Beyond Bank Grade: trust is key to unlocking the success of digital assets

bank vault

The recent events surrounding FTX and Alameda Research have shaken the crypto world to its core more than any other in its short history. Throughout this year we have seen continued failings and an erosion of trust in the crypto industry.

Trust is key when managing people’s money, and without it no customer, retail or wholesale, will use your services. For over three hundred years consumers and institutions have placed their trust in banks to safekeep and manage their money. Today the threshold a regulated financial institution must meet to become a bank afford those that successfully pass the regulatory scrutiny and ongoing supervision with this badge that conveys certain trust in consumers. In the banking world it is the understanding that those regulators and supervisors ensure daily that high standards and capital requirements are met by the institutions under their remit, so they can be trusted with their customers money.

Trust must be earned. Outside of crypto, many payments and e-money fintech start-ups look to transition to a banking license at some stage in their lifecycle where they can usually then hold funds on deposit and lend it out to others adding profitable net interest margin revenue. Even more critical is that it provides them with greater trust from their customers which is a must if they build up a large and sticky deposit base with the goal of overtaking their incumbent and archaic banking competitors.

Many in the crypto and digital asset world have held themselves up with the lofty statement of being “bank-grade” particularly in the areas of risk management, financial crime, compliance, and information security in the hope that they are assigned with the same trust to them as you would your bank. What does this really mean for crypto, which is for the most part currently unregulated, with supervisors having limited legislative powers under which to supervise the firms operating?

The numerous examples of failings this year across compliance, risk management, and information security breaches, such as large hacks and data leakage, highlight that at very least the controls in place are not working and certainly would not pass if they were part of a regulated financial institution:

Regulatory fines:

  • CFTC Orders Coinbase Inc. to Pay $6.5 Million for False, Misleading, or Inaccurate Reporting and Wash Trading – https://www.cftc.gov/PressRoom/PressReleases/8369-21

Risk Management:

  • Crypto lender Celsius looked a lot like a Ponzi, says state regulator – https://www.ft.com/content/7380ac24-76b1-4a3e-a2df-688ff4b6d0b1
  • US Regulators Probing Bankrupt Crypto Hedge Fund Three Arrows Capital – https://www.bloomberg.com/news/articles/2022-10-17/us-investigating-bankrupt-crypto-hedge-fund-three-arrows-capital

Hacks:

  • Crypto hackers steal $3 billion in 2022, set to be biggest year for digital-asset heists – https://www.moneycontrol.com/news/business/cryptocurrency/crypto-hackers-steal-3-billion-in-2022-set-to-be-biggest-year-for-digital-asset-heists-9347301.html

This is not to say banks are anywhere near perfect, and we continue to see many failings in traditional finance over recent years, in similar areas including financial crime, risk management and information security. This too has eroded trust in the financial services industry. However, these failings have resulted in tighter controls and regulation in traditional finance; the same is now very likely to be true of crypto and wider digital assets.

How does Zodia Markets uphold gold standards in compliance and security?

There are certainly better ways of doing things differently, whilst building on the frameworks and standards which have been formed through translating experience and learning from past failings, into legislation and regulation. Zodia Market is the only UK FCA registered cryptoasset firm majority owned by a Bank. Zodia Markets has built the exchange and brokerage business with the following key tenets:

  • Non-custodial exchange – Zodia Markets provides pure market access with no custody or market making services in a familiar segregation of duties which allows our clients to mitigate a lot of risks we have crystalise in crypto over recent years.
  • True bank standard compliance and regulation – Zodia Markets adheres to policies and standards which are inherited from our globally regulated bank parent.
  • Principal to transactions – all clients and counterparties face Zodia Markets in our matched principal trading model, enabling trust in the business they transact with.
  • Battle tested cyber security controls – Zodia Markets leverages controls and best practices specific to cryptoassets from our shareholder, OSL, sister company, Zodia Custody as well as Centres of Excellence within Standard Chartered itself.

Trust always has been a key to unlocking success in financial services and is just as important now in this world of digital assets. Zodia Markets has taken the rigour found in the well understood and highly regulated traditional finance world and applied this in running its digital asset business. Familiar standards bring trust, making Zodia Markets the obvious choice of the institutions we partner with.

