The Crypto Industry Struggles for a Way Forward

Not long after several Wall Street banks collapsed in 2008, a nine-page document circulated on an obscure mailing list, proposing a new kind of financial system that wouldn’t rely on any “trusted third party.”

The paper was the basis for what became the cryptocurrency industry. Using sweeping, idealistic language, its adherents vowed to conduct business in a transparent and egalitarian way, rejecting the high-risk practices of a small number of powerful financial firms that caused the Great Recession.

But last month, the actions of a single crypto firm — the $32 billion exchange FTX — plunged the emerging industry into its own version of a 2008-style crisis. Once considered a safe marketplace for people to trade virtual currencies, FTX filed for bankruptcy after the crypto equivalent of a bank run, forcing industry executives, investors and enthusiasts to grapple with how a technology meant to correct the shortcomings of traditional finance ended up replicating them.

Executives who just a year ago were reveling amid crypto’s seemingly unstoppable growth are now scrambling to prove that they can learn from the mistakes and recapture the industry’s early ideals. Binance, the world’s largest exchange, announced last month that it would release more information about its finances and recruit independent auditors to review those disclosures. Coinbase, the biggest U.S. crypto exchange, proclaimed that it was committed to a “decentralized system where you don’t have to trust us.”

Many crypto advocates are pushing for more drastic reforms, urging investors not to store their digital holdings with big companies and instead turn to more experimental platforms run solely by code.

But for all the promises of change, FTX’s collapse shows how far crypto remains from fulfilling its original aims and gaining widespread acceptance. Consumer distrust has mounted this year amid major financial losses, criminal investigations and an increasingly skeptical regulatory climate in Washington. At a conference last month, Changpeng Zhao, Binance’s chief executive, said that FTX’s implosion would set the industry back by years.

The exchange’s downfall compounded months of losses in the virtual currency market set off by a devastating crash in the spring that unfolded amid a broader pullback from risky assets. The upheaval sent some prominent crypto firms into bankruptcy. Bitcoin, the original and most popular cryptocurrency, has been trading at less than $17,000, down about 75 percent from its high of nearly $70,000 almost exactly a year ago.

“You start to go though these problems, and they stack up one after the other after the other,” said John Reed Stark, a former Securities and Exchange Commission official who has become an outspoken crypto critic. “More and more people are seeing this for the scam that it is.”

The crypto industry has bounced back after previous crashes, attracting big-name investors who poured even more money into experimental companies. But FTX’s collapse has been widely described as the worst moment in the industry’s short history.

The origins of crypto date to 2008, when a mysterious figure known as Satoshi Nakamoto published a white paper on Bitcoin, laying out a detailed vision for what became cryptocurrencies. The paper outlined Bitcoin’s technological foundation, which was a publicly viewable ledger called a blockchain where transactions would be recorded for all to see.

Early enthusiasts thought Bitcoin could become the foundation of a more transparent, egalitarian financial system. Many of the paper’s supporters were libertarians who had grown disillusioned with traditional finance, especially the concentration of power among a small number of companies.

At first, crypto’s primary use was criminal. Thieves and drug dealers used Bitcoin to transfer large amounts of money without relying on a bank or another intermediary to process transactions.

But over the years, law enforcement got better at tracking crypto crime, and the technology evolved to allow more sophisticated financial applications, like borrowing and lending. People who started their careers on Wall Street — including FTX’s founder, Sam Bankman-Fried, who worked at the trading firm Jane Street — got involved in the nascent industry, looking to profit from the technology.

As the industry grew, it started assuming some of the same characteristics as the Wall Street institutions that it was designed to replace. Crypto trading became increasingly centralized, with a large portion of transactions taking place on a handful of big exchanges, including Binance, FTX and Coinbase. In the months leading up to FTX’s collapse, the trading volume of cryptocurrencies on Binance alone was greater than the combined totals of its seven closest competitors, according to an industry data tracker.

The original vision of crypto “was an attempt to rewrite the rules of finance on a global basis,” said Charley Cooper, managing director at the blockchain company R3. “And here we are again — we’re in an even more centralized industry than we’d see in banking.”

Cryptocurrencies soared in value last year and into 2022 — until May. That was when a popular cryptocurrency called Luna crashed, sending the crypto economy into free-fall. Two major lending companies, Celsius Network and Voyager Digital, filed for bankruptcy. Enthusiasts lamented the onset of a “crypto winter” of depressed prices and fading enthusiasm.

Amid the crisis, FTX was considered a relatively trustworthy force. Based in the Bahamas, the company served as a marketplace for people to buy and sell cryptocurrencies, offering high-risk but popular trading options that are illegal in the United States. Mr. Bankman-Fried, 30, who had built FTX into a $32 billion company, bailed out struggling firms and built a reputation as a benevolent figure willing to extend a lifeline to colleagues.

Then last month, a run on deposits exposed an $8 billion hole in FTX’s accounts. The company filed for bankruptcy within a week. The Securities and Exchange Commission and the Justice Department opened investigations, focused on whether FTX illegally