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8 min read

FTX Was Regulated But Wasn’t Web3

Published on
October 11, 2023
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When Bitcoin launched on Jan 03, 2009 it’s pseudonymous creator Satoshi Nakamoto, in the first immutable transaction of the Bitcoin ledger, embedded the text from the Times headline of the day reading “Chancellor on brink of second bailout for banks”. Bitcoin was meant to fix an issue with central banking that was the subject of global crisis and outrage. Today Nov 13, 2022 a Sunday Times headline about the FTX crypto meltdown reads “The nerd king who lost $16bn with one click”. What went wrong?

Many including the SEC claim that what’s missing is “more regulation for crypto”. What is uncomfortable is that FTX was heavily regulated. In fact a major strategy of FTX was to have highly credible licensure. Here's their US Licensure and Non-US Licensure from the internet archive. More awkwardly, FTX spent $39M+ supporting democratic campaigns in 2021-2022 including being one of the larger donors to the Biden campaign ($5.2M), as well as donating to various Republican entities as well. FTX did not lack regulatory oversight. FTX's CEO Sam Bankman-Fried’s activities were not under the radar - he was recently meeting with the Biden Administration at the White House accompanied by a former regulator.

Yes, we need clearer regulatory rule making that is specific to crypto. I’ve been on a lot of legal calls about crypto regulations and I can tell you that US crypto regulations are not clear and haven’t been getting much clearer in the last 8 years. It can cost millions of dollars of legal fees for legitimate projects to figure out how to be compliant. I know of at least one 500 page Reg A+ filing for a highly credible crypto project that has been in review by the SEC for 2 years.

But ironically, FTX had paid those legal fees to understand how to be compliant with the traditional rules, acquired the licensure, ingratiated itself with regulators and was seen as being a model company within the traditional rules even though those rules seem almost diabolically designed to be impossible to adhere to within the crypto space. Rather than being unregulated, FTX seemed closer to creating a regulated monopoly or at least building an unassailable regulatory moat against competitors. FTX was literally drafting new regulations with regulators while many in the industry protested about the framing of the bill advantaging FTX over its rivals. As Ryan Selkis put it “The Stabenow-Boozman-FTX bill would not have prevented this disaster because FTX helped write it!”

Actually, lobbying bias that allows big problems to slip through the cracks and centralized custody that allows exchanges to treat depositors as creditors in high risk unsecured loans are both species of the same problem of centralized trust. Transparently operating blockchain enforced code is more reliable than centralized systems secured by the judgment of a strongly interlinked insider network.

In contrast, decentralized exchanges are not going bankrupt like FTX. This is because they for example do not surreptitiously use customer assets as collateral in their own high leverage illiquid investments like FTX. DeFi protocols are not going bankrupt and claiming underlying smart contract deposits to repay company creditors like FTX because the collateral and assets are transparently controlled by immutable blockchain smart contracts with independently auditable functionality that cannot be overridden by administrators.

Are these infallible, no - but they are an order of magnitude improvement over the contagious corruptibility of centralized administrators and fallibility of regulators. These smart contract systems also clear instantly, are cheaper per transaction than lawyers in the private markets, provide immediate verifiability and are less subject to the politicized judgment caused by lobbying. 

However, we lose when we think that new centralized systems like FTX actually provide the protections of secured decentralized Web3 systems. This happens frequently in crypto because the vision of decentralized “trustless” systems is compelling - but actually building decentralized systems is incredibly rigorous. Meanwhile we put funds into projects masquerading as decentralized that use a single shared wallet private key instead of decentralized autonomous organization governance; and centralized exchanges that carry the banner of decentralization while finding clever ways to run centralized depression era banking practices that we regulated into obscurity in the 1930s (but only on paper).

Beyond clear regulatory rule making, the major institutional upgrade is to adopt the actual vision of Web3 - not the fake scammer version which pummels the industry every few months in a new form.

We should adopt the version of Web3 that follows the ethical framework that brought people to the movement originally.

Yes I just said Web3 is an ethical framework. It follows these principles: 

  • Don’t trust, verify
  • Not your keys not your crypto
  • Transparent independently auditable smart contract operations and holdings
  • Enforce contracts through consensus protocols not centralized intermediaries

Our existing institutions are challenged by political economic shifts and changing technology - similar to when the printing press triggered the reformation in the 16th century. We’re in the thick of that kind of political technical revolution and we need to upgrade our financial and social institutions to be capable of supporting our highest values with integrity.

The protagonists the authentic Web3 movement wants to empower are local communities, retail investors, ethical VCs and entrepreneurs who want to build our society’s prosperity by fairly solving real problems with a long term view. This is and always has been the north star at Upside which inspires us to build the future of Web3 native organizations.

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