By Brett Munster
Good Morning!
There is a lot to cover including the latest on FTX and some non-FTX related news. Yes, there are other things happening in crypto besides FTX.
Ripple gets its hands on the Hinman documents
Back in our October 4th edition, we detailed Ripple’s court case with the SEC. As a reminder, in 2018, SEC Director of Corporation Finance Bill Hinman stated that Ether is not a security. We suggested that these statements would likely be key in determining the outcome of the case. Ripple has cited Hinman’s speech numerous times arguing that the Ripple network is also decentralized and thus XRP, by the SEC’s own standards, cannot be classified as a security. The SEC has tried to argue that the comments made by Hinman were his personal opinion and not representative of the agency’s stance on the matter. To debunk the SEC’s argument, Ripple’s lawyers have routinely asked for emails from Hinman’s tenure because if Ripple can prove that Hinman did consult with others at the agency, rather than act as a lone wolf, the SEC’s objection falls apart. The SEC had previously refused to hand over the documents despite being ordered by the judge five separate times. That is, until now.
On October 20th, the SEC finally handed over internal SEC emails and drafts of Hinman’s now infamous 2018 speech. Although the documents have yet to be made public, Ripple’s General Counsel Stuart Alderoty did state that “that it was well worth the fight to get them” and “I’ve always felt good about our legal arguments, and I feel even better now.”
Then a week later, the news continued to get better for Ripple when Coinbase petitioned a federal court for permission to file an amicus brief in the ongoing lawsuit. An amicus curiae brief is written testimony by a person or organization not part of the case but granted permission to submit an opinion to the court in order to influence the court’s decision. Ripple has already had amicus briefs filed on its behalf by lobby groups Chamber of Digital Commerce (CDC) and Blockchain Association (BA). Coinbase’s filing argued that the SEC has not provided clear guidance to businesses in the process and has been inconsistent about its enforcement approach.
The Hinman documents and numerous amicus briefs filed in support of Ripple seem to be turning this case in Ripple’s favor. Should Ripple prevail over the SEC, it could prove to be a landmark win for the crypto industry.
DeFi is gaining adoption from users and institutions
The goal of the Decentralized Finance movement (aka DeFi) is to build financial products and services without the need for middlemen. Operating in an open, peer to peer manner has the potential to create far greater efficiencies than the current traditional financial infrastructure allows.
One example is allowing users to retain full control of their assets which is in stark contrast to traditional financial services. Banks and other centralized financial companies require users to hand over their assets to use their services. When a customer deposits assets with that centralized entity, the central authority takes custody (aka ownership and control) of those assets. This means that when you deposit funds into a bank, legally speaking, it is no longer your money. Technically, the funds in the account are owned by the bank and users simply have a claim on those assets.
In contrast, DeFi platforms are non-custodial meaning users retain full ownership and control of their assets when accessing these services. For example, Uniswap (a decentralized exchange) does not take customer deposits but instead provides the platform for users to execute trades in various liquidity pools. The assets in these liquidity pools are provided by other users and are governed by immutable smart contract logic that makes it impossible for Uniswap to misappropriate funds. Unlike what we saw with FTX (a centralized entity), Uniswap cannot lend your funds, nor can it leverage them for its own personal trading because it never has control or ownership of your funds in the first place.
Another way DeFi is more efficient is with costs. By removing middlemen, DeFi can lower the costs to transact in various ways. As we have written about in the past, the Bitcoin network allows anyone in the world to send value across borders near instantaneously and for practically free. Because of this, it’s simply the fastest, most secure and cheapest settlement and remittance network to ever exist. Why pay 10-30% to use Western Union or Moneygram when you can accomplish the same thing for pennies on the bitcoin network?
But what if you want to transact in something other than bitcoin? Well, DeFi can solve that too. Rather than trading BTC for ETH on Uniswap, imagine trading Dollars for Pounds. Or Euros for Yen. All without the need for banks or any other intermediary. Well, that’s exactly what is beginning to happen. Just recently central banks from France, Switzerland, and Singapore are attempting to automate foreign exchange markets using decentralized finance (DeFi) protocols to cut the cost of cross-border payments. In fact, the Bank of International Settlements (BIS) stated that “DeFi and its applications have the potential to become systemically important parts of the financial ecosystem.”
But DeFi has one more trick up its sleeve: it may enable better regulatory compliance. Because all smart contracts are software, they are programmable which means it’s possible to embed regulatory rules and restrictions directly into the code. This could make compliance easier, faster, and prevent many fraudulent activities from occurring in the first place. And this isn’t just theoretical anymore. Earlier this month, JP Morgan executed its first DeFi transaction as part of a joint pilot with Singapore’s central bank. JP Morgan issued tokenized Singapore dollar deposits and then traded for tokenized yen with Japan’s SBI Digital Asset Holdings. The transaction all occurred on the Polygon blockchain and was cheaper and faster to execute than traditional methods.
