Is FTX Crash the End of Cryptocurrencies?

Hi. Hi. Welcome to this masterclass on FTX. The failure of FTX was a bit of a shock, especially for those who deposited their money on it. FTX was a centralized exchange to trade cryptocurrencies. The acronym for centralized exchange is CEX. This was not safe CEX. We're going to try to understand why, what happened and what the consequences of that event would be.

You answered, we got lots of answers. That's great. We had a poll. We asked what will be the impact of the FTX collapse on cryptocurrencies. The majority says 40%: it'll steer regulators into action, and I hope so. That's one of the things I'm going to argue in favor of. 30% think it's going to shatter investor confidence. You're probably right. 20% say it's going to set back the adoption of cryptocurrencies. Maybe that's true, although maybe there's a silver lining: maybe what's going to happen is better adoption, in the sense that FTX reveals some foolishness that hopefully future actors will avoid. 10% think it's going to foster innovation, and I think there's room for that, both on the technology side and on the regulatory side.

What are we going to do? First, we will explain the environment: Bitcoin, blockchain, cryptocurrencies, centralized exchanges. Once equipped with these, we'll dive into the failure of FTX, what happened. Finally we'll discuss the consequences.

First, the building blocks. The story starts in 2007. Nakamoto — we don't know who Nakamoto was; was it a group? — issued a paper explaining Bitcoin. Bitcoin's goal was to enable people to transfer payments without institutions, without banks, without central banks. That's the birth of Bitcoin.

Bitcoin has two sides: blockchain and the cryptocurrency. Blockchains are the infrastructure upon which cryptocurrencies are based. If Alice has some Bitcoins and wants to send them to Bob because she's buying Bob's car, she has a private key and uses it to sign a message that she's sending on the network to the nodes that participate in this peer-to-peer network. She says, "I'm transferring one Bitcoin to Bob." All the nodes get that message. Some nodes are validators; their job is to include this message in the blockchain. The blockchain is a ledger in which we register who owns the Bitcoins. We move the ledger from the state where Alice owns the Bitcoin to the state where Bob owns it. That transaction is put by the validators in a block, and that block is added to the blockchain. No institutions, no banks, but validators instead.

Can we trust the validators? Validators are supposed to follow a protocol. The white paper of Nakamoto described the protocol. So far the protocol has worked fine.

The infrastructure explained, then the cryptocurrency. A cryptocurrency is a currency. A currency is something you can use as a means of payment. I accept euros because I expect others will accept euros. A cryptocurrency is the same: people accept it because they think others will accept it. The difference between the dollar and Bitcoin is that Bitcoin has no central bank, no government — instead there is blockchain. There are pros and cons: banks and governments can stabilize and discipline behavior, but sometimes the state is unruly. In places like Venezuela or Zimbabwe, maybe you don't trust the banks or the state, so having an alternative payments infrastructure that is not controlled by those institutions can be desirable. That's a fundamental value of Bitcoin or blockchain-based cryptocurrencies.

Cryptocurrencies have value because we believe they have value. That's why they are volatile: beliefs change, and prices move with beliefs.

Next important concept: on-chain vs off-chain. On-chain are transactions recorded on the blockchain; they are transparent. Off-chain are not recorded on the blockchain: cars, houses, dollars, euros — their ownership is not registered on the blockchain. When you want to trade those things for crypto, you often use a cryptocurrency exchange like FTX. You wire dollars to the exchange's bank account (off-chain), they credit your account on their books (off-chain), then they buy crypto on behalf of customers and hold it in the exchange's wallet (on-chain). So exchanges' internal books are off-chain.

What happened at FTX? FTX was a centralized exchange that took customer deposits and instead of holding safe assets or buying the cryptocurrencies customers expected, they used customer funds in different ways without informing customers. They lent money to Alameda Research, a sister firm, and Alameda bought FTT, the token issued by FTX. FTT was not very liquid or broadly valuable. Customers' money was used to buy assets that mainly benefited those who issued FTT. That looks like misuse of customer funds.

