Rebuild or retreat? The crypto industry faces a difficult choice in the aftermath of FTX

Hours after FTX co-founder and one-time crypto mogul Sam Bankman-Fried was convicted of fraud and money laundering in New York, one of his major venture capital backers spoke out.

“Immediately following the collapse of FTX, we extensively reviewed our due diligence processes and evaluated our 18-month relationship with Sam Bankman-Fried,” said Alfred Lin, a partner at Sequoia Capital . “We concluded that we were intentionally misled and deceived.”

Crypto skeptics will argue that Lin is not the first to fall for the scam. Since Bitcoin’s inception in 2009, the industry has been associated with illicit transactions, such as the now-defunct Silk Road marketplace, or business failures, such as 2014’s Mt. Gox, which at its peak handled nearly three-quarters of all Bitcoins in circulation.

In SBF’s heyday, he was seen as the industry’s most likely path to respectability. In addition to Sequoia, FTX has mainstream backers such as Tiger Global, Singapore’s state-owned Temasek and the Ontario Teachers’ Pension Plan.

In Washington, SBF testified before congressional committees, supported increased regulation, and became a major political donor.

In the Bahamas, where FTX is headquartered, Prime Minister Philip Davis supported the company as a major acquisition as the Caribbean nation's economy seeks its next economic growth point.

Meanwhile, FTX has secured celebrity endorsements and signed sponsorship deals with Major League Baseball, the Miami Heat basketball team and the International Cricket Council. It filmed a Super Bowl ad with actor and producer Larry David.

But on November 2, a 12-member New York jury took less than five hours to reach a consensus and convicted SBF of seven counts.

"SBF committed one of the largest financial frauds in U.S. history," said Damian Williams, U.S. Attorney for the Southern District of New York. "This fraud and corruption has been going on for a long time, and we will no longer tolerate it."

As a former leading figure in crypto considers the possibility of a lengthy prison sentence, the industry he championed could go one of two ways: either collectively reorganize and try again to be accepted by the mainstream financial world, or retreat back into its long-standing image as a “niche market” for speculators, day traders, and those who firmly believe that money should be separated from the state.

For John Reed Stark , former head of the U.S. Securities and Exchange Commission’s ( SEC ) Office of Internet Enforcement, the trial verdict is “the death knell for cryptocurrency, Web 3, and blockchain.”

“This industry has run its course,” he said. “If everything disappeared tomorrow, it wouldn’t affect anyone on the planet except speculators.”

But others believe the industry can recover from the failure of the SBF trial and become part of mainstream finance.

“The public image of cryptocurrencies is at an all-time low, but the industry is not done yet,” said Charles Storry, head of growth at cryptocurrency futures index platform Phuture .

An ignoble history

SBF’s career ended in prison after more than a decade of flouting traditional financial rules, angering regulators around the world and facing accusations that cryptocurrencies were used to finance terrorism and nuclear proliferation. Meanwhile, the computing power required to “mine” crypto assets like Bitcoin creates a carbon footprint roughly the size of Ukraine.

FTX went bankrupt in 2022, capping a crisis of confidence that caused popular digital assets like Bitcoin and Ethereum to lose more than half their value. Other once-prominent companies like Terraform Labs and Three Arrows Capital also collapsed.

In response, lawmakers and regulators in multiple jurisdictions have stepped up their oversight of the industry to an unprecedented level in 2023. U.S. regulators have launched a series of enforcement cases and lawsuits against some of the largest cryptocurrency companies still in existence. These include U.S.-listed Coinbase , which is facing action from the SEC for alleged securities violations, and Binance , FTX’s main competitor and the world’s largest cryptocurrency exchange.

The Commodity Futures Trading Commission ( CFTC ) sued Binance in March, alleging that it illegally reached U.S. customers and knowingly facilitated potentially illegal activity.

Three months later, the SEC filed a lawsuit against Binance, alleging that the exchange commingled customer cash with a separate trading firm owned by its CEO, Changpeng Zhao. Both Binance and Coinbase have denied the allegations and said they will fight their respective lawsuits.

Following the Oct. 7 atrocity, Israeli law enforcement authorities shut down more than 100 Binance accounts and identified around 150 Hamas-linked cryptocurrency donation schemes, sparking new accusations of the industry’s links to terrorism financing and fresh calls for a crackdown.

“After the Mt Gox failure and the Silk Road controversy, the industry has seen a lot of bad press,” said Charley Cooper, former chief of staff at the U.S. Commodity Futures Trading Commission (CFTC). “Throughout its history, it seems to have had more scandals than any other industry – its market share is much larger.”

Cooper added: "Most doctors don't defraud the health care system, most lawyers don't violate court ethics. The Wall Street guys, you can say they're greedy, but they're not breaking the law."

Yesha Yadav, a law professor at Vanderbilt Law School, described Bankman-Fried’s conviction as “a landmark and significant moment” for the broader cryptocurrency industry. “The fact that the jury concluded so decisively really highlights how far and how deep a key figure in the industry has fallen… It’s hard to imagine a bigger reputational blow.”

Those working in the industry are concerned that their career prospects could be harmed as a result. One professional who contacted the Financial Times said he was “a little concerned about how traditional industry recruiting will view the relationship with cryptocurrencies.”

He lost money at FTX as well as at Voyager, another cryptocurrency firm that collapsed last year. “This experience has made me more conservative,” he added .

Encryption transparency

After FTX filed for bankruptcy last November, leading figures in the industry called for a renewed focus on transparency.

Zhao Changpeng said that “all cryptocurrency exchanges” should provide proof of reserves and pledged to be “fully transparent” about their operations. Days later, rival exchange OKX said it would launch the first proof of reserves “to set a new standard for transparency, risk management and user protection.”

