Thousands of people have lost everything. Many others, in the millions, have lost a sizeable amount of their life savings.
But being thousands or millions, all share one feeling: the feeling of being scammed.
Despite this, few in the industry are setting their minds on tackling the real root cause to stop these events from occurring ever again.
Because let’s be real, times like these are the best for honest change.
Needless to say, as I said in my last article, there are that many opportunities that society will give this industry before just sentencing it as the “tulip mania of the 21st century”.
We are all aware that’s bullsh*t.
But, undeniably, now more people than not think this way. That’s simply the truth. Thus, our quest is harder now, as we must convince them otherwise.
We have the tools, so let’s make things right.
But how do we do this?
Many in the industry are already talking about proof of reserves, and many exchanges are indeed trying to prove them.
However, the industry seems to be missing another element that needs as much proof as having the appropriate liquidity reserves, an element that was the main driver of FTX’s collapse.
What is everyone missing?
Ending fractional reserves and limiting debt
Four things come clear when analyzing the FTX collapse. Well, five if you consider that we now know that SBF is a fraudster:
- Fractional reserves are a huge no-no in Crypto
- There’s no omnipresent entity to bail out insolvent companies
- Volatility is still a problem
- Liabilities must be exposed
Our financial systems are fractional-reserve banking systems
Fractional reserves, albeit a common practice in traditional finance, is a practice that has no place in Crypto.
But why? To understand this, we first need to understand what this is.
Fractional reserves represent when a custodial entity (an entity that holds your assets for you, that being Crypto or fiat, with an IOU contract that states that those assets are yours) only has a partial share of your assets as reserves.
It’s basically an enhancement to their business model, which is essentially lending your money to others and charging an interest for it.
Thus, it allows banks, as long as volatility levels stay below a certain threshold, to push leverage to extreme levels in exchange for extra profits.
It seems incredibly risky! For sure this activity is very limited, right?
In fact, it’s not.
It’s quite the contrary actually!
The truth is that banks are allowed to loan out up to 90% of their deposits to increase profits.
In layman’s terms, when you look at your bank account and see your balance number, there’s a big chance that only 10% of that is actually in the bank’s reserves.
But before you run to your bank to withdraw your funds, there are two reasons why banks are allowed to do this, reasons that, alternatively, prevent Crypto from being viable if custodial solutions continue to engage in fractionalizing reserves.
Nobody is bailing you out in Crypto… for the moment
Repeat after me: “If I fuck*d up, nobody is saving me in Crypto.”
Crypto is like a jungle, everyone’s in for themselves, no matter how rich or poor you are.
Hence, if you bite more than you can chew, you’re doomed. For that reason, events like the FTX or the Terra collapse occur and customers lose everything.
Repeat after me: “As of today, Crypto has no customer protection”.
On the flip side, in the banking system, your funds are secured by FDIC (Federal Deposit Insurance Corporation) insurance.
In other words, deposit insurance against default.
But what the h*ll is that?
In simple terms, it means that in case the bank becomes insolvent, you are entitled to receive $100,000 to $250,000, at least in the US.
It must be said that FDIC insurance varies from country to country. For instance, in my country, Spain, the insurance is up to $100,000 per deposit (assuming actual euro/dollar parity).
Also, please have in mind that, in case banks, or even whole countries, f*ck up, central banks and the International Monetary Fund respectively will bail out the sh*t up out of them.
In turn, nobody was willing to take the hit for FTX and save it, not even Binance, as the hole was too big.
Therefore, sadly for us, we aren’t that lucky in Crypto… although Binance wants to change that. But that’s news for tomorrow’s article.
Hint: It’s not a good idea, but more on that tomorrow.
Apart from that “small” difference, other elements must be taken into account.
Reserves must be constant in value and they must be easy to sell
The point of having reserves is to act in case of emergency, right?
So, what if your reserves suddenly lose a lot of their value, become worthless, or are simply illiquid?
When people figured out how illiquid FTX’s reserves were, people got frightened of FTX having insolvency issues, and withdrew their money.
Adding insult to injury, the assets were in FTX’s native cryptocurrency, FTT, making people sell their FTT positions and making the reserves become worthless.