But here is where things get interesting. Blockchains offer the ability for individuals and entities to maintain self-sovereign identities. Rather than having users set up an account controlled by the service they want to use, users can maintain their own Verifiable Credentials (ie: identification that can be cryptographically verified) on a blockchain that various services can verify on-chain anytime you want to use that product. The benefit to this is two-fold. No more signing up and inputting the same personal information over and over again every time you want to sign up for a new service or access your financial accounts. Second, the user retains control such that he can present necessary compliance information to access services without revealing any sensitive personal data. This is exactly what JP Morgan did. It was able to provide fully compliant access using Verifiable Credentials which it verified on-chain. It’s possible that in time Verifiable Credentials could not only be used in financial products, but could potentially replace driver’s licenses, passports, and birth certificates.
In light of all the centralized entities that have collapsed this year (Celsius, Voyager, FTX and more), the importance and benefits of self-custody has begun to take center stage. We are already beginning to see signs of users flocking to DeFi solutions. In the wake of FTX, most DeFi protocols have experienced double-digit percentage growth in users and transactions as users pull their assets off centralized entities and opt into decentralized ones. Uniswap, the decentralized exchange we mentioned earlier, is now processing more Ethereum trades than any other exchange other than Binance and is on pace for one of its highest volume months in its history. dYdX, a decentralized crypto exchange in the Cosmos ecosystem, has seen users increase by 99% and transactions climb by 136% and Aave, a decentralized lender, grew users by 70% and transactions by 99%.
Currently the user interface for centralized entities is much easier to use but that gap is quickly shrinking. In time, more and more users will get comfortable self custodying their assets and taking advantage of the security and cost benefits DeFi has to offer.
Ramifications from FTX
Oh man, where to begin? Last newsletter we detailed the rapid collapse of FTX, the world’s second largest crypto exchange. Since then, investigations have been launched, the bankruptcy filing contained some startling revelations, other companies have been severely impacted, regulators are speaking up, and SBF gave a shockingly honest, albeit appalling, interview in which he didn’t hold back his true feelings on the matter.
Given the magnitude of the collapse and the facts that have come to light, FTX and Sam Bankman-Fried are being investigated by an ever-growing number of organizations. In the US, the Manhattan US attorney’s office has launched a criminal investigation into FTX. The DOJ and SEC have also launched their own investigations. According to the bankruptcy filings, the CFTC and dozens of Federal and state regulatory agencies have been in contact with FTX as well. In fact, there are reports that the FBI is working with their counterparts in the Bahamas, where SBF is still holed up, to extradite him to the US and bring him in for questioning.
Outside the US, law enforcement in the Bahamas are pursuing a criminal investigation and Japanese regulators have opened probes into FTX. Singapore’s regulator issued a statement that said FTX was not licensed in the city-state, and that the watchdog was reviewing a license issued to a FTX subsidiary called Quoine.
All those investigations were launched prior to the bankruptcy filing which itself contained some startling revelations. The filing claims there is evidence that SBF and his CTO received texts from the Bahamian government instructing them to move funds after the company declared bankruptcy. It goes without saying that withdrawing funds once a company has declared bankruptcy is a serious issue. The Bahamian government originally denied any such allegations but once the evidence was released, they released a statement that they did in fact take these actions but did so in order to “protect the interest of clients and creditors under its jurisdiction.”
In conjunction with the filing, there was also a declaration filed by new CEO John Jay describing a total lack of financial or business controls at the company. John Jay is one of the most qualified individuals to handle this situation. He has over 40 years of legal and restructuring experience including several of the largest corporate failures in history. But even Jay was struck by how poorly managed FTX was saying “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” This coming from the man who oversaw the bankruptcy of Enron.
In his filing, Ray highlighted the lack of corporate structure in place at FTX despite the company being valued as high as $32 billion earlier this year. There was no formal management system in place to keep track of cash flows, the company did not have an accurate list of bank accounts, and employees submitted expense reimbursements over chat where a random manager would accept or reject those reimbursements using emojis. In other words, no functional accounting department. The company was unable to provide a complete list of who worked for FTX or the terms of their employment. In other words, no suitable HR department. And the company did not have a board of directors or board meetings. In other words, no corporate governance.
