Last week the crypto exchange Binance had processed $6 billion in outflows by Wednesday. It’s been a bad year for cryptocurrency holders with the price of a bitcoin dropping from a high of around $65,000 last November to $16,720 just over a year later. However, the rush of Binance account holders to withdraw $1 billion worth of cryptocurrencies from the exchange is not thought to be because they have given up on their prospects. Bitcoin and other cryptocurrency prices rose slightly last week.

Those left holding onto cryptocurrencies at the tail end of 2022 are unlikely to be easily convinced to cut their losses and cash in residual value at this stage. Bitcoin, the bellwether for the wider cryptocurrency sector,  has lost 65% of its value this year and around 75% since the highs of November 2021. The rest of the crypto market has seen a similar trajectory.

Those who are still holding onto crypto assets look determined to ride out what many see as a “crypto winter” that will eventually give way to spring. Those that have lost faith, would have been expected to have sold off crypto assets already with prices gripped in a downward spiral for most of the year.

Source: CoinMarketCap.com

But the last month has actually seen the price of bitcoin and most other cryptocurrencies stabilise after months of heavy losses. So why the rush of withdrawals from crypto exchanges now?

Crypto exchanges have lost the trust of users since the early November collapse of FTX, one of the biggest and valued at $18 billion as recently as July. As far as anyone can tell, Binance’s insistence that it is in a healthy financial position is true. The exchange has repeated multiple times that it holds assets that are equal to or greater than its liabilities to customers. It boasted it was able to meet the $6 billion in withdrawals between last Monday and Wednesday “without breaking stride”.

Why the FTX collapse has shaken faith in other crypto exchanges

The problem is, users are worried about how far “as far as anyone can tell” is. Nobody expected the FTX collapse. The exchange and its founder Sam Bankman-Fried had been considered one of the crypto sector’s best practice examples and a ‘white knight’ after stepping in to steady the sector by bailing out two platforms earlier in the year.

FTX engaged with the wider financial markets establishment, taking a lead in dialogue around the need for sector regulation and stamp out the fraudsters and dubious practices the crypto space has long suffered from. Its founder, the 30-year-old Bankman-Fried, known by his initials SBF, was a loud and consistent voice on the need for the sector to clean up its act.

He was also a prominent voice advocating effective altruism, a school of thought that encourages those successful in business to make as much money as possible and then donate it to good causes in the most impactful way possible. The Bill and Melinda Gates Foundation is arguably the best known example of philanthropy that follows the effective altruism mantra. In 2021, SMF announced the set-up of the FTX Foundation, which promised to give away billions of dollars of the exchange’s profits over the coming decade.

However, it turned out that the well-intentioned talk from SBF and FTX was just that – talk. The reality was far less altruistic and what was going on behind the scenes at FTX is now being described as potentially being one of the biggest examples of financial fraud in U.S. corporate history.

FTX’s administrators brought in corporate-restructuring veteran John Ray III who is best known for leading up the investigation and administration of the collapse of Enron 20 years ago. He recently told a U.S. senate committee that the situation at FTX was worse than what he had discovered at Enron, one of the highest-profile cases of corporate fraud and mismanagement in history. He has labelled what happened at FTX as “good old-fashioned embezzlement”.

The core problem was that FTX had been lending money, allegedly more than half of its customer funds, to its affiliated trading firm Alameda Research. Alameda Research then lost those funds on risky trading positions, covering the losses by minting its own cryptocurrency called FTT. When the paper value of FTT collapsed after it became apparent it was the only thing propping up FTX’s balance sheet, helped along by rival Binance publically liquidising its own large holdings of the token, the exchange came down like a pack of cards.

Despite SBF’s attempts to pass off the spectacular loss of billions in customer deposits with the exchange as naivety and mistakes made in good faith, he has been arrested on fraud charges and faces extradition from the Bahamas, where FTX was based, to the USA. Ray’s preliminary findings pour scorn on the idea that the exchange’s collapse was because it was the victim of a combination of unfortunate circumstances or that naivety and inexperience can be blamed.

At the very least, it appears that gross incompetence was behind FTX’s demise with Ray stating “this is not something that happened overnight or in a context of a week.”

When asked to elaborate by Rep. Ann Wagner, R-Mo., Ray said, “Literally, there’s no record-keeping whatsoever”, and revealed, to incredulity, that finances were managed with QuickBooks, a subscription accountancy software popular with small and medium-sized businesses. He concluded:

“FTX Group’s collapse appears to stem from the absolute concentration of control in the hands of a very small group of grossly inexperienced and unsophisticated individuals who failed to implement virtually any of the systems or controls that are necessary for a company that is entrusted with other people’s money or assets”.

There’s not much more insight into the financial heart of other major crypto exchanges than there was into FTX

The problem for Binance and other major crypto exchanges like Crypto.com and KuCoin is that they are making promises to users around their own liquidity and finances that rely on a lot of trust. Like FTX, there isn’t anywhere near the level of transparency that regulated exchanges have to provide.

Binance says it has more reserves than liabilities and could theoretically cover withdrawals of all the assets held on the exchange. But FTX said the same thing, shortly before it imploded.