But only about a third of cryptocurrency exchanges currently offer proof of reserves or alternatives, such as regularly audited financial statements, according to industry data provider CCData .

Exchanges that offer some form of financial transparency to their customers make up about 81% of the market, but that’s down from 86% in March and is roughly the same level as when FTX went bankrupt in November 2022.

CCData research analyst Jacob Joseph said this suggests that “users may have become less discerning about proof of reserves than they were in the early months following the FTX debacle.”

James Newman, co-head of perfORM Due Diligence Services Limited, said the largest and most influential exchanges “have taken steps to increase transparency into their holdings”.

“However, many have been slow to adopt proof of reserves,” he added, saying this “may be symptomatic of the continued dominance of retail funds held on exchanges, which do not speak with one voice.”

Retail traders – individuals who trade for themselves – have been instrumental in the industry’s growth. But many believe it now needs to broaden its appeal. “Crypto’s survival relies on outside support and trust from other industries,” Storry said. “Retail investors have come on board, but we now need institutional support to take the industry to the next level.”

There are signs that this is happening. This summer, payments giant PayPal became the first major financial institution to launch a crypto token pegged to the U.S. dollar. The company has offered trading in the world’s most popular cryptocurrency since 2020, but the launch of so-called stablecoins — a crypto asset whose price tracks that of a more recognized asset, usually a traditional currency — has given the struggling crypto industry a shot in the arm.

Greater hopes for institutional support lie with BlackRock , the world's largest asset manager, which has applied to the SEC to launch a spot Bitcoin ETF, which would allow investors to speculate on Bitcoin in a regulated financial instrument operated by a well-known brand.

Last month, as speculation grew that BlackRock's application could be approved, the price of Bitcoin soared to $35,000, erasing all losses since the crypto market crisis began in May 2022.

Ilan Solot, co-head of digital asset financial services firm Marex, said: "If you know where to look, there are signs of entry into the industry: we are talking about BlackRock launching a bitcoin ETF and Paypal launching a stablecoin pegged to the dollar."

But not all is certain. The SEC, led by Chairman Gary Gensler, has so far refused to approve any such applications, and may never give BlackRock or any other candidate the green light to bring bitcoin to the mass market.

Lawmakers have also become more cautious. Last month, Sen. Cynthia Lummis and Rep. French Hill urged the Justice Department to consider filing criminal charges against Binance and Tether, the largest stablecoin issuer.

After the Hamas attack on Israel, more than 100 lawmakers from both major U.S. political parties signed a letter urging the Biden administration to outline steps it is taking to reduce the use of cryptocurrencies as a means of financing terrorism.

“It’s going to be harder to pass legislation in the U.S., and Congress will be more apathetic,” said one cryptocurrency industry lobbyist in Washington. By 2024, it remains to be seen whether Coinbase and Binance will be willing — or even able — to lobby regulators and politicians the way FTX has.

Back to First Principles

Former SEC Commissioner Reed Stark believes: "All these cryptocurrency people are in desperate need of a Bitcoin ETF now, but they started the Bitcoin project because they were uneasy about the 2008 banking crisis. They are uneasy about the government being able to monitor their financial transactions."

He added: “So what do they do? They cling to the thighs of the largest financial services company in the world because there is nothing left, which is the ultimate hypocrisy and hypocrisy.”

However, while many in the industry are pinning their hopes on a mainstream future, another branch would rather cryptocurrencies return to their roots.

Erik Voorhees , the libertarian founder of cryptocurrency platform ShapeShift , issued a rallying cry last month to those who remain loyal to the original crypto cause.

He said: "Why should we accept a world where we can trade freely only with strangers' conditional approval? This is certainly not freedom. This is submission, this is serfdom, and in most cases the chains press lightly, but that should not make us forget that they exist."

Rather than dive headfirst into an increasingly hostile group of regulators and lawmakers, Voorhees and others are pushing the industry back to first principles: permissionless finance, a clear rejection of the establishment, government oversight and unelected regulators.

Author, investor and former Coinbase CTO Balaji Srinivasan launched the Network State conference in Amsterdam last month with the aim of “building a parallel institution”.

Speakers included Vitalik Buterin and Anatoly Yakovenko , the thought leaders behind the Ethereum and Solana crypto blockchains, respectively, and the Winklevoss brothers, the founders of the Gemini cryptocurrency exchange.

“This is a meeting of all those who are building parallel institutions. It’s not just parallel currency. It’s parallel media, parallel education, parallel science, parallel construction, even parallel cities,” Srinivasan said .

While it may be tempting to retreat from a losing battle with lawmakers and regulators after the fallout from the SBF scandal has cleared, the decision could destabilize a market where trading is already sluggish.

According to data shared by data provider CCData, at the beginning of 2023, more than 1,400 BTC (about $23 million at the time) would need to be purchased to increase the token price by more than 1%.

But by the end of April, it took only 462 BTC – then worth about $13 million – to achieve the same market move. This is the lowest point in market depth for Bitcoin and Tether, the world's largest stablecoin, since the industry fell into chaos in May 2022.

Today’s data showed some improvement, with retail momentum picking up and new money flowing in; it now takes 752 BTC (worth about $26 million) to move the price of Bitcoin higher.

But it’s far from enough. Marex ’s Solot said: “In my opinion, the negative impact of SBF’s guilty verdict has long been priced in by the market. But if this proves to be a watershed moment in which crypto adoption slows down or even fails, then the risk is that only internal funds are trading in the market, and it can basically be expected to continue to shrink... There will be no new funds, no growth.”