And I wish I could say that was the worst of it. Turns out, Alameda lent billions of dollars to FTX insiders, including $1 billion to Sam Bankman-Fried, $543 million to co-founder Nishad Singh and $55 million to executive Ryan Salame. In addition, FTX corporate funds were used to purchase homes that were owned by certain employees. And according to a recent WSJ report, when FTX raised $420m last October, $300m of it went directly to SBF who then sold his personal stake in the company.
Unfortunately, all this mismanagement impacts the crypto industry beyond just FTX and Alameda. Over the summer, crypto lender BlockFi took a $400 million loan from FTX to help solidify its own balance sheet after LUNA collapsed. BlockFi’s exposure to FTX also includes deposits, an undrawn credit line, and obligations from Alameda. Given this significant exposure, BlockFi was forced to halt withdrawals and eventually filed for Chapter 11 bankruptcy this week. SALT, another crypto lender with exposure to FTX, also paused withdrawals. Crypto.com, a rival exchange now infamous for its “fortune favors the brave” commercial with Matt Damon, saw $53 million worth of withdrawals in under 12 hours, soon after halted withdrawals, and only avoided illiquidity issues with a $33 million capital infusion to meet user demand. An FTX owned Japanese exchange called Liquid Global halted withdrawals on its platform following FTX’s collapse. Other crypto exchanges such as OKX, Gemini, Huobi, and Gate.io have experienced severe outflows as well.
The FTX logo was taken down from the Miami Heat arena and all in-arena promotions and advertisements at the Golden State Warriors stadium have been removed. There was even a class action lawsuit filed against various celebrities such as Tom Brady, Larry David, Steph Curry and more for endorsing FTX. Now celebrities, politicians and other prominent figures are rushing to erase evidence of any relationship with SBF or FTX.
But of all the potential fallout, the most concerning is likely Genesis. Genesis Global Capital, a subsidiary of crypto giant Digital Currency Group (DCG), was the largest lender in the crypto industry and had a much larger footprint than FTX. Genesis was already negatively impacted by the collapse of Three Arrows Capital earlier this year (to which they loaned $2.4 billion) but the FTX implosion created further stress on the company. When FTX halted withdrawals, it created a need for liquidity to replace funds locked on the exchange. Thus, people started pulling money out of Genesis. This rush quickly exceeded Genesis’s ability to match those demands and as a result, the company stopped its lending activities, suspended withdrawals, and has reportedly been seeking an emergency loan of $1 billion to help fill the liquidity the mismatch between the long-term loans it made and the short term deposits that were being pulled out. However, as of writing this, Genesis has not been able to find a source of capital and according to a Bloomberg report, is warning potential investors it could possibly file for bankruptcy if it is unable to do so. The following day, DCG CEO Barry Silbert confirmed that DCG owes roughly $575 million to Genesis but we don’t know yet what other obligations might exist between the two companies and how DCG might be impacted if Genesis is unable to raise the $1 billion.
As a result of this uncertainty, the market began to speculate about the health of DCG, whose subsidiaries include CoinDesk, Foundry Mining, Genesis, and Grayscale Investments. If you remember our July 26 issue, we covered Grayscale and its bitcoin trust product better known as GBTC. At the time, we explained how it went from trading from a premium to a discount and how it was intertwined with the collapse of Three Arrows and Celsius. Given the state of Genesis and the speculation about DCG, GBTC’s discount to spot BTC fell to as low as 45%, the largest discount in its history.
Genesis was also a capital provider to many players in the industry including Gemini (one of the largest US crypto exchanges), who had partnered with Genesis on its Earn product. Shortly after Genesis’s announcement, Gemini began to experience a rush of outflows due to concerns over liquidity. As a result, Gemini also paused withdrawals from their yield product though the exchange noted that their other products and services are unaffected, stating that “Gemini is a full-reserve exchange and custodian. All customer funds held on the Gemini exchange are held 1:1 and available for withdrawal at any time.” GBTC and Gemini are likely not the only companies impacted as Genesis’s pause on redemptions will not only lead to more balance sheet impairments, but the lack of new loan origination going forward will lead to a financing crunch throughout the industry.
The large loss of customer funds, poor management, and the resulting fallout has drawn the attention of many regulators as FTX is dominating debates and leading to strident calls for a crypto clampdown. So far, two Congressional committees have said they will hold a hearing specifically on the events surrounding FTX. The House Financial Services Committee, chaired by Maxine Waters, announced it will hold a hearing on FTX in December in which they expect to hear from the companies and individuals involved, including Sam Bankman-Fried, Alameda Research, Binance, FTX, and other related entities. The Senate Banking Committee is also planning a hearing, though no date has been set at this time.
