As the fallout from the FTX fiasco continues, Stockhead spoke again with Jeremy Balding and Pratik Kala from DigitalX to get their updated takes on that, and more.

DigitalX is a leading Australian blockchain technology and investment firm, Balding is its Head of Funds Management and Kala is the company’s Digital Asset Investment Analyst.

 

‘We will see regulations ushered in at a faster pace globally’

Hi, both. So, a fair bit’s happened with the FTX situation since we spoke about a week ago. What are your thoughts on it all now?

Jeremy Balding: When we last chatted with you about it, we mentioned we didn’t think the FTX situation was going to be that bad. Well, it’s turned out to be worse than we had all expected.

There is still a lot more to come out on regulation globally over the next few months.  We are pleased to see the Australian Treasury department pledge to introduce exchange and custodial regulation to parliament next year. This is crucial for investor protection and confidence in the sector.

And then, of course, we just need to see what reveals there are still to come in terms of FTX exposure across the industry, and how the industry shapes up as a result.

[Update: further significant players in the space have now shown to be affected by the FTX contagion effect, with Genesis’ lending unit, for example, pausing withdrawals.]

In terms of regulation then, what do you think needs to happen? Can Australia’s regulators play a big role? 

JB: Australia can definitely play a big part with crypto regulations. The government’s been working on their token mapping exercise and they’ve consulted the market on a few of these topics already. But it’s definitely time to speed it up and bring in the investor protections that I think the industry and investors want and need.

I think we will see regulations ushered in at a faster pace globally. That in turn, should lead to greater confidence in the industry, which should lead to the next rally in digital assets.

 

FTX fiasco may have been avoided with better licensing regimes

Do you think the crypto world has been looking to the US to lead the regulatory conversation?

Pratik Kala: Europe’s actually leading the charge at the moment with their MiCA (Market in Crypto Assets) regulations. They seem to be the furthest ahead in terms of formalising their position.

But obviously the majority of the crypto flows are US denominated – so it would be nice to have some clarity coming out of the US which will allow for some sort of transparency for the industry going forward.

One of the reasons some of these exchanges were forced to locate offshore was because of regulatory uncertainty – FTX was in the Bahamas, and others are in the British Virgin Islands, Seychelles and Panama. 

The only exchange that is 100% US regulated at the moment is Coinbase; and even they have been having issues because of unclear rules on what they can or can’t list and what is or isn’t a security.

Hopefully everything that has happened over the past week will be the wake-up call for regulators to push ahead.

But in the meantime, crypto platforms just need to carry on and mitigate risk as best they can?

JB: The view that we’ve always had is, even though we operate in an unregulated market, we self regulate. And I just think that needs to be industry wide – whether it’s a centralised organisation or a decentralised application.

And for example, exchanges could do a better job with blacklisting certain wallets – where do hacked funds go? Someone’s wallet. The industry across the board should move faster to ban those wallets from entering into applications.

They shouldn’t have to wait to be told to do it. They should just take proactive steps to try and self regulate and stop those funds from moving.

 

Proof of reserves, proof of liabilities

We spoke last time, too, about the “proof of reserves” idea for crypto exchanges and how that could be a great thing for better industry transparency. But there have been some rumours about some exchanges supposedly fudging their audits? 

PK: So, overall, it’s a great initiative and it’s about time that more exchanges talked about the reserves they have on their books. Proof of Reserves is basically a cryptographic proof where you list all your cold wallets so the assets they contain and overall balances are public.

The alleged fudging is coming from the fact that some of these exchanges have proof of reserves snapshots, which is like a monthly audit, so to speak.

How can that play out in a fudging sense?

PK: So let’s say they end up having a shortfall of $100 million. They could in theory call another exchange and with help, just before the audit snapshot, fill that $100 million for the purposes of the audit. After the audit snapshot these funds can be returned. This is speculation at this point in time and nothing has been confirmed.

What we need is live proof of reserves that are updated per block – not a monthly audit. But here’s the thing, the industry also needs proof of liabilities.