On Friday, the international audit company Mazars announced it would no longer work with crypto exchange clients, putting its name to “proof of reserves” reports designed to allay concerns account deposits are covered. The auditors cited concerns about how the public sees these reports, often taking them as proof that their funds are safe and fully backed. That is understandable but, it turns out, not really the case.

Proof of reserves reports in the crypto space are far less complete than a traditional audit and are based on procedures agreed on with the company. However, crucially, the issuer of the report issues no assurance or opinion on whether those procedures are sufficient.

The reality, admitted Mazars, is that these reports are so limited in their scope, it doesn’t have much real insight into the finances of the crypto exchanges it produces them for. Proof of reserves reports do not examine the internal controls of exchanges, something that was ultimately the downfall of FTX.

Binance insists it embraces “traditional transparency and we are looking into how best to provide those details in the coming months” but admitted other major auditors it had reached out to, including the Big Four, are unwilling to conduct proof of reserve reports for private crypto companies. Presumably for fear of the reputational damage that would result if an exchange they were producing such reports for ran into trouble.

Paul MacIntosh, EY’s US financial services crypto co-leader, has commented that crypto exchanges need to provide much more than dubiously informed proof of reserves reports, stating:

“To move to true transparency and trust in the industry requires a much bigger step up.”

How can crypto exchanges win back user trust?

Many still believe the crypto sector will make a comeback from the travails of the past year, comparing the 2022 crypto bear market to the 2000 bursting of the dotcom bubble that saw most of the early wave of hyped internet companies fail. A new generation and some survivors subsequently rose from the ashes to become among the most valuable companies in history.

But a newly sustainable crypto sector that fulfils the promises made by its advocates will need trustworthy exchanges. The question for Binance and the other survivors is how they will regain the trust so badly damaged by FTX’s collapse.

Self-issued cryptocurrencies are a problem

One of the major concerns around Binance is that, like FTX, the exchange has issued its own cryptocurrencies, a stablecoin called BUSD and a native token BNB. Bloomberg reports that almost half of Binance’s $75 billion in reserves are made up of holdings of those two cryptocurrencies, mirroring FTX’s exposure to its FTT token. Were the exchange value of BUSD and BNB to plunge, Binance could also face a major liquidity issue.

Binance insists BUSD is backed by cash dollar reserves and “equivalents” 1-1, while FTX’s FTT wasn’t. However, there are concerns about what exactly counts as “equivalents” and if balance sheets could be shored up in less than fully transparent ways.

Crypto exchanges completely decoupling user capital from their own self-issued cryptocurrencies and tokens seems like a first step towards greater transparency.

Regulation

While die-hard advocates of cryptocurrencies and their independence from central control and traditional financial markets won’t like it, there seems little alternative to regulation being part of any long term rebuilding of trust in crypto exchanges.

Former Commodity Futures Trading Commission chairman Timothy Massad, who’s now the director of the Digital Assets Policy Project at the Harvard Kennedy School comments:

“We need basic standards to protect customer assets adequately. We need standards to prevent the operation of conflicting businesses and prohibit entities from trading with themselves and their own affiliates.”

Coinbase Founder and CEO Brian Armstrong has argued in favour of regulation. However, he also notes that the kind of irresponsible practices and conflicts of interest that led to FTX’s downfall also exist in traditional finance and that blockchain technology will make it easier to track and prosecute such instances of fraud, in both crypto and traditional finance.

He also places much of the blame at the door of U.S. regulators, who he says have so far failed to provide a workable framework for how financial services available in traditional finance can be offered in a safe, transparent way in the crypto space. This, he believes, is what has pushed users to offshore platforms outside of U.S. jurisdiction and the protection of regulators. The same can be said of users elsewhere such as Europe.

Rebuilding trust will require a regulatory framework

The near and mid-term prospects of the cryptocurrency sector and especially exchanges will be heavily influenced by their regulatory environment. If major markets like the USA, UK and Europe continue to adopt the approach of keeping crypto out of regulated financial markets, crypto exchanges and other products and services will remain offshore in low-regulation environments like the Bahamas.

It would then be naïve to presume the sector will self-police itself effectively enough to prevent repeats of the FTX collapse and multiple other failures and scams to blight the crypto space over the years. That will see crypto limited to a role in shadow economy finance and all the risks that would entail. The dream of a place alongside mainstream financial markets, if not replacing them, would no longer be realistic without some kind of global political revolution taking place.

Regulation would also be considered heresy by staunch advocates of the original cryptocurrency philosophy of finance being entirely decoupled from the state and central control more generally. But many might admit, especially after the evidence of the past year, humanity possibly isn’t there yet and that central control might be necessary to prevent cryptocurrencies from being hijacked by bad actors.

Realpolitik may mean crypto exchanges and cryptocurrencies themselves accept regulation as the price to pay to regain the trust they need if they are to have a future. The bigger players like Binance are actively lobbying for major economies to introduce the regulatory frameworks that would bring them into the mainstream. However, regulators themselves, and governments, are less keen. Convincing them is the next big hurdle exchanges like Binance will have to clear.