Cryptos in search of a solution

Shortly after the collapse of several Wall Street banks in 2008, a nine-page document circulated on an obscure mailing list proposing a new type of financial system that would not rely on any “trusted third party.”

This document is the origin of what has become the cryptocurrency industry. In idealistic language, its adherents have sworn to conduct their business in a transparent and equal manner, rejecting the high-risk practices of a small number of powerful financial firms that caused the Great Recession.

But last month, the shares of just one cryptocurrency company — the $32 billion FTX exchange — plunged the emerging sector into its own version of the 2008 meltdown. Considered a safe marketplace for virtual currency trading, FTX filed for bankruptcy after the crypto equivalent of a bank attack, leaving industry executives, investors and enthusiasts wondering how a technology supposed to fix the shortcomings of traditional finance ended up reproducing them.

Leaders who just a year ago rejoiced in cryptocurrency’s seemingly uninterrupted growth are now scrambling to prove they can learn from the mistakes made and return to the industry’s earliest ideals. Binance, the world’s largest exchange, announced last month that it would release more information about its finances and hire independent auditors to review those disclosures. Coinbase, the largest US cryptocurrency exchange, has proclaimed its commitment to a “decentralized system” where users would not have to “trust” it.

Many crypto advocates are pushing for more sweeping reforms, urging investors not to store their digital assets with big corporations and instead turn to more experimental platforms run solely by code.

A revealing collapse

But despite all the promises of change, the collapse of FTX shows how far the crypto is from fulfilling its original goals and gaining widespread acceptance. Consumer distrust has grown this year amid deep financial losses, criminal investigations and an increasingly skeptical regulatory climate in Washington. At a conference last month, Changpeng Zhao, CEO of Binance, said the FTX implosion would set the industry back years.

The fall in the stock market came on top of months of losses in the virtual currency market, caused by a devastating crash in the spring, which took place against the backdrop of a general decline in risk assets. This upheaval has led to the bankruptcy of some leading cryptocurrency companies. Bitcoin, the original and most popular cryptocurrency, is trading below $17,000, down about 75% from the peak of nearly $70,000 reached almost exactly a year ago.

“You start going through these issues, and they’re piling on top of each other,” said John Reed Stark, a former Securities and Exchange Commission (SEC) official who has become an outspoken critic of the crypto.

In the beginning, the main use of cryptocurrency was criminal. Thieves and drug dealers used bitcoin to transfer large sums of money without going through a bank or other middleman to process the transactions.

But over the years, law enforcement has become more effective at tracking down cryptocurrency-related crime, and technology has evolved to enable more sophisticated financial applications, like borrowing and lending. People who started their careers on Wall Street — including FTX founder Sam Bankman-Fried, who worked for trading firm Jane Street — got involved in the fledgling industry, seeking to cash in on the technology.

As the industry grew, it began to exhibit some of the characteristics of the Wall Street institutions it was meant to replace. Cryptocurrency exchanges have become increasingly centralized, with much of the trading taking place on a handful of major exchanges, including Binance, FTX, and Coinbase. In the months leading up to FTX’s collapse, cryptocurrency trading volume on Binance alone exceeded the combined totals of its seven closest competitors, according to an industry data tracker.

The original vision for crypto “was an attempt to rewrite the rules of finance on a global basis,” said Charley Cooper, chief executive of blockchain firm R3. “And here we are again – we are in an even more centralized industry than what we would see in the banking sector. »

Collapse

The value of cryptocurrencies has skyrocketed in the last year and in 2022 – until May. That’s when a popular cryptocurrency called luna crashed, sending the cryptoeconomy into a tailspin. Two major lending companies, Celsius Network and Voyager Digital, have filed for bankruptcy. Enthusiasts have complained about the onset of a “crypto winter” characterized by depressed prices and dwindling enthusiasm.

Amid the crisis, FTX was considered a relatively trustworthy force. Based in the Bahamas, the company served as a marketplace for buying and selling cryptocurrency, offering high-risk, yet popular trading options that are illegal in the United States. Bankman-Fried, 30, who had made FTX a $32 billion company, bailed out struggling businesses and earned a reputation as a benevolent figure willing to extend a lifeline to his colleagues.

Then, last month, a run on deposits revealed an $8 billion hole in FTX’s accounts. The company filed for bankruptcy within a week. The SEC and the Department of Justice have opened investigations, aimed at determining whether FTX illegally loaned its users’ funds to Alameda Research, a cryptocurrency hedge fund that Bankman-Fried also founded and owned.

Binance is essentially doing the same type of business as FTX, but CEO Zhao has recently been careful to differentiate himself from Bankman-Fried, calling his former rival a liar and criticizing FTX’s most dangerous practices. On Nov. 25, Binance announced a new “Proof of Reserves System,” promising to keep users informed about the amount of cryptocurrency in its accounts and allay fears that it could be vulnerable to the kind of deposit rush that is happening. destroyed FTX. (But Binance’s plans have been heavily criticized for missing some key information.)

Coinbase has also tried to ease fears of a collapse by posting a blog post that says it still holds the same amount of money that customers have deposited. “There can be no ‘run on the bank’ at Coinbase,” the post read.

Yet the mere existence of big companies like Binance, Coinbase, and FTX goes against the ideals of crypto, according to some industry experts. Since the collapse of FTX, some crypto enthusiasts have turned to smaller ventures in the experimental field of decentralized finance, which allows operators to borrow, lend and transact without banks or brokers, by based on a public system governed by a code.

But DeFi has its own issues, including its vulnerability to hackers, which has drained billions of dollars this year into experimental projects.

“They based it on clunky technology that’s very inefficient,” said American University finance expert Hilary Allen. “They are very fragile operationally. »

This article was originally published in the New York Times.