Von Alexander Brunner

The crypto exchange FTX’s bankruptcy in late 2022 rattled the crypto and blockchain community worldwide. It is important to remember that crypto is only one use case for the blockchain technology. There are others such as the digitization of financial assets or Web3. Switzerland, with its responsible and regulatory thoughtful approach to innovation remains a globally leading blockchain ecosystem.

In mid-December of 2022 the founder and CEO of the crypto exchange FTX, Sam Bankman-Fried, was charged by US prosecutors with fraud and conspiracy over the collapse of his firm. The collapse resulted in USD 8 billion of missing customer funds. This was not the outcome the Bitcoin whitepaper aspired for, a fairer decentralized financial system, when in 2022 highly centralized crypto institutions such as FTX started to fail in dramatic fashion. The wave of bankruptcies highlighted two uncomfortable facts: its high centralization and utter lack of risk management.

Luckily, the Swiss blockchain ecosystem so far has not seen any total failures. This can be attributed to the “Swiss way” of “slow and steady” and responsible innovation. It is important to remember that crypto is only one use-case of the blockchain technology. There are others such as the digitization of financial assets, the so-called tokenization, as well as Web3 solutions. Due to its advanced ecosystem and prudent regulation, Switzerland remains at the forefront of the blockchain technology.

FTX Carnage

The presumably genius founder of the Bahamas-based crypto exchange FTX portrayed himself as a responsible crypto leader. He donated to the democratic party, lobbied in Washington and had conversations with the US regulators CFTC (Commodity Futures Trading Commission) and SEC (Securities and Exchange Commission). At the same time his exchange attracted multi-billion dollars of venture capital funding, pushing the valuation of FTX to USD 32 billion. As a self-proclaimed “effective altruist” the billionaire promised to give away his fortune. In late November 2022, the CEO of the largest crypto exchange, Changpeng Zhao, started a bank run, when he began withdrawing FTT tokens, a crypto coin issued by FTX. This led to the bankruptcy of FTX within weeks and criminal charges against its founder, Sam Bankman-Fried. The crypto dream of a new, fairer, and decentralized financial system was unravelling fast.

What was supposed to happen and what happened?

The Bitcoin whitepaper in 2008 painted a vision of a peer-to-peer payment system without financial intermediaries, such as a bank, that allows direct transactions between individuals. It was a dream of decentralization that would prevent financial actors, such as banks from dominating and reap disproportionate profits. It was supposed to enable any citizen in a “permissionless” way, without any background checks to access a fairer and more equitable financial system. Unfortunately, in 2022 things turned out differently with the emergence and eventual collapse of highly centralized crypto actors from stablecoins (Luna/Terra) to exchanges (FTX) and lenders (Celsius). The collapse of many large crypto companies, in addition to fraud, was enabled by two powerful contributing factors  that are important to understand: the power dynamics of digital platforms and the lack of risk management in crypto.

Dominant Digital Platforms

In recent years, we have seen the rise of dominant digital platforms from Meta to TikTok and Amazon. This occurred due to network effects: users gravitate to where other users are. Economies of scale make dominant platforms super-efficient and convenient to use, entrenching their market dominance. Decentralized or distributed systems in contrast are slower and more cumbersome to use than centralized systems. The same economic laws apply to the blockchain and crypto industry that saw the rise of centralized exchanges, marketplaces and lenders. They facilitated convenience and transaction speed. As a result, they became a fix for the design flaws of slow and cumbersome decentralized systems. Unfortunately, it all ended in tears enabled by a second factor: the absence of financial risk management.

Risk Management

At the PointZero Forum in Zurich in June 2022 Augustin Carstens, the general manager of the Bank of International Settlement BIS, highlighted a very important concept in financial markets: risk management. It has, according to him, three elements: leverage, liquidity and capital reserves. Combining illiquid assets with leverage (credit) without sufficient capital reserves to absorb losses lead to financial disasters. FTX, an exchange, broker, lender, hedge funds and venture capital investor combined, is a very graphic example of the absence of risk management. Its FTT crypto coin lost value and became illiquid, while it had large outstanding liabilities (leverage) and no sufficient capital to absorb losses. The result was an incredibly fast bankruptcy and the loss of billions of investor’s capital.

