Impact of FTX

There has been a ton of ink spilled about what happened at FTX. Misallocation of customer funds, fraud, a hack, SBF maybe on the run, and more. I covered this in a post last week here. More facts continue to pour out daily. However, I want to try and look forward to the impact this major failure will have on the industry. Here are some things I think will happen next.

1. This will slow investment to the web3 sector

The chorus of “I told you so” has reached a fever pitch in the last few days. Every Crypto naysayer is shouting how dumb this industry is and people are listening. Investors who were hesitant before will be unlikely to consider anything in web3 in the coming quarters (or years?). Limited partners will be less likely to fund Crypto or web3 venture firms or trading shops. Business executives that were skeptical will ignore partnership opportunities or product launches. Individuals will be less likely to try new products or platforms.

This one is fairly obvious, but investment into web3 is going to slow a bunch in 2023. If you are building a startup in this space, you better have a lot of runway to survive the down times. I still believe in the long-term prospects of this technology, but winter is here and it will be harsh.

2. Regulation will come faster and harder

The other big message I heard over and over again from pundits and industry insiders is that the regulations for Crypto must happen now. Consumer protection has been sacrificed with the infighting between the SEC and CFTC and the lack of action by Congress.

We need to get a stablecoin law that stops the next Terra/Luna from happening. This should look something like the rules around money market funds. If a company wants to raise cash into a money market fund, they must register with the SEC, provide disclosures, limit the types of assets held, and be properly audited. The same thing needs to happen for stablecoins. If a company wants to market to investors using that terminology, I want to see the same requirements as a money market fund. Otherwise, find another term that does not imply safety and security.

Rules for Crypto brokerage firms or exchanges need to be implemented ASAP. The exchanges should be regulated like stock markets or commodities exchanges. I don’t care whether it is the SEC or CFTC, but someone needs authority to oversee the exchanges now. If you are a brokerage style firm for Crypto in the U.S., you should be forced to register with the SEC and be subject to similar oversight to a stockbroker.

Clear guidance is needed for what types of tokens will be treated as securities and require registration with the SEC. I’m guessing this will be too heavy handed and most tokens will fall into this regulatory trap. At this point, I’m generally OK with this outcome since it would be much safer than nothing being registered. Hopefully, we can get clear guidance with a safe harbor that establishes rules that can be followed to alleviate the need to register. We’ll see.

3. Some companies will fail

Press reports state that FTX has investments in 100+ startups across the web3 ecosystem. Some of these will be small and others won’t. FTX may liquidate these equity positions in a forced sale, impacting the market value for the equity of these companies.

Even if the FTX investment was small, some of these startups might have used FTX to custody their Crypto assets. Those assets are going to be tied up for a year or longer in bankruptcy court and may never be returned.

FTX also had a big relationship and holding in Solana. That Crypto has gotten slammed and may see more hits. Tons of startups I speak with are building on Solana and held onto the token on their balance sheet. Those startups will have a market loss on their assets, and they may need to retool to a different blockchain. There will be other disruptions like this as the full details on FTX come to light.

There are likely other knock-on effects for the startup community that cannot be seen right now.

4. Governance will get cleaner

Even with significant VC dollars invested, FTX did not have a Board of Directors. The company was so red hot and their founder such a rockstar that the VCs were willing to live with this condition to get a piece of the action. This is super uncommon at such an advanced stage of company with such a high valuation. If there was a proper Board, maybe things wouldn’t have gotten so out of hand here. VCs will hopefully be more cautious in the future.

Also, with the lack of regulatory clarity in the U.S. these past few years, more entities moved offshore. FTX was based in the Bahamas and was mostly outside the U.S. regulators reach. U.S. venture investors and U.S. customers ignored this red flag as this was somewhat normal in the Crypto space. I doubt people will be so willing to support companies existing outside a clean regulatory environment.

5. DeFi may be dead this time

I have written about my concerns for DeFi lending previously here. Quick answer, I’m not a fan. No amount of fancy onchain contracts will make this work. It is just patently a bad idea to lend money against a highly volatile and illiquid asset without recourse to the borrower. I’ve worked in every major financial center across the globe, and I’ve been involved in tons of securitized markets. Nonrecourse loans are super risky and should only be done with liquid and less volatile assets. And don’t tell me a Cryptocurrency is liquid. Even the biggest ones like $BTC and $ETH can have significant price gap movements, and the smaller ones regularly do.

At the core of the FTX problem were loans against a highly illiquid $FTT token from FTX to their related party Alameda. Rumors are these loans were to prop up losses Alameda had from the failures of DeFi lenders Voyager, Celsius, and/or BlockFi. Whether these rumors are true or not almost doesn’t matter. This could be the final nail in the coffin of a bad idea to lend against these assets in this manner. In the future, this should be rebuilt like stock lending, with full recourse to the borrower and a proper underwriting process.

The FTX situation is moving real fast and details are still coming to light. I’m sure there will be other implications I didn’t cover here that will be explored in a future post.

Please follow me on LinkedIn for more frequent updates.

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