The digital asset industry has enjoyed a meteoric rise in popular interest and investment over the past few years. This influx of new capital has led to the establishment of many new crypto exchanges, all vying for a piece of the pie.
While regulated financial institutions have been slow to adopt digital assets, these unregulated exchanges have operated with near-total impunity. This freedom worked for a time, but recent events have shown that it comes at a cost.
This year alone, we've seen three major crypto exchange meltdowns: FTX, Voyager, and Celsius.
In each case, the exchange faced allegations of operating without a 1-to-1 reserve of customer funds. This means that the exchange used customer deposits to cover their own expenses and investments rather than holding them in a safe and separate account.
The fallout from these meltdowns has been significant. Billions have been shed from the total value of digital assets, and confidence in the industry as a whole has taken a significant hit.
However, rather than panic and halt engagement with the digital asset market, regulated financial institutions can use this opportunity to step in and provide the stability that the industry needs.
A common conversation within digital asset markets is regulation - a Catch-22 for the industry that needs it to legitimize itself, but one that many in the industry fear would strangle innovation.
For better or for worse, exchanges have largely been left to their own devices when it comes to regulation. In the early days of digital assets, this laissez-faire approach was understandable. The industry was new and small, and there wasn't enough at stake to warrant intervention from governmental bodies.
However, as crypto asset prices have skyrocketed and the industry has ballooned, this hands-off approach is no longer tenable. Exchanges that now handle hundreds of billions of dollars in transactions have seen their control of customer funds grow exponentially.
A simple price comparison can sum up the rise and fall of asset value due to exchange collapse.
On January 1, 2022, investors could sell a single Bitcoin asset for $46,000. 11 months later, that same coin was valued at $18,500 - even before the FTX collapse grabbed headlines.
While wild price gyrations are nothing new in the world of digital assets, asset values can often signal deeper issues below the surface.
Let's take a look at a timeline of events occurring just in the past year:
The Terra network was one of the hottest projects in the crypto world, with big-shot investors queuing up to pour money into it.
The network launched in 2018 with a promise to revolutionize the world of payments with its algorithmic stablecoin, terraUSD (UST). UST was pegged to the dollar and supposed to maintain a $1 price.
However, within a few days in May 2022, the entire system fell apart. The price of UST started to wobble and fell to 35 cents on May 9. The value of its companion token, LUNA, which was meant to stabilize UST's price, also collapsed, falling from $80 to a few cents by May 12.
Terra's founder, Do Kwon, is being pursued by regulators and lawsuits while on the run.
Hot on the tail of the Terra Network collapse came news that two major exchanges, Celsius and Three Arrows, were also in trouble.
Celsius, founded by former Goldman Sachs trader Alex Mashinsky, was one of the most well-funded exchanges in the industry. It was hailed as the first marriage of centralized and decentralized financial systems - collecting deposits of digital assets and giving loans.
For investors who staked their assets with Celsius, the platform promised returns of up to 18% yield on investments.
However, in June of 2022, the network suddenly halted USD withdrawals for its 1.7 million customers, citing market conditions due to the upheaval of the Terra collapse. However, by July, the network had filed for bankruptcy - while operating on a reserve of only $167 million of its claimed $24 billion in managed reserves.
Three Arrows Capital (3AC) was another network that collapsed in the "crypto winter" of the spring. The Singapore-based firm, which managed $10 billion in assets as of March 2022, failed to pay on a loan of $670 million to broker Voyager Digital in late June. That news, and an admission of losing nearly $200 million in investment during the LUNA/Terra collapse, forced the network's hand and bankruptcy filings soon followed.
In early June, cryptocurrency exchange Voyager fell victim to the cascading effects of the Terra and Celsius collapses, as the default on the 3AC loan called into question Voyager's own solvency.
The New York-based company, which offered digital asset trading and custody services, had been one of the fastest-growing exchanges in the industry - propelled by a wave of new investors flocking to digital assets.
However, unable to recoup the losses from the 3AC loan, Voyager was forced to file for bankruptcy. Trading was halted on the platform, and the value of Voyager's stock plummeted by 12%.
In an effort to stave off disaster, FTX CEO Sam Bankman-Fried, CEO set up credit lines through his associated company Alameda Research - bringing their unsecured loan amounts through Alameda to $75 million. While bankruptcy filings and internal restructuring were slated to happen, most investors believed that FTX would consume the loss-making Voyager exchange.
However, despite ongoing reassurance that FTX would cover losses and continue to operate, by November 2022, it became clear that the exchange was also struggling.
On November 8, Bankman-Fried announced that FTX would be acquired by Binance after investors began to report withdrawal failures. However, within 24 hours, Binance walked back on its offer to buy FTX after due diligence uncovered numerous solvency issues.
