​FTX acted like a bank

​Following the blow-up of FTX and the numerous articles written, one important fact often got overlooked:
FTX is described as a centralized token exchange - actually it acted like a bank.
​
In the wake of historical blow-ups rules have been created to segregate the operations between exchanges and banks.
​This segregation is required as a bank has to follow strict transparency guidelines to proof that assets are protected against misappropriation or liquidity risks. An exchange does not have that risk as it is a mere marketplace: If it goes bust the investor does not lose her assets. Here comes the misunderstanding: FTX took custody of assets and invested them without the user knowing: Like a bank, the amount of the tokens is stored on an internal accounting system as part of its balance sheet. There was a lack of transparency as there was no settlement of the trades on-chain or on a separate exchange that could have verified the asset holdings to the users. When the user opened the trading application s/he only saw accounting records while FTX used the funds to buy mostly less-liquid assets.​

This liquidity risk resulted in a situation that, when solvency issues emerged, FTX had to look for buyers for the assets and needed to provide a discount, which worsened the solvency situation and resulted in bankruptcy.

If you read that far, you have realized that the FTX blow-up had nothing to do with tokenized assets per se. Actually, the technology behind decentralized protocols can solve this issue providing technological trust through transparency.


How can investors make sure their assets are secure?

  1. ​Self-custody using bearer instruments: Investors can self-custody their assets and use transparent protocols without centralized counterparty risk. This becomes possible for an increasing number of assets through adaptations in civil law and token-based bearer instruments.
  2. Due-Diligence with institutions: In the European Economic Area, MiCAR would enforce that centralized token exchanges that take custody of user assets have to provide transparency in the form of segregated accounts and audited balance sheets. Even with these traditional measures there have been blow-ups as in the case of Wirecard. Fortunately, a technological solution is available: Proof of Solvency

What is Proof of Solvency?

Custodians can proof to their clients publicly that their assets are available, without revealing individual holdings, using a cryptographic proof. This proof is an invaluable tool to build trust with clients, enabling them to continuously verify that the custodian's asset holdings are enough to cover its liabilities.

What are the use-cases for Proof of Solvency?

The power of such proofs doesn't just stop here: It opens novel possibilities for a traditional bank or insurance company to build relationships, where clients are ensured that it can only use funds according to a predefined contract.


​