Besides not relying your liquidity on your native token (Ponzi scheme levels off the charts), the assets you hold on your reserves must be easy to sell and have very reduced volatility.
In the end, it’s all about risk management.
Would you sleep at night knowing the reserves of the custodial entity safeguarding your assets are 90% plots of land in Greenland or in Apple put options?
I for sure wouldn’t.
However, if you know the reserves are 90% US dollars, you may feel concerned as they are losing 8% of their value over the year, but they aren’t losing 80% of their value overnight, which is the main scenario you want to avoid.
Crypto.com, one of the biggest cryptocurrency exchanges, has 20% of its cold wallet reserves in sh*tcoin Shiba Inu.
It’s so pathetic it’s not even funny.
Crypto companies love leverage
Besides Ponzis, the other great sin that Crypto companies have embraced is… getting into debt.
As Crypto surfed the biggest bull run in history, Crypto assets seemed to never stop going up. Consequently, in order to attract customers, Crypto companies offered insane yields in turn for customer deposits.
Of course, apart from the fact that the majority of cryptocurrencies were super inflationary (in part to pay those insane yields by printing tokens), these companies had to make increasingly-risky trades to earn super high yields, in order to pay their customers the promised premiums.
All this was great for bootstrapping growth, but it had a problem.
When your growth is so correlated to positive market sentiment, the moment things go south, you’re done.
As legendary investor Warren Buffet once said, “A rising tide floats all boats….. only when the tide goes out do you discover who’s been swimming naked.”
Consequently, unbeknownst to the majority of their customers, the majority of Crypto projects and protocols were secretly insolvent the moment markets went south.
For instance, with FTX, the moment Terra collapsed left a huge hole in Alameda Research, which ended up destroying the exchange.
Therefore, as customers, it is our right to understand how exposed the custodial entities we are using really are.
Finally, now that we understand the no-nos, what are the do-dos?
On-chain transparency and FEXes
In order to correct those shortcomings, we need three things:
- Merkle trees Proof-of-full-reserves
- Fully Encrypted Exchanges for self-custody
- On-chain Proof-of-liabilities
Merkle trees Proof-of-reserves
We need cryptographically-verifiable, on-chain proof that the custodial solution has full reserves of our funds. Nothing below a 1:1 deposit/reserve is acceptable.
How do we ensure that?
With Merkle trees.
Merkle trees are used on blockchains to store a storage-optimized hash of the transaction data stored in a block. Instead of storing the hash of each transaction, you store the root hash of all transactions in the block.
The root of this tree is then stored in the block header of the next block, thereby creating the concept of a chain of blocks, hence the name ‘blockchain’.
This is done for two security reasons:
- Increase the hacking difficulty proportionally to the increase in the length of the blockchain
- To ensure data integrity, as the moment some transaction is tampered the hash changes, and that malicious blockchain state is automatically detected.
Therefore, with Merkle trees we can have proof that the reserves are, in fact, legit. Also, to carry out these proof of reserves, we need third parties to serve as unbiased judges.
For that reason, projects like Chainlink are already offering on-chain-proof services.
Cryptographically-verifiable full reserves are non-negotiable.
Fully Encrypted Exchanges are the best of both worlds
Making investing in Crypto easy while letting you own your coins is simply beautiful.
Simple, if non-custodial solutions were the norm, collapses like FTX’s would never have happened.
As I outlined in this article, fully encrypted exchanges offer the best of both worlds for exchanges; the performance of a centralized exchange with the non-custodial features of decentralized exchanges.
We need to promote solutions that foster self-custody without compromising simpleness nor performance.
On-chain proof-of-liabilities, a problem no one talks about
Finally, we need to start forcing custodial solutions to show how exposed or leveraged they are.
It’s a right we must claim, as leverage is all too common in Crypto.
Cryptographically-verifiable proof-of-liabilities are non-negotiable.
As Kratos from God of War would have said: we must be better
In short, the one thing that would have prevented FTX’s end was… transparency.
We shouldn’t be asking for transparency, we should be demanding it.
If we all decide to reject any custodial solution that doesn’t commit to proving its reserves and liabilities, or isn’t working its way to a self-custodial ownership model, then and only then this industry will start moving in the right direction.