The collapse of FTX should not be blamed on blockchain technology

Source: Prof Bill Buchanan OBE, Professor of Cryptography, “The Collapse of FTX Is Perhaps Not The Fault of Cryptocurrency, But Bad Finance Models”

Compiled by: ChinaDeFi

Cryptography and Blockchain are Sciences

Cryptography is an ancient technique for information confidentiality. It has the strongest mathematical and scientific foundations among computer science subjects and possesses a highly active (and supportive) peer review infrastructure. Researchers dedicated to this discipline are working to improve its core methods, remaining open to discovering potential weaknesses in its scientific foundations. As a science and practice, it has existed long before all other "new" fields such as artificial intelligence, big data, the internet, and cybersecurity.

As a discipline, cryptography translates well from theory to practice, and it has now become central to internet security.

Without cryptography, our cybersecurity would be nearly zero. Thus, the magical "s" in "https" transforms our online world from one open to malicious activities into a world that liberates us from those who wish to steal or damage our data. It essentially fixes the design flaws of the internet.

Blockchain is Not Hype

For blockchain, we also have a highly trusted infrastructure that uses Merkle Trees to define high levels of trust for all associated transactions. Cryptocurrencies are the core users of blockchain—just as cars use engines, but engines can be used for many other applications. Therefore, blockchain does not exist as a technology in itself but as an engine that drives other things.

Dismissing blockchain technology entirely is a superficial reaction. "Blockchain skeptics" often come from a lack of scientific methodology, and they can be equated with 5G skeptics or those who were skeptical about the rise of the internet.

During the development of blockchain, some terms have been distorted and generalized, losing some meaning in the media. The scientific world of cryptography has turned into a binary world of likes and dislikes. Personally, I believe that cryptography and Merkle Trees can establish a more trustworthy world.

Cryptocurrency

Once, "crypto" was an abbreviation for cryptography, but it is no longer the case. The sale of the domain "crypto.com" highlights that this term is now primarily associated with "cryptocurrency."

At the core of cryptocurrency is the art of applying public key cryptography and using blockchain infrastructure to create transaction credibility. It is peer-reviewed science, with much of the knowledge created in the 1970s and 1980s, and the technology has continued to evolve with scientific practice since then. Blockchain can handle any transaction, including transfers. Its potential may not yet be fully realized. It is not a solution, just another tool in the toolbox.

Cryptocurrency indeed has the potential to create a more trustworthy infrastructure for transactions, but some have hijacked cryptocurrency in pursuit of poor financial models. The main approach is to support the company's value with company-owned currency. Moreover, another core issue with cryptocurrency is the industry's widespread lack of regulation and transparency.

Thus, if we create cryptocurrencies, it naturally requires a way to trade them, allowing customers to create wallets, sell their assets using their private keys, and receive cryptocurrencies through their public keys. At this point, exchanges become trading halls where people can buy and sell. It is no different from a trading hall for buying and selling stocks, where supply and demand determine prices. However, exchanges must have a way to guarantee the trading value they hold and have enough reserves to ensure normal trading in difficult situations.

Fraud is Just Fraud

Fraud is just fraud, regardless of the currency used. It was not auditors or regulators who discovered the potential fraud at FTX, but CoinDesk. They found that FTX was primarily associated with Alameda Research, which kept most of its assets in FTX's native token (FTT).

Reportedly, Alameda had $14.6 billion in assets, but most of it was related to FTT tokens. This is a circular financial model.

Binance considered acquiring FTX but decided to sell its investment in the company due to concerns about the risks posed by FTT. The related run on FTT led FTX to file for bankruptcy on November 11, 2022.

I cannot understand this business model of supporting company assets with tokens produced by the company. This is clearly a Ponzi scheme.

Who Should We Blame?

I think we should share the blame equally. Firstly, we did not see any regulation in this, and secondly, we did not see any public funding and assets supporting the operation of the exchange.

I am not an economist, but I know that banks need reserves. These reserves must be real, relatively liquid, and the bank must be able to pay out most of the withdrawals by customers. For example, in the UK, Northern Rock experienced a run:

For many customers, this was a terrifying time, but the bank overcame the difficulties and was later acquired by Virgin Money. Whether we like it or not, no bank can withstand a run on withdrawals; banks must have sufficient reserves to ensure their value can be balanced with trustworthy valuations.

Transferring Assets to Evade Audits

People must also worry about the lack of skills among audit firms and regulators to properly audit such companies, as there are rumors that cryptocurrencies flow between companies. Auditors may consider these transfers as part of the company's assets and then remove them from the company after the audit is completed.

Conclusion

Fundamentally, this is not the fault of cryptocurrency. Using crypto tokens is undoubtedly a better way to execute financial transactions between verified entities.

With the near certainty of cryptographic technology, the dream of creating peer-to-peer fund transfers still exists. However, cryptocurrency is an industry in its infancy, and it needs to gain the trust of users.

The dream of creating a more trustworthy, auditable, and transparent financial world remains; it is just that some have used it to create failed financial models.

Strengthening Regulation and Auditing?

We need better regulation of the industry and to ensure that healthy companies can develop, capable of building a new economy and moving away from paper-based transfer methods. Therefore, everyone needs to wake up and accept the role of crypto tokens, as well as how we need to better match these tokens with our existing financial world.

I personally believe we can use cryptography and Merkle Trees to build a more trustworthy world. In the realm of trustworthy finance, regulators and auditors need to better understand these situations and be able to detect any potential fraud and risks.

Because they protect our money, our investments, and our future. My understanding of finance may be overly simplistic, but it seems reasonable to evaluate a company's valuation with something stable, while the ability to convert its asset base into cash seems to be simple economics.