Examining the need for Proof of Reserve following FTX’s crash, unveiling how Proof of Reserve works, describing its limitations, and exploring how to move beyond Proof of Reserve is the purpose of this blog series. This is the first of four pieces uncovering the events that led to the fall of FTX. Our next post will introduce how Proof of Reserve works in practice.
Proof of Reserve: Picking Up FTX’s Pieces
November 11th, 2022 will forever be remembered as the day FTX, one of the world’s largest cryptocurrency exchanges, filed for voluntary bankruptcy. The company’s shocking fall from grace has led to at least $1 billion of customer funds disappearing altogether.
The collapse of the crypto exchange FTX and its subsequent bankruptcy filing underscores the dire need for robust digital asset risk compliance. Although the FTX fallout has accelerated pressure for increased regulatory scrutiny, it also offers some stark lessons for the industry in matters of risk management, disclosure, and oversight.
Before exploring how this tragic situation could have been avoided, it is imperative to shed light on the timeline of events, examine its cascading effects, and analyze how the fallout has acted as a catalyst for the 4th biggest bitcoin capitulation causing holders’ over $10 billion in losses.
It took Sam Bankman-Fried (SBF) six years of tireless effort to build Alameda and FTX from the ground up, but it took mere weeks for it to all crumble. At the time of writing, the details available with the authorities suggest that FTX’s downfall left in its wake:
A financial obligation to its top 50 unsecured creditors amounting to an astounding $3.1 billion, with a handful of clients due more than $200 million each.
Affiliated companies owe their single largest creditor more than $226 million, according to a redacted list of the top 50 creditors released on November 19th, 2022. All of them were named customers, and 11 of them demanded nearly $100 million, according to the papers.
But to understand the full chain of events, here is a brief timeline leading up to the fallout:
The FTX downfall can be traced back to its close links with Alameda Research, a cryptocurrency hedge fund that SBF founded in 2017. Concerns about FTX surfaced in early November after CoinDesk published a piece disclosing that the majority of Alameda Research's holdings consisted of FTT, the native token of the FTX.
Because FTT could not be converted into cash easily, the report highlighted concerns about Alameda Research's capital reserves. In response to the report, Binance CEO, Changpeng Zhao (known as CZ), stated that he will sell all of Binance’s shares of FTT - amounting to $584 million. Within two days Binance announced a letter of intent to buy FTX, subject to due diligence.
SBF was optimistic about the deal, saying that it is “a user-centered development that helps the entire industry.” He further added that "CZ has done and will continue to do an excellent job building the global crypto ecosystem and creating a more decentralised economic ecosystem…What is important is that the clients are protected," he continued.
Unfortunately, Binance’s due diligence into FTX combined with recent press stories indicating abuse of customer assets and probable US government investigations caused the deal to fall apart, leaving FTX with no path forward.
The failed acquisition set in motion a chain of events that started with Sequoia Capital reducing its over $210 million holding in FTX to zero. Meanwhile, the SEC and the Justice Department launched investigations into the alleged mishandling of user funds by FTX, according to the Wall Street Journal. The confluence of a massive selloff by a crypto behemoth, Sequoia, and others’ reduction of their FTX holdings, and the threat of regulatory action caused FTX to become unstable.
Facing a liquidity shortage, FTX suspended all customer withdrawals. Just days later, the company filed for Chapter 11 bankruptcy protection.
TOP 25 EXCHANGES BY OUTGOING VOLUME (ETH)
As a result of the sudden downfall of FTX, the cryptocurrency ecosystem experienced an unprecedented upheaval. One of the first players to crumble was Gemini, one of the top cryptocurrency exchanges.
Shortly after FTX filed for bankruptcy, Gemini suffered a massive rush of withdrawals. Gemini’s total outflows starting from November 16th exceeded $1.163 billion, while their inflows only amounted to ~$550 million across Bitcoin, Ethereum, Bitcoin Cash, Litecoin, and Dogecoin within the same period of time.
This sudden rush of withdrawals can be attributed to the following factors:
Gemini warned its customers about the possibility of delay in the withdrawal from their earn product, which was run by Genesis Global, as Genesis was temporarily unable to meet customer redemptions. According to Genesis Global, this happened due to asset volatility, market dislocation, and loss of confidence in the industry after the FTX collapse.
Gemini also reported that it suffered an Amazon Web Services EBS outage involving one of its primary databases. This fueled the existing fear around the suspension of withdrawals from the earning program, leading to a massive amount of outflows from the protocol.
TOP 25 EXCHANGES BY OUTGOING VOLUME (ETH)
While Gemini was put in a tough position, other crypto companies were not so lucky as contagion from the collapse of FTX spread across the industry. BlockFi, a cryptocurrency exchange, and the lender filed for bankruptcy due to its significant exposure to FTX and associated corporate entities.
Beyond individual companies, FTX’s troubles have had a profound effect on the entire U.S. crypto market:
- Bitcoin’s price dipped below $16,000 on Nov. 9, and again on Nov. 14
- $3.2 billion in Bitcoin was taken off exchanges between Nov. 8 and Nov. 15
- Ethereum's price dipped below $1,100 on Nov. 9
- Solana dipped below $13 on Nov. 9, following CoinDesk’s report that Alameda held a large amount of it
- Applications on the Solana network have lost over $700 million in combined assets, and Solana dipped below $13 again on Nov. 13
- Tether briefly de pegged from the U.S. dollar by 3% on Nov. 10
In the aftermath of the collapse, the cryptocurrency ecosystem is yearning for a more robust disclosure mechanism to be adopted by centralised cryptocurrency exchanges - one that strengthens user security ensures privacy protection, and provides transparency into how funds are managed and maintained.
Introducing Proof of Reserve
To achieve the aforementioned outcomes, one idea that is rapidly gaining interest is the concept of Proof of Reserves or PoR. Proof of Reserve provides transparency into the total amount of funds and allocation of funds held by an exchange. PoR is not only limited to exchanges, as any entity holding client funds can use this technique to ensure its clients that their funds are in reserve and are truly backed 1:1. This in theory would help identify red flags, prevent misuse of clients' funds, and can avoid Alameda and FTX-like events from happening in the future.
The Wormhole Protocol hack in February 2022 and the Ronin Network hack in March 2022, where the hackers stole $320 million in wETH (Wrapped ETH) and 620 million in ETH and USDC tokens, respectively.
Proof of Reserve requires exchanges to confirm that digital assets like fiat-backed stablecoins and wrapped tokens are collateralised by the appropriate value of assets. It also entails an impartial audit carried out by a third-party auditor to verify that a custodian of digital assets genuinely owns the assets that it represents to its clients.
Proof of Reserve entails significant benefits. First, it instills confidence in users and boosts trust in the crypto ecosystem. Second, it provides greater transparency and allows users to verify that an exchange or wallet has the necessary funds on hand. Third, it helps to protect against fraud and malicious activity by ensuring that exchanges and wallets have the resources they need to cover customer withdrawals.
What’s perhaps most shocking about FTX’s crash is how avoidable it could have been. While there are countless ways to have prevented what happened, providing visibility into Proof of Reserves is perhaps the best method of ensuring any business holding client funds uses them responsibly moving forward. To continue learning more about Proof of Reserve look out for our next piece, demystifying how PoR works in practice.