First Stage Investor

FTX and the Crypto Regulations Still to Come

FTX and the Crypto Regulations Still to Come
By Vin Narayanan
Date November 21, 2022

It’s been a crazy couple of weeks in the crypto market as it tries to sort through the fallout of crypto exchange FTX filing for bankruptcy. For a more detailed account of how it happened, please read this update I wrote for Early Investing members.

Today, I’m focusing on how large-cap crypto investors should approach investing in the wake of the FTX mess, aspects of it that need more exploration and what the legacy of this scandal might be.

First, I suggest everyone take a breather from the markets for now until we better understand which coins or projects had exposure to FTX — and what problems that exposure might cause. That’s why I won’t be sending out a crypto pick this month. It’s going to take a few weeks to sort out the damage.

If you want to add to your bitcoin or ethereum positions right now, you’re likely pretty safe there. Both coins will likely see price drops in the near term. But when the market recovers (and I believe it will), the current prices for bitcoin (around $16,000) and ethereum (around $1,100) will feel like a bargain. As always, remember to dollar cost average (buy a little bit every week) into your position. That way, you can take advantage of the falling market and lower your overall acquisition costs without worrying about timing the market.

Portfolio Update

The First Stage Investor portfolio is holding up reasonably well given the circumstances. As I write, bitcoin, ethereum, monero, litecoin and polygon are in the green with either double-digit or triple-digit percentage gains. Chainlink, quant and polkadot are down anywhere from 15% to 30%. 

Avalanche is down about 55%. But I’m not really worried about it. The macro pressure caused by FTX (and apparently some market manipulation as well) has depressed the coin’s price. I believe it’s still a good project and should rebound fairly well.

The only coin in the portfolio that I’m worried about is Solana. I recommended this coin just before a major market crash. Then it suffered some major network outages, though it appears to have found a fix for them. But what worries me the most is its exposure to FTX.

The Solana Foundation had about $1 million in assets on FTX. But more importantly (as if losing $1 million isn’t bad enough), FTX had invested significantly in developing Solana’s ecosystem. 

This Decrypt piece does a good job of cataloging Solana’s exposure to FTX. Here’s the critical paragraph from Decrypt’s reporting:

FTX, once one of the biggest exchanges, has deep ties to Solana: the company has invested heavily in several Solana-related crypto projects and was instrumental in developing Solana’s primary decentralized exchange and DeFi liquidity provider, Serum.

Decrypt also reports that Tether has moved $1 billion off of Solana and onto Ethereum and that various exchanges briefly suspended deposits of stablecoins on Solana.

None of this is good news. And it explains why Solana has fallen so hard. I believe Solana still holds much promise. Crypto needs high-speed efficient networks. Solana provides a really innovative solution that should be able to scale. And if it succeeds, everyone will wish they bought Solana right now. But Solana needs to survive the FTX fiasco in order to reach that goal. That remains an open question right now.

Let’s keep an eye on Solana over the next 30 to 45 days. If this is rock bottom-ish, then Solana might be worth holding on to. But if the bad news keeps piling up, then selling and redeploying that capital will make sense.

FTX founder Sam Bankman-Fried (SBF) and his team are the biggest culprits in this mess. The financial malfeasance they engaged in is Enron-like in its audacity. And it’s completely inexcusable. But there are two other issues that need examining: 

  1. How did SBF’s rivalry with Binance founder Changpeng Zhao (CZ) affect the trajectory of this crisis?
  2. Where were the venture capitalists (VCs)?

Unhealthy Rivalry

Binance was an early investor in FTX. But at some point, the relationship between CZ and SBF soured. And SBF bought out Binance’s stake in FTX. 

On November 6, days after a balance sheet from SBF’s trading company Alameda Research leaked, CZ tweeted this:

As part of Binance’s exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have come to light, we have decided to liquidate any remaining FTT on our books.

I believe CZ had to know that this would trigger a bank run that would tank the markets and shut FTX down for good. Yet he decided to do it anyway. CZ said he did it because there’s a “limit” to holding and he announced it in the name of transparency. But that explanation feels like weak tea to me. There has to be more to this story. Hopefully, we’ll find out one day.

The VC Dodge

FTX was backed by some major VC investors, including Sequoia Capital, Tiger Global, SoftBank, Lightspeed Venture Partners and BlackRock. And those VCs let FTX operate without a board or any financial oversight!!

Assets (that belonged to customers) were transferred from FTX to Alameda Research to cover bad bets made by SBF’s trading company. Expense reports were approved in a chat platform using emojis. Employees received lavish perks. And that’s just the beginning of the mess.

The real question is how did VCs allow FTX to operate like this? Board oversight is the minimum for a multimillion-dollar company, let alone a multibillion-dollar operation like FTX. Yet VCs let SBF and FTX operate without it.

VCs usually don’t hesitate to tell their portfolio companies how to operate. They insist on proper supervision and accounting. Yet the world’s top VCs let SBF manage everything with no oversight whatsoever.

And what’s worse is they don’t think they did anything wrong. “We’ve looked at it,” said Sequoia Partner Doug Leone at a conference in Finland. “There’s nothing much we could have done any differently.”

Seriously? How about providing some adult supervision? That’s your job. VCs were asleep at the switch on Theranos. They botched the FTX investment. And in both cases, they’ve tried to claim it wasn’t their fault. I’m guessing they think denial is just a river in Egypt too.

The FTX Legacy

The FTX debacle will likely usher in a set of regulations to govern crypto exchanges. And that’s a good thing. Crypto exchanges need to follow smart, pragmatic rules to make sure investor funds are secured and can’t be used for other purposes.

Centralized exchanges are a weak point in the crypto ecosystem. Crypto needs them to increase adoption rates and make crypto easy to use. But when centralized exchanges fail, they can either bring down the system or damage the ecosystem. Regulating them has become a necessity.

There’s a good chance that policymakers will try to regulate decentralized finance (DeFi) as a result of this mess too. That’s a bad idea. DeFi is still in its infancy. It’s trying to build a new financial system that’s more fair, more equitable and more responsive to the needs and wants of its customers. Regulating DeFi now will limit its growth and innovation.

The upcoming regulatory push will define crypto for years to come. And FTX will long be remembered as the flash point that began the process.

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