In the institutional market, understanding the business model of your counterparties is paramount. Following the financial crisis of 2008, regulatory initiatives in the over-the-counter (OTC) derivatives market have made this a key focus. The question is: Will the FTX bankruptcy be enough to push through new reforms in the digital assets markets?
A lot more will be uncovered in the coming days as regulators step in. The ripple effects will certainly extend well beyond naming conventions for sports stadiums. Though there are many facets to FTX and the crypto-exchanges business model, here are the three key takeaways we are watching today.
Entity, Subsidiary, Brand
Financial institutions have a responsibility to understand their vendors, service providers, and counterparties. FTX was the brand, but the business was carried out by more than 130 companies across the globe. Though crypto-trading was one part of the business, FTX had built its trading firm and other businesses to increase the velocity of investment brought into its ecosystem.
- FTX’s non-U.S. business is not regulated for day-to-day operations in the U.S., but the company filed for bankruptcy in the U.S. for roughly 130 affiliated companies. Its U.S. business under LedgerX LLC and FTX Digital Markets Ltd. is outside bankruptcy. The impact of the bankruptcy of these affiliated companies will take time to be felt by the market. The Legal Entity Identifier (LEI) was created for institutions to easily identify the entity and its legal status. With only a handful of FTX entities registered as LEI, the market will likely see a significant increase in institutional crypto-market participants registering for an LEI.
- In January 2022, FTX was planning to launch stock trading and video games and had looked to acquire Robinhood, the online brokerage firm. Had FTX succeeded as planned, the impact and potential for market contagion would have been much greater.
- FTX trading relied on leveraged loans and increased its valuation by holding a variety of assets in the ecosystem. Traditionally, an exchange value was driven by volume and price discovery. The market can expect to see more scrutiny by private market investors exploring investment opportunities in cryptocurrency firms.
It’s Collateral Management. Again…
Collateral management is key to opening the doors to the next business day. FTX created FTX Tokens (FTT), promoted FTT via rebates, and then created a centralized collateral pool mostly of FTT. It was interesting to note statements such as, “Unrealized PnL from open futures positions is settled in USD every ~30 seconds” on FTX’s website demanding a high reserve balance on the clients to meet any calls. FTX seems to have used clients’ funds as collateral for its own business to mitigate losses while simultaneously bringing on more investors.
- Expect more hair cut on securities issued by an entity and used as collateral. Using clients’ funds as collateral for business works only in the regulatory environment, and regulators would have to address the jurisdiction aspect when dealing with global crypto firms.
- Expect significant global regulations around collateral management such as Uncleared Margin Rules in the cryptocurrency market.
Regulators, Lawyers, and Accountants Are Going to Be Busy.
A precipitating event is generally followed by a bold initiative by a regulator to take the risk of developing the rules. The risk refers to understanding the complexity involved in the market and defining the rules since these rules then act as a baseline guide for other global regulators.
The CFTC rules that emerged after the 2008 financial crisis under the Dodd-Frank Act emerged to help global regulators bring transparency in business.
- There is a lot of work for regulators to unpeel the layers of FTX’s business model and review audits that would have shown Alameda Research’s balance sheet assets were in FTT.
- More work for auditors is on the horizon, as every crypto-exchange is in the race for a Proof of Reserves (PoR) audit to ensure that a custodian holds the assets it claims to on behalf of its clients. The market can expect an increase in activities related to reconciliation and break resolution.
Fortunately, cryptocurrency is not the main economic currency, and thus traditional finance has seen little impact and no signs of market contagion to date. Time will tell if regulators will promote the integration of cryptocurrency into the traditional market infrastructure or keep those assets in their current ecosystem. Have more thoughts on cryptocurrency and regulation in the wake of FTX’s collapse? Contact me at [email protected].
