(so)Bitcoin to Zero - Money Moves #7

DeFi on Solana rekt because of SBF's terrible asset wrappers. We can do better....

Samuel McCulloch
Samuel McCulloch
Nov 25, 2022

16149 Bitcoin priced at $1000 each. Seems like a steal right?

This should be the greatest arbitrage of all time with Bitcoin at $16k.

Unfortunately, the Wrapped Sollet BTC (soBTC) on the Solana network is yet another victim of the FTX fraud. After the company revealed that it was insolvent and had entered into a non-binding LOI for purchase with Binance, investors rapidly dumped the now unbacked and probably worthless token.

Now with FTX in Chapter 11 bankruptcy, its surprising that soBTC is trading as high as it is. At this early stage of the proceedings, there is too much uncertainty around how senior soBTC claims will be. If soBTC is treated like a user deposit on the exchange, then the recovery amount might be significant. However, if the soBTC is deemed less senior than user deposits, holders of the now insolvent asset might only receive pennies on the dollar. The current pricing at less than 90% of BTCs price probably suggest the latter, however, as the bankruptcy proceedings unfold, soBTC’s seniority in its money claim will be made clear. Additionally, it might take years or decades to recoup any funds. What a mess.

Wrapped assets are debt instruments. The buyer is entering into a contract with the custodian/issuer whereby the latter is promising to ensure redemptions on demand. It’s practically similar to the method used by Circle and Tether when they issue their stablecoins. Wrapped assets should never face solvency risk. It was a general failure at the operator and regulatory level to protect individuals against the fraud of FTX that allowed comingling of customer assets held on chain.

FTX screwed up an incredible amount legally. It blows my mind that they did not create a fully separate entity for soBTC in which custodied assets were not co-mingled with whatever was happening with Alameda. All of this is in hindsight though. Before the collapse the warning signs were there. The amount of Bitcoin on FTX dropped rapidly after the 3AC/Luna collapse. At the time people thought that the Bitcoin was just moved to other wallets, but in reality it was loaned to Alameda to cover their losses.

At a minimum, all issuers of wrapped crypto assets that are centralized and incorporated must be legally bound to protect and not commingle assets. This is basic financial structuring. Companies should not be able to issue wrapped assets and rehypothecate collateral.

The gross lack of oversight and fraudulent activity perpetrated by the FTX team across many jurisdictions hopefully will drive necessary regulatory changes in these offshore jurisdictions. It’s the standard now for crypto companies to move offshore because of the burdensome, expensive and onerous regulations in Europe and the USA. The SEC regulation by enforcement and congress’ unwillingness to provide comprehensive crypto regulation enabled this behavior.

There are a few lessons that we can learn from this debacle (other than what the bankruptcy attorneys are dealing with)

1. Custodian rules need to be strengthened and onshored

The biggest problem with soBTC was that it had no qualified custodian. FTX was co-mingling customer funds with Alameda. This caused the mess we are in now because the Bahamanian regulators refused to do their job and allowed FTX to set up and run their company in a way which enabled fraud. Their reputation as a competent regulator will be ruined for years.

Thankfully we don’t have these types of issues inside the United States. We have clear rules that designate what is a “qualified custodian.” As a US issuer of wrapped assets, it's impossible to engage in commingling of funds like FTX. however, because of retail and institutions wanting to engage in regulatory arbitrage, these core services were offshored to jurisdictions with less ability to enforce.

“Custody in America” can be the shining vision of institutional trust and security for the future. Losing custody of trillions of dollars of assets to overseas venues that have minimal (zero) risk controls, asset protections, and security setups is a huge loss for the industry. American investors flocked to FTX because it had lax onboarding rules and welcomed most any fund to come trade on their books. We now know why.

2. On-Exchange crypto needs to be a security.

When you buy crypto on an exchange you aren’t buying actual tokens. You get an IOU from the company that they will pay you back at a later date. Most exchanges that aren’t trying to steal from you will credit the funds to your account and place a hold on assets to ensure 1:1 backing with the IOU.

Unfortunately, this model has been proven to be too prone to scams and fraudulent activity. Before SBF, a Canadian exchange called QuadrigaCX lost nearly 180m CAD in customer funds after the exchange founder mysteriously died in India. There was no backup of the private keys anywhere and the funds were supposedly lost for good.

In the wake of this too real to be true story, the Canadian regulators made all of these IOU contracts securities. It didn’t matter whether the underlying assets were commodities like Bitcoin if held in a non-custodial wallet. On the exchange it's an IOU. A debt instrument… which is an investment contract and strictly regulated by the SEC.

JP Konig noted that

The CSA’s list of requirements is long and demanding (see Appendix B of this document). Canadian exchanges and dealers, a category that now includes Coinbase, must abide by a set of universal market integrity requirements that cover things like abusive trading, front running, client priority, and more. Coinbase would be required to consider appropriateness and suitability when dealing with clients. And that’s just a sample.

Many exchanges won’t meet the CSA’s requirements, or can’t. Binance quit Ontario in June. FTX no longer onboards users from Ontario either. OKEX stopped serving Quebec and Ontario customers and Huobi has declared all of Canada to be a ‘restricted jurisdiction.’

If exchanges can’t meet these basic standards for market operations, they shouldn’t be able to operate…. Anywhere. Remember, not your keys, not your crypto. On exchange = everything a security… Defi = maybe.

Once assets go off exchange, the token swaps to the wrapped IOU. These tokens shouldn’t be securities on chain, but offchain definitely.

3. Exchanges need better transparency

Banks are some of the most highly regulated entities outside of nuclear power plants and toxic waste dumps. For good reason too. The same malfeasance perpetrated at FTX was yet another telling of a story of fraud, only with different characters. In 2011, MF Global, a global financial derivatives broker, fell into bankruptcy after it was discovered they had used customer funds to paper holes in their leveraged loan book.

The flavor of their story is the closest to FTXs. MFGlobal made a lot of bad, leveraged bets. They tried to hide the losses. Eventually they dipped into client funds to plug the hole. Nothing worked and their fraud was ultimately discovered.

The beauty of crypto is that every single token can be accounted for at all times. Just look at the glassnode chart below. All of the onchain data leading to FTX’s collapse was public to see. Billions of dollars of Bitcoin flowed out of FTX months before their collapse. No one commented on it until the Coindesk article because Sam was the golden boy and was thought to have cash on the side to back it all.

Going forward, we need to demand that all crypto financial third party brokers need to attest and prove they have control over their assets on a block by block basis. This isn’t hard. It doesn’t degrade security, nor does it invite hackers.

Exchanges must attest to the soundness of their reserves by publishing all exchange controlled hot and cold wallets. The total amount of crypto in these wallets should at all times add up to the total customer liabilities held on exchange. One of stories recounted about SBF from multiple sources was that Alameda never could balance their book at the end of the day. While difficult, they could never say exactly how much they profited or lost. Gross negligence and accounting allowed SBF and crew to siphon off funds thinking they were still fully backed. This shouldn’t ever be allowed to happen again.

We need real-time proof-of reserve monitoring systems in place run by independent third party validators to track balances. These need to be up to date at best block by block, otherwise within the shortest given period of time that allows for accurate synchronization of the exchanges back end with the reserve wallet balances.

For these wrapped crypto products it’s essential to maintain clear attestations. If ever the delta between on-chain analytics and the exchange’s official attestations diverge by more than a few basis points over a 24 hour period regulators should step in and rectify all inaccuracies. Keeping track of all of the assets in custody should not be hard or opaque. We deserve better.

4. We need better decentralized wrappers

Bitcoin maxi’s are a great source of meme worthy phrases for crypto security. One of the best is “Don’t trust, verify” a switchup of a famous phrase Ronald Regan learned from the Russians during nuclear disarmament talks. We put too much trust in unregulated, for profit institutions this last cycle. They’ve proven to be “compromised” and undeserving of our trust.

We can remedy this problem by building strong interchain wrappers for assets that don’t require any trust at all other than what's in a public, open source codebase. The best outcome from this whole FTX debacle is a firm conversion to onchain, decentralized, open, transparent wrapping solutions. No more messing around with sociopathic egos and malfeasance. Open source software running on a blockchain will disinfect all the rot we’ve seen this cycle.

We can do better

There’s no doubt in my mind that this cycle of crypto expansion was fraught due to the incestuous relationships between centralized opaque offshore venues and the networks they provided services for. It was too easy for VC’s to apply the same Web2 models to this new network state. It was a mistake to let founder’s egos drive the narrative. Maybe this is inevitable, as humans naturally latch onto stories and people, rather than code.

But code is what built this space. Open, anonymous, immutable code.

We can’t let these (and I hate using this term) “first principles” fall by the wayside in the face of juicy VC rounds.

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