The crypto industry was soaring just a year ago, with most tokens experiencing all-time highs. Now, crypto exchanges are shutting down left and right. However, there are two patterns across most exchange bankruptcies. First, most of those had ties to Sam Bankman-Fried, FTX, or Alameda Research. And second, they were all involved in crypto lending. Cryptocurrency, at its core, is meant to be a new form of the financial system. Seeing that most bankrupt exchanges reached insolvency through crypto lending schemes, it’s time to ask whether crypto is failing or if the real issue is that we failed crypto.
Crypto’s origin
As we dive into the latest happenings in the cryptosphere, let’s take a moment to remember how this whole thing started. In the aftermath of the Great Recession, an anonymous individual used the pseudonym Satoshi Nakamoto to introduce Bitcoin to the world. Satoshi put out a paper explaining Bitcoin was the first of a new type of decentralized currency.
The idea was to create a currency that could self-verify accounts and transactions. The ultimate goal of a decentralized economy would be to remove banks from the equation. With peer-to-peer (P2P) transactions, banks would not need to be involved in managing finances. Blockchain self-verifies account values and transactions against nodes on its decentralized network.
In other words, a worldwide server network would hold the blockchain’s information and constantly verify it. If someone managed to take over one of the nodes and change its information, the other nodes on the network would override the change. Bitcoin’s blockchain network is technically vulnerable to a 51% attack.
Crypto trending up
Crypto slowly gained popularity with time but was mostly dismissed as a passing trend. New crypto tokens like Litecoin and Stellar Lumens started to appear, called altcoins, to separate them from Bitcoin. One of the main issues crypto faced in its early days was how complicated the decentralized system was for newcomers. On top of that, the lack of regulations led to cryptocurrency becoming a black market favorite, which scared more people away. Even without the black market taboo, purchasing crypto from a decentralized exchange and storing it in a cold wallet (AKA a crypto-purposed USB) seemed like a hassle for many.
Enter centralized exchanges. Binance, Robinhood, Kraken, Gemini, and Coinbase presented people with a simple, accessible way to trade crypto. You could even link your bank account for instant transfers back and forth. The main difference is how online exchanges store crypto compared to storing it on a personal USB wallet. It’s not so much about the contrast between hot wallets (online, always active) and more about where exchanges store your crypto.
Where is your crypto stored?
When your crypto is on a USB wallet, it is only stored there. What we’ve found out recently is that exchanges weren’t doing that. Instead, several exchanges used user funds to purchase crypto but apparently kept the crypto in a central pool instead of users’ assigned wallets. A look at the terms and conditions for several exchanges reveals you agree to let the exchange manage your funds. Whether that’s ownership or not is debatable, but it’s certainly not decentralized.
It’s a flawed system, clearly, and entirely against the concept of decentralized currency crypto means to serve. Since nothing had failed, it seemed crypto had found a home in a system closer to what we already knew. It wasn’t ideal, but centralized exchanges offered a comfortable gateway to a new environment.
A financial revolution in the making
Then, in 2021, crypto reached all-time highs and became a craze as people rushed to invest and hopefully become millionaires overnight. Or not overnight, but sooner than retirement age. As competition grew stiff to see which exchange would dominate crypto markets worldwide, crypto exchanges found new ways of expanding their business. One of the more popular ways they did this was through crypto-backed loans.
Exchanges like Coinbase would offer loans against their users’ crypto. It was a way for people who had made money early in crypto to try the billionaire lifestyle. In brief, the process goes as follows: have equity. Approach an institution that can give you a loan on that equity. Pay no income tax since you had no income– only a loan, which is, technically, debt.
This starts to sound more complicated, as exchanges would have to either have vast reserves of cash or sell their own crypto. In truth, exchanges weren’t keeping customers’ crypto in their wallets. Instead, it appears exchanges pooled and redistributed customers’ holdings according to customer withdrawals. That’s when the term “CeFi” (centralized finance) came about as a criticism that crypto was no longer DeFi (Decentralized finance).
Crypto loans, institution to institution
Next, exchanges started offering loans to more than individuals. It seemed like a crypto revolution was inevitable, and this new tech-backed currency would soon take over global finances. The public didn’t realize exchanges were loaning money to each other. At this point, it was clear the crypto wave wasn’t functioning through P2P transactions. Instead, crypto trading looked increasingly like it was happening from institution to institution, which mirrors current financial systems.
Chair of the SEC, Gary Gensler, insisted crypto- except Bitcoin- was under the SEC’s jurisdiction like any other security. The SEC went on a spree of lawsuits against crypto projects. It’s worth noting that, despite having a surprising amount of lawsuits against crypto projects, the SEC never batted an eye in FTX’s or Alameda Research’s direction.
The aftermath
Then, crypto winter began. As the value of crypto holdings went down, exchanges with loans needed capital to stay afloat. When it came out that Three Arrows Capital had gone under, we learned they had loans from FTX’s Sam Bankkman-Fried’s (SBF) hedge fund, Alameda Research. The same thing happened when Voyager Digital went under, and it became a pattern. Due to positive media exposure, or rose-colored glasses, it looked like SBF was trying to save the crypto industry. We failed to see how FTX was the heart of the crypto collapse.
Eventually, FTX went under after Changpeng Zhao (CZ), founder of Binance, announced his company would sell their FTT (FTX’s signature crypto token) holdings. People started to sell en masse, and we soon learned FTX and Alameda Research engaged in all sorts of nefarious activities. The fallout from FTX’s collapse shows us we failed crypto by trying to turn it into our current financial system.
