The Race to Fill Crypto’s FTX-Shaped Hole

The fall of FTX created a “huge vacuum” in the cryptocurrency market, says Can Sun, cofounder of Backpack, a new crypto exchange under development in the United Arab Emirates. Sun knows that better than most: He was previously the general counsel at FTX, whose high-profile collapse has led to industry-wide turmoil this year. Backpack is one of the parties racing to fill the hole FTX left behind. It’s a “winner-takes-all” opportunity, Sun says.

Sun has partnered with Armani Ferrante, previously a software engineer at Alameda Research, the sibling company through which FTX founder Sam Bankman-Fried ran billions of dollars that weren’t his before spending them. Their front-row perspective of the FTX debacle, the duo say, could help give Backpack a competitive advantage.

The rise and rapid fall of FTX “taught us a number of lessons,” says Sun. The biggest? The precarious art of balancing the need to reel in customers with a deep range of trading options, including riskier trades involving borrowed money, with the regulatory compliance necessary to ensure their funds remain protected.

The ambition is for Backpack to serve customers outside the United States, as the US Securities and Exchange Commission and Department of Justice have filed a raft of charges against crypto businesses. Crypto firms elsewhere face a less hostile reception. It will provide a similar selection of trades as FTX did, says Sun, but under a regulatory regime in Dubai, whose crypto-specific rules—including daily checks for accounting aberrations—are meant to prevent customer funds from being siphoned away.

There are only a “few teams in the world” capable of threading the needle correctly, claims Sun. Embroiled as they are in legal battles with regulators, many of the large incumbent exchanges, he says, are not well placed to “take over the FTX mantle.” The trick will be in beating the competition to the punch.

FTX demonstrated what can go wrong when a crypto exchange is given the latitude to operate in an opaque fashion and with minimal external oversight. It changed what is now expected of other exchanges, too.

Within a week of FTX’s collapse, Binance, the world’s largest exchange, had proposed a new minimum standard. In a blog post published on November 15, 2022, Changpeng Zhao, then Binance CEO, set out a series of best practices for exchanges that boiled down to: Don’t gamble, don’t borrow, and don’t cheat. Zhao said that Binance would begin to publish a transparent “proof of reserves,” a kind of internal audit that would demonstrate the exchange kept enough in its coffers to meet withdrawals. A number of its peers, from Bitfinex and to Huobi and OKX, followed suit.

It was a start, but an imperfect one: Proofs of reserves provide only a snapshot of assets at a particular moment in time, not a real-time picture, creating room for numbers to be fudged. They also don’t illustrate an exchange’s liabilities, so they provide only a partial indication of financial health.

There are a lot of exchanges even with FTX out of the picture, says venture investor William Quigley, who also cofounded the Tether stablecoin. But there is an opening, he says, for an exchange that can demonstrate it stores customer assets responsibly, protects against market manipulation, and follows rigorous compliance procedures. “That’s an area ripe for improvement,” Quigley says.

New players are pitching more technically elaborate methods of proving that customer funds have not been FTX-ed. Backpack is developing a new proof of reserves, updated automatically on a daily basis, explains Ferrante, whereby the availability of funds for withdrawal is demonstrated “cryptographically” as opposed to through an opaque internal audit. To prevent funds from being quietly shifted about, the exchange will operate under a system whereby each crypto token transfer must be authorized by multiple parties. The aim is to ensure “there is no single point of failure,” says Ferrante, and the exchange has “multiple levels of defense.”

Other competitors, like OPNX, an exchange launched in April by Kyle Davies and Su Zhu, the cofounders of bankrupt crypto hedge fund Three Arrows Capital, are trying to scoop up former FTX customers with a different approach. OPNX provides regular crypto trading, but also lets customers trade their bankruptcy claims. Instead of waiting out a lengthy bankruptcy process, someone with money locked up on FTX could choose to sell off their claim for a certain number of cents on the dollar, swapping maximum recovery potential for immediate access to funds.

OPNX declined a request for an interview, but speaking to WIRED in March, CEO Leslie Lamb said she hoped to “give people a path to get back into crypto if they choose” and tap into an “incredibly underserved market”: traders whose assets are stranded in bankruptcy proceedings.

Backpack has signed tens of thousands of prospective customers to a waitlist, claim Sun and Ferrante, but the exchange will not go live until the first quarter of 2024. Meanwhile, OPNX has struggled to muscle its way into the market in its first six months in operation: In October, the firm announced it had serviced $10 billion in total trades, a volume FTX racked up in just a few days at its peak.

Incumbents like Binance have also struggled to capture FTX’s corner of the market. In the months after FTX fell, Binance’s market share rose as high as 66 percent. Data shared with WIRED by blockchain analytics firm Nansen shows that even now, the exchange consistently attracts the highest total value of crypto deposits. After US regulators filed lawsuits against the firm in the summer, though, with rumors of criminal charges to follow, customers retreated from Binance.

After reaching a settlement with the Department of Justice in November, in which Binance pleaded guilty to historical money-laundering and sanctions violations, the exchange is hoping to turn over a new leaf—and in particular, to attract new high-value institutional investors. However, the firm acknowledges there is work to be done from a reputational standpoint. “It is difficult for [institutional investors] to work with businesses and exchanges that have question marks over their compliance status,” says Catherine Chen, a Binance executive tasked with attracting high-value customers. “We know that removing concerns about illicit finance in crypto is one of the most important things we need to drive mainstream adoption and more institutional investment.”

There’s another argument that the most suitable replacement for FTX could, somewhat curiously, be FTX itself. In April, a campaign began among a group of FTX creditors—the FTX 2.0 Coalition—who sought to convince those in charge of the bankruptcy estate to consider rebooting the exchange.

The idea is for FTX to be auctioned off to bidders willing to restart it and to swap creditors’ debt for equity in the new venture. If the new FTX succeeded thereafter, the value of each creditor’s equity might some day exceed the amount they originally lost, creating an incentive for those people to trade on the platform.

The inertia of the bankruptcy court means a reboot effort is unlikely to progress swiftly, says Pat Rabbitte, one of the leaders of the FTX 2.0 Coalition, but the built-in customer base will help to compensate for the delay. “In crypto, the customer churn rate is really high and customer acquisition is really expensive,” says Rabbitte. “But here is a unique opportunity.”

FTX did not respond to a request for interview, but the administrators of the bankruptcy estate are reportedly fielding proposals from three bidders willing to restart the exchange.

The difficulty facing the pretenders to the FTX throne lies in establishing trust among crypto investors. After 18 months of turbulence and high-profile litigation involving some of the largest crypto firms, in which consumers have lost billions of dollars in aggregate, “there’s no faith in the industry anymore,” says Sun. “People think this is a scam.”

Newcomers like Backpack are proposing a techno-regulatory solution to dodge around that trust issue. In effect, they’re arguing that customers don’t need to trust the companies or their founders because the technology proves that assets are not being misused and regulators are keeping watch. With FTX 2.0, the idea is that everyone whose fingerprints might be found on a damaging crypto collapse be “taken out of the equation entirely,” says Rabbitte.

There is a feeling at Backpack that the window of opportunity is closing rapidly, as more stringent regulatory restrictions imposed on crypto businesses increase the cost of entry. “It’s going to become harder and harder [to launch new exchanges] as time goes on,” says Ferrante. The legacy of FTX—that exchanges will be held to higher standards—will benefit investors, he argues, but make it harder to build something from scratch. “Time is of the essence,” he says.

Source : Wired