As FTX implodes, the crypto exchange model draws scrutiny

The revelation this week that up to a million investors may be harmed by the collapse of the FTX cryptocurrency exchange exposes what critics say is a fundamental flaw in the foundations of the $850 billion market for digital currencies.

As the implosion of the Bahamas-based company continued Wednesday to stir turmoil across crypto markets, experts said the concern lies less in crypto itself than in the lightly regulated companies that serve crypto investors.

For investors, FTX was a gateway to the crypto world, an exciting marketplace where celebrity ambassadors like quarterback Tom Brady invited them to open accounts and trade digital currencies such as bitcoin and ether. FTX in turn functioned in many ways like the banks and brokers of traditional finance, maintaining customer accounts, exchanging currencies and making loans and investments with customer assets.

But like other crypto exchanges, FTX operated outside the traditional banking system, and this created enormous risks. Though they act like banks and brokers, crypto exchanges typically are not subject to the same type of regulation, insurance and disclosure rules that protect customers of traditional banks.

“At some level, the fall of FTX is not a crypto story at all,” said Adam Levitin, a Georgetown University law professor and a principal at Gordian Crypto Advisors, a firm that provides advice regarding crypto bankruptcies. “People invested billions in an unregulated financial institution based in a Caribbean island. How could this end well?”

What the FTX case shows on a vast scale is that companies holding crypto for customers can make investment decisions that end in disaster, and when they do, there’s no clear guarantee that customers will get their assets back.

According to Reuters, at least $1 billion worth of customer funds have vanished from FTX, one of the industry’s largest exchanges, under circumstances that are under investigation by the Justice Department and Securities and Exchange Commission. In bankruptcy filings, FTX revealed that it could owe money to more than a million people and organizations.

The collapse has drawn attention because FTX is one of the largest crypto exchanges, and its founder, 30-year-old Sam Bankman-Fried, had been widely hailed as a crypto wunderkind and top Democratic donor. But over the past year, as the overall value of the crypto market has plummeted from a peak of more than $3 trillion, other crypto firms also have run into financial trouble.

Crypto lenders Celsius Network and Voyager Digital filed for bankruptcy earlier this year after they were unable to meet customer demands for withdrawals. Last week, another lender, BlockFi, announced that it was “not able to operate business as usual” and was “pausing client withdrawals” in the wake of the FTX collapse. This week, crypto exchange AAX announced that it had called a halt to withdrawals, citing technical problems with a third-party partner. And on Wednesday, cryptocurrency lender Genesis said it is temporarily suspending redemptions and new loan originations.

These troubles have spooked investors, prompting executives at other large crypto exchanges - including Coinbase, Crypto.com and Binance - to assure customers that their balance sheets are strong. Some have portrayed the FTX collapse as an anomaly in an otherwise safe industry. “This is the direct result of a rogue actor breaking every single basic rule of fiscal responsibility,” Patrick Hillmann, chief strategy officer at Binance, the largest of the crypto exchanges, said in a statement to The Washington Post, referring to Bankman-Fried. “While the rest of the industry operates under an extreme measure of scrutiny, the cult of personality shrouding FTX allowed them a dangerous level of privilege that wasn’t earned.”

But the lack of regulation creates risks for crypto investors, experts said. In the United States, the financial condition of a traditional bank is subject to regulations and official examination. Had FTX been subject to the same scrutiny, the weaknesses in its financial condition might have been revealed earlier. In addition, customer deposits at traditional banks are insured up to $250,000 by the FDIC. No such protections will aid those who have lost money at FTX.

FTX is one of several large crypto exchanges that have played a critical role in popularizing cryptocurrencies, including by paying for Super Bowl ads to reach large audiences. According to a survey by Pew Research Center, 16 percent of U.S. adults say they have at some point invested or traded in cryptocurrency.

Some “companies have been allowed to become very large despite their obvious disregard for the rules imposed on traditional financial institutions,” said Tyler Gellasch, president of the Healthy Markets Association, a group focused on increasing transparency and reducing conflicts of interest in the capital markets.

“The banking and securities rules were set up to ensure that if the bank or broker fails, you can still get your assets back,” Gellasch said. “The crypto exchanges don’t appear to be complying with any of them.”

Since FTX filed for bankruptcy last week, several large exchanges have sought to become more transparent. Last week, Binance published a brief account of its cryptocurrency holdings, though not its liabilities.

Binance chief Changpeng Zhao said the company would publish a fuller account of its finances within weeks, once a third-party auditor can complete its work. Zhao did not identify the auditor but said the same firm had also worked for FTX.

“Nothing is risk free, right? Crypto exchanges are inherently quite risky businesses,” Zhao said Monday in a Twitter Spaces chat. “You have to run them well. You have to do security well. You have to do a number of things well.”

Unlike FTX, Zhao said Binance does not carry debt. “We’re a very clean, very simple business,” he said. “We’re not trying to be a pawnshop or hedge fund shop.”

At Crypto.com, CEO Kris Marszalek held a video live stream Monday amid online rumors that the company had stopped processing withdrawals. Marszalek acknowledged that the number of withdrawals had temporarily surged after the company mishandled a transaction worth approximately $400 million that he says was inadvertently sent to the company’s account on a competitors’s exchange.

But he called rumors of a pause “absolutely not true,” adding: “We are operating as usual again.”

In what Marszalek touted as an effort to restore the trust of depositors, Crypto.com published a partial breakdown of its cryptocurrency holdings, revealing that as of Nov. 14, the company held at least $2.3 billion in cryptocurrency reserves. But the company’s outstanding liabilities are not publicly known and were not included in the initial report the company released after the collapse of FTX.