A more competitive market means a stronger need for unsustainable incentives and more "dumb" bets by smart investors. Here's how to make the most of it.
FTX is the latest crypto exchange to go down in flames. The details are still coming to light. But they seem to include a heady mix of fraud, bad governance, and a classic pyramid. It's a fascinating story that highlights three inconvenient truths about our world and, more specifically, about uncertainty, venture capital, decentralized finance, and the limits of control in a complex world.
Before we get to these, let's take a paragraph or three to summarize what allegedly happened, highlighting the few details that I find meaningful.
The Rise and Fall of FTX in a Nutshell
FTX is a crypto exchange. It allowed customers to exchange traditional currencies into various tokens and to trade such tokens and related financial products. FTX also had its own native token, FTT. Customers who held the token enjoyed benefits such as lower trading fees and higher rewards for referring their friends to FTX. Notably, such rewards included getting a percentage of fees paid by people they referred. So, FTT holders had a direct incentive to encourage other people to buy and hold FTT.
You can think of FTT as "house money." Instead of keeping their funds in USD, traders could keep them in FTT and earn generous rewards. We'll get to the problem with this arrangement in a moment. But first, one final allegation, as reported by the Wall Street Journal: FTX lent customer funds to Alameda Research, a hedge fund founded by FTX's founder and CEO.
FTX incentivized customers to deposit their money with rewards. It then lent that money to an affiliate that made risky bets. As a result, FTX had less money than its customers thought. When too many customers tried to withdraw their funds simultaneously, the whole thing collapsed. The withdrawal may have been spontaneous (customers responding to market conditions) or part of a coordinated attack by rivals (accumulating and dumping FTT in one go + spreading rumors that cause other FTT holders to sell).
Truth One: More choice means worse choices
FTX's token incentives seem like the foundation of a pyramid. And they are, in a sense: The company raised money from professional investors. It then used this money to pay its early customers to recruit even more customers. And then used the money paid by newer customers to pay the rewards it promised to earlier customers.
The problem is other crypto exchanges were doing more or less the same thing — launching their own tokens and offering generous referral fees. They did so for two main reasons:
- Because they could.
- Because they had to.
They could because blockchains such as Ethereum and Solana enable anyone to launch a new token with a few lines of code. Such tokens can be used by millions of people. They can be transferred around the world within seconds. And they can be governed by smart contracts that automatically pay out royalties and referral fees.
They had to because, in a world where customers can buy and sell tokens anywhere they want, they'll only do it with you if you offer something that's not available elsewhere.
Let me elaborate: In the world of traditional finance, customers are forced to rely on a small number of centralized institutions — banks, exchanges, clearing houses, credit card issuers, payment transfer systems, and government-issued currencies.
In the world of decentralized finance, "currencies" can be issued, bought, sold, stored, and transferred without relying on such institutions. This means customers have much more choice in how to store, build, and destroy value.
Ironically, the fact that customers have more choices means that exchanges must create complex incentive schemes to attract them. A popular exchange can ultimately offer real benefits such as higher liquidity, better customer service, and superior technology. Such benefits are a result of economies of scale and network effects. To achieve such scale and kickstart network effects, you first have to incentivize a massive number of people to store and trade their tokens with you.
Crypto tokens make it both possible and necessary to provide such incentives. VC-funded companies like FTX need to become very big, and they need to do it quickly. That they rely on all the growth tools at their disposal should not be a surprise.
And yet, FTX was more than an innovative startup looking to grow at all costs. If all the allegations are true, FTX was also a good old-fashioned fraud: Its founder funneled customer money into personal investments until nothing was left.
It's easy to see how FTX fooled its individual customers. But how did it manage to fool its own investors?
Truth Two: FOMO is a reasonable strategy
FTX's backers include some of the world's largest and most sophisticated investors— Sequoia Capital, NEA, Tiger Global, Temasek Holdings, Softbank, and Blackrock. At its peak, the company was valued at $32 billion.
And yet, despite pouring more than $2 billion into the company, these investors did not appoint anyone to its board of directors. Instead, as The New York Times reports, the board consisted of FTX Founder Sam Bankman-Fried, together with another FTX employee and a lawyer. For reference, even Adam Neumann's WeWork had a board of directors with representatives from its largest investors.
