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5 Lessons for Crypto Economy after FTX Collapse

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“Is crypto about to go extinct?” The question posed by numerous media in January followed a number of major crypto companies collapsing in 2022. Global media concerns came to a climax in November with the FTX imploding and its founder Sam Bankman-Fried placed under arrest. To better gauge the stakes behind this crypto-crisis, HEC Paris Professor Bruno Biais held a Masterclass on January 19. It retraced the Bitcoin’s history, from its inception by Satoshi Nakamoto in 2008 to current calls for regulation. Here are five of the key takeaways.

bruno biais masterclass FTX blockchain - cover

Watch the replay of the Masterclass:

1.    The Origin of the Bitcoin and How it Works

The bitcoin story starts in 2007, just after the great financial crisis. At that time a certain Satoshi Nakamoto (a pseudonym of the creator/creators of the bitcoin, Ed) issues a paper explaining what the goal of bitcoin was. At the time, people had a deep mistrust of institutions like banks. Nakamoto wondered if they could do without those institutions and suggested a project to perform one of the main functions of banks (facilitating payments) without the banks. And this gave birth to the Bitcoin. But there are two sides to the coin. One is the blockchain and the other is cryptocurrency.

What are blockchains? They are the infrastructure upon which the cryptocurrencies are based. Let's say Alice has some bitcoins and she wants to send those bitcoins to Bob because she's buying Bob's car. She uses a private key (a cryptographic device) to sign a message that she's sending on the network to the nodes that participate in this peer-to-peer network. And she says: “I'm transferring one bitcoin to Bob” and so all the nodes get that information. 

Now, some of the nodes are validators and their job is to take this message and include it in the blockchain. The blockchain is a ledger in which we register who owns the bitcoins. So, we want to move the ledger from the state in which Alice owns the Bitcoin to the state in which Bob owns this bitcoin and so that transaction is going to be put in a block. And that block will be added to the blockchain. No institutions, no banks, but validators instead.

2.    Explaining the Volatility of the Bitcoin

A cryptocurrency is a currency, just like the euro or the dollar. The Bitcoin or the Ether are currencies, something you can use as a means of payment. Now, why do you accept the means of payment? Well, a currency is something that I accept as a means of payment because I anticipate the others will. A cryptocurrency is just the same.

So what's the difference between the dollar and the bitcoin? The difference is no central bank. No government and, instead, a blockchain. There are pros and cons. Having banks and governments is not always bad. Sometimes it can help stabilize and give rules and disciplined behavior, but sometimes it doesn't. Why? Because of the nation it operates in: if you if you're trading in Venezuela or Zimbabwe, you might not trust the banks, the state and so maybe having the ability to use a means of payment and payment infrastructure that is not controlled by these big institutions could be a good thing. I think that’s the fundamental value of the bitcoin or cryptocurrency and its blockchain. 

Now, all this value of cryptocurrencies is something that has to do with beliefs. It has value because we believe it has value. And, why are cryptocurrencies so volatile? Well, maybe the beliefs are changing, those beliefs about whether the cryptocurrencies are really respectable and valuable; the beliefs about whether people will accept them. And when the beliefs move, the price moves. 

3.    What Happened at FTX?

FTX was a centralized exchange platform; The problem is when the customers came and deposited their money on the cryptocurrency exchange, instead of holding some safe assets or buying the cryptocurrencies that the customers wanted, FTX used their money in completely different ways, without even informing them. What kind of ways? For example, they were lending money to Alameda Research, a subsidiary of FTX. And what did Alameda do with it? Alameda then bought a cryptocurrency, called FTT, which is the token issued by FTX. 

And frankly, this is not a very popular token. It's not a token that people use in exchanges to trade. It's not something that is very valuable. So they were basically using the customer's money to buy things that were only valuable for the person who was issuing the FTT and getting dollars in exchange. And who was that guy? Sam Bankman-Fried, the CEO of FTX. While I’m no legal expert, this sounds like fraud to me. It sounds like you're using other people's money to do things they didn't want you to do just because you want to get rich. 