But some policymakers aren’t waiting for these hearings to start discussing the topic. On Tuesday November 15th, the Senate banking committee grilled members of the Fed, including Gary Gensler, about why the agency didn’t do more to prevent the collapse of FTX and instead, chose to spend their time going after Kim Kardashian for celebrity endorsement deals. Gensler chose to defend himself by blaming the CFTC even though he has spent the last several years claiming the SEC has jurisdiction over the industry. The new GOP whip Tom Emmer has already begun signaling he will investigate Gensler’s meeting with SBF in March in which it is believed the two discussed plans to create a regulatory monopoly in the U.S. for FTX. Even departing senator Pat Toomey took to Twitter to criticize the SEC saying “Congress’ failure to pass legislation creating regulatory guardrails for crypto trading, combined with the complete hostility and lack of transparency by the SEC, has generated a debilitating amount of legal uncertainty. These failures have driven crypto development to foreign jurisdictions that have little or insufficient regulation.” It’s clear that the events surrounding FTX are going to be a topic of much debate within Washington in months to come and will likely influence legislation put forth next year. Hopefully, this event will catalyze the need for regulatory clarity with regards to common sense consumer protection such as segregated client deposits, requiring basic controls and disclosures, implementing proof-of-reserves and finally producing a framework to classify various cryptoassets as commodities or securities.
And while all this was going on, you would think the one person we wouldn’t hear from would be Sam Bankman-Fried. I mean, he is the son of two law professors. He has retained counsel at Paul Weiss (the same firm that defended the Madoff family), who I must assume advised him not to say anything that could further incriminate himself. And yet you would be wrong.
On November 16th, less than a week after FTX collapsed into bankruptcy, SBF gave an interview with a Vox reporter via text message. In that interview, SBF had some harsh words for regulators while at the same time confirming that the persona he cultivated in Washington was a lie. He admitted that Alameda had no real accounting system and thus borrowed far more money from FTX’s balance sheet for investments than he had realized. When pressed on why he didn’t notice it until it was too late, he responded “sometimes life creeps up on you.” Even when he did try to apologize, he refused to take accountability by saying the single biggest mistake he made was listening to others who encouraged him to file for bankruptcy – he believed he could still dig the company out of the hole he created. A week later SBF wrote an apology letter to employees trying to explain the series of events that resulted in the collapse of FTX. In the letter he cited the market crash as the reason the collateral FTX held (largely FTT) fell sharply in value and thus the liabilities eventually became bigger than the assets of the firm. Bankman-Fried did not address why they chose to back customer funds with volatile tokens rather than just holding the accounts as they were, nor did he address allegations that FTX loaned customer funds to Alameda Research. He also didn’t address why FTX made personal loans to employees nor took responsibility for the utter lack of basic financial and corporate controls.
You might be thinking: it’s one thing to provide written statements, but there is no possible way he would agree to do a live, in person interview. And surely there is no possible universe in which that interview would be on stage, in front of thousands of people, in the US which has multiple ongoing criminal investigations. And yet, you would be wrong again. It was revealed last Thursday that SBF will be interviewed by Andrew Ross Sorkin at the NY Times Dealbook Summit on Wednesday November 30th in New York. Sam Bankman-Fried should be arrested, not invited to speak at a prestigious financial conference. But on the positive side, at least the FBI no longer needs to extradite him from the Bahamas.
In Other News
Binance CEO Changpeng “CZ” Zhao announced his exchange is setting up an industry recovery fund open to industry investors and developers affected by the FTX contagion.
Apparel giant Nike has launched a new Web3 platform called .Swoosh that will offer NFT products.
A new filing in FTX’s nascent bankruptcy case shows the exchange and its associated companies may have more than a million creditors.
Bahamas approves provisional liquidators for FTX assets.
FTX is under criminal investigation in the Bahamas surrounding the collapse of the cryptocurrency exchange.
US banks are working with the Federal Reserve to test a blockchain based, digital dollar platform.
Sony tries to patent NFT and blockchain technology usage in games.
Binance.US, the American arm of the world’s largest cryptocurrency exchange, is preparing to bid for bankrupt lending platform Voyager Digital.
Over $600 million funds stolen from FTX were steadily converted to ether and then ren bitcoin (renBTC), a token that represents bitcoin on other blockchains, early on Sunday, as the unknown hacker looks to capitalize on the exploit of the bankrupt exchange.
While FTX contagion continues, the action on Aave and Uniswap reminds us that DeFi tools continue to work properly.
El Salvador is now working on a Digital Asset Issuance Law, which would facilitate operations with any crypto asset.
Binance is launching a Proof-of-Reserve system.
US regulators are investigating crypto trading firm Genesis Global Capital.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.
BACK TO INSIGHTS