How did investors let this happen?
The answer is FOMO, fear of missing out. The crypto market was growing quickly. Some investors were rushing to back FTX. So, other investors followed them there. Softbank's former chairman admitted as much in a tweet earlier this week:
The media — and investors who happened not to invest — were quick to criticize FTX's backers. They should have been more cautious. They should have insisted on better governance. They should have heeded the signs of a megalomaniac founder.
But is that true?
Sure. In an ideal world, investors should have done all this and more. But our world is far from ideal. Venture capital investors operate with limited information. They take it as a given that every decision they make will likely result in failure. Their biggest risk is not one or more failures; their biggest risk is missing out on one huge success.
Crypto intensifies this dynamic. As mentioned above, blockchains enable a near-infinite number of companies and projects to provide the same services. And tokens can incentivize large groups of people and create network effects that turn early success into a lasting competitive advantage.
In light of the above, was it reasonable to invest in FTX? Could it have become a giant company? Of course, it could — it actually did. Sure, the story didn't end well, but it was close enough.
Given the opportunity, most of FTX's investors would do exactly the same thing tomorrow. Their job is not to avoid failure; it is to avoid missing out on the biggest success.
It is also their job to say they learned their lesson before they do it again.
But beyond lip service, they know they haven't learned anything because there is nothing to learn. To paraphrase Gordon Gecko, "FOMO, for lack of a better word, is good."
Does this mean we should accept fraud as a fact of life? Should we continue to empower founders to squander billions of dollars?
No, but we should stop expecting investors to know better. What can we do instead?
Truth Three: The Only Way To Control Complexity is to Embrace It
FTX epitomizes the story of crypto: a young genius that builds a huge pyramid and tells himself he's only doing it for the greater good.
But on closer inspection, FTX is the opposite of everything "crypto" is or wants to be. FTX enabled people to buy crypto tokens and participate in decentralized finance. But the company and its platform operated very much like a traditional financial institution. It was centrally managed, putting control in the hands of a few individuals and keeping these decisions hidden even from its largest investors. It relied on traditional trust: Its customers and investors gave it money because they trusted its management team.
That trust was betrayed.
In contrast, decentralized exchanges such as Uniswap operate on very different principles. Uniswap offers many of the same "services" as FTX. But instead of being "managed," it relies on a protocol — a set of rules that apply equally to all transactions. The code that powers this protocol is publicly available for review and constantly updated by a small team and other contributors. It was developed by Uniswap Labs, a company. But since it is open source, the company does not own it. And since all transactions are governed by code, no one in the company has the ability to funnel customer funds to his personal business.
The fees generated by the protocol are shared with its customers and contributors that help update its code and identify bugs and potential exploits. Such people receive UNI tokens that they can exchange for cash or use to vote on important decisions. Since its launch in 2018, Uniswap has processed more than $1.2 trillion in transactions and accumulated billions in revenue from transaction fees. Around $2.5b of that revenue is stored in a treasury that anyone can audit, and hundreds of thousands of UNI token holders can spend on initiatives that they vote on.
I am not here to argue that Uniswap is perfect or ideal. But it does point towards a more sensible approach: Instead of trying to reign in the abundance and complexity of our financial markets by praying for better managers or smarter investors, we need to embrace abundance and complexity and get them to work for us: Code and financial balances should be transparent and available for anyone to review in real time. Crowds of customers should be empowered to participate in governance and get rewarded for maintaining and upgrading shared resources. And more.
The world is becoming more complex: Information flows faster than anyone can absorb, and the decisions of billions of people interact to produce results that no one can predict. Instead of trying to suppress or ignore this complexity, we need to build systems that become less fragile as they grow, systems that become less prone to human error or abuse as they become more attractive to crooks and charlatans.
Decentralized finance is full of experiments to find new ways of doing so. It is also full of even more experiments to defraud people. This is a tragedy. But the tragedy will be compounded if we throw away everything we've learned so far and double down on applying old solutions to a completely new world.
Dror Poleg Newsletter
Join the newsletter to receive the latest updates in your inbox.