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Viewpoint - Lessons from the year of crypto

In aftermath of FTX, markets must recognize value of intermediation but not abandon innovation 

4 January 2023

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Is there anything more that can be said about the collapse of FTX, and its disgraced founder Sam Bankman-Fried? The public's obsession with this catastrophic event seems unquenchable. Billions of dollars have vanished, and multiple investigations are now underway into what looks like a massive misuse of customer funds.

The characters of this Shakespearian play are equally intriguing, from the disheveled shorts-wearing founder himself to his protective law professor parents to the nerdy business partner/girlfriend. Truth is indeed stranger than fiction, and we cannot get enough of it.

Sadly, there is no way to sugarcoat this disaster. It is a tragedy for the thousands of people who opened accounts at FTX and lost everything they invested. And it is an enormous black eye for the credibility of the crypto industry.

But it would be a mistake to simply throw FTX on the same pile as other infamous corporate swindlings—like Enron, WorldCom and Bernie Madoff—without examining what made FTX so intriguing in the first place.

At the end of the day, FTX likely failed because it violated the oldest commandment in markets: Thou shall not covet customer funds. This sin has been at the center of most scandals dating back to the beginnings of finance, and really has nothing to do with crypto currencies or blockchain. (Ironically, the only solvent affiliate of FTX with customer funds intact is the US Commodity Futures Trading Commission-regulated LedgerX, a fact worth noting for the CFTC-bashers out there.)

But FTX's unlawful use of customer money should not completely overshadow the groundbreaking ideas it was proposing to disrupt finance. Direct access to exchanges, auto-liquidation, real-time margining—these ideas are not going away. Whether we like it or not, these new approaches to market structure will continue to challenge our way of doing business.

If you put aside the daily FTX drama and step back a bit, what can we learn from the rollercoaster of events over the last year? 

Lesson 1 - Systems matter 

It turns out that the traditional way of doing business in our futures markets would have likely prevented this sort of fraud. Today's market structure is a result of years of lessons and adjustments based on past failings. Last decade's MF Global and Peregrine scandals led to improved margining, daily electronic bank confirmations, and other customer funds protections.

Is it inefficient to do independent verifications on customer accounts? Hell yeah, but it protects the sanctity of customer money and the integrity of the system.

Our markets are resilient because our trading and clearing system is truly a system—a system of independent controls built up over years that compartmentalize functions and socialize risk. Exchanges, clearinghouses, intermediaries, and custody banks serve as important checks on one another, each with their own responsibilities and roles.

Whether you are a crypto firm or an incumbent exchange, models that collapse these functions into one organization must be approached with extreme caution. When these independent checks are bypassed or omitted, conflicts of interest inevitably arise, particularly for those with self-regulatory responsibilities. And risk may be further concentrated as we saw in FTX and its many inter-related affiliates. FIA noted these very concerns in our CFTC response to the FTX application and in my written testimony to the US Congress on evolving market structures.

The question now before us is whether some elements of the FTX model will survive. FTX is not the only company that wanted to combine infrastructure and intermediary functions. There are several other companies in the US – including at least two traditional futures exchanges – that are going down this path. Before we throw out the old model of intermediation, we need to think long and hard about whether such a market structure can be managed appropriately, given the embedded conflicts of interest and the concentration of risk.

Lesson 2 - Risk management requires management 

I'll go out on a limb: risk management is benefitted by human judgment. There…I said it. I know it's old fashioned, but there are years of proof behind my theory. 

FTX's new model replaced intermediaries with algorithms that automatically liquidated positions into the central market when customer money ran out. That makes sense, but what if the market is illiquid or disorderly? What if traders reverse-engineer the algorithm and trade ahead of or even cause such liquidations? What if the liquidation of large positions causes a cascade of liquidations in a distressed market?

Every seasoned risk manager says the same thing: each crisis is different, and you must preserve flexibility and judgment. As much as you can game theory a clearing member or clearinghouse default, risk managers need tools beyond an algorithm to deal with such a catastrophe.

That is not to say that there isn't a role for models, algorithms, and prescriptive rules. But rigid over-reliance on humans' ability to code or model every possible scenario is fantasy. 

There is a reason that FTX's model struck a nerve. We all know that there is room for improvement in the processing of trades and the movement of collateral in our markets. Even in the most advanced markets, bottlenecks in the back office can lead to painful delays when there is a big spike in trading activity.  

FTX has crumbled, but its new approaches should challenge us to reflect on how we manage risk. Some parts of the futures ecosystem move in microseconds, but other parts are still based on end-of-day batch processing. And the lag between executing a trade and collecting the margin can be quickened.

I sense a renewed industry commitment to addressing this issue. More and more companies are investing in post-trade technology and preparing for a world where trading and clearing operate continuously around the clock.

In line with this trend, FIA has joined with other industry participants to form the Derivatives Market Institute for Standards (DMIST) aimed at standardizing and expediting post trade settlement. These efforts are aimed at rethinking the entire workflow, from front to back, while at the same time maintaining our absolute commitment to customer protection and market integrity. This is a worthy lesson of this crisis. 

Conclusion 

Whether you are a believer or skeptic, the crypto industry is here to stay. Our industry should welcome this competition but only those entrants that rise to the standards of the rest of the industry around customer protection, conflicts of interest and risk management.

I have said it many times: same activity, same risk, same regulation. If you are performing certain activities in the market, there should be a level playing field of regulation that the public can rely on. 

The story of Sam Bankman-Fried and the firm he founded will play out in front of our eyes for years to come. The good news is that we can build on this crisis, as we have done many times before, to improve our markets and its protections for customers.

That is certainly a silver lining to this tragedy and a lesson that FIA welcomes. 

 

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