With this high bar set, we will evolve and support our clients in navigating the fast-changing digital asset landscape to set them up for success. There is much more to deep dive into on this, including segregation of exchange and custody, the future path of regulation, and how, if approached thoughtfully and with impact, it can help build a stronger crypto industry.

Digital Déjà Vu – FTX and Refco

refco fx

It is a bit more of a challenge to find a historical analogy for the very recent FTX vs Binance saga. The United States markets of the nineteenth century had plenty of examples of industrialists putting one another out of business. For example, Cornelius Vanderbilt ordering his son to close the Albany Bridge, which meant that he controlled the only bridge into New York city, home of the busiest port in the country, to put his competitors out of business.

Unfortunately, these examples do not really include one where one party, FTX, was assisted with its launch by the other, Binance.

The FTT token, which among other things allows for discounts on trading fees and OTC rebates has the trappings of a commercial loyalty programme, such as Starbucks Rewards. While these reward the consumer, they do also benefit the retailer through access to data (look at Tesco and Dunnhumby in the UK), providing access to cheap funding and making clients stickier.

A better example though, is the Refco collapse in 2005. Refco was a New York-based financial services company, mainly focusing on commodities broking. It boasted over $75bn in assets with thousands of customer accounts and was the largest broker in the CME. In August of that year it had run an IPO that ironically had the same sale price of $22 a share, the same price Alameda offered to Binance for its FTT tokens.

In October of that year the CEO, Phil Bennett, announced he was taking a leave of absence after he had been found to be in control of an entity that owed Refco a sum of $430m. He had been hiding millions of bad debts in a wholly owned and unregulated subsidiary that he controlled, which was based in Bermuda (FTX is based in the Bahamas). The cause of the losses is unclear, although leaks have pointed to losses by large clients as well as an offshore entity with $525m in fake bonds. What was clear was that at the end of each quarter the CEO had arranged for Refco to lend to a hedge fund called Liberty Corner Capital Strategy, which in turn lent to the Bermudan company Bennett controlled, Refco Group Holdings, which then paid the money back to Refco.

According to Reuters articles, a similar move took place between FTX and Alameda. In May and June Alameda suffered losses, so Sam Bankman-Fried sought to prop them up with a $4bn transfer of FTX funds secured by assets including FTT and shares in Robinhood. He did not tell FTX executives about the move, as was the case with Bennett.

In the bankruptcy proceedings, Refco’s large creditors managed to convince the bankruptcy court that its customers were unsecured creditors because of Refco’s failure to segregate the customer accounts from their general funds. This left Refco’s thousands of trading account customers with 23-37 cents on the dollar. Reuters reports that a portion of the bailout of Alameda by FTX included customer funds, which were presumably also not segregated.

Refco joined the top 20 bankruptcies in US history and Bennett was imprisoned for eight years and was released from prison in 2020, at the age of 71, on health grounds. The FTX story has some way to go.

Responsibility and Sustainability in a Decentralised Environment: The ETH Merge

eth-merge

The Ethereum merge, completed in September, transitioned the blockchain’s consensus mechanism from an energy-intensive proof-of-work (POW) to a proof-of-stake (POS) protocol. This has reduced energy consumption by more than 99.9%.1

For institutions, sustainability is a primary consideration when making investment decisions, as can be seen in the 5,000 signatories of the UN-backed Principles for Responsible Investment, including asset managers, pension funds, and banks.2

Sustainable investments are also a focus for individual investors: 53% of investors overall and 59% of millennials invest in companies or funds that have a strong profile of positive social or environmental impact.3 The improvement in Ethereum’s energy use enables it to act as a bellwether for broader investment into digital assets.

How Does ETH Proof-of-Stake Reduce Energy Consumption?

Proof-of-work protocols use computationally-intensive, and therefore energy-intensive, methods to validate and secure transactions. The cost of the energy and computer hardware required to gain control of 51% of the network, necessary for a hostile participant to have fraudulent transactions approved as valid, provides a preventative control.

With proof-of-stake, participants stake (pledge) 32 ETH, equivalent to around USD 41,0004 to become a validator. Validators are chosen at random to create a block of transactions or to verify (attest) blocks they do not create. They are rewarded for both. Since each node only validates a specified set of transactions, rather validating all new blocks under POW, the energy use is significantly reduced.

The staked ETH and rewards for validating and attesting are incentives for good behaviour. For bad behaviour, including collusion in attesting to malicious blocks or failing to validate when required, part or all of the staked ETH may be forfeited.

Institutional-grade Change

The Merge represents more than just a reduction in energy use and an improvement in the sustainability of the network. It also demonstrates that a decentralised blockchain community can come together to successfully implement change with the reliability and rigour expected of institutional-grade financial market infrastructure.

Unlike the traditional financial system, Ethereum does not have a central issuer or controlling body. Instead, it has a community which includes core protocol developers, validators/miners, application developers, market participants (exchanges, brokerages, and custodians), and holders of Ethereum.

The Merge has taken many years and the fact the final stage was implemented on a live global 24/7 network, which processes more than a million transactions per day5, without taking it offline is a significant achievement. The Merge has been likened by some to changing the engines of an aircraft, mid-flight. While time is needed to fully measure the outcomes, so far it is a success.

Looking to the future, it is time for the blockchain community more broadly to continue to do their part in improving the sustainability of digital assets, their energy use, and their energy sources, and for the Ethereum community to respond to other network challenges such as scalability or transaction costs.

     

      1. https://digiconomist.net/ethereum-energy-consumption (8 November 2022)

      1. https://www.unpri.org/annual-report-2021/how-we-work/more/new-and-former-signatories https://www.unpri.org/searchresults?qkeyword=&parametrics=WVSECTIONCODE%7c1018

      1. Morgan Stanley (2021) study of 800 US investors and 203 millennial investors with minimum investible assets of USD100,000 https://www.morganstanley.com/assets/pdfs/2021-Sustainable_Signals_Individual_Investor.pdf

      1. messari.io: 1.4million on (12 September 2022)

      1. messari.io: USD 1,270 (13 October 2022)

    Digital Déjà Vu – ICOs and 17th Century Treasure Hunters

    ICOs and Treasure Hunters

    Cryptoasset markets are often thought of as innovative, which is true in some cases, but not all. Slow processes and regulation can certainly be frustrating, but market participants should always be careful to not be blinded by neophilia, or a love of novelty. In this article we show that the growth of finance in England in the late seventeenth century, and the craze in Initial Public Offerings (IPO) that it gave rise to, provides a direct parallel with the Initial Coin Offering (ICO) craze that swept cryptoasset markets in 2017.

    The late seventeenth century was a period of swashbuckling and piracy. In the late 1680s the Duke of Albemarle assembled a group of investors to form a joint stock company to fund and expedition under Captain William Phipps to search for treasure near modern day Cuba. While it is difficult to put a date on the first joint stock companies, it was still a novel concept in England at the time. The idea had arrived from Holland along with several other financial innovations such as sovereign bonds, which Holland had first adopted in 1517, and stock exchanges, one of the first of which was the Amsterdam stock exchange, which had been established in 1602.

    In late 1686 Phips discovered the wreck of a Spanish ship and recovered 34 tons of treasure, which yielded the investors a 10,000% return on their original investment. This sparked a craze in diving companies with some IPOs rising 500% after listing. The mania for diving stocks translated to other companies promoting newly patented technologies including linen, paper, burglar alarms and even a system that used lights for catching fish. For example, the White Paper Company tripled, and the Linen Company quadrupled in value during the four years after their IPO. Even celebrities became involved: Daniel Defoe, who went on to write Robinson Crusoe, invested in, and became treasurer of a diving company.

    Cryptoasset markets had a similar experience with the craze in Initial Coin Offerings (ICO). This is a form of fundraising using cryptoassets that many innovative companies used to raise capital, which started on the Bitcoin network with the ICO of Mastercoin in 2013. Ethereum was also originally funded through an ICO, which took place in 2014 and raised over $17m. ICOs were not limited to digital asset projects: Brave, a new internet browser, raised $35m in approximately 30 seconds after launch. In all, the ICO craze saw some 800 companies raise a total of about $20 billion. Similarly, celebrities such as Paris Hilton and Floyd Mayweather became involved, endorsing some ICOs. Mayweather’s promotions included a message to his Twitter followers that Centra’s ICO:

    “Starts in a few hours. Get yours before they sell out, I got mine…”

    The crash in 1696 was significant. 70% of companies that had been listed in 1693 companies went under. Tighter regulation swiftly followed. To dampen speculation the number of market makers (jobbers) and brokers was limited to 100, proprietary trading was forbidden, and high commissions were abolished. Similarly, to bring the ICO craze to an end, the SEC asserted its jurisdiction in 2017 and pursued high-profile cases against issuers and endorsers, including Block.one who settled charges related to the ICO of EOS for $24m. Consumer warnings were issued by regulators in Australia, Switzerland, and the UK, and ICOs were banned in places like China and South Korea.

    In the end, Floyd Mayweather settled with the SEC for the sum of $615k. Daniel Defoe was not as fortunate. He lost his fortune after a further speculation failed, this one involving civets, and became a lifelong critic of financial speculation. However, he started his writing career the year after the crash in 1697 so it can be argued that his failure in the markets was a net benefit to mankind.

    Digital Déjà Vu – Voyager Digital and Knickerbocker Trust

    Voyager Digital and Knickerbocker Trust

    This story covers three topics. First, as markets evolve, they often see a wave of new entrants who are subject to lower regulatory requirements than the incumbents, sometimes known as ‘regulatory arbitrage’. Second, since crypto asset firms and crypto assets do not pose a systemic risk to the economy, there tends to be no lender of last resort, although the hazard of state support does not exist as a moral hazard. Third, while markets are seemingly impersonal and digitised, the importance of trust remains paramount. Once a reputation is damaged, the effect on confidence can be swift and devastating.

    The nineteenth century saw the growth of trust companies. Originally formed to handle various financial tasks for private estates and corporations, these provided similar services to banks but were less heavily regulated and capitalised, meaning they could generate higher returns.

    Among other services, trusts, unlike banks, provided uncollateralised loans to brokers for the purchase of stocks that had to be repaid by the end of the day. The brokers used the securities as collateral for overnight loans from banks, which were used to repay the initial loan from the trusts. Similarities are found in crypto asset flash loans, which are also short-term, uncollateralised and designed to facilitate trading.

    Voyager Digital, which recently filed for bankruptcy, had similarities to a trust company. Clients deposited crypto assets at Voyager and were able to earn returns that were not available from traditional financial service providers. For example, Voyager offered 12% annual interest on Polkadot deposits, with other crypto assets earning up to 8%. This led to it experiencing significantly rapid growth, reporting in Q1 2022 that it held over $5bn in deposits. Voyager then lent these assets to market makers and hedge funds on a largely uncollateralised basis. One of their borrowers was Three Arrows Capital.

    By 1907 the Knickerbocker Trust company was one of the largest in the US. Its president, Charles Barney, was a leading figure in New York society with a good reputation. In the same year Charles Morse, an associate of Barney’s, tried and failed to repeat a successful corner of the ice market by trying to corner the market in United Copper stock. The New York Clearing House was almost able to contain the failure. However, Barney’s previous association with Morse became public and this was enough to cause a run on Knickerbocker. The impact on the overnight lending market against stock collateral was rapid as rates jumped from 9.5% to 100% in two days and the market seized.

    Voyager was similarly impacted by the collapse of 3AC. Its bankruptcy filing showed it was owed $689 million by 3AC with no indication that this was collateralised in any way. Voyager’s earnings for Q2 2022 showed it held $227m of collateral against over $2bn of loans. In addition, it was impacted by both the fall in prices of stETH, a promissory note for ETH on the upcoming Ethereum 2.0, and GBTC, which began to trade at discounted rates to the Bitcoin that backed it. All these circumstances, combined with Celsius’s collapse, led to a run-on Voyager very similar to the one on the Knickerbocker. In 1907, J.P. Morgan convened the presidents of 14 banks in his New York office who pledged nearly $25m, saving numerous firms from collapse, however, Knickerbocker was not among them. Sam Bankman-Fried of FTX similarly attempted to save Voyager but, unlike J.P. Morgan, he was unable to gain support from any other parties. As we can see, the comparison between Sam Bankman-Fried’s and JP Morgan’s experience is not a perfect one.