CrypTalk ep 10 – The catastrophic collapse of FTX

In this episode of CrypTalk, BizNew’s Ross Sinclair and Jaltech’s Gaurav Nair discuss the collapse of one of the largest crypto exchanges, FTX, how the company got away with limited liquidity for so long, and the broader implications for the crypto market as a whole. 

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Gaurav Nair on crypto being recognised as a financial product in South Africa

Gaurav: [00:00:40] One of the reactions of the regulator FSCA is saying that crypto is now recognised as a financial asset. For the purposes of phase, a lot of people started to believe that this means that financial advisors can now sell crypto assets or advise on it or intermediate their sale. And actually what was the case beforehand was that it was unregulated. Anyone could do it beforehand. Now, by FSCA bringing it into phase, it means it’s now a regulated activity. And the consequences were that most financial advisors were quite nervous to actually sell or advise on crypto assets, even though it is unregulated. And anyone could do it because it wasn’t regulated. And now that it’s actually regulated, many financial advisors are dipping their toe in. They’ve been facing demand from some of their clients. They have sometimes seen a position in certain clients’ portfolios for crypto and allocation. And now that it’s regulated the advice or intermediary services on crypto assets, they’re actually getting more involved in the space. 

On what happened with FTX

Gaurav: [00:02:45] I’ve got to tell you that this took me by surprise, too, and it felt like a personal betrayal, even though I myself and Jaltech didn’t have any exposure to FTX, just because of the type of personality that Sam Bankman-Fried had. He seemed to be one of the only responsible players in this space, as you had many other big personalities and their various funds and exchanges blowing up. FTX and Sam continued on with his hedge fund. Alameda Research also continued on and didn’t seem to have blown up earlier in the year when all the other funds were and then FTX and Sam were going about rescuing some of these other exchanges and institutions that had become insolvent. And so it seemed like Sam was kind of the saviour of crypto. And then furthermore, Sam was lobbying in Washington DC for crypto regulations, and right at the very end, it seemed like potentially he was actually lobbying just to entrench FTX as one of the biggest players and actually block other players from coming in. However before that he was seen as someone who was fighting for crypto interests in Washington DC and there was a bit of a spat on Twitter between Sam and the founder and CEO of the Biggest Exchange by volume, Binance. A guy named Changpeng Zhao or “CZ” as he’s known in the crypto circles. And through this spat, it seems like CZ triggered a run on FTX and now normally a bank run is a scenario where all the depositors come to the bank at the same time trying to withdraw their money. And for a bank, it kind of makes sense because they’ve taken depositor money and made loans to other people so they don’t actually have the money there, which is fine as long as not everyone comes at once. However, with an exchange around shouldn’t be possible because exchanges shouldn’t be taking their clients money and lending it out. If people have deposited crypto or bought crypto on the exchange to just be there, it shouldn’t be anywhere else. However, as people started withdrawing their funds from FTX, FTX then paused withdrawals. Of course, indicating they didn’t have the liquidity that they should have as an exchange. So a number of our clients have actually found that they can’t withdraw their funds. And then after that, FTX filed for bankruptcy and as we start to see these bankruptcy filings come out, the records around it, we see that FTX may have as many as one million creditors, which is really a mind-blowing number. And the size of the hole may be as much as $8 billion or more. It’s kind of the number that’s the most often reported. But all of these facts are developing as we speak. So these numbers are due to change at any time. 

On how Investors like Sequoia Capital missed all the red flags. 

