The crypto world needs to be made safer for investors and users

The author is an independent financial commentator

The sudden collapse of crypto exchange FTX raises serious questions about the state of the crypto ecosystem. Without serious changes to how it works, it is hard to imagine how it could even become part of the existing mainstream financial system, let alone replace it as some would like to see.

The crisis at FTX and before it crypto lender Celsius, Voyager, hedge fund Three Arrows Capital and digital tokens TerraUSD and Luna have little to do with cryptocurrency as a technology. Rather, it shows what financial systems look like when there are insufficient checks and balances. Crypto people rail against central banks and regulators, but they exist for good reasons.

What exactly went wrong at FTX is still unclear. Chief executive Sam Bankman-Fried insisted it was just a liquidity shortfall. But Binance, which originally agreed to buy FTX to shore up liquidity, pulled out of the deal after looking at its books. There are reports that FTX has a balance sheet hole of around $8 billion. If someone is not willing to invest a lot of capital, FTX will eventually declare bankruptcy. Investors are expecting the worst: Sequoia Capital has already written down its stake to zero.

Even more worrying is that customer funds appear to be at risk. In fact, it's hard to imagine how a balance sheet hole of this size could have developed if the exchange hadn't lent out customer money.

Reuters reported that FTX Alameda Research lent client funds after it was hit hard by the bankruptcies of Three Arrows Capital and Voyager in May this year. And the U.S. Department of Justice and U.S. regulators are now investigating the relationship between FTX and Alameda, including whether customer funds may have been misused.

If customer funds have been lent out and Bankman-Fried fails to find a buyer who will pay almost full price (which seems to be a tall order), customers of FTX's international exchange appear to be losing a significant portion of their funds. Some - perhaps many, as FTX attracted retail traders and encouraged ordinary people to deposit their wages into its accounts - will suffer hardship as a result.

FTX is far from the first crypto company to fall amid token collapses, bank runs and allegations about the use of customer funds. The recent outages of Celsius, Voyager and, in 2021, crypto lender Cred share similar characteristics. Underlying these errors are four key weaknesses in the crypto ecosystem:

• Interconnections between companies in the form of opaque cross-shareholdings and circular credit practices such as rehypothecation. Rival crypto exchange Binance had a significant stake in FTX's native token, FTT. When it announced it was selling its stake, it sent people scrambling to sell FTT itself and withdraw their funds from FTX.

• Too much trust in personalities. Crypto should eliminate the need for trust between people. “Don’t trust, verify” was the mantra. But the entire system now seems to depend on a few big personalities trusted by thousands. Bankman-Fried is one. He built a huge empire in a short period of time and donated a lot of money to good causes. He seemed like an all-around good guy. So people trusted him with their money. Investors in particular have shown a remarkable willingness to support his ventures without the usual financial due diligence.

• Concentration. There aren't many large crypto exchanges and banks, and those who run them all know each other and invest in each other's companies. When they get in, everything is fine; but if they fall out, they can cause immense damage. It shouldn't be possible for a tweet from Binance's chief executive to spur a run that will topple its biggest rival; but that's exactly what happened.

• Opacity. Crypto should improve the transparency of financial transactions. But crypto companies like FTX reveal very little about their financial status – much less than you would expect from a traditional bank. The opacity of Bankman-Fried's companies, FTX and Alameda, was worsened by a complex corporate structure, intercompany transfers and reported use of holdings of a native token to bolster balance sheets.

These problems will be painfully familiar to anyone who has studied the history of financial panics and banking crises. They appear to be endemic to financial systems. Crypto has shown that it is no different.

If crypto is to have a future as a mainstream financial product, it must now accept the regulation and controls that make financial systems safe for investors, creditors and depositors.