Today the Financial Stability Board (FSB) published a report outlining the risks of multifunction crypto-asset intermediaries. Most exchanges combine functions that would otherwise be separated in traditional exchanges. In many ways, FTX was a textbook case for several scenarios. (The FTX emphasis is ours.)
FTX allowed unlimited leverage to Alameda. There was a liquidity mismatch – it needed to pay back FTX account holders in the short term but had committed some of their funds to venture investments. And it was very interconnected with the rest of the crypto ecosystem, bringing down Genesis and others when it collapsed.
The FSB notes that the combination of functions taken on by intermediaries is compounded by other factors also evident in FTX. It had weak controls, poor or no disclosures and massive conflicts of interest.
The report digs deeper into these issues. One highlight is the risks of crypto exchanges engaging in venture investing. In FTX’s case, it was using customer funds rather than profits. But a bigger issue is conflict of interest. If the token relating to an investment is listed on the exchange, does it ensure the same level of due diligence as other token listings? Have there been adequate disclosures? The exchange is incentivized to push the investment to make its price go up.
However, many of these risks are not stability risks. Aside from conflict of interest, if investee tokens are listed on an exchange there are also risks of price manipulation, fraud and front running. The primary financial stability risks relate to interconnectedness and contagion.
FTX’s collapse was triggered by the disclosure that a large proportion of Alameda’s assets was made up of FTT and other investee tokens. At that stage there was no public awareness of the $8 billion balance sheet hole.
The report concludes that the current financial stability risk is small because of the size of the crypto-asset market and its limited interconnectedness with traditional finance (TradFi). However, it acknowledges that crypto already contributed to the closure (Silvergate) or failure (Signature) of crypto friendly banks. Times change and with institutional adoption, interconnectedness is likely to increase.