange to the value of their reserves and proof of solvency.
In an interview with VALR's co-founder and Chief Product Officer, Badi Sudhakaran, we asked about regulations for centralised crypto exchanges in Africa. Badi, who co-founded the second largest cryptocurrency exchange in Africa, spoke about the need for effective regulations that won't hinder growth. He mentioned that VALR has been actively engaging with regulators to find a common understanding. ""We have been in engaging the regulators to try to understand their point of view and for them to understand our point of view,"" said Badi.
How can one ensure that a crypto exchange is fulfilling its responsibilities as a custodian and managing customer funds appropriately? “Crypto exchanges cannot operate under a fractional reserve system, they have to have 1:1 proof of reserves”, Badi said as he suggested more effective methods that can be implemented in producing proof of reserves, such as cryptographic proof using Merkle trees which cannot be tampered with or limited by a scope of work (such as in a case of audited proof of reserves). Another method that is more effective than the Merkle trees that Badi mentioned, was the Zero-knowledge proof. Having these effective tools in place for proof of reserves could help with the early detection or prevention of catastrophic disasters such as that of FTX.
Regulation in the South African context
In South Africa, the Financial Services Conduct Authority (FSCA) announced, in October 2022, that crypto assets will now be regarded as financial products. This means that they will now fall under the ambit of the Financial Advisory and Intermediary Services (FAIS) Act. Crypto Currency providers/exchanges must register as financial services providers, under the applicable licence, by 30 November 2023. This would mean that these providers must abide by the regulations of the FAIS Act and its General Code of Conduct; namely offering products honestly, fairly and with due skill, care and diligence to customers. In addition, the regulator can stop providers who are involved in fraudulent activities or have found to have been dishonest. This is great news for customers, as they can verify that they are dealing with licenced service providers. They will now also be able to lodge complaints to the Ombud in situations where the provider did not act in the client’s best interest; and can receive financial compensation up to R800 000. Customers can now have some degree of protection, and providers will be required to act with a certain degree of skill and due diligence. This will hopefully prevent situations like FTX from occurring in the future.
Financial Failures
Having a look at FTX once again, as our case study, let’s go further into some of the financial failures that could have been avoided.
FTX experienced numerous financial failures that were the result of poor corporate governance practices and inadequate internal controls. The new FTX CEO, who previously oversaw Enron's bankruptcy, stated in a court filing that in his ""40 years of legal and restructuring experience"" he had never seen ""such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."" The accounting function at FTX was insufficient, lacking basic financial controls such as a complete charter of accounts to keep track of transactions, bank account tracking, and accurate bookkeeping.
Furthermore, there was no segregation of duties, with Sam overseeing the approval and execution of major business decisions without input from other executives. This contributed to the risky decisions made in managing customer funds, which ultimately did not pay off. The system’s integrity of FTX was also compromised with backdoor access for Alameda research, adding to the already significant risks associated with the cryptocurrency industry. Furthermore, FTX’s insufficient cybersecurity and data protection controls also contributed to the vulnerability of its financial system.
Businesses usually don’t realise there’s a problem with their financial control systems – until there’s a problem. By then it’s too late. Sometimes that can be a major event that puts the future of the business at risk and in FTX’s case, that was a bank run.
Financial controls serve as a preventative measure against fraudulent activities in an organisation, helping to prevent unauthorised activities such as fraud, theft and embezzlement of company assets ironically, this is exactly what SBF neglected to implement with FTX and for what reason I wonder. Looking at the broader scale of events at FTX, with financial lenses, we have certainly learnt what not to do from a financial and or commercial perspective. Financial controls and systems are meant to safeguard all stakeholders and their lack thereof, perceived or actual, is a worrying tale of what is to come.
Conclusion
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