Tokenized Conflicts of Interest
Yesterday FTX imploded in a classic “Emperors New Clothes” moment. It appears that they are insolvent and may be sold in a fire sale or declare bankruptcy. All of the details have yet to emerge, but it’s clear that this is the end of the road for FTX and CEO Sam Bankman-Fried. It is also looking like the majority of customer funds will be lost as FDIC does not insure crypto exchanges.
At the root of this implosion is the relationship between FTX and its trading arm Alameda Research. The leaked Alameda balance sheet revealed $5.8B FTT (the token issued by FTX) and “FTT collateral” plus another $3.4B in other crypto and $2.1B in equities or cash. These assets were held against $8B of liabilities.
In other words, Alameda was using illiquid alt-coins (including one they minted themselves) to collateralize loans. The sudden decrease in the price of FTT forced multiple liquidations, further driving the price lower and causing a run on the FTX exchange.
This alone would be bad for Alameda, but shouldn’t have compromised customer funds which are typically segregated. Indeed, if FTX were behaving the way their customers expected, this run would have depleted their treasury but not had any broader implications. However FTX had also been secretly lending customer funds to Alameda for trading. This is likely criminal and means that customers may lose everything. Even if FTX goes to bankruptcy court, it’s remains will be preyed on by bankruptcy lawyers for years before customers see anything. It’s absolutely devastating situation for their customers, employees, and for public confidence in crypto at large.
Two weeks prior to this, SBF went on the Bankless podcast to discuss crypto regulation. In a spirited exchange with Eric Voorhees, SBF reasoned that crypto frontends should be licensed in order to comply with KYC.
These arguments have aged like milk, and in hindsight it seems like Sam was more interested in throwing up walls for his competitors or consolidating power in DC. Indeed none of the regulation he proposed would have prevented this collapse. Eric, on the other hand, articulated that the need for regulation grows with greater centralization.
Discussions like these on crypto regulation tends to focus on a few key areas, like the treatment of customer funds within centralized exchanges (CEXs) and what constitutes a security. For example, a “Glass-Steagall Act for crypto” could prevent the kind of relationship that FTX and Alameda shared. While these are worthwhile, I believe that the root of significant bad behavior in crypto is not caused by a direct desire to evade regulation but instead arises from the perverse incentives created when a company issues their own tokens.
Companies that issue tokens and generate revenue from the sale of those tokens face a fierce conflict of interest.
Consider how this immediately introduces a new objective: should a business focus on maximizing revenue/core metrics or the the underlying token value?
Imagine a hypothetical startup generating $5M in annual revenue. Investors reasonably value this company at $100M, and the startups raises $10M from well-known VCs. The startup is building something in the “future of work” involving crypto payments, and they have a huge Twitter following. The executives get together and decide they are going to issue a token that may be used in future projects or for payouts on their platform. Because of their great brand and institutional credibility, they are able to get their token listed on Coinbase. Although only 20% of the total supply are in circulation, retail interest drives the price to a fully diluted market cap of $1.5B (bonus points if you’re able to pinpoint which real-life startup these numbers are pulled from)!
So the startup finds themselves in an interesting position: they have $100M in illiquid startup equity and 15x that in illiquid tokens. Just a 7% increase in token price affects their total value more than doubling their equity value. So which one should they focus on? Consider two possible ways they could create $100M in paper value for shareholders:
- Double their revenue.
- Tweet about an upcoming project causing a 7% rise in token price.
Most entrepreneurs are sensible people who know they should focus on revenue and traditional metrics, but it would no doubt be tempting to take the easy route.
For exchanges, this is an easy fix.
I was recently in Portugal and learned about how they regulate their fisheries. The government licenses fishermen and acts as a market maker for their catch. The demand side (canneries and seafood distributors) are prohibited from fishing and must purchase their catch from licensed fishermen directly. The fishermen are likewise prohibited from selling outside of these specific markets.
Similarly, I propose the following regulation for centralized exchanges. The statements are made in decreasing strength.
- Don’t issue tokens.
- If you issue tokens, don’t trade them yourself.
- If you trade them yourself, don’t use them to collateralize loans.
- If you want to take loans and act like a hedge fund, don’t gamble with customer funds (see Glass-Steagall).
These also probably apply to most crypto businesses, although there are many valid businesses that both issue tokens and generate non-token revenue.
Finally, until we have auditable proof of reserves, get your coins off exchanges and into your custody. I like Coinbase Wallet and Phantom right now.