However, the reality stood in stark contrast to claims that the digital asset market was simply struggling to maintain value. Investigations into FTX revealed that Bankman-Fried had used the investments of FTX users to fund $10 billion in loans via Alameda Research. Notably, Alameda was involved in loaning out capital reserves to other crypto exchanges struggling to maintain solvency due to the ongoing collapse from May.
As of November 11, 2022, FTX has officially filed for bankruptcy, and CEO Sam Bankman-Fried has resigned from his role, admitting that he had made mistakes in the aftermath of the Voyager debacle.
While the meltdown of 2022 has shown little signs of stopping, the systemic issues that led to the collapse of FTX, Voyager, and Celsius have been brought to light - which can bring hope that mistakes will not be repeated in the future.
The problem lies in the way that many digital asset exchanges have chosen to operate without regulation and required oversight of their financial stability.
Banks and credit unions are required to report their financial positions regularly with their regulators (FDIC, OCC, FED and NCUA) and maintain certain ratios to ensure the health of financial institutions.
With regulation, banks and credit unions are unable to use customer’s fiat deposits in the ways that some of the exchanges used digital asset deposits. However, this regulation has not been established in crypto exchanges.
While the exchanges may be able to operate without clarity on where the money is coming from, it's incredibly risky. If too many customers try to cash out simultaneously, the exchange might not have enough money to cover all of the withdrawals - leading to a run on the exchange.
This is exactly what happened with Voyager, Celsius, and FTX. The LUNA collapse led to a sharp decrease in the values of digital assets across the board. As investors began to lose confidence and cash out, the exchanges were exposed as being only partially solvent. The following chain reaction has continued to unravel, leading to billions of dollars in losses.
This was the case with FTX, which used the investments of its users to fund $10 billion in loans via Alameda Research. While this allowed FTX to continue operating, it also meant that the exchange was incredibly reliant on Alameda - and when Alameda began to have financial troubles of its own, FTX was left without a way to cover customer withdrawals.
In the wake of the FTX, Voyager, and Celsius collapses, it is clear that more needs to be done to protect consumers. Regulation may be a less-than-desirable word among many in the cryptocurrency and digital asset markets, but the failures of many unregulated exchanges have exposed the risk of giving ownership over a user’s funds without oversight.
A lack of regulation and the variable nature of digital asset value has led to a worst-case scenario that has devastated many investors' financial situations. But there are ways that digital assets can flourish while providing protections for consumers.
Watching the digital asset industry implode has been difficult for those of us who have been involved in the space for years. We have seen exchanges come and go, but the recent problems at FTX, Voyager, and Celsius have been on a whole other level.
While hackers or bad actors have played a role in different chapters of the current crisis, their business models ultimately brought down these exchanges. The fact that they could operate for as long as they did is a testament to the power of FOMO in the digital asset industry.
The extreme interest in digital assets led to a wave of new users, and exchanges were happy to take their money - even if it meant they could not fulfill all of their obligations.
Instead of fleeing from the potential that digital assets hold, it is time to ask ourselves how we can prevent this from happening again. The answer, we believe, lies in traditional financial institutions.
Banks and credit unions are regulated for a reason - to protect consumers from the risks of financial collapse. Their stability and oversight can be a powerful force for good in the digital asset industry, which is currently largely unregulated.
One way that traditional financial institutions can implement change is with the creation and implementation of secure digital asset on and off-ramps. These would allow traditional financial institutions to interface with the digital asset industry in a way that is safe and compliant.
For instance, a bank could offer a digital asset exchange service that allows its customers to buy and sell digital assets without worrying about the risks of an unregulated exchange.
This would provide consumers with a way to buy and sell digital assets without going through an exchange. It would also give traditional financial institutions a way to monitor the digital asset industry and ensure that it is meeting their obligations to consumers. The benefits of such a system are clear:
The time for change is now. The recent problems at FTX, Voyager, and Celsius have exposed the weaknesses of the current system. It is time for traditional financial institutions to step up and provide stability and oversight that the digital asset industry needs.
At Sequoir, we have built API-driven software that makes it easy for traditional financial institutions to interface with the digital asset industry. We believe that this is a crucial step in ensuring that the digital asset industry is safe and compliant.
While we are unsure how the current situation will play out, we are confident that traditional financial institutions can help to bring about a brighter future for the digital asset industry. By working together, we can build a system that is safe and transparent for all.
If you are interested in learning more about our work or getting involved, reach out today. Together, we can bring about the change that the digital asset industry needs.
Disclaimer: The cryptocurrency and digital asset market is volatile, and this content is not intended to offer investment advice. Readers should not make any investment decisions without first consulting their own financial advisor and conducting their own research.