Crypto Wars: the return of Self-Custody

The young Bankman-Fried was once seen a promising crypto supporter. Climbing up the ranks too fast, he became over-confident and followed the same path as a certain Skywalker before him. Blinded by his own success and power, he ended up turning his back on the dreams of decentralized cryptocurrencies and fell for the dark side of crypto.

TL;DR

The setting

Crypto and exchanges

One of the characteristics of decentralized cryptocurrencies like bitcoin or ether is that they can be stored, received and sent without the help of any third-party. Unfortunately, this is still complicated for most people.

Hopefully (or not …), exchanges help most people buy and trade cryptocurrencies by abstracting their complexity. To provide this ease of use, they need to hold their clients’ funds on their behalf…

Do you start seeing the trap laid in front of all those exchange users?

Native crypto users can be harsh critics of exchanges. They see it as going against the crypto’s value of decentralization. However, exchanges have also done a lot for the industry by introducing many new people to it.

Undoubtedly, using an exchange means trusting a third party, which introduces risks beyond the security of decentralized cryptos.

The birth and rise of FTX

SBF was quickly praised as a genius due to his fund’s success, and a lot of big names in crypto invested in both the fund and the exchange. The ties between the two entities started firing off some alarms, but most chose to ignore them.

2021 really set the stage for the situation we are in today when two forces acted simultaneously:

  • European and Asian regulators cracked down on crypto derivatives exchanges, forcing Binance to close derivatives trading there.
  • FTX created a separate US-regulated entity, and started an aggressive marketing directed towards the public (TV ads, Miami stadium naming, …).

The consequences are not hard to guess. Traders barred from Binance moved to FTX, and more retail from all around the world joined FTX attracted by their apparent regulation and approval in the US.

No one could realize at the time the extent to which SBF would abuse the customers’ funds of the Bahamas-registered entity.

Spring — Winter 2022

Contagion

  • Three Arrows Capital (3AC) was the biggest crypto hedge fund at the time. It owed a lof of other funds money, and vice versa.
  • Luna and UST collapse is explained in this article. Basically, the UST stablecoin was backed by LUNA, an illiquid token like FTT.
  • FTT is FTX’s own token. The exchange and Alameda already owned most of the supply, and its value was artificially inflated.
  • The issue of having an illiquid token like LUNA or FTT as collateral is that when the loan needs to be repaid, you can’t sell the tokens easily on the market. This is why Alameda was trapped when FTT price started dropping.

The first domino to fall is always the obvious one. It started in March 2022 with the crash of the LUNA/UST ponzi, that many were calling out for a long time. For unclear reasons, it had still managed to gather some strong supporters. This included 3AC, one of the most renowned fund in the space with ties to guess who: Alameda.

When UST collapsed, 3AC went bust. The ripple effects sent the whole market down, and ended up affecting Alameda as well. It needed more capital quickly to keep its operations running, operations that were for the most part happening on FTX and was helping it thrive. Without Alameda, no more FTX.

So FTX provided Alameda with enough liquidity to keep functioning. But where could they find that much money so quickly? Well, remember how exchanges like FTX hold users assets? Sam apparently believed that they were his to use. He had built a backdoor allowing Alameda to draw funds from the exchange without firing off any alarm, behind the backs of FTX’s employees.

Though regulated banks can use people’s money to lend it to others, crypto exchanges are far from that. It looks like Bankman-Fried mistook his crypto exchange for a bank, a dream he had already evoked in the past …

The final blow

Alameda found themselves with worthless collateral (FTT) and loans to FTX they couldn’t repay. Users tried to withdraw their funds from the exchange. When withdrawals stopped, it became clear that funds were missing and this sent FTT down more than 90% in two days.

Events’ summary

Disbelief

  • Alameda was unequivocally seen as the most promising fund in crypto when it started around 2019, and one of the best in the last three years.
  • FTX was one of the top exchanges, praised by most traders and fund managers.
  • FTX sponsored the Miami Arena and renamed it FTX Arena.
  • FTX ran several ads on TV involving Tom Brady, one of the most known American football player.
  • FTX was listed as a sponsor of the World Economic Forum.
  • SBF made the cover of Fortune Magazine in August 2022 and Forbes more than a year ago.
  • SBF was the 2nd largest donor to the Democrats party, and regularly meeting with US government officials including Gary Gensler, SEC’s president.

It’s a reminder of how thrown off most people must be. Many if not all FTX investors, famous in crypto, didn’t have the slightest idea about what was going on there.

This same SBF that was praised by both the public and the media, appears to have stolen customer funds while lying to its own employees and the public about it.

Another argument for decentralized crypto

Though self-custody is already possible today, it is still too tiresome. In that sense, crypto has failed.

But its raison d’être is more important than ever. If enough of us keep this in mind and push to make it accessible, the ideals of decentralization will progress and reshape where money and investment risks lie.

Disclaimer

This article has been written only one week after FTX’s failure. These facts are based on declarations shared by insiders that haven’t been officially confirmed. In any case, the situation and conclusion still stand: users were defrauded by SBF, and holding your private keys is necessary to be protected from third-party risks.

Sources:

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Bitcoin & Decentralized Protocols

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