The crypto industry struggles for a way forward
By David Yaffe-Bellany
Not long after several Wall Street banks collapsed in 2008, a nine-page document circulated on an obscure mailing list, proposing a new kind of financial system that wouldn’t rely on any “trusted third party.”
The paper was the basis for what became the cryptocurrency industry. Using sweeping, idealistic language, its adherents vowed to conduct business in a transparent and egalitarian way, rejecting the high-risk practices of a small number of powerful financial firms that caused the Great Recession.
But last month, the actions of a single crypto firm — the $32 billion exchange FTX — plunged the emerging industry into its own version of a 2008-style crisis. Once considered a safe marketplace for people to trade virtual currencies, FTX filed for bankruptcy after the crypto equivalent of a bank run, forcing industry executives, investors and enthusiasts to grapple with how a technology meant to correct the shortcomings of traditional finance ended up replicating them.
Executives who just a year ago were reveling amid crypto’s seemingly unstoppable growth are now scrambling to prove that they can learn from the mistakes and recapture the industry’s early ideals. Binance, the world’s largest exchange, announced last month that it would release more information about its finances and recruit independent auditors to review those disclosures. Coinbase, the biggest U.S. crypto exchange, proclaimed that it was committed to a “decentralized system where you don’t have to trust us.”
Many crypto advocates are pushing for more drastic reforms, urging investors not to store their digital holdings with big companies and instead turn to more experimental platforms run solely by code.
But for all the promises of change, FTX’s collapse shows how far crypto remains from fulfilling its original aims and gaining widespread acceptance. Consumer distrust has mounted this year amid major financial losses, criminal investigations and an increasingly skeptical regulatory climate in Washington. At a conference last month, Changpeng Zhao, Binance’s CEO, said that FTX’s implosion would set the industry back by years.
The exchange’s downfall compounded months of losses in the virtual currency market set off by a devastating crash in the spring that unfolded amid a broader pullback from risky assets. The upheaval sent some prominent crypto firms into bankruptcy. Bitcoin, the original and most popular cryptocurrency, has been trading at less than $17,000, down about 75% from its high of nearly $70,000 almost exactly a year ago.
“You start to go through these problems, and they stack up one after the other after the other,” said John Reed Stark, a former Securities and Exchange Commission official who has become an outspoken crypto critic. “More and more people are seeing this for the scam that it is.”
At first, crypto’s primary use was criminal. Thieves and drug dealers used bitcoin to transfer large amounts of money without relying on a bank or another intermediary to process transactions.
But over the years, law enforcement got better at tracking crypto crime, and the technology evolved to allow more sophisticated financial applications, like borrowing and lending. People who started their careers on Wall Street — including FTX’s founder, Sam Bankman-Fried, who worked at the trading firm Jane Street — got involved in the nascent industry, looking to profit from the technology.
As the industry grew, it started assuming some of the same characteristics as the Wall Street institutions that it was designed to replace. Crypto trading became increasingly centralized, with a large portion of transactions taking place on a handful of big exchanges, including Binance, FTX and Coinbase. In the months leading up to FTX’s collapse, the trading volume of cryptocurrencies on Binance alone was greater than the combined totals of its seven closest competitors, according to an industry data tracker.
The original vision of crypto “was an attempt to rewrite the rules of finance on a global basis,” said Charley Cooper, managing director at the blockchain company R3. “And here we are again — we’re in an even more centralized industry than we’d see in banking.”
Cryptocurrencies soared in value last year and into 2022 — until May. That was when a popular cryptocurrency called luna crashed, sending the crypto economy into free-fall. Two major lending companies, Celsius Network and Voyager Digital, filed for bankruptcy. Enthusiasts lamented the onset of a “crypto winter” of depressed prices and fading enthusiasm.
Amid the crisis, FTX was considered a relatively trustworthy force. Based in the Bahamas, the company served as a marketplace for people to buy and sell cryptocurrencies, offering high-risk but popular trading options that are illegal in the United States. Bankman-Fried, 30, who had built FTX into a $32 billion company, bailed out struggling firms and built a reputation as a benevolent figure willing to extend a lifeline to colleagues.
Then last month, a run on deposits exposed an $8 billion hole in FTX’s accounts. The company filed for bankruptcy within a week. The SEC and the Justice Department opened investigations, focused on whether FTX illegally lent its users’ funds to Alameda Research, a crypto hedge fund that Bankman-Fried also founded and owned.
Binance operates essentially the same type of business as FTX, but Zhao, the CEO, has recently been careful to differentiate himself from Bankman-Fried, calling his one-time rival a liar and criticizing FTX’s most dangerous practices. On Nov. 25, Binance announced a new “proof of reserves system,” promising to keep users informed about the amount of cryptocurrency in its accounts and to dispel fears that it might be vulnerable to the type of run on deposits that destroyed FTX. (But Binance’s plans were heavily criticized for lacking some key information.)
Coinbase has also tried to alleviate fears of a collapse, publishing a blog post that said it always holds the same amount of money that customers deposited. “There can’t be a ‘run on the bank’ at Coinbase,” the post said.
Still, the mere existence of large companies like Binance, Coinbase and FTX is antithetical to the ideals of crypto, some industry experts argue. Since FTX’s collapse, some crypto enthusiasts have flocked to smaller firms in the experimental field of decentralized finance, which allows traders to borrow, lend and conduct transactions without banks or brokers, relying instead on a publicly viewable system governed by code.
But DeFi has its own problems, including vulnerability to hackers, who have drained billions of dollars this year from the experimental projects.
“They’ve based it on clunky technology that is very inefficient,” said Hilary Allen, a finance expert at American University. “They’re operationally very fragile.”