Can you explain that a bit further?

PK: Just say a platform has $10 billion in its wallet. It could have rehypothecated some of those assets to external lenders, or have taken out further loans. Unless they’re disclosed as well, then a clear conclusion of reserves can never be fully drawn.

Hopefully as the industry matures we get one of the big four audit firms looking at it all and doing a more formal audit using technology that can offer real time proof of reserves and a system for proof of liabilities.

 

Make it a cold one

There’s been a lot of talk through all the FTX drama about how retail investors should consider getting their funds off exchanges and into cold-wallet storage. DigitalX stores funds in cold wallets, correct? 

JB: Absolutely, and we use institutional-grade cold storage for our purposes. We only leave a small amount of assets on exchanges for a small amount of time – the minimal amount of time needed.

PK: An institutional grade cold wallet handles keys offline and uses “air-gapped” devices (not connected to the internet) to sign transactions securely. Several rounds of approvals are required before anything can get unlocked.

JB: But for retail investors, I’d say it’s definitely time to explore self custody and cold-storage options. I think there’s been a huge uptick in the sales of cold-storage devices in the past week, for obvious reasons.

 

Expect more fallout over the coming weeks

What short-term expectations do you have for the market? 

PK: I expect more fallout over the coming weeks. And until that’s completely settled, it’s very hard to say because some companies have not yet publicly come out stating if they had any exposure to FTX or not.

We’ve seen that BlockFi and Voyager, which FTX was supposed to bail out [after Voyager’s Terra Luna-contagion liquidity issues earlier this year], have a lot of FTX exposure, and there will be others.

So there’s a lot of uncertainty still in the market. And, of course, there’s also the fact that Bitcoin’s hash rate has hit all time highs and plenty of the miners are struggling in the wake of all this, too. If some of the miners were also managing their treasuries with FTX in an already tough and competitive market, then we might see more forced selling.

We need the dust to settle before we can have more clarity.

 

‘Crypto is here to stay’

Do you think the market has at least shown some resilience after its initial dump on the FTX news? Price wise, it seems to be holding on at the moment. 

JB: To a degree, yes. I think some of that can be put down to the industry-led rescue package from Binance. They’ve stepped forward and tried to offer liquidity lifelines to certain protocols. I think that helped steady the market a bit.

PK: And then the second point is people thought the Crypto.com exchange was also potentially having liquidity issues – their CEO has essentially tempered those fears, and last I checked their withdrawals were being processed as expected. This has restored some confidence in the short term, but we still have to wait for other players in the industry to disclose the extent of their exposure.

JB:  The ecosystem has held up pretty well throughout this. It’s really just one player that has misappropriated funds and become insolvent – yes there are knock-on effects from that. But the actual tech and crypto itself is still sound and here to stay.

It’s important to make the distinction that FTX is not a blockchain company – people aren’t building on top of it. It’s an exchange only.

PK: And completely centralised. By comparison decentralised finance applications have seen a huge spike up in the last three or four days, because that’s what people have fallen back to as a source of truth and trust.

 

Code is king in DeFi

Why is DeFi seen as a source of trust then? 

Because it’s not run by humans and personal relationships. It’s run by code, which is baked into the protocol, which just executes no matter what anybody has to say. At its core, nobody can manipulate it – it just executes set parameters and people have found some confidence in that sector.

But DeFi is far from perfect, right? 

PK: Yes. DeFi has suffered from a whole bunch of hacks this year. Absolutely. The entire industry just needs to uplift its game in terms of security, building more secure bridges and so on.

So DeFi is not perfect, but amid this entire carnage of this specific situation, it’s operated perfectly well based on the rules that it was programmed to do.

But at the end of the day it’s code and code can have bugs – there needs to be a lot of work on a centralised front and the decentralised front as well.

 

At Stockhead we tell it like it is. While DigitalX is a Stockhead advertiser, it did not sponsor this article. None of the contents of this article represent financial advice.

 

 

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