In November 2022, CoinDesk revealed that FTX and Alameda held huge amounts of FTT. Customers then tried to withdraw their funds. FTX could not give them their money because the assets were illiquid or worthless. They had to sell FTT, its market crashed, and FTX declared bankruptcy on November 11, 2022. The collapse hit FTT, FTX, and also wider crypto markets like Ether and Bitcoin. It was a huge shock.

Importantly, the crash did not involve the blockchain itself: Bitcoin and Ethereum blockchains continued to function. The problem was opaque off-chain activity at the exchange. Because it happened off-chain, it was not observable to customers.

What next? Two possibilities: cryptocurrencies and blockchains disappear from public discourse, or they survive. I hope they survive. Blockchain is a useful technology if used properly, but for survival the off-chain component must be regulated. When I say regulated, I mean the off-chain part: when customers deposit on a centralized exchange, there must be transparency, audits, possibly deposit insurance — the same protections you expect with banks. FTX behaved like a bank without regulation, transparency, or audits — recipe for disaster.

Europe is working on a directive called Markets in Crypto-Assets (MiCA) which defines crypto-asset service providers, custodians, centralized trading platforms. MiCA will require regulation, risk management, bank accounts for customer funds, and transparency. That type of regulation is what crypto needs to regain confidence.

Now let's take questions.

Nicola asks about proof of reserves announced by tier-one exchanges after FTX. Proof of reserves can be helpful, but it depends on the protocol: is it on-chain? how will it be verified? Proof of reserves is meaningful only if the method is robust and transparent. The risk at FTX was that customer deposits were used as risky bets, not reserves. Proof of reserves should demonstrate actual reserves, not risky positions.

Sue Kenya asks how people interacted before centralized exchanges with on-chain transactions. In the beginning, transactions were like over-the-counter bilateral trades: seller creates an address, buyer transfers Bitcoin to that address, validators include it on-chain. Real-world transfer (pizza) and on-chain transfer happened in parallel. This is like over-the-counter markets in finance.

Patrick asks why off-chain exchanges were unregulated despite collecting public money. Off-chain resembles banking activity but many centralized crypto exchanges were not classified as banks or brokers and thus avoided regulation. Regulators must focus on off-chain activities, not on-chain protocols. Some actors claimed decentralization to avoid oversight, but FTX was very centralized.

Matthew asks about worldwide regulation dynamics: my sense is the EU is ahead with MiCA, while the US and UK lag in comprehensive regulation. EU moved earlier to create a framework, though the process is lengthy.

AFO asks how to protect against manipulation by rich players. Crypto markets can be manipulated due to fragmentation and low liquidity; big players can move prices. Market fragmentation and lack of depth facilitate manipulation. Belief-driven assets are vulnerable to influential figures who sway sentiment. Regulation and market maturation (liquidity, consolidation, oversight) can reduce manipulation.

Axel asks whether another platform might acquire FTX for the user base. Binance briefly indicated interest, then walked back. It's possible, but acquiring a tarnished brand may not be attractive. I cannot predict acquisition outcomes.

Emmanuel asks: the promise of crypto was to avoid regulation — what advantage does regulated crypto offer compared to fiat? Answer: crypto can offer protection from bad monetary policy because some cryptos have fixed issuance rules embedded in protocol (Bitcoin). That can be an advantage over weak fiat currencies. Avoiding bad regulation is good, but avoiding all regulation is not. Regulation can prevent money laundering and protect investors in the off-chain part.

Enzo asks whether ETFs could mitigate platform risk. ETFs are regulated financial instruments; if ETFs hold crypto in a regulated way, they can reduce platform risk, provided they are properly regulated and transparent.

Nicola asks about NFTs. Some NFTs were speculative; others can be useful for proving on-chain ownership. For NFTs to be valuable long-term, on-chain ownership must correspond to off-chain rights tracked by legal authorities. Stronger on-chain/off-chain verification would help useful NFT applications; superficial or speculative NFTs may fade.

Thank you for joining and participating. I hope it was clear. See you next time.