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FTX fallout shows tension between need for regulation and push for decentralization

TORONTO — The collapse of crypto-exchange giant FTX is being pointed to both as a clear example of the importance of industry regulation and, on the other hand, of the need for bitcoin to get back to its decentralized roots.
The FTX logo appears on a home plate umpire's jacket at a baseball game with the Minnesota Twins, in Minneapolis, Sept. 27, 2022. The rapid collapse and bankruptcy of crypto-exchange giant FTX shows the importance of regulation in the space where Canada has been a leader, experts say. THE CANADIAN PRESS/AP-Bruce Kluckhohn

TORONTO — The collapse of crypto-exchange giant FTX is being pointed to both as a clear example of the importance of industry regulation and, on the other hand, of the need for bitcoin to get back to its decentralized roots.

The two opposite conclusions underline the tension between the ideals of the early-adopting bitcoin faithful and the speculative fervour that helped Sam Bankman-Fried build FTX from nothing in 2019 to the world's third-largest exchange by volume with a $32-billion valuation, before he stepped down from the helm last week as the company filed for bankruptcy protection.

“There's a irony in the crypto space that's becoming increasingly clear," said Ryan Clements, chair in business law and regulation at the University of Calgary's Faculty of Law.

"Crypto was supposed to be about getting rid of banks and getting rid of intermediaries. The evolution of the crypto market has turned into one where intermediaries are widely used. And intermediaries are taking custody of client funds and client crypto in a way that banks do.”

The increasing "bankification" of crypto created a need for regulators to step into the space to prevent collapses such as the one at FTX, which ultimately fell apart in the equivalent of a bank run, from hitting the wider stock market or leaving retail investors destitute.

Canadian regulators learned that lesson with the implosion of Quadriga, which vaporized $169 million in customer funds as it fell apart in 2018. An review by the Ontario Securities Commission found the company operated like a Ponzi scheme, and concluded in a 2020 report that what happened at Quadriga "was an old-fashioned fraud wrapped in modern technology."

In response, provincial securities regulators have been notably co-ordinated in their response to crypto exchanges with a focus on intermediaries as they set out rules around the need for third parties to hold the crypto assets, insurance requirements, and limits on what can be traded.

The rules means some of the alleged practices at FTX, including the use of customer funds for company trading, wouldn't be allowed by Canadian registered exchanges.

“We actually have in this country quite a robust regulatory framework that was created after Quadriga,” said Clements.

Several Canadian exchanges have been emphasizing their adherence to these measures in recent days as they try and distance themselves from the likes of FTX.

"Although some see regulation as overreaching, it plays a critical role in ensuring that these tragedies do not happen," said Coinsquare chief executive Martin Piszel in a statement.

"While we were working with regulators ... our global competitors were launching products like 100x margin, unregulated derivatives products, and lending out client assets. All of us have now seen the results of some of these experiments," said Piszel.

The chance to trade options or derivatives and other risky bets in more active markets has however tempted some Canadians to look abroad, said Clements, pointing to the potential need for regulators to put more effort into cracking down on access to international exchanges.

"If you're a Canadian you should be using a registered trading platform. Because there are better controls for you. The problem is these huge offshore platforms ... just because something is bigger and just because something has celebrity endorsements, doesn't necessarily mean it’s safer.”

But while some point to the FTX debacle as an example of the need for more regulation, others say it's a sign for people to get away from exchanges entirely and hold crypto at an individual level instead. 

Compared with the centralized FTX, "a lot of the bitcoin movement has been antithetical to it, (bitcoin) was always basically this idea of self custody," said Mariam Humayun, an assistant professor at the University of Ottawa's Telfer School of Management.

She said that what happens at FTX shows that keeping crypto on an exchange creates a risk of losing it, pointing to the phrase, "not your keys, not your coins," as the philosophy of many core bitcoin believers.

Holding crypto offline in so-called cold wallets comes with its own risks, including physical theft and lost passwords and is not to be taken casually, said Henry Kim, an associate professor at York University's Schulich School of Business and director of the school's Blockchain.Lab.

“For those that are really, really savvy, they can still hold crypto in their wallets ... you have to know what you're doing. And I wouldn't advise that unless you do.”

He said that while exchanges can go bankrupt, most long-term investors would do well to hold their crypto on an established, promininet exchange. 

Yet the collapse of FTX shows how difficult that research can be.

"There's a contagion effect because FTX was the gold standard, because they were heavily involved with investment," said Kim. “It says there's not enough regulation. It says that it's too centralized. It says that we still don't have enough grown-ups in the room.”

Several Canadian crypto companies have already announced some knock-on effects from FTX. 

Calgary-based Bitvo Inc. announced in June that FTX was going to buy it for an undisclosed sum. On Monday, the company clarified that the transaction has not closed and it remains independent from the FTX group of companies. 

The company also emphasized that it operates on a full-reserve basis and in compliance with Canadian regulations.

Vancouver-based Layer Zero Labs said it had bought out FTX's positions in the company, and is treating the $11.5 million it had at FTX as zero for the moment as the company digests the fallout.

“This one definitely hits differently," said co-founder Bryan Pellegrino. "I think because we’ve evolved tremendously over the past decade and FTX and Sam stood at the centre of what everybody seems to be coalescing around as the future of the industry.”

He said, however, that the company is still dedicated to moving forward with crypto as it continues to evolve.

“Throughout all of the fund blowups, dog coins, overleveraged apes and Ponzis, the underlying technology has never ceased to amaze us and we’re all as obsessed as we have ever been with the core mission.”

This report by The Canadian Press was first published Nov. 14, 2022.

Ian Bickis, The Canadian Press

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