SARAH KREPS: I'm Sarah Kreps. I'm the director of the Tech Policy Institute at the Cornell Brooks School of Public Policy. And I'm delighted to be joined today by Susan Joseph, who is the executive director of the FinTech initiative at Cornell's Johnson School of Business. She has a JD and MBA, and has worked in the space of digital assets for more than five years.
And so she and I have worked in the FinTech initiative at Cornell for some time now. And with everything going on in this world, I wanted to bring Susan in on a conversation to help explain and tell us what we need to know about everything we're hearing in the news this week in crypto.
So we're going to have a conversation that tries to make sense of those developments. So let's get started. So in the last 72 hours, we've had a lot of news about some combination of acronyms and names-- FTX, Sam Bankman-Fried, Alameda Binance. They've become household names.
And I think this space-- it's fair to say the crypto space, digital asset space-- has been a fairly niche and, in some ways, arcane space. But now this is in everyone's newsfeed, and I think people are trying to make sense of this industry-- who these actors are, and why it's so important. So I wonder if you could start, Susan, by giving us a lay explanation of what has happened this week and why it's important.
SUSAN JOSEPH: Sure. I would be happy to. And just want to first say thank you for inviting me to do this. And because I'm a lawyer, I have to put forward the disclosure that none of this is legal advice, and this is all a representation, my personal observations. So that out of the way. We're talking about cryptocurrency markets, exchanges, and trading firms.
So why is it interesting? According to S&P, the market size was about $1.1 trillion, down from $3 trillion around a year ago, which represents about 2.5% of the US equity market cap. Today, CoinGecko shows the market cap of $930 billion. So why is it interesting? Well, that market's quadrupled from 2020.
High growth, high risk, high rewards in their current structure. So who are these household names? FTX, a crypto-based exchange in the Bahamas. Sam Bankman-Fried is the CEO. He also has a trading firm called Alameda. Bih-nance, or Bye-nance-- however you want to pronounce it-- is a global crypto exchange originally from China but now registered in the Caymans.
Its CEO is known as CZ. Both leaders of these exchanges are very well-known in the crypto space. Both of these companies have separate USA divisions that are licensed in the USA. But when I talk about this, I'm talking about the global companies. And as we speak today, FTX is teetering on bankruptcy. And for all I know, they could be filing while we're doing this podcast. That's how fast this world moves. So I think that's some good background.
SARAH KREPS: Yeah. No, that's really helpful. And so what we've-- as you said, FTX is teetering on bankruptcy. But it seems like there-- and we could spend-- and people will be spending days and years trying to do deep dives into this. But there are ways in which this became-- and, in fact, the CEO this morning said he effed up.
And so I want to just unpack that a little bit. So what did he do to mess up? And what is the analogy that we might think about in terms of the world of finance? Is this like Lehman? I've seen all kinds of analogies. Is this like Enron? Is this a Ponzi scheme? How should we be thinking about what happened by way of making sense of where we are now?
SUSAN JOSEPH: So I do believe that it is a Lehman-type moment. Whether or not it's a Ponzi scheme, I don't know enough to know, and I don't think anybody knows until you see all the documents and what's behind it to determine that. But to put it in familiar terms, what really happened. You had two market rivals, both with very opaque holdings. And I want to reference that again, that both of the holdings are opaque.
So it's extremely difficult to understand what's there and what's backed by what. In the marketplace, over the weekend, one of the rivals, Binance, bid down FTX's assets. In many countries, this can be viewed as market manipulation, and is not legal. There was a run on the bank, so to speak, to pay off all of the people trying to withdraw, and not enough funds to pay out, and put FTX in a very precarious position.
Beyond that, separately, it came to light that FTX's balance sheet contains a lot of holes. And it appears that a lot of their funds were being used-- customer funds-- that were being used to prop up their trading operations in Alameda. That is a big no no. In the US, we have segregated accounts.
But remember, this is a exchange out of the Bahamas. I can't predict what prosecutors are going to do, but I do believe it's unethical, fraudulent, and, in my view, rises pretty close to criminal, if not criminal. It is a black mark for the crypto industry and a call for us to look at what we're doing and how we get our houses in order.
