Opinion: Gleaning Lessons from the FTX Trial – A Tale of Unyielding Vigilance Towards Miscreants

Disclaimer: The opinions and views expressed in this article are solely those of the author and do not reflect the opinions and views of crypto.news’ editorial team.

The aftermath of the FTX collapse and the resulting media frenzy caused unexpected and far-reaching disruptions. However, it also accelerated the realization that centralized exchanges (CEXs) are flawed. How we address this issue will have a lasting impact on our industry. It is not the responsibility of regulators to prevent another FTX collapse.

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Without meaningful change, we will continue to repeat the mistakes of the past in this new monetary system. Our industry and emerging technologies must demonstrate that compliant decentralization is achievable.

Compliance is the starting point

The FTX case highlights the risks of neglecting corporate compliance. One major takeaway from the FTX case is the need for improved compliance. We must do a better job of tracking the flow of funds. The loss of nearly $9 billion in customer funds from the troubled exchange clearly shows that CEXs must be built on a strong framework. This will establish a foundation of trust and security for industry growth.

In a post-FTX world, prioritizing compliance and transparency is crucial. The FTX case emphasizes the importance of corporate governance, including cash controls, HR protocols, approval mechanisms, financial reporting, and internal and external audits.

However, better regulation is just the beginning.

Regulation alone is insufficient

Following the collapse of FTX, regulated exchanges quickly began promoting their regulated custodial services. In the United States, regulated CEXs are required to separate customer funds from their own to ensure that the funds are only used as authorized by the users.

Regulators have also been increasingly focused on enforcing new rules, but this does not eliminate significant risks. Traditional finance, despite its strict regulations to prevent centralized failures, has experienced numerous instances of mismanagement of risks. The collapses of Bear Stearns, Lehman Brothers, and most recently, Credit Suisse, have highlighted the dangers of relying too heavily on human intervention.

Regulation alone is not enough. Bad actors can still cause havoc when they have control over the funds.

Self-custody is the solution

Therefore, the other important lesson is self-custody. This concept is often discussed in the industry, but its practical implications are often debated. The Bitcoin whitepaper serves as a reminder of the basics: if you trust exchanges and other third parties with your private keys, you are surrendering control over your funds.

FTX was once considered a reputable exchange, a safe place for crypto transactions. It was even regarded as an industry favorite. However, the reality was quite different. A secret backdoor was established, allowing Alameda Research, the trading firm linked to FTX’s downfall, to withdraw billions of customer funds. While this was beneficial during bullish markets, Alameda’s excessive leverage amplified losses during downturns. When faced with margin calls during the crisis, selling off collateral risked significant depreciation in value.

Investors were traumatized by the sudden and unexpected collapse of the world’s second-largest exchange. The fortunes of this industry favorite had dramatically reversed overnight. Due to FTX’s extravagant marketing spending and public perception, the whole world took notice.

Unfortunately, customers mistakenly believed that their funds would be protected from speculative activities like those conducted by Alameda Research. In reality, after FTX’s bankruptcy, the U.S. Securities and Exchange Commission (SEC) described FTX as providing Alameda Research with a “virtually unlimited line of credit,” resulting in a multibillion-dollar deficit for retail investors.

The lesson learned was both shocking and damaging. Storing cryptocurrencies in any centralized exchange is risky. This was evident when several platforms suddenly halted withdrawals due to fears of a bank run, where everyone rushes to withdraw their funds at once, and the bank, or in this case, the centralized exchange, cannot meet the demand.

That’s why self-custody is crucial. Keeping assets under your control is the only way to mitigate the risks of loss. However, in the event of a crypto exchange failure, retail investors should not settle for receiving only a small portion of their assets years later. They should have immediate access to 100% of their crypto at all times. While regulation and compliance are important safeguards for an exchange, new models are emerging that combine traditional legal funds management controls with self-custody.

Shifting the paradigm with hybrid models

No amount of regulation can completely eliminate the risk of failure in a financial platform. Even within regulated exchanges, users entrust their assets to third parties for safekeeping. However, there is potential for a paradigm shift. What if CEXs could offer 100% self-custodial solutions?

In recent years, hybrid exchanges have emerged as a solution. By combining the best aspects of CEXs and decentralized exchanges (DEXs), we can foster innovation and enhance asset security. Users can trade directly on the blockchain without intermediaries. At the same time, traditional institutions can access decentralized finance features while benefiting from the security and liquidity of CEXs.

Most importantly, the hybrid model addresses concerns by relying on code rather than human intervention to effectively manage risks. These exchanges blend regulatory compliance with decentralized features, allowing users to directly engage with cryptocurrencies in secure wallets through smart contracts. Users also maintain full control over their funds, bypassing custodians. All of this is done through user-friendly interfaces similar to those of CEXs. The result is an advanced trading system that mitigates the weaknesses of both CEXs and DEXs, potentially revolutionizing the crypto exchange landscape.

A wake-up call for the crypto industry

As the FTX trial continues to attract attention, it’s important to recognize that industries often experience upheavals. Wall Street itself has faced scandals and challenges similar to those in the crypto space, such as the Enron Scandal and the Bernie Madoff Ponzi Scheme in the early 2000s.

However, as custodians of the crypto industry, we must not dismiss this case as a minor setback. Such scandals tarnish the industry’s reputation and set us back each time. The crypto industry is still evolving and maturing, but there are now better paths forward.

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Hong Yea, the founder of GRVT, a self-custodial crypto exchange, previously held executive positions at Goldman Sachs and Credit Suisse for a combined period of over nine years.