Gaurav: [00:06:59] Well, I mean, that’s, of course, a pressing question right now that everyone’s asking. It seems like many reputable investors that are responsible for some of the biggest companies, the biggest tech companies around, were also invested into FTX. And how do they not notice this? And the only explanation that seems likely is that in the mania that was going on, as crypto prices were just climbing and many investors felt like they had to get in quickly. There were stories being reported of investors, large venture capital investors, sometimes investing within 24 hours. That’s not enough time at all to do due diligence. And so it seems like FTX and Sam Bankman-Fried took advantage of this environment and raised a lot of money without the necessary due diligence around the controls that should have been in place for an exchange. If this had not been a crypto exchange, but let’s say a stock exchange, then these controls would have had to be in place in order for that exchange to have a licence. And so what you also see is the fact that these crypto exchanges were unregulated. It really allowed anything to go. But you’re quite right that these blue chip investors should have actually looked into this and realised that the controls were sorely lacking.

On when the contagion will spread to South Africa

Gaurav: [00:13:03] Yeah. So that’s a great question. I mean, how long it takes to spread is anyone’s guess. It seems like when a lot of the institutions blew up earlier in the year, in the first half of the year, it seems at that point Alameda research had blown up, however, because they were taking funds from FTX, no one knew. And so sometimes I think that when these exchanges, even in the world of traditional finance or institutions, find themselves insolvent, as long as no one knows they carry on, and it takes an event for everyone to find out. Sometimes I guess the market turns in their favour and they make it back and then they’re okay. However, it’s only when people start trying to withdraw their funds that we then find out that they don’t actually have the assets that they should have. And so really, I guess the question about when we find out if it’s spread to South Africa is that it’s highly likely it’s spread to South Africa. We’ll only find out when customers actually start trying to withdraw their funds. And if an exchange is already insolvent, it makes it a bit of a self-fulfilling prophecy because the customers that get out first, get all of their funds. And so it then actually precipitates a rush. Now, when it comes to crypto, it has this feature that you can take it into your own custody, you can take it off-exchange. If you have shares in a listed company, you can actually take those shares off the stock exchange. However, with crypto, you can, and that’s one way for clients to protect themselves. However, it’s quite risky to do so. It requires quite a bit of skill actually to do so. It’s lower risk in some ways, and we’ve discussed this before as well. Self-custody And the thing is that when you take crypto into your own custody, put onto a device or onto your computer and that’s no longer on the exchange, and you run the risk that the device breaks down or you lose access to that device or you forget the password. 

And unlike with an email account where you can just click forgot password and you get a reset message, that’s not what happens with these wallets. It’s estimated that about 20% of all cryptocurrency has been lost and where people have just lost access to it, they’ve forgotten about it. They can’t have they can’t, they can’t get in, the device is broken, etc. And one of the main reasons for loss as well is that often people pass away and their heirs either are unaware that they even had this crypto or they can’t get into these devices, and can actually recover the crypto even if they are aware of it. And so self-custody provides a lot of challenges, however, for people who have the skill and the confidence to do so, then that’s one option for them. A lot of people don’t want to do that. That’s why they’ve often left their coins and tokens on exchange. The other option is to use a professional custody provider like Jaltech. We have professional custody services that we offer, and the beauty of that is that the coins are taken off-exchange and they are put into a place where no one has access to it except for the custody provider, the systems and processes in place. And we use the leading infrastructure provider in this space, a company called Fireblocks, which is one of the largest in the world. 

They also provide the custody infrastructure for the largest custodian in the world, the Bank of New York, which has custody of 20% of the world’s financial assets, not just crypto assets, financial assets. So the gold standard in terms of technology and processes and what we’ve done is, seeing all this happening and being fearful about it coming to South Africa, in order to try and protect investors and the market, we’ve provided a special offer to investors that for the next six months, any investors that come and custody their assets for this, we won’t charge them any custody fees. And if they’re unhappy with the service, they can withdraw it at any time during the six months with no withdrawal fees. So this just allows investors to take the assets of exchange. While this all plays out, the exchanges that are sound should be able to meet all withdrawals. And when this is all out of the system, we’ll know that they’re still sound. However, I mean, this whole thing kind of reminds me of what Warren Buffett said: when the tide goes out, you find out who’s swimming naked. And we don’t want investors to be exposed to exchanges that are swimming naked. 

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