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Crypto Is A Tool That Was Exploited.

We have some explaining to do. And there’s no getting out of that.

“We” (meaning those involved in the industry; NFX was not an investor) let one centralized entity grow to a scale of such massive proportions – including objective size, financial power within the ecosystem, and political influence – with effectively no checks and balances in place.

In doing so, we bore witness to the egregious misuse of that position of power – made possible, mechanically, by crypto. Instead of being used as a tool to create a fairer, more transparent, and safer financial system, crypto was wielded to propagate fraud – and broad swaths of end-users are bearing the brunt of the damage.

As VFX artist John Knoll once said, “Any tool can be used for good or bad. It’s really the ethics of the artist using it.”

Let’s rewind. What happened?

We still don’t fully know. There are still a lot of unknown-unknowns. But a known-known is that an organization was horribly (criminally) managed. As FTX’s new CEO John J. Ray III wrote in FTX’s Chapter 11 First Day Affidavit, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information… this situation is unprecedented.” And that’s saying something; Ray III led Enron through bankruptcy proceedings, along with several other of the largest corporate failures in history.

To contextualize the situation: Alameda is — was — a hedge fund, and hedge funds blow up from time to time. That’s simply the nature of them. The major complication here was that the founder of Alameda also happened to be the founder of FTX, who was thus able to shore off Alameda’s losses via FTX’s balance sheet (read: customer deposits). At some point, FTX’s liquid assets were not enough to shore off Alameda’s losses, leading to the collapse of both FTX and Alameda.

Almost every deduction leads us to believe that FTX rehypothecated its customers’ deposits to Alameda and took its own exchange token, FTT, as collateral. Last week, market sentiment on FTT dropped — the price went along with it — and both FTX and Alameda found themselves in unrecoverable holes. FTX’s liquidity shortage is estimated to be as much as $8B. And as we’re already beginning to see, this is likely just the tip of the iceberg.

History repeats itself

So, a centralized exchange used customer deposits to engage in highly-risky trading strategies — and then became insolvent. That sentence rings true for several “centralized custodians” over the last 12 months alone. We’re having déjà vu with all-too-recent fallouts including Celsius, Blockfi, and Voyager.

Crypto, so it seems, never misses an opportunity to miss an opportunity.

It is human nature to learn, unlearn, and relearn the same lessons — massive collapses of centralized entities have happened before, and many of them rhyme with FTX: Long-Term Capital Management, Lehman, Enron, etc. But the lessons typically become deeper entrenched in industry with each collapse, and then the collapses become more and more infrequent (e.g. there have been few major collapses in TradFi [traditional finance] since 2008).

Without consequential change, crypto will end up with another 3AC, FTX, or Celsius. To move forward in a meaningful way, we need to become our own harshest critics and skeptics; we must begin to vilify the rationale that allowed us to even get to this point, not just the individuals and companies directly responsible for the pain and financial loss of many — though of course, these folks need to be held strictly accountable as well.

Not your keys, not your coins has been a rallying point for many who espouse decentralization. And we’ll get there. But if we’re being honest, centralized wallets and exchanges will likely be the answer for many users for the short-to-medium, to maybe even long-term. The question then becomes: “How can we all learn from both the industry’s indiscretions and our own ignorance to prevent something like this from happening again?

You can’t become a dictator through checks and balances

There will undoubtedly be countless conversations within–and outside of (e.g., on Capitol Hill)–the industry aiming to answer this exact question.

Whether bull or bear, we need to utilize the wisdom of the crowd to ensure checks and balances are properly in place to avoid perpetuating the same mistakes over and over again. Below are a series of questions we must continuously ask ourselves, regardless of the extent of our confidence in a particular company, market, or person.

