Tim’s Tech Tidbits #10 — The Boy named SBF

Photo by Jonathan Borba on Unsplash

Hi friends,

There are decades where nothing happens, and there are weeks where decades happen. Crypto is currently experiencing its own “Lehman moment” as an unfortunate series of events unfolded over the past week and has cumulated to the bankruptcy of FTX, the third largest global crypto exchange. In a matter of days, crypto (ex-)poster boy Sam Bankman-Fried saw his $16 billion net worth eviscerated and left investors scrambling, writing-off hundreds of millions worth of investments in the company.

The drama that took place would easily put the most sensationalized movie plots to shame. From the elaborate web of deceits, incestuous and elusive inner circle expose, last-ditch attempt by a “white knight” to save the company and the $400 million alleged hack that practically drained FTX of its remaining funds. The plot continues to thicken as more revelations come to light.

Many things are uncertain and several questions remain unanswered as official investigations and proceedings are underway. What is certain, though, is that the digital assets industry has been set back by years: trust with users is irreparably broken and will take time to rebuild. The crypto winter has definitely started with a bang this year, from the fall of Luna, 3AC, Celsius and now FTX. In this newsletter, I will discuss why this is actually a good thing for the industry and share my view on what is going to happen next.

Today’s topics

1. What does crypto mean to you? Keeping the bigger picture in mind
2. Don’t trust, verify: rethinking the importance of due diligence
3. Crypto’s defining moment: putting on the big boy pants

What does crypto mean to you? Keeping the bigger picture in mind

• In sobering times like these, I find it helpful to revisit the underlying thesis. Blockchain technology remains the most significant evolution of software since the internet. Crypto, like its predecessor the internet, is inevitable. Underneath the market turbulence, the digital assets ecosystem continues to mature quietly and resolutely. Compared to where the industry was a few years ago, we are fundamentally in a different place with regards to the level of capital, talent and regulations. The space has become too big to ignore, with institutional interest and participation growing day by day
• The reality is that there is no progress without experimentation and failure. Economists call this “creative destruction” — you will never know whether something works or does not works unless you actually try. In crypto, there has been multiple waves of boom and bust, and this time is no different. The failure of the few is not the failure of the entire industry, and in fact is an important mechanism to weed out rotten apples including irresponsible actors and unsustainable business models
• Periods of contractions also force builders to return to the drawing board to scrutinize and reassess every single aspect of their businesses. When markets crash, “tourists” or founders with low conviction run for the hills, while capital and users become so scarce that getting them back requires new use cases, new product-market fit, or new user experiences. These takes time, often months if not years to develop. It is hard to separate a founder’s solid execution from the upside of a growing market in its contribution to business growth. But when markets turn, it is much easier to separate which entrepreneurs are average and which are truly great

Don’t trust, verify — rethinking the importance of due diligence

• The FTX debacle took many by surprise mainly because SBF failed to show any integrity, and lacked a basic understanding on how any exchange, let alone an exchange of its scale, should be professionally managed and operated. Unlike banks that operate on a fractional reserve and are at liberty to lend out the remaining, exchanges are meant to keep their customers deposits in separate accounts and covered 1:1 at all times. Exchanges and banks are two fundamentally different business models — the former taking fee on trading volume, while the latter taking a spread (net interest margin) between rates on deposits and loans
• In bull markets, it is easy to fall prey to FOMO and focus on funding the next big startup that proper diligence may only get a cursory review. Investors in FTX were initially putting money into what was perceived to be a safe and profitable exchange business, but in reality came with a high-risk prop trading business on the side which relied on customer deposits and FTX’s native token FTT as collateral. The goal is not to avoid risk completely, but to fully understand the risk and weight decisions accordingly
• This also extends to how we do business at J.P. Morgan. Over the past year, we spoke to dozens of crypto companies across Asia and had to turn down opportunities for one reason or another. These decisions are never easy — but we want to partner with founders and management that are aligned with our philosophy, respects regulatory guidelines, operates soundly and build enduring businesses that will be around for decades to come. Furthermore, the due diligence can in fact help companies stress test and bring more rigor to existing systems and structures in place. Regardless of whether you are an investor or advisor, it is important never to take anything at face value and exercise a healthy dose of professional skepticism

Crypto’s defining moment: putting on the big boy pants

• So what’s next? Moving forward, investors will likely spend more time diligencing companies before investing. The scope of the due diligence will also become more comprehensive, with a particular focus on security, risk management, client wallet segregation, internal controls, corporate governance etc. Companies that step up to the heightened rigor and are able to embrace these changes will ultimately mature into leading, professional businesses that will thrive in the new era
• Crypto will require greater user confidence and participation to achieve mainstream adoption, which can be enabled through the implementation of clear and supportive regulatory policies to allow crypto companies to be regulated under the oversight of relevant authorities. The collapse of FTX underscored the importance and urgency of such regulations and will likely accelerate its rollout globally. Governments will also need to strike a balance between ensuring proper supervision and actively embracing innovation. This will widen the divide between regulated and non-regulated crypto players as users will opt for crypto exchanges that are perceived to be safe
• Recent events have also culminated in productive conversations around how the industry can voluntarily adopt best practices to improve transparency and restore trust. For example, Proof of Reserves (PoR) audits allow users to verify that centralized exchanges are solvent and hold the funds they claim to hold by matching them to on-chain records. Many exchanges have come forward to adopt this, including Kraken, BitMex, Binance, KuCoin, Huobi and Crypto.com. It’s a good start and a step in the right direction

If you found this useful, please feel free to share with a friend or colleague who may find this interesting and/or relevant. If there is any topic you would like me to cover or expand on, please let me know and I will see what I can do.

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