The Aftermath of FTX

Research

• Nov 22, 2022

Lionel Rebibo, Trakx CEO, and Ryan Shea, Trakx Crypto Economist discussed the aftermath of FTX in a Webinar held on the 16th of November 2022.

Here is the summary:

In the wake of the collapse of the FTX Exchange, many crypto and digital asset services providers have been affected by either direct exposure to the FTT token or the resulting liquidity loss seen throughout the crypto industry. In this instalment of our webinar series, we will be examining the effects of the FTX collapse, the minimal exposure Trakx has to this event, and some industry best practices we have employed that we believe should become core tenets of the digital asset community.

Winter Extended

Many are calling the failure of FTX the “Lehman Moment” of the crypto world. Major tokens like Bitcoin and Ethereum are down 30% over the past two months and the Solana token, championed by Sam Bankman-Fried, is down almost 70%. These heavy losses are likely not the end of the cycle bottom, and a further 20-30% drop in prices over the next six months would not be terribly surprising.

The lasting effects of the FTX contagion are still not fully understood, given that we do not know exactly where “the bodies are buried”. The crypto industry as a whole is becoming far more risk averse, evident by the fact that many daily users are taking self-custody of their coins. The old adage “not your keys, not your crypto” is being proved right now despite the confidence investors had in exchanges a mere six months ago.

There are other warning signs to take note of. The Tether stablecoin, which has for a long time had many concerns about the reserves backing it, saw its share in 3pool, one of the Liquidity Pools on Curve.fi, jump sharply relative to DAI and USDC, signalling a preference by Curve users to hold those over Tether. To allay concerns Tether released its latest reserve attestation, showing it was backed by just over 80% of cash or cash equivalents.

Proof of reserves and proof of solvency will become the next big focus for major players, as this signals both stability and the health of customer deposits on the exchange. Proof of liability will continue to be a key area for improvement for crypto.

Binance to the Rescue?

In the wake of FTX, Binance has set up a recovery fund to help strong firms that are struggling from the impact of the contagion. While this seems like a positive, it also poses a few questions. Most notably, how does this differ from a traditional bank using a lender of last resort? And who determines which firms are strong? These are some of the centralised finance problems that crypto was meant to make redundant.

Many of the mistakes being made now are the same exact mistakes that traditional finance have always made. The only difference for crypto is the incredibly accelerated timetable on how these mistakes are impacting the market as a whole.

Regulations to Ramp Up

Policy makers will never let a good crisis go to waste, and crypto is no exception. The CFTC Commissioner was even quoted as saying this in the midst of the FTX debacle. This is a clear sign that regulation will be implemented in the crypto space much faster now, which isn’t necessarily a bad thing. Regulations often provide a level of legitimacy to an industry and help spread adoption.

One thing to understand is that the technology is not to blame, but the leaders. This industry is unlikely to go away because of the value it provides and while some may be worried about over-regulation in the space, the end result will likely be a stronger crypto community in the long run. Winter might still be just ahead, but Spring always follows with new life.

Trakx Exposure to FTX is Minimal

At a very high level, Trakx has very little direct exposure to FTX and the FTT token. The products offered by Trakx are Delta 1, which are defined as long-only fully asset backed for users. None of the products offered are levered in any way, and there is no use of derivatives whatsoever. Lastly there is no lending of client assets in any form, meaning user funds are safe with Trakx.

Additionally, Trakx CTIs are built with diversification as a top priority. All constituents go through a robust selection process and there is a 15-30% cap per constituent to avoid overexposure based simply on a brand name. Currently, there are very few CTIs impacted by FTT, those being CEX and ESG. Direct impact on these CTIs is approximately 12%. We look at the volume of trading on exchanges that we have vetted, and follow a number of rules on each exchange.

We use an index methodology that has strict rules, meaning that there is some due diligence on each token, including regulatory and governance assessments. This is not our core business and we borrow information from research firms. This is the reason that FTT was a part of the core asset total for Trakx and affected some of our CTIs.

Custody through Trakx

There is a good reason that users are taking custody of their keys across the industry, and at Trakx we have always seen the value of this. Nearly all of the assets offered are custodied at reputable organisations like Fireblocks, substantially reducing counterparty risk. We do not play with our customer’s money.

There are also very strict governance rules to move assets from one custodian to another or from a custodian to an exchange. Only non-custodiable tokens are ever left on exchanges, and this accounts for a relatively small 2% of Trakx holdings. Roughly half of these non-custodiable tokens, around 1%, were on the FTX exchange, which will be completely covered by Trakx.

Going forward, Trakx will change the index methodology to completely exclude non-custodiable tokens and coins in all product offerings. It is also important to not co-mingle our assets with client assets moving forward, which is why Trakx implements strict segregation protocols.

We have decided from day one to place a heavy focus on regulation. This is why Trakx has registered with the AMF under the DASP regime and is currently focused on licensing for 2023 to anticipate the transition to MiCA.

Reputation and Governance

Reputation and governance have taken a back seat in the industry until recently, but Trakx has always understood the value of these tenets. We employ a team of fit and proper professionals with decades of experience in traditional finance. These professionals understand the importance of regulation and why it is imperative to remain trustworthy and transparent. Our board is also composed of renowned traditional finance veterans, making every level of Trakx offering overseen by the best in the business.

Our recent fundraising went very well, with high capitalisation, making it much easier for Trakx to weather these uncertain times. Trakx does not use a native token in reserve as collateral and does not use USDT as a base currency, only USDC. This limits our exposure to other market events and puts us in a good position to pivot should new issues arise.

Key Best Practices

Exchanges should try as best as possible to separate their assets from the assets of their users. While it cannot be achieved with 100% accuracy, commingling should be mitigated to the highest extent possible and oversight over the governance of these assets should be strict.

Additionally, as we have seen from current market behaviour, private keys should not be managed by the exchange itself. In many exchanges, including FTX, these assets tend to be put in omnibus accounts with very loose terms and conditions, making these assets only owned indirectly. Using a third-party custodian for user assets and keys provides an additional buffer that would reduce the risk for retail investors.

Proof of reserves is not likely to solve the problem. Exchanges and crypto asset firms will likely need to be audited externally in order for the problem to truly be solved and it will likely take months, or even years, for regulations to catch up with the market. We expect that many exchanges that “show” proof of reserves are not reporting this properly.

Transparency should be a key goal for the industry, but this again will take time to implement.