December 4, 2022 | Issue 44 TIRED OF SAM BANKMAN-FRIED? I'm not. With each interview I watch, he either describes a business practice I am familiar with or he mentions something new. If it's new, I research it and try to understand it so the next time it is mentioned, I will have a basic understanding of the concept. For example, this week I learned about the multiple functions of FTX: crypto exchange, market maker, broker-dealer, lender, and custodian. In traditional finance, no one firm could offer all those services. The inherent conflicts-of-interest, self-dealing, and investor risks would be too great. When I started paying attention to crypto last year, I did not understand those functions. Heck, I was a starry-eyed enthusiast who believed crypto, blockchain, decentralized finance, NFTs, and the metaverse were going to change the world and our little real estate corner. My views have evolved. After watching massive wealth destruction caused by crypto companies led by unsavory characters, I now view crypto as a set of valuable tools that will only gain acceptance once the risks are understood and, where appropriate, properly regulated. Today, I watched a Senate hearing and was heartened by what many Senators said. They believe in crypto's potential and feel urgency to craft smart legislation. Also, I'm encouraged that in the midst of the latest crypto bankruptcies, the crypto market's volatility has narrowed. Perhaps crypto is transitioning from a highly volatile speculative investment with a $3T market cap to an $855B stable asset positioned for wide adoption and growth. We'll see. However, there's one thing that I'm sure about. The industry is in its infancy. If you want to talk crypto, reach out to me. If you want to see past issues of my crypto newsletter, go Crypto News for Realtors. Also, check out my YouTube videos and Podcast Crypto News for Realtors wherever you get your podcasts. Have a productive week and stay crypto curious! Rich Hopen email@example.com | 908.917.7926 PS. This newsletter is supported by home buyers and sellers in NJ who retain me as their real estate agent. If you know of anyone looking to buy or sell a home, please reach out to me.
CRYPTO NEWS ▸ SBF: "LOOK, I WASN'T RUNNING ALAMEDA" Sam Bankman-Fried, former CEO of crypto trading firm FTX, was interviewed by Andrew Ross-Sorkin at the DealBook conference, George Stephanopolous at Good Morning America, Jen Wieczner at New York magazine, and others. Agreeing to long interviews is unusual for a fired CEO who inevitably will be hauled in front of Congressional committees and put on a witness stand by a prosecutor. What have we learned watching SBF struggle to answer tough questions? He is sorry so many people lost money. He should have spent some time on risk management instead of just growing revenue. He is not the only person who bears blame. Many questions were specific to trading and unless you are in finance, it is not easy to understand what precipitated FTX's collapse. Here's how I understand what happened. FTX had many types of services for its crypto customers. There are the novice investors who bought crypto and were not active traders. They didn't loan money to FTX to earn a yield. They simply wanted to own crypto and keep their assets at FTX. These were custodial accounts. Think of these people as bank customers who put valuables in a bank's safety deposit box. It's clear that custodial account funds belong to the customer, not the custodian. Yet, FTX treated these customer funds as FTX assets. Their action violated the customer terms of services and FTX's misrepresentation that the funds would not be used by FTX will likely trigger allegations of fraud. Another type of customer were leveraged traders. These traders borrowed funds from FTX to make risky bets, high risk for potentially high reward. This is where exchanges can make a high return IF they manage the margin of risk. While there were some questions about FTX previously claiming these leverage traders' customer funds were also segregated, that does not make a lot of sense. However, FTX claimed they had a highly sophisticated risk management software system that tracked all trades and customers' collateral. If any trade was too risky based on the collateral, FTX would "close the position" to ensure FTX would not lose money. Ironically, FTX's failure to do this very thing is what brought the company down. It failed to manage the margin of risk for the biggest trader on its exchange. Here's how Matt Levine of Bloomberg described FTX's risk management system: "FTX was going around misrepresenting how it managed risk. That stuff about a computer that saw everyone’s positions, knew the value of their collateral, and acted instantly to close any positions without a loss to FTX all seems to have been misleading. In fact, FTX apparently managed its most important market risk — Alameda’s huge leveraged position — more or less by someone writing Alameda’s position on a napkin, and getting the math wrong, and then handing the napkin to Bankman-Fried, and Bankman-Fried being afraid to look at the napkin." The contagion from FTX's failure is ongoing. FTX owes $3.1B to its largest 50 customers. Crypto lender BlockFi filed for bankruptcy this week after FTX affiliate Alameda Research defaulted on $680M owed to BlockFi.
▸ Treasury Sec Yellen Calls For Crypto Regulations Yellen said at the DealBook Summit, "I think everything we've lived through over the last couple of weeks, but earlier as well, says this is an industry that really needs to have adequate regulation and it doesn't." Yellen acknowledges benefits of digital assets, such as low service costs to underbanked customers. However, she is focused on the "substantial harm to investors, and particularly people who aren't well informed about the risk." ▸ US Department of Justice submitted a court filing to the bankruptcy court requesting an independent examiner look into potential wrongdoing at FTX. DOJ Trustee Andrew R. Vara said, "An examiner could – and should – investigate the substantial and serious allegations of fraud, dishonesty, incompetence, misconduct and mismanagement by the Debtors."
