FTX today. Celsius and BlockFi yesterday. Why? Will there be more? Yes.
First the “why?”, then I’ll discuss “who’s next?” (yes, there will be more).
Why? A combination of greed & incompetence on the part of crypto exchanges, lenders and OTC desks combined with improper (or lack of) regulation.
It all comes down to this: “balance sheet assets”.
Explain: In the US we see crypto exchanges and others obtaining simple money-transmitter licenses and holding investor assets (cash, crypto, securities, NFTs, etc) on their balance sheets. Offshore, these entities have either no licenses or money-transmitter-type licenses that also permit them to hold customer assets on balance sheet. This means those assets are the property of the exchange (or lender). Customers are just unsecured liabilities on the that balance sheet. Now, since these are company assets the company can use those for its benefit. They can lend them, invest them, and do other things to juice corporate returns…which, of course, can go down in flames. And if a company goes out of business then others may have a superior claim on those assets over investors, including the government (taxes, fines), debt holders, and secured vendors. Customers get whatever might be left, if anything.
In the case of FTX, they are short $10B. This means that they made investments with the assets on the balance sheet to try and make money for the company (not customers), then those investments obviously went south and now there aren’t enough assets to cover investor accounts (unsecured liabilities on the balance sheet).
=> The CEO says “oops, sorry, I f***’d up“, which is true to the tune of $10 billion…but never should have been permitted by regulation in the first place.
Regulation of entities who hold customer assets:
There are 3 types of “qualified” custodians –
- Trust companies
- Banks
- Clearing brokers
Of those…
=> Trust companies and clearing brokers can <<NOT>> hold customer assets on balance sheet. They have to hold them “FBO” (for benefit of) customers. They can not comingle customer cash or other assets with company cash or assets. They have to be segregated. They can not be used or misused. And no third-party creditors have any claim on them. If a trust company or clearing broker fails, their regulator (banking commissioner or OCC for a trust company, FINRA for a clearing broker) steps in and ensures an orderly transfer of assets to another financial institution. 100% of assets.
=> Banks can hold customer assets on their balance sheet, and they can invest them to make profits. This includes lending, stocks, bonds, life insurance pre-funds, credit card advances, letters of credit, etc. All using customer assets. If a bank makes terrible investments and fails, then in this case the FDIC steps in and makes up the difference between assets on the banks balance sheet vs customer liabilities (up to $250,000). This is why the FDIC has onerous regulations on what banks can and cannot invest in, and how much of their balance sheet they can invest into any particular thing no matter how good it seems. It is tightly restricted, controlled and regulated.
And of those, clearing brokers generally don’t hold private securities or tokenized assets (including cryptocurrency). There are a variety of deliberate and nuanced regulations that make it impractical for them to do this. Banks can not hold tokenized assets on their balance sheets, only in their trusts, and while a very few of those hold the common forms of cryptocurrency (BTC, ETH), none hold the vast array of cryptocurrency, private securities, real estate interests, or tokens representing rewards programs, health care records, event tickets, collectibles, etc. That leaves trust companies as the only qualified custodian.
Money Transmitters –
Here’s where a regulatory loophole is resulting in tens-of-billions of dollars in consumer losses. A money-transmitter is a state-by-state licensed entity that was originally intended for firms moving small amounts of cash point-to-point between people (which might very temporarily land in the money transmitters account). Money transmitters carry these customer assets on their balance sheet, as opposed to trust co’s and clearing brokers who do not. Thus the crypto industry has leveraged this loophole to get “licenses”, and these licenses enable them to hold assets on their balance sheets and thus they can do stupid things with other peoples money. Regulation is enabling this behavior.
Who’s Next?
Ah, the multi-billion dollar question. There will be others. FTX is a big shoe, as was Celsius and BlockFi. Brace yourself for more.
Example?
Lets talk about Coinbase. “A note to the financial statements explains that as of June 2022, Coinbase has taken all customer assets on to its own balance sheet…it still has $12bn of its own and customers’ cash (both on its balance sheet).”
The first thing that hit me when I read that was “why the heck would they do that???!!!” They own a trust company, so why wouldn’t they just keep all customer cash and crypto at their trust company to ensure it’s safeguarded and protected. Why the heck would they put all those assets on the exchange, which only has money-transmitter licenses? The only reason I can think of is that they can’t use other peoples money/crypto for their own benefit if it’s at the trust company, but only if it’s at the exchange. Maybe there is something else, but I don’t see it. So the natural question is “okay, so what exactly are they doing with those customer assets?” Possibly no different than what FTX was doing, maybe not, who knows for sure.
They might say “oh the assets are protected under UCC Article 8“, but my understanding is that really is meant to apply to securities and even then just attempts to put customer balance sheet liabilities ahead of other creditors on available assets in the event of failure of the company…it does not prevent the company from using customer cash and assets for its own interests and potentially losing those a la FTX. So Article 8 wouldn’t matter much even if it is held to be applicable in a disaster scenario.
And others?
Yes, any firm operating as a simple money-transmitter, what I call a pseudo-custodian, is capable of doing these things. That’s all crypto exchanges who don’t use a trust company, whether their own or independent, all crypto lenders, etc.
I have a lot of respect for the team at Coinbase, as well as Binance.us, Zero Hash, Bittrex, and other such money transmitters. I have no idea if they’ve used/misused customer assets or done anything stupid or wrong. Maybe they are safe and perfect. But when you are permitted by lax regulation to use customer assets for your benefit, greed almost always prevails.
Protect Yourself:
How? Easy. If you have cash, crypto, NFTs, or other assets at any of these psuedo-custodians who operate with money-transmitter licenses…get it out of there. Now. Right now. Move it to a qualified custodian or to self-custody. Don’t walk…run…right now.
Next Steps for the Industry?
Regulation is (finally) coming. Legislation is coming. We…as an industry…don’t want another Dodd-Frank or Sarbanes Oxley knee-jerk reaction that overcorrects a problem. I’ve got the CEO of Fortress Trust, Albert Forkner, former Banking Commissioner and Chairman of the State Bank Supervisors going out to work with members of Congress including Senators Lummis and Gillibrand and Representatives McHenry and Waters as they craft legislation, and to work with the SEC, CFTC, CFPB and other government agencies on sensible regulation.
And I pray that the states modify their money-transmitter regulations to immediately retract/cancel licenses from any out-of-state entity other than trust companies, banks and clearing brokers.
Does this affect Web3?
Not in the slightest. The tokenization of rewards programs, real estate, healthcare records, insurance receivables, securities, event tickets, estate records, music, film, sports, photography, books, art and everything else electronic in the world is continuing without any delay. These things, tokenized so the blockchain acts as the ledger of record, are not cryptocurrency. Every company has Web3 initiatives, and this will utterly transform the world just as the internet did beforehand. Blue ocean continues for those of us in this space.
Note: these are my own opinions and observations. I’m not advocating anyone take any investment or other actions, you should always rely only on the advice of your lawyers, accountants and licensed investment professionals.
