What I Told My Mom About FTX

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December 12, 2022

...the demand for crypto has led to a supply of centralized services—and these significantly compromise the leading value of crypto by controlling custody and access.

The FTX failure is big. When a large crypto exchange implodes, everybody in crypto knows about it. But even big news in the crypto space is usually inconsequential to outsiders. This event was so big that the news spilled over into mainstream media and caught the attention of people who know very little about bitcoin and crypto. Since my work relates to bitcoin, I've had a number of people ask me about the implosion of FTX. When my sister and then my mom asked me about it, I realized this must be truly big news!

It occurred to me that most people have very little context for understanding the FTX debacle. Thousands of articles, tweets, Twitter spaces, blog posts, and memes have been produced to discuss it, and more information is coming out constantly. I don’t have anything to add to all that. However, I did write up a simple explanation of the situation and emailed it to my mom and sister.

Here is what I wrote…Don’t worry, I’ll spare you the ‘Hi Mom’ intro...

FTX was founded in 2019 and quickly grew to be one of the largest crypto exchanges in the world. Founder Sam Bankman-Fried, an MIT graduate, was portrayed as a financial wunderkind. Seemingly out of nowhere he quickly became a public figure in the crypto space. He gave billions to political figures and (ironically!) lobbied vigorously for more regulation of crypto financial institutions and transactions. Hints of financial instability surfaced in early November, and within a few days it was confirmed that FTX did not have the assets to back all their liabilities.

As it turns out, FTX was using customer assets on deposit and making highly speculative trades with insufficient capital. Once their financial position became clear, there was essentially a "run on the bank" where people tried to withdraw funds but couldn't because FTX no longer had the funds. This led to its collapse. Many questions are still unanswered about other entities that were involved with or impacted by FTX. Questions have also arisen about possible unethical political influence being bought and sold and funds being laundered through FTX.

This could not happen so easily with a bank or a brokerage because they have many regulations and auditing requirements that have not yet been put in place for crypto exchanges. But don’t be fooled—it still happens at times with these regulated institutions!

For the record, I make a sharp distinction between bitcoin and crypto. Bitcoin has a solid case as a strong, non-government, non-inflationary, decentralized monetary asset—still immature but with all the features necessary to become Gold 2.0 and the world's preferred monetary reserve asset as it matures.

"Crypto", on the other hand, is a wild mess of crazy ideas (some good and some bad) and Ponzi-like and casino-like get-rich-quick schemes that borrow some of their concepts from bitcoin. I personally would stay far, far away from "crypto" as an investment. It is too difficult to get sufficient information to evaluate the risks and make a sound judgment. There are rare exceptions for those who are willing to do a great deal of research.

If bitcoin and crypto are so different, why did the price of bitcoin go down in light of this debacle? Two reasons I can think of: 

1) people don't understand the sharp distinction between bitcoin and crypto, and 

2) many affected entities had to sell bitcoin to raise the funds to pay off customers. 

In spite of the impact on the price, bitcoin as a network has continued to hum along, and its fundamental value isn't impacted by this event at all. If anything, it underscores the need to store assets like bitcoin through self-custody—without trusting an organization to take care of your funds. With bitcoin, you self-custody by keeping and protecting your private keys—essentially long passwords that give you and only you the right to hold and transact with your bitcoin.

The leading justification for crypto to begin with was to break the control that centralized authorities have over money and individual finances by allowing people to self-custody and to transact without interference. But the demand for crypto has led to a supply of centralized services—and these significantly compromise the leading value of crypto by controlling custody and access.

Monetary and financial service providers and applications should only be able to operate in one of two ways:

1) Centralized entities (like companies, banks, and brokerages, e.g. FTX) are inherently opaque and have lots of power over user funds. These entities need rules for transparency and custody, either through government regulation or preferably through industry-wide standards that customers can trust.

FTX was centralized and violated both transparency and custody.

2) Decentralized entities have no central control and do not custody user funds. They exist only as nodes on a network. Decentralized entities are a new form of organization that have no central authority or coordination. They function using a blockchain—an online ledger replicated at each node on the network. They operate based on rules set in software. These rules can only be changed by a form of community consensus. These organizations are inherently transparent because the code, the assets, and the transactions are visible on the blockchain.

Privacy in decentralized entities is maintained because your blockchain wallet is not associated with your name, but with a private key that you control, that no one else knows. 

That way:

  • Everyone can see what financial transactions are taking place (no way for an institution to hide or cheat because their wallet address should be public).
  • No one can use or access your funds without your permission and oversight. Funds and transactions are private. Funds cannot be confiscated. 
  • Transactions don't require permission from the government and cannot be prevented by a third party (including government).

Even though FTX was a crypto exchange, it illustrates that all traditional financial systems are vulnerable to the same kind of manipulation and collapse because they are centralized and opaque. Decentralized assets like bitcoin and decentralized financial organizations are a growing solution to these problems.

I know this was long and not easy to get your head around if you're not familiar with all this. But it is increasingly important for everyone to understand. Bitcoin is a profound, healthy innovation that should be embraced. Most crypto projects will fail, but a minority will likely survive and will provide greater freedom of transaction than we currently have. All of this will take time.

Stay Sovryn, and help your family and friends become Sovryn! You might consider sharing this article with some of them to help them understand not just FTX but the larger issues at stake.

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