Broken Dreams

In 2022, it became glaringly obvious that crypto has not lived up to its lofty ideals of a fairer and equitable financial system. It became clear that the laws of financial markets, and in particular risk management, also apply in the world of crypto. Maybe 2022 was also the beginning of the end of the American libertarian dream. A dream of uncontrolled innovation and a “get rich quick” and “move fast and break things” type of capitalism, that was supercharged by a tsunami of cheap money. It showed that unchecked financial markets result in heavily skewed financial outcomes for a few insiders and losses for society. However, there is a different innovation approach of “slow and steady that wins the race”. This approach led Switzerland to the forefront of the global blockchain ecosystem as it provided innovation with guardrails.

The responsible Swiss way of innovation

Switzerland has a long tradition in crypto, digital assets and blockchain since the foundation of the first companies back in 2013. In 2015 the Swiss regulator started a fintech desk, issued ICO (Initial Coin Offering) guidelines in 2018, licensed the first two crypto banks in 2019 and amended its law to accommodate blockchain technology in 2021. Switzerland’s “slow and steady” approach led to the following (preliminary) result: no bankruptcy of a Swiss entity due to the FTX fallout. Quite in contrary. The Swiss crypto bank Sygnum for example saw significant Net New Money inflows of CHF 845 million in the fourth quarter of 2022 as clients looked for regulated and safe custodians.

Switzerland pioneer in Blockchain

2023 will be all about responsible innovation in blockchain. While crypto was the first big use case, other uses cases from the digitization of financial assets to Web3 will gain prominence. 2022 was a setback for unregulated and irresponsible crypto companies but will move the industry towards advanced ecosystems, such as Switzerland, that offer innovation with guardrails. Here are some exciting innovations that are based on the blockchain-technology.

Decentralized Financial Infrastructure

Crypto is often seen as a new asset class. However, the approximately 20’000 coins mostly lack an underlying economic value. They do not represent income from debt or dividends from companies. They do have a price as they can be traded but are based on thin air. However, more and more blockchain projects represent underlying assets from bonds to stocks to smaller companies. In January 2023 the City of Lugano issued its first native digital bond with a volume of CHF 100 million. Today many traditional Swiss financial companies are experimenting with processing bonds or fiat-currencies, national currencies like CHF, EUR or USD, on the blockchain. The Swiss National Bank, together with the Bank of International Settlement Innovation Hub in Basel, has been at the forefront of this trend. The digitization of financial asset is hoped to increase liquidity, price-discovery and also risk management. If successful, many large non-transparent markets from bonds to private equity could be made accessible to a wider investor community, creating fairer markets.

Efficiency and Security

Decentralized and open-source systems are slow, often costly and lack user-friendliness. The challenge will be to properly address these shortcomings while at the same time not to create another dominant centralized actor. Likely the answer is not either or but, it is somewhere in between; completely decentralized and centralized. Decentralization has clear advantages in the form of security and trustworthiness of distributed systems. In a world of increasingly interconnected devices, so called Internet of Things (IoT), making such systems tamper-proof is paramount. The blockchain will enable this.

Creator Economy and Web3

Ethereum has become a thriving global peer-to-peer and open-source e-commerce platform with an in-built financing system of coins. It has a large global community with new projects launching daily. It has the potential to become a platform for creators to directly launch new projects and access a large community. Nowadays, Big Tech to luxury goods companies experiment with the blockchain to prevent fraud or increase fan-engagement.

Internet of Value

Going back to first principle, the global blockchain community must remember the vision of the Bitcoin whitepaper: build a fairer, more heterogenous and equitable financial system. It should not be about “getting rich quick”, but building responsibly towards an “internet of value”. Switzerland is leading the way with a sophisticated ecosystem and pioneering projects!

Der nächste Beitrag auf dem Blog Economic Crime erscheint nach den Sportferien am 27. Februar 2023.

Autor: Alexander Brunner

Alexander Brunner studied at the University of St. Gallen before working in alternative investments. He is the author of the book “Crypto Nation Switzerland”, the “Swiss Digital Asset and Wealth Management Report 2021” and the “Swiss Digital Asset Market Report 2022”. In 2022 he launched the “Home of Blockchain” public-private partnership that promotes Switzerland’s blockchain ecosystem. He is a former Member of Parliament. Today he is a senior advisor to international tech companies and governments.

* Die meisten Blogbeiträge erscheinen in Deutsch. Ausnahmsweise erscheinen Beiträge auch in Englisch und Französisch, den Sprachen, in denen Schweizer Expertinnen und Experten in der Bekämpfung von Wirtschaftskriminalität häufig arbeiten.