The crypto industry suffered a major shock in November 2022 when the Bahamas-based cryptocurrency exchange FTX collapsed due to mismanagement of funds. The fallout of the collapse was felt across the industry, with a dozen other crypto firms either buckling or struggling to stay afloat. On a recent episode of The Chopping Block on Laura Shin’s Unchained podcast, Dragonfly’s Haseeb Qureshi and Tom Schmidt analyzed the impact of the FTX fiasco on the way that VCs operate in crypto.
The collapse of FTX is indicative of a distinct lack of due diligence from both crypto and traditional venture capital. Despite being backed by industry heavyweights like Paradigm, Sequoia Capital, and Blackrock, as well as the massive Singapore sovereign wealth fund Temasek, FTX managed to raise more than $1.5B at a valuation of $32 billion by January 2022. It was later discovered that the exchange had an $8 billion hole in its balance sheet.
It is now clear that dozens of prominent VCs and backers are now set to record heavy losses on their books. For example, Sequoia Capital has already written off its $210 million investment in the company. What went wrong that would have caused the investors to be blindsided by this exchange?
Part of this boils down to the aura that Sam Bankman-Fried had developed over the last year — which was largely fueled by crypto media painting him as a savant. Many things that would be considered as odd/red flags, would become lionized as part of his genius. This was underscored by the horde of glowing profiles that appeared in mainstream media about SBF. Unfortunately, this allowed him and FTX to simply shirk off investors who asked too many questions.
After FTX, diligence standards will almost certainly increase across the industry. We are likely to see more VCs demanding board seats and other corporate controls when investing into CeFi companies. On the demand side, most institutional traders are now demanding Proof of Reserves (PoR), a cryptographic method by which exchanges can prove their assets on hand match their liabilities. Many exchanges have begun offering this already, and it’s likely this will become a standard industry practice going forward.
We’re also likely to see more disaggregation of the exchange stack. Today, exchanges serve as custodians, brokerages, lenders, and exchanges, all in the same bundle. Going forward, we’re likely to see these different functions break out among different entities as they do in traditional finance; this makes it much more difficult for an exchange to steal a customer’s funds (since they don’t have access; the custodian does).
Altogether, these changes should help reduce the likelihood of the next FTX taking place on our watch. Although crypto is often chaotic, the learnings are always public, and it is ultimately up to the users of these platforms (and their investors) to demand these changes. The FTX fiasco has taught the crypto industry a valuable lesson in the importance of due diligence and the need for increased transparency and accountability. It is now up to the industry to ensure that these changes are implemented and that investors are protected from similar catastrophes in the future.
The FTX collapse has underscored a need for greater due diligence from both crypto and traditional venture capital. It is now clear that exchanges and investors need to be more aware of the risks associated with investing in crypto, and to ensure that proper due diligence is carried out. This includes demanding board seats and other corporate controls when investing into CeFi companies, as well as demanding Proof of Reserves (PoR).
We’re also likely to see more disaggregation of the exchange stack, with different functions breaking out among different entities as they do in traditional finance. This should help reduce the likelihood of a similar catastrophe taking place in the future. In addition, VC firms should also be more aware of the need to conduct proper due diligence and not get caught up in the hype of a particular individual or company.
Ultimately, it is up to the users of these platforms (and their investors) to demand these changes. The FTX fiasco has taught the crypto industry a valuable lesson in the importance of due diligence and the need for increased transparency and accountability. It is now up to the industry to ensure that these changes are implemented and that investors are protected from similar catastrophes in the future.
