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The aftermath of the FTX collapse and the resulting media frenzy caused unexpected and far-reaching disruption. However, it also accelerated the realization that centralized exchanges (CEXs) are flawed. The way we handle the aftermath will have a lasting impact on our industry. Regulators should not be solely responsible for preventing another FTX collapse.
Lessons must be learned from the FTX case, particularly when it comes to corporate compliance. Improved compliance is crucial. We need to do a better job of tracking funds. The loss of nearly $9 billion in customer funds from the troubled exchange clearly demonstrates the need for CEXs to be built on a strong framework that fosters trust and security.
Post-FTX, compliance and transparency must be prioritized. The case highlights the importance of corporate governance, including cash controls, HR protocols, approval mechanisms, financial reporting, and internal and external audits.
However, regulation alone is not sufficient. After the collapse of FTX, regulated exchanges quickly began promoting their regulated custodial services. While regulators have been enforcing new rules, this does not eliminate significant risks. Traditional finance has also experienced risk mismanagement despite strict regulations. The collapses of Bear Stearns, Lehman Brothers, and Credit Suisse serve as examples of the dangers of relying too much on human intervention. Regulation alone cannot prevent bad actors from causing damage when they have control over funds.
Therefore, self-custody is the key. The concept of self-custody is often discussed in the industry, but its practical implications are often debated. The Bitcoin whitepaper reminds us that entrusting exchanges and third parties with private keys means relinquishing control over funds.
FTX, once considered a reputable exchange, turned out to be a different story. Alameda Research, the trading firm linked to FTX’s downfall, had established a secret backdoor that allowed them to withdraw billions of customer funds. Alameda’s excessive leverage amplified losses during market downturns. The collapse of the world’s second-largest exchange shocked investors and drew global attention due to FTX’s marketing spending and public perception.
Unfortunately, customers mistakenly believed their funds would be protected from speculative activities like those conducted by Alameda Research. In reality, FTX provided Alameda Research with a “virtually unlimited line of credit,” resulting in a multibillion-dollar deficit for retail investors. Storing cryptocurrencies in centralized exchanges proved hazardous, as evidenced by platforms suddenly halting withdrawals due to fears of a bank run.
This is why self-custody is crucial. Keeping assets under one’s control is the only way to mitigate risks. However, in the event of a crypto exchange failure, retail investors should not have to wait years to access only a fraction of their assets. They deserve immediate access to 100% of their crypto at all times. While regulation and compliance are important safeguards, newer models are emerging that combine traditional legal funds management controls with self-custody.
Hybrid exchanges have emerged as a solution, blending the best aspects of CEXs and decentralized exchanges (DEXs). This allows for innovation and strengthens asset security. Users can trade directly on-chain without intermediaries while still benefiting from CEX security and liquidity. The hybrid model relies on code rather than human intervention to manage risks effectively, combining regulatory compliance with decentralized features. Users maintain control over their funds and engage with cryptocurrencies through secure wallets and smart contracts. These hybrid crypto exchanges have the potential to revolutionize the industry.
The FTX case serves as a wake-up call for the crypto industry. Similar upheavals have occurred in other industries, such as Wall Street with scandals like Enron and Bernie Madoff. However, we cannot dismiss this case as a minor setback. Scandals like these tarnish the industry’s reputation and hinder progress. The crypto industry is still evolving and maturing, but there are better paths forward.
Hong Yea, the founder of GRVT, a self-custody crypto exchange, brings his experience from Goldman Sachs and Credit Suisse to the industry.