So, what happened in November 2022? CoinDesk, an information platform covering the crypto economy, revealed that FTX was holding FTTs that it should not have been holding, to the tune of maybe $5-6 billion (that’s not exactly the value of what it held, it's the price they paid for it - and you know who got that money...). So, now people are saying: “Oh my gosh, I didn't know that they were not holding what we wanted.” So people left FTX and demanded their money back.

But FTX couldn’t give them their money because they had none! They just had FTTs, so they were trying to sell the FTTs. The market for FTTs crashed, and so they couldn’t pay the depositors, and had to declare bankruptcy. On November 11 they filed for bankruptcy. Meanwhile, the price of FTT and FTX crashed to close to zero, and not only the price of FTT and FTTX, but also the price of Ether and of Bitcoin. It was a huge shock for the crypto economy.

4.    The End of the Crypto Economy?

It would be unfair if the crash of FTX triggered the demise of blockchains. Wrongdoing at FTX did not involve the blockchain. At the time of the crash, the blockchains of Ether and Bitcoin were working very smoothly. There was no glitch in the blockchain itself. In fact, the problem at FTX was that the money deposited by customers to buy bitcoin or ether was not used to buy these currencies, so there was no ownership of these currencies registered on the blockchain. What FTX did with its customers’ deposits was opaque precisely to the extent that it was not on blockchain.


It would be unfair if the crash of FTX triggered the demise of blockchains because wrongdoing at FTX did not involve the blockchain.


Are cryptocurrencies and blockchains history or do they survive? I hope they survive. I think blockchain is a great technology if it's used properly. It can be very useful. But to survive it must be regulated. To be more precise, what must be regulated is all that is off-chain. Transactions that are on-chain are registered on the blockchain. The ownership of say Ethers is registered on the blockchain, because transactions in Ethers are registered in blocks appended to the chain. Off-chain transactions, in contrast, cannot be registered in blocks when they involve objects that like cars, houses, dollars, euros whose ownership is not registered on-chain. Thus, the transfer of dollars is not registered on-chain but on the off-chain infrastructure: financial institutions. 


I think blockchain is a great technology if it's used properly.


What is off chain is therefore subject to the same problem that Nakamoto was fighting against back in 2007. It involves institutions. So that's the off-chain part, which absolutely must be regulated. You need audits. You need regulation. Possibly deposit insurance. You need transparency. While FTX was very close to being a bank, it was not regulated. It was not transparent, it was not audited. That was the recipe for disaster. That disaster took place. 

So I think the future of cryptocurrencies is going to rely on whether regulators and governments can provide a proper regulation to the institutional, off-chain, part of the crypto-economy. It turns out that the European Union is working on a directive called the Markets in Crypto-Assets Regulation. This is one of the first legal attempts to regulate cryptocurrency markets and says that institutions trading and holding cryptocurrencies in Europe must ensure a degree of transparency and risk management, something that was completely absent at FTX.

5.    Can Cryptocurrency Markets Be Manipulated?

I'm afraid they can. Let’s first look at what manipulation is. Manipulation aims at forcing the price up, or down. What you do is you trade and trade, driving the price where you want it to go. The ability to do so is limited if you're operating in a very liquid market with lots of participants, because then your own trade will be negligible, or not very big relative to the rest of the market. Cryptocurrency markets so far have not been extremely liquid and deep. They are fragmented. There are different centralized and decentralized exchanges, different geographical zones. So, for example, there’s a big difference between the price of the Bitcoin in South Korea and of the Bitcoin in Europe. 

All this fragmentation, all this lack of liquidity facilitates manipulation. But it's not the only type of manipulation. There's another one that we have seen at play in cryptocurrencies. And to understand that we need to remember that beliefs are crucial for cryptocurrencies. The value of a cryptocurrency is what people believe it is. So if you're able to manipulate beliefs, you're going to be able to manipulate the price. Elon Musk is very good at doing that. Some time ago he just tweeted " Bitcoin”. That mere action made the price of Bitcoin shoot up. It's a market in which beliefs are very important, very visible figures have an impact on beliefs and that could help them manipulate people. And that could explain the very high volatility of cryptocurrencies. 


Learn more about cryptocurrencies and blockchains in the research articles of Finance Professor Bruno Biais here.

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