And it's also a call for the regulators to provide an environment that is responsible for innovation and not just come screaming, saying shutting everything down, particularly when you have global markets.
SARAH KREPS: So I have a quick question on this jurisdiction issue. So if this is based in the Bahamas, does the SEC have any jurisdiction--
SUSAN JOSEPH: US citizens were involved in trading with it. So I would imagine there's quite a lot that the SEC has to say about this, that FinCEN has to say about this, that the DOJ has to say about this. I know they've already started saying things about this. So yes, there is jurisdiction here in however it is technically pinned.
SARAH KREPS: Uh-huh. But one of the things you hear-- can I just--
SUSAN JOSEPH: I was going to say--
SARAH KREPS: Uh-huh. I was going to ask a related question. So one of the things you'll hear on NPR is, well, there's no FDIC when it comes to the crypto world, and so consumers aren't really protected in the same way. And so what is that about?
SUSAN JOSEPH: That is true. There is no FDIC because, generally, in crypto-- there is not a quick answer to this other than to say that truly peer-to-peer type trading is different than peer-to-peer type trading with centralized, typical banking functions on top of it. And in a highly volatile market that is near liquid, that's a really bad combination.
So should there be something of last resort? Your true peer-to-peer traders and advocates would say, no. The market is what the market is. And what's on chain is transparent. And we can see what the assets are. And buyer beware. I bet everybody who's been stung by this doesn't have the same opinion.
It's interesting. So FTX was attempting to build an exchange in kind of a quasi-bank where you could borrow against crypto holdings. But they aren't a bank. They didn't follow bank strictures. They didn't hold capital like a bank. And I don't even know how you could hold capital, enough of it, in such a volatile market.
I mean, you certainly can diversify your risk. We've seen speculative assets before. But it's a tough thing to manage. And personally, I think they crossed the line when they try to put those business functions all together. I don't think this could have been done this way in the USA.
Having enough capital to deal with a run on your bank when the asset's extremely speculative, I don't know how you actually manage that. Again, it's a tough thing, and we don't know how anybody managed any of their assets internally. Again, back to opaque. So we'll learn more, but we don't know yet.
SARAH KREPS: So you had indicated that this was more like a-- well, what the metaphor of this was. But one of the-- just coming back to Lehman, let's say, of 2008, one of the reasons why the government felt like they needed to provide massive amounts of assistance is because of what was thought of as systemic risk, that if Lehman went under, this would just create this contagion to the entire banking industry.
Do you think that sort of systemic risk exists in these digital assets?
SUSAN JOSEPH: I think that it could as they get bigger. But as a small percentage of the market, maybe not today. I also think I could be proven wrong in 10 minutes. So it's that fluid of a situation, and we're living through it. So I think we can really learn from living through it and see what's going on.
Crypto's touted to be different-- transparent, trackable transactions, close to immediate settlement. So are they really transparent? I mean, there's talk about tracking the assets back and showing what the reserves are for the exchanges. Does that mean that the reserves aren't pledged elsewhere? How would you know? Just seeing a reserve is, to me, maybe a start of something, but it's never going to be the full proof.
I mean, that's-- I just would have diligence questions about that. But factors that led to today include lack of transparency, lack of audited-- truly audited financial statements, lack of reserves, fractionalization, and the nature of the timing. So those are all things that we should figure out how to deal with to make this move forward.
SARAH KREPS: And so that issue on the lack of reserves is why then FTX was using client funds to address this liquidity crunch. And you had said that's a no-no. What does a no-no really mean? Is that this is not legal or-- can we put--
SUSAN JOSEPH: So in the US, it's not legal. But the terms of service in the Bahamas say that money can be used. Is it clear? I don't know. It would really depend on how a court's going to interpret what went on. But a no-no-- you don't mix that. You have a big hole in trading, you don't try and fix it by taking funds from somewhere else. I mean, that's pretty clear. That's what I mean by a no-no.
And that, to me, is something that you don't just do by accident. You're filling a hole that you know you created instead of taking the loss and disclosing something.
SARAH KREPS: So where do you think this industry-- I mean, you've made it sound like there's not so much a systemic risk, but there clearly has been spillover within and across the industry. Where do you think it's going from here? I mean, there are I think some in this community that say, hey, look, the crypto digital assets have weathered previous storms. They'll weather this one as well. Or do you think this time it's different?
SUSAN JOSEPH: I do think that crypto assets will weather the storm. I think what comes out the other end is going to look a lot different than what went into it. The lack of opacity, the lack of transparency, the lack of rules around this. That's a big issue. And anybody who's been impacted by this would agree with that.
So I think that there'll be some reckoning within the industry about how to prove assets. There's certainly a call from every regulator that I've seen to clamp down on this. And I have issues with that type of over-- I believe, overreaction. Not to minimize anybody's loss or pain on this. A lot of good people got caught up and got hurt.
But I think that the regulators here need to provide an environment of innovation rather than an environment of enforcement. I've been saying this for a long time. A lot of people in the industry have been saying this for a long time. And really, what's happened is the regulators-- particularly the SEC-- has provided an environment of enforcement.
You can imagine that, if there had been clear regulation, maybe FTX would have formed in the US and been subject to US regulation. As it stands, when you've got the largest crypto trading organization by volume, Binance, outside of the US and investors flocking to it outside of the US, well, US investors are going to get hurt if the situation is opaque and something happens again that's very similar.
And they have to flee outside of the US because there's nothing in the US that encourages innovation here. And I think that is a big red mark on us on the US to get our act together and to start putting out some sensible regulation and an environment for innovation. Because crypto is global. It's not going away.
You saw by the numbers that I put in the beginning-- out in the beginning of the year, and the interest and the appetite. And even today, with all of this going on, I personally am getting calls to say, well, we are thinking of investing in X. We are thinking of doing Y. It's not stopping. So the question is, how are we going to get on board and make it useful and realistic?
SARAH KREPS: One question that comes to mind on your point about this being global-- and just mapping this stakeholder terrain-- the FCC chair, Gary Gensler, is I think coming out guns blazing and-- the runway's running out, he said. Investors around the globe are getting hurt.
But the SEC, obviously, is US based. And I'm wondering from a global regulatory perspective, if you think about how popular crypto has been in countries like Ecuador and Turkey, one wonders-- and I'm curious if you have any insights on this-- what that more international recourse and regulatory space might be, or this is really just going to be an FCC kind of recourse. Curious about the global impact of this.
SUSAN JOSEPH: In general, in the US, I think it's fair to say there's bee views on having very [? good ?] markets that people aspire to trade with. And so I think the US will be a model. Will that be the only model? I don't think so. My real fear is that the US doesn't address any of this and continues to just slap it, try stamp it out.
And in that case, investors are going to go elsewhere. The innovation is going to go elsewhere. You're not going to stop it. And so it's just a big loss for the US overall, in brain trust, in providing new ways to do things. I feel pretty strongly about that. Is it a case of the global regulators looking at it?
Well, they have been looking at some of the money transmission things. I certainly think that when Facebook tried to launch Libra, that was a call to all of the global regulators to wake up that you need to get on this. And so they do look at this, and there are conversations.
But different countries are going to handle things differently. And they're serving different populations too. So if you're looking at an economy that's very mature like the US, it might have a different view of how crypto should go versus an economy that perhaps isn't as sophisticated or wants to have more-- considers crypto as a stable currency compared to their national currency. We aren't the arbiter of how all this goes. It's global.
SARAH KREPS: That's what's so fascinating. That's the decentralized aspect of this. Well, Susan, I think this story is evolving. Maybe we can follow up at another time. I think you've given us a lot of incredible insights. And we'll see where things go. But I really appreciate your time.
SUSAN JOSEPH: Thank you for having me. Happy to be here.
SARAH KREPS: Thank you, Susan.
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In this video recorded November 10, 2022, Fintech at Cornell executive director Susan Joseph speaks with Cornell policy and law professor Sarah Kreps about the specifics of the collapse of FTX, its promised but rescinded buyout by Binance, and the situation’s implications for the developing cryptocurrency industry.