  1. Key man risk: What is the key man risk within this company? In other words, would this company change materially in the absence of any particular person or persons? The lower the key man risk, the better.
  2. Sufficient decentralization: More broadly, what is the key man risk from a macro perspective? i.e., What does industry consolidation look like? Are there certain centralized companies and protocols that control too much of the market? Would the market collapse without those entities? These questions aim to answer whether a subsector – or entire industry itself – is sufficiently decentralized, and thus, will endure almost anything thrown its way.
  3. Don’t trust, verify: Can we verifiably prove that this entity has sufficient risk-mitigating elements or features in place? In the case of FTX, what would have happened – or better yet, not happened – if it had proof-of-reserves on-chain? Don’t trust, verify.
  4. Lawfully good: Is this entity and the people at the top acting in a “lawfully good” way? With unclear regulation – at least in the US, for now – we need to be vigilant of anyone who has a) historically acted lawfully, b) is currently doing so, and c) if they even have the ability to unilaterally act unlawfully as to have a negative impact on end-users. Until we have clear, steady-handed regulation, we need to draw our own lines in the sand.
  5. Sensible tokenomics: Is this company giving unreasonably high incentives for locking or staking your tokens? Is the total token supply disproportionately greater than its circulation supply? And perhaps most critically, is this company sustaining itself by selling its own tokens?

Of course, there are many other red flags that were overlooked in the case of FTX. Most notably, how does a company that raised over $2B in institutional capital have no Board of Directors?

FTX’s demise dents, but doesn’t break the promise of crypto

Crypto is part of the story here, but it is not the story. It’s important to note that the past few days are not a damning of crypto writ-large, nor of even company-created tokens like FTT, but of nefarious actions taken by centralized entities off-chain. While it may seem like these collapses are unique to crypto, in truth, they could happen to any company that so egregiously mismanages its business. FTX failed due to an astounding lack of governance and internal controls at the behest of a criminal. It is simply bad business, bad judgment, and worst of all, bad ethics. What we have here is fraud, and fraud existed long before crypto.

The irony is that this type of centralized collapse–and fraudulent activity–is the exact paradigm that crypto aims to solve. Critically, one of the many goals of crypto is to help prevent this type of fraud from occurring by creating open, permissionless, ubiquitously auditable, and transparent financial systems.

We’re not promising that nothing will go wrong in DeFi (decentralized finance). But, when things have gone wrong in the past, there has been immediate transparency in precisely what went wrong, why it went wrong, and how we could prevent the same mistake from happening again. Anyone–not just investigators, auditors, liquidators, the government, or employees – can simply look at the on-chain data. In the case of FTX and other CeFi (centralized finance) collapses in the past, many of the key details take months to unravel and become available to the public–and sometimes never do. For now, we wait to learn more specifics of what happened with FTX while using deductive reasoning to fill in the blanks. And that is unacceptable.

It’s hard to not blanket all of crypto together. But you can’t. CeFi is inherently different from DeFi. Comparing FTT to Bitcoin and Ethereum is comparing apples to oranges. Bitcoin, Ethereum, the projects building on top of those L1s and within other decentralized ecosystems still work–and they’re getting exponentially better each day.

As Aztec Head of Growth Jon Wu eloquently said in the immediate aftermath of FTX’s collapse, “In a year of turmoil the last 24 hours have been the worst thing that has happened for the crypto space, by orders. It underscores the need again for transparent, overcollateralized systems that can deleverage in an orderly manner. It ironically underscores the need for crypto.”

While the ripple effect of FTX’s collapse will have massive ramifications for the industry, we all have a responsibility to safeguard, evangelize, and ultimately deliver crypto in its purest form. When we do, we will come out the other side, purged of the fruit flies, with a renewed focus on creating a more transparent, efficient, decentralized, and safe financial system for all. That was and is the original promise of crypto, and it’s more critical now, than ever, that collectively we – as founders, operators, and investors – build toward fulfilling it.


Thank you to our new web3 associate Daniel Museles for the brainstorming, sanity checking, and writing help on this essay.  

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Morgan Beller
General Partner
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