The Collapse of FTX Is Not The Fault of Cryptocurrency, But Bad Business Models
The Collapse of FTX Is Perhaps Not The Fault of Cryptocurrency, But Bad Finance Models
Fraud is Fraud — No Matter If Done Through Cryptocurrencies or Fiat Currency
And, first the science: cryptography and blockchain
Cryptography is the ancient art of preserving the secrecy of messages. It has one of the strongest mathematical and scientific bases of any topic in computer science and has a highly active (and supportive) peer review infrastructure. It also has dedicated researchers striving to improve its core methods and who are open to the discovery of potential weaknesses in its scientific base. As a science and practice, it also existed long before AI, Big Data, the Internet, networking, and all the other “new” areas.
As a discipline, cryptography scales well from theory into practice, and now provides the core of the security on the Internet. In the connection you have with this web page, public key encryption has proven that Medium.com is a trustworthy site, and hashing methods have proven the correctness of the data that is being transferred. Digital signing is then used to continually prove the identity of the site you are connecting to, and where symmetric key encryption is used to stop someone spying on your network accesses.
Without cryptography, our online security would be almost zero. And so, the magical “s” on “https”, transforms our online world from one which is open to malicous activities to one which frees us from spies, criminal entities who wish to release us from our money, and those who want to steal or compromise our data. It basically fixed a flawed design for the Internet.
Blockchain is not hype — it is a solid principle of technical trust
With blockchain, too, we have a highly trustworthy infrastructure that uses a Merkle Tree to define a high level of trust for all associated transactions. Cryptocurrency is a core user of blockchain — in the same way, that a car uses an engine, but where engines can be used in many other applications. Blockchain thus does not exist on its own as a technology, but as an engine which drives something else.
To say that blockchain — and its associated Merkle Tree — is not a true formal method, is like saying that quadradric equations to do actually exist. The blanket dismissal of blockchain as a technology is a shallow response that has no scientific base, but only where its application by others can be called into questioned. The use of “blockchain sceptic” thus lacks any real base in a scientific approach, and can be likened to those who are 5G skeptics, or, in fact, those who were sceptical about rise of the Internet.
Somewhere along the way, some of these terms have been hijacked and generalised, and have lost a bit of their meaning in the media. A scientific world of cryptography becomes a binary world of like verses dislike. I personally believe in cryptography and Merkle Trees in building a more trustworthy world, and in the same way that I believe in John Napier’s logarithms are a true representation of a core mathematical principle, and that Maxwell’s equations truly define the propagation of radio waves.
And crypto?
At one time, “crypto” was a shortened version of cryptography, but not anymore. The sale of the “crypto.com” domain highlighted that the term now is mostly associated with “cryptocurrency”.
At the core of cryptocurrency is the art of applying public key encryption and in using a blockchain infrastructure to create the trustworthiness of transactions. It is peer-reviewed science, and most created in the 1970s and 1980s, and since enhanced with scientific practice. Blockchain, though, can work with any transaction, including financial transfers. Its potential has perhaps not been fully utilized yet, especially where trust and auditability are core elements of our system. It is not the solution, it is just another tool in the toolkit.
Cryptocurrency does have the potential to create a more trustworthy infrastructure for transactions, but some have highjacked it in the pursuit of poor finance models. At the core of this is to back the worth of a company on a currency that is owned by the company. And, the fault at the core of cryptocurrency is thus that there is a general lack of regulation of the industry and a lack of transparency.
So, if we create cryptocurrencies, we need a way to trade them, and where customers can create wallets, and then use their private key to sell their assets, and receive them through their public key. The exchange then becomes a trading floor, and where people sell and other people buy. It is no different to the trading floors for the buying and selling of stocks and shares — and where the laws of supply and demand dictate the prices. The exchange, though, must have a way to underwrite the value of transactions that it can hold, and have enough reserves to enable trading within difficult circumstances.
Fraud is fraud — no matter if it is done with cryptocurrency or fiat
And, so, fraud is fraud, no matter if it is done with fiat currency or cryptocurrency. But it was not an auditor or a regulator who uncovered the potential fraud with FFX, it was CoinDesk. They discovered that FTX’s main association was with Alameda Research, and which kept most of its assets in the FTX’s sourced native token (FTT):
It was thus reported that Alameda had $14.6 billion of assets, but most of this was related to the FTX-source FTT token. It was a circluar finance model. After the article, Binance investigated FTX’s setup:
Binance looked to potentially purchasing FTX, but decided to sell its investments in the company due to the risks around the backing from FTT. The associated run on FTT caused FTX to file for bankruptcy on 11 November 2022:
How this business model of backing the assets of a company with the coin produced by the company is beyond me. This is a like a bank taking your money, and then creating its own currency to back it. It’s a ponzi scheme!
Who is to blame?
It is basically the fault of countries around the world to fully understand how cryptocurrency actually works, and how to regulate it. A customer can see an exchange that has a strong brand and goes with it. But, in this case, where were the regulators? Where is the open transparency of funds and assets which back the operation of an exchange?
I am not an economist, but I do know that a bank needs to have reserves. These reserves need to be real and relatively liquid, and where the bank can cover most of the withdrawls of its customers. In the UK, for example, we had a run on Northern Rock:
It was a scary time for many customers, but the bank coped and was since acquired by Virgin Money. Like it or not, no bank can ever be secure against a run on withdrawals, and must have enough reserves there to ensure that its worth can be measured against trustworthy valuations.
Moving assets around to dodge audits
One must worry, too, that auditers and regulators lack the skills to be able to properly audit companies, as there are rumours of cryptocurrency being moved around between companies. These transfers can then be seen as part of the assets of a company by an auditer, before moving them back out of the company after the audit.
Conclusions
At a fundamental level, it is not the fault of cryptocurrency here. The use of cryptographic tokens is certainly a better way to perform financial transactions between one proven entity and another.
The dream of creating a peer-to-peer transfer to funds with cryptographic near certainty is still there. But, cryptocurrency is an infant industry, and it needs to gain the trust of customers.
The dream is created a more trustworthy, a more auditable, and a more transparent finance world is also still there; it is just that some have used it as a way of creating failed finance models. Our old world of fiat currency is certainly flawed but it has more inherent trust than cryptocurrencies at the current time.
More regulation and auditing?
We thus need better regulation of the industry, and to make sure that we can grow healthy companies, and which can build new economies, and remove ourselves from our paper-based transfer approaches. The central banks in each country thus need to wake up and accept that cryptographic tokens are here to say, and where we need to be better match these to our existing world of finance.
How FTX was allowed to trade for one second, is beyond me. But, I suppose that’s why I do cryptography, and not finance. I personally believe we can use cryptography and Merkle Trees to build a more trustworthy world. We are just not there yet in terms of its adoption in the trusted world of finance. Our regulators and auditors need to have a better understanding of how these improvements will improve things, and to be able to spot fraud and risks wherever they exist.
Because, it’s our money, it’s our investments, and it’s our futures, that they are protecting. To move from paper to cryptographic near certainty is a good move, but open to abuse. I may be simplistic in my understanding of finance, but to assess the valuation of a business against something that is stable seems obvious to me, and the ability to transfer its asset base into cash just seems to be simple economics. But, as I said, I am a cryptography reseacher, and I understand how the maths work, and not how it can be applied into an ecomonic infrastructure.
It’s all about trust
Human trust is a lot less dependent on maths, than cryptography is. I will thus stick to maths for my research and the belief in the peer review process for scientific advancement, and leave the human trust to others.