FTX collapse and the impact on the enterprise blockchain market

Introduction

The dust is beginning to settle on the collapse of FTX Trading Ltd., and as it does, the scale of the crisis is becoming increasingly apparent. Blockchain vendors serving corporate clients have filled analyst and investor inboxes with assurances about their companies’ distance from the cryptocurrency exchange. Some of these emails suggest that the impact will be negligible. Others even predict a positive impact due to escalated calls for regulatory reform. The least realistic suggested that the collapse is not a commentary on blockchain at all. It is this thread that we will draw upon, not only looking at what FTX reveals about the state of blockchain ecosystems, but also the likely impact FTX will have on the enterprise blockchain market.

It is tempting to position the FTX collapse as a positive for enterprise blockchain applications. A stimulus for further regulation, the collapse could also trigger a transition away from the unsustainable business models and valuable assets associated with blockchain. Established companies planning to integrate blockchain into their product offerings, or technology vendors already competing with Web3-native vendors, could see their position strengthened as a once-burgeoning startup market cools further. However, the reality is more complicated. Lower investor confidence in cryptocurrency may limit the value organizations see in establishing “on chain” offerings from businesses to consumers. The vision of selling into public blockchain networks has driven much of the convergence between the corporate and cryptocurrency blockchain ecosystems. Lower cryptocurrency values ​​will also reduce the capital available for many innovative projects, reducing improvements to tools as well as critical initiatives around interoperability, scalability and security.

FTX collapses a lens to scrutinize a volatile market

FTX Trading Limited was founded in 2017, incorporated in Antigua and Barbuda, and is headquartered in the Bahamas. The founders were Sam Bankman-Fried, who became the CEO of the company, and Gary Wang, Chief Technology Officer. The privately held entity operated a major cryptocurrency derivatives exchange and trading platform, FTX.com, and claimed over 1.2 million registered users in early 2021. In January, FTX raised $400 million in a Series C funding round, valuing the cryptocurrency exchange at $32 billion dollars. In March, the FTX token, FTT, had a capitalization of $14 billion. FTX was often cited as the second largest cryptocurrency exchange after behemoth Binance Holdings Ltd., dwarfing competing exchanges.

Concerns about the sustainability of FTX along with its sister company, trading company Alameda Research, were first raised by media CoinDesk on November 2. Fear generated by this article led to a run on FTX, which had lent over $10 billion in funds, including customer deposits, to Alameda; this made it impossible to meet the scope of withdrawal requirements. Bankman-Fried, with FTX facing a major “liquidity crisis”, agreed to a non-binding letter of intent to sell the business to Binance. That deal fell through, with Binance CEO Changpeng Zhao citing the company’s due diligence concerns, along with alleged US agency investigations. The cryptocurrency exchange subsequently filed for Chapter 11 bankruptcy protection in the US, and reports suggest it may owe money to more than a million creditors.

A familiar refrain emerging from the collapse surrounds the credibility of the cryptocurrency industry and the degree of confidence investors have in the space. The market has already faced significant pressure from major crypto projects derailing, such as the popular UST stablecoin, and easily spooked investors are prone to shifting portfolios at a pace. The influence of a small number of people on social media, such as the CEO of Binance, also makes the market difficult to predict. Another problem that has been thrown into the spotlight is the lack of a robust regulatory framework for cryptocurrency trading.

FTX will have a significant direct impact

FTX had been seen as a stabilizing force in the cryptocurrency space, having backed troubled cryptocurrency lender BlockFi Inc. in July with a $400 million credit facility backed by its own balance sheet. Part of this stabilizing veneer stems from the company’s claim to be the “most regulated” exchange on the market. FTX — and FTX US Services Inc. — engaged in a large volume of acquisitions, including a number to obtain trading licenses for regulatory purposes. FTX.US acquired LedgerX, renamed FTX US Derivatives LLC, in September 2021. Other acquisitions included FTX’s 2020 acquisition of Blockfolio Inc., a mobile cryptocurrency tracking and management application; and QUOINE Corp., a cryptocurrency exchange platform.

When FTX declared bankruptcy, 130 affiliated entities did the same. Exposed companies with significant exposure to FTX include Genesis Trading, Galaxy Digital and Voyager Digital. Genesis Trading has lost access to $175 million on the FTX platform, and frozen funds have a large spillover effect for clients or business partners. These frozen funds, along with the bankruptcies themselves, are generating waves of collapse in a market too nascent to be resilient to shocks — and one that had yet to recover from the collapse of the luna cryptocurrency network earlier this year.

FTX’s collapse removes a prominent investment pool for blockchain startups. Alameda Research, FTX and FTX Ventures invested aggressively. FTX Ventures first launched in January but had participated in 47 funding rounds, including leading a $300 million Series B round for Mysten Labs Inc. and leading a $135 million Series A round for blockchain interoperability startup LayerZero Labs Ltd . As with Alameda Research, a large share of investment in volume was with early-stage vendors, and the unit supported startups across the Web3 and blockchain sectors.

The post-crisis fall in the value of major cryptocurrencies suggests the run on FTX could be prolonging a “crypto winter,” which some analysts suggested was beginning to thaw. The token associated with the large public blockchain network Solana (“sol”), an ecosystem in which FTX and Bankman-Fried had each made significant investments, has performed particularly poorly. In addition to these direct consequences, however, the collapse of FTX could lead to long-term transitions in how distributed ledger technology evolves.

A call for further decentralisation

FTX’s collapse is a further reflection of the shortcomings of the CeFi (centralized finance) framework for trading cryptocurrencies. As with DeFi (decentralized finance), CeFi services provide a platform for cryptocurrency financial services, but require customers to trust the technology providers as intermediaries. CeFi platforms provide users with a custodial wallet, which leads to some ambiguity about who owns the cryptocurrency on these platforms. Celsius Network, a CeFi cryptocurrency lending platform that filed for Chapter 11 bankruptcy in September, claims it owned all cryptocurrency held on the platform. This position, so far accepted by bankruptcy judges, means that recovery of customer funds is low on the priority list as assets are recovered.

While CeFi platforms are associated with better customer support and ease of use than DeFi alternatives, another collapse of a major provider is likely to generate further skepticism in the model, which continues to underpin the major exchanges, such as Binance and Coinbase Global Inc. Attempts to correct to address the situation, many of the major stock exchanges have declared an obligation to publish statements illustrating the depth of their reserves on an ongoing basis. This is unlikely to completely assuage the concerns of investors or market commentators, with many calling for a transition away from CeFi platforms.

An effort to further reduce reliance on intermediaries could place greater emphasis on ensuring trustlessness and decentralization, an interesting trend in a blockchain space that has claimed both aspects as differentiating characteristics since its emergence. That could pose a threat to vendors hoping to position themselves as an intermediary between users and the blockchain — such as blockchain-as-a-service providers — although this may be less of a concern for potential business customers who are likely to do more due diligence than consumers when it comes to identifying partners.

A challenge for developing commercial models

Blockchain ecosystems represent a hotbed for new business models. A notable trend is for providers to generate revenue from the appreciation of tokenized assets associated with their offerings, and this commercial model has kept many blockchain products and services free. The sustainability of such frameworks now appears to be under threat. Whether this prompts blockchain utility projects to move to alternative funding models—using free-price strategies, for example, or becoming more reliant on subscriptions or corporate customers—remains to be seen. Blockchain vendors that already have paying customers, or are actively targeting corporate customers, are likely to be in a relatively stronger position than vendors that rely on interest in their cryptocurrencies. For vendors with tokens that have a clear utility value—for example, used to power applications or vote on the direction of a project—this challenge may be less pronounced than for projects that rely on funding from users who want to speculate on valuations.

The collapse of FTX could further strangle the once-booming area of ​​non-fungible tokens and cryptocurrency projects centered on appreciation. Quick investors in such projects in early 2021 saw significant returns, despite many of these tokenized assets having little use beyond speculation. Even before the recent events surrounding FTX, many of these assets had collapsed in value and some projects had to change their value proposition to suggest greater utility. From membership-only communities to the representation of tokenized avatars in games or movies, new NFT projects seemed to be responding to an existential crisis – one that will only escalate with a further reduction in investor confidence. Corporate interest and capital may well transfer to projects with a more concrete value proposition; be it asset tracking, decentralized identity or secure data exchange.

Hardening regulatory environment

Bankman-Fried was a prominent figure in regulatory discussions and was a major donor during the midterms in the United States. Revelations about his companies will now make him even more visible, albeit in a debate he is perhaps significantly less welcome to contribute to. Statements from, among others, leading figures in the US House Financial Services Committee, the Bank of England and the EU Financial Stability Board in the wake of the crisis suggest an upcoming regulatory response. A number of politicians in the US have taken aim at regulatory ambiguity and risk around digital assets.

The collapse occurred at a critical time for cryptocurrency legislation. The EU expects to implement its Markets in Crypto Assets regulation by 2024. The Digital Commodities Consumer Protection Act bill in the US is still pending. It is hard to imagine that upcoming regulations will not place significantly more regulatory restrictions on the breadth of providers that can offer cryptocurrency services and increase levels of oversight. Stronger regulations may be seen as a boon by enterprise-focused blockchain vendors. By improving the quality of assets and services “on-chain”, the reputation of the technology can be improved and companies can be able to reduce the risk of engaging in public blockchain ecosystems. Concerns will surround the role that regulation can play in reducing financial inclusion – for example through “know your customer” rules – or access to innovation. A tougher regulatory environment stimulated by FTX’s collapse may improve the legitimacy of the space, but it may also close new use cases, reduce the number of potential customers in the chain, or significantly condense the supplier space.

^{This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.
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