▸ FTX Invited to House Financial Services Committee Hearing Rep. Maxine Waters, D-CA, Committee Chair tweeted to Bankman-Fried, "We appreciate that you've been candid in your discussions about what happened at #FTX. Your willingness to talk to the public will help the company's customers, investors, and others. To that end, we would welcome your participation in our hearing on the 13th."
CRYPTO CLASS – Crypto's Regulatory Gaps
On December 1, 2022, Commodities Futures Trading Commission Chair Rostin Behnam testified before the US Senate Committee on Agriculture, Nutrition, and Forestry. Behnam was asked to testify about the regulatory gaps that allowed for FTX’s mishandling of customer funds and FTX’s subsequent bankruptcy. In answers to the Senators questions, Behnam referred to the close cooperation among regulatory entities and the shared goal to identify the areas where regulations are needed and which regulatory entities should be granted the legislative authority. Benham’s fundamental argument is that crypto exchanges offer functions that create inherent conflicts of interest that hurt investors. This includes being a market maker (creates a market for investors to buy or sell), broker-dealer (buys and sells for its customer or for its own account), lender, and custodian. Below are excerpts from his testimony. "The events of the past few weeks embody – in the most regrettable way — the perilous state of the digital asset market. For years many have recognized that a patchwork of federal and state-based regulation is an unsuitable substitute for a comprehensive approach. In the absence of stringent and uniform standards, the digital asset market rapidly expanded. With nominal barriers to entry for new products and new consumers, massive speculative interest has taken the place of legitimate market forces, putting the American public at significant risk. Failure to act will leave consumers who have made investments in digital commodities largely unprotected. Unlike other federal financial regulators, the CFTC lacks the necessary and direct authority to write rules and to oversee this marketplace. Instead, we may only reach it through more limited authority activated when fraud or manipulation has already occurred. The CFTC does not have direct statutory authority to comprehensively regulate cash digital commodity markets. But as I suggested over a year ago, the fraud that we are able to prosecute is likely a fraction of what exists in the shadows. Limited enforcement authority is no substitute for comprehensive regulation in which trading platforms, dealers, custodians, and other critical infrastructure participants are required to be registered and subject to direct oversight by a regulator such as the CFTC. To understand why comprehensive regulation of trading platforms is critically important to protect the largely retail customer base of these speculative digital commodity markets, one need look no further than where the CFTC’s regime intersected with FTX. Most of the coverage about FTX in the past weeks has focused on the over 130 different entities that filed for bankruptcy, which includes an offshore-based exchange for trading digital assets and digital asset-based derivatives, a highly leveraged market making firm trading throughout the digital asset market, and a US-based spot exchange. Of significantly less focus is the entity registered with and overseen by the CFTC – a derivatives exchange and clearinghouse called LedgerX LLC (“LedgerX”). Since 2017, LedgerX has been registered with the CFTC as a designated contract market (DCM), swap execution facility (SEF), and derivatives clearing organization (DCO). 6 LedgerX is one of the few FTX entities to not file for bankruptcy. …LedgerX customer property remains secure and LedgerX has the financial resources to continue operating for the foreseeable future. LedgerX is required by CFTC regulations to ensure segregation and security of customer property (including digital assets), maintain capital to cover up to a year’s worth of projected operating costs on a rolling basis, and maintain accurate books and records, in addition to numerous other important requirements. LedgerX must engage an independent certified public accountant to audit its digital asset balances and issue an opinion on accounting treatment of digital assets held by LedgerX annually.8 Many public reports indicate that segregation and customer security failures at the bankrupt FTX entities resulted in huge amounts of FTX customer funds being misappropriated by Alameda for its proprietary trading. But the customer property at LedgerX – the CFTC regulated entity – has remained exactly where it should be, segregated and secure. This is regulation working. CFTC regulations further require that LedgerX be completely walled off from the other unregulated FTX entities in order to properly protect customer property. To that end, as part of the ongoing bankruptcy, FTX has reported that LedgerX holds more cash than all the other FTX debtor entities combined. Whereas this separation has seemingly been extremely important to protecting the customers of the CFTC-registered entity, it is critically important to emphasize that it also means that the CFTC lacked any legal authority to examine any entity other than the registered entity, and had no insight to the operations and treatment of customer property in the unregulated FTX entities. At the CFTC, we lacked the authority to comprehensively regulate the digital commodity market, and to prevent this from happening again, we must be provided appropriate authority by Congress. Without new authority for the CFTC, there will remain gaps in a federal regulatory framework, even if other regulators act within their existing authority."
Resource – Video, Podcast, Blog Sam Bankman-Fried has been interviewed a lot over the past week. He is a master at obfuscation and skirting pointed questions. George Stephanopolous did an excellent job on Good Morning America in his follow up questions whenever SBF danced away from the question.
CRYPTO WORD – ERC-20 tokens ERC-20 tokens are based on the Ethereum blockchain. Just like mainstream cryptocurrencies such as Bitcoin, they can be used to make purchases — or traded for fiat currencies and crypto. Generally speaking, ERC-20 tokens are fungible — meaning that each of them are identical and can be easily exchanged. Some of the use cases for ERC-20 tokens include as in-game assets, and these assets have also been shaping up the world of loyalty points. (From CoinMarketCap) OH, ONE MORE THING – When FTX declared bankruptcy, many observers asked if VC investors conducted a thorough due diligence process. Here's how they do it in Silicon Valley...
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