Failures in the crypto world

Following the FTX case, the crypto world is shaken by other traumatic events at close intervals: first, the bankruptcy of Celsius, and a few days later, the case of the BlockFi platform, which has filed for Chapter 11 proceedings (i.e., a receivership). And the bad news does not end there: rumors are persistently circulating in the environment that the Genesis platform is also in crisis and also close to bankruptcy.

There is talk of a domino effect. And indeed, in the case of Celsius and BlockFi, it seems confirmed that the connections are there: according to what has emerged, both platforms had in place a series of debt and credit relationships with various entities in the FTX galaxy.

Now, this chain of events undoubtedly has a dramatic impact on an entire ecosystem (that of the crypto world) that lives and thrives on one key ingredient: trust.

Then again, emotionality is a hallmark of the crypto-asset market, which reacts sometimes violently to rumors, news and signals, with sometimes disproportionate peaks of pessimism or euphoria.

The interconnections between crypto market failures

In the case of the FTX crisis, though, markets have held and, on balance, continue to hold, despite the alarming news about the Celsius and BlockFi cases.

On the other hand, it is quite evident that the origins of all these crises have little to do with the inherent nature of crypto assets, the fact that they may not be pegged to underlyings, or that they have inherent volatility.

In particular, it is even more evident that these crises have nothing to do with the decentralized nature of cryptographic assets: the three platforms that ended up in a state of insolvency, in fact, are exchanges that have nothing decentralized about them, apart from the assets they held and traded.

They were intermediaries, and therefore, centralized entities, that approached savers and investors, mostly non-professionals, to receive funds in trust to convert into crypto assets, for a fee, and if necessary convert them back and return them according to the users’ requests.

Thus, the crux of the matter is not that these entities were trading on behalf of users in cryptographic assets instead of other kinds of, say, more secure assets.

The central problem, much more trivially, is that these entities misused in an unsupervised manner the funds and assets entrusted to them. They have used them for careless investments, or for extremely questionable operations, lending them to each other, they have resorted to corporate architectures aimed at evading the IRS and the claims of creditors, but whatever the case, and whatever the nature of these operations, they have executed them by employing the money and assets of the users. Not simply the fruit of their profit margins on activities carried out on behalf of clients.

In an article in Milano Finanza on 15 November, Davide Zanichelli, an expert and authoritative figure on crypto and blockchain (it is no coincidence that in the past legislature, as an M5S deputy, he created and coordinated the parliamentary intergroup on cryptocurrencies and blockchain and was the signatory of a bill on the fiscal regulation of cryptocurrencies), made a comprehensive examination and many shareable reflections on the matter.

The questionability of centralized entities

In the article, Zanichelli points out that it is originated at a level that does not touch on the decentralization and trustless characteristics proper to the blockchain, but on the role and qualification of custodial, de facto centralized intermediaries, to which a wide audience of users turn.

On the subject, very interesting also appear the reflections of Lorenzo Savastano, an officer of the Guardia di Finanza, who is always very active with authoritative publications on crypto, blockchain and anti-money laundering matters, which can be found on the web [ https://www.linkedin.com/in/lorenzosavastano/ ], who, in a post of his on LinkedIn makes a careful reconstruction of the FTX archipelago.

In his reconstruction, Savastano highlights the role of the extreme parcelization of the FTX constellation, the location of many subsidiaries in tax-privileged jurisdictions and the opacity in the group’s tax policies, and the fact that, thanks to the complex branching of this empire, it is nearly impossible to understand where FTX ultimately paid taxes.

In practice, it highlights the fact that FTX’s crisis can be traced to off-chain factors, mainly related to the corporate architectures employed and intra-group relationships between the various entities, which are far from clear.

There are many voices converging on one point: namely, that disasters like FTX’s have nothing to do with the specific issue of the use of cryptography and decentralized technologies underlying blockchain.

There was, however, a voice out of the chorus, and for that matter, a prominent one: the starkly contrary opinion expressed by Paolo Savona, who also intervened in the debate on the FTX case, through the pages of Milano Finanza.

This position, on the one hand expresses the full weight of the office of Consob president, and on the other hand suffers from the fact that the person who holds it is known to be a historical opponent of cryptocurrencies.

In his intervention, Savona, moving from the FTX affair, points his finger precisely at decentralization, which he identifies as a critical factor, and argues that, in his view, DLT-based technology allows banking and financial intermediaries to be excluded from certifying the existence of assets and liabilities and their transfers, and therefore would prevent any form of control by supervisory authorities. Indeed, according to Savona, these authorities “know little about these technologies or do not have appropriate organizations to operate them.”

He then laments that although cryptocurrencies perform a basically monetary function, due to a:

“benign attention or (as also claimed) inattention to monetary and financial developments taking place in the infosphere. It has allowed this new market to expand and hybridize the traditional asset market.”

Kind of like saying, that the virus of uncontrollable crypto finance, is in danger of infecting the healthy world of conventional finance.

What is the role of regulation in safeguarding the ecosystem?

The solution to stem the threat of contagion would lie in the intervention of monetary and fiscal authorities, hoping that states in this perspective will not each act on their own.

Frankly, this analysis, with all due respect to the authoritative source from which it comes, raises several concerns.

First, the analysis of the Consob chairman seems to completely disregard the merits of the causes that gave rise to the collapse of FTX (and today also of Celsius and BlockFi). Causes that, as is now clear, have nothing to do with decentralization and distributed ledger technology. On the contrary, it is clear that the crashes we are talking about were caused by ill-considered financial conduct and investments.

A second consideration, is that the Lehman Brothers case (cited by Savona himself in his MF op-ed) and the subprime crisis occurred precisely in the world of conventional finance.

So, despite state and federal audits, audit firms and the whole circus of horsetrading around it, it does not appear that regulators and supervisors have been able to do anything tangible to avert that disaster.

For the sake of fairness, one avoids analytically going through the entire war bulletin of Italian credit companies (from Montepaschi, to Banca Etruria, and so on) that ended up down the drain with the savings of blameless users. However, one cannot help but wonder: the whole apparatus of supervision and control, the whole system of rules regarding professional qualification and honorability, transparency and fairness in lending, what concretely has it been able to do to prevent all these cases from occurring?

Now, it is clear that the problem lies precisely in the centralization and in particular in the effective verification of the prerequisites on which the trust that implies the role of qualified intermediary should be based. 

A verification system that, with all evidence, is nonexistent when it comes to cryptographic asset exchange platforms but which, on the other hand, in recent history has repeatedly shown its inadequacy even when it comes to banking and financial intermediaries. 

This problem could perhaps be given an initial answer by the European MiCA Regulation, which in effect imposes on service operators in certain types of cryptographic assets the possession of minimum requirements for market access and a set of conduct obligations.

However, it is not possible to predict how effective this body of legislation will be in preventing events such as FTX or BlockFi. 

One lesson can certainly be drawn from these events: namely, that the focus of regulatory and supervisory actions must be shifted, from the issue of decentralization to that of the professional, financial, capital and technological qualification of operators and also to the field of governance controls and supervision.

A lesson that Consob’s top management seems not yet to have learned.