The second largest Virtual Digital Asset (VDA) trading platform in the world, FTX, its sister company Alameda Research, and 134 associated corporate entities filed for Chapter 11 voluntary bankruptcy, following a catastrophic solvency crisis on November 11. Despite being a company valued at $32 billion, on the cutting edge of the revolution of payments and finance, its demise was rooted in the kind of malpractice and short-sightedness that have existed for a long time in the world of finance.

As new evidence pours in, it appears that FTX misappropriated client funds to cover losses in Alameda by extending a loan, which was backed by self-created tokens (FTT) as collateral. Once this information was revealed to the public, a bank-run and eventual death spiral ensued resulting in the bankruptcy for both companies and their subsidiaries.

Also, tokens worth nearly $1 billion were ‘hacked’ during the same period. Now, an estimated $10 billion of client funds are missing, with the full effect of the contagion yet to be felt.

For those who were not affected by the crash, there are some silver linings. Exchanges like Binance, Zebpay and Bybit, for example, will soon implement proof of reserves via Merkle Trees — a method by which each user can verify that his/ her funds are backed up in real time — providing a level of transparency not seen in any other market.

However, a crucial takeaway from the FTX saga is that periodic audits of reserves will be insufficient to prevent a similar collapse, as they represent only assets and not liabilities. A framework for a stronger ‘Proof of Solvency’ protocol for platforms could help remedy this, but like any business, it is still vulnerable to fictitious accounting.

The collapse of FTX is not exceptional as corporate history is rife with similar financial disasters.

What is idiosyncratic to the VDA industry is the ability to create tokens akin to shares, which provide little to no rights or guaranteed value to its holders. This can be abused in the way FTX used such tokens in lieu of collateral. In fact, exchange tokens are an analogue to initial coin offerings (ICOs) and the current crisis provides a strong case that they should be regulated in a similar fashion.

Regardless of similarities to the past, One of the biggest consequences of FTX’s spectacular collapse is the loss of confidence that will likely occur with larger, institutional investors. It is crucial that investors be provided the same level of protection and assurances as found in comparable industries. For example, most countries require banks to pay for deposit insurance and submit to regulatory oversight. VDA trading platforms, which often act as lenders and brokers rather than just straightforward trading venues, lack such guardrails.

However, appropriate regulation of centralised international platforms has thus far proven elusive due to the ability to arbitrage jurisdictions. In this case, FTX US was forced to shut down, with a class-action lawsuit already in the works — for international customers, like those from India, there is little legal recourse or potential for repayment.

Regardless of best practices, or local licensing schemes and regulations, regulatory arbitrage by centralised platforms will lead to poor compliance, risk management, and consequent loss. Undoubtedly, a cross-border solution to engage with, and (as appropriate) rein in opaque mega platforms like FTX is a crucial issue; the ability to enforce regulation at a global or domestic level will be important here.

Decentralised finance

Speaking of difficulties in regulating international organisations, as a result of the FTX downfall crypto traders are increasingly turning toward decentralised-finance (DeFi) protocols — as Ethereum tokens flow off big centralised crypto exchanges like Binance and OKX. In fact, DeFi protocols have seen double-digit growth over the last week according to data analytics firm Nansen.

Roughly $3.7 billion in BTC and $2.5 billion in ETH were withdrawn from centralised platforms, further indicative of a significant and sudden loss of trust in centralised platforms. While decentralised platforms do provide a greater degree of transparency, and do align more with the libertarian ethos of VDAs, they are not without risk to users — several million dollars have been hacked from poorly coded DeFi platforms, while the proliferation of decentralised finance would potentially deter government’s ability to trace transactions.

An immediate remedy available to policymakers is to mitigate risks that arise due to regulatory arbitrage..

Centralised exchanges, particularly those that operate in low-regulation jurisdictions, will always be prone to such issues of mistrust. So transparency, accountability, regulation and protection for investors are indispensable for VDA trading.

Otherwise, the system is bound to be misused by bad actors. FTX was not the first high-profile international exchange to fail and it won’t be the last — the purpose of choosing such jurisdictions is to offer increasingly exotic products that would not be allowed elsewhere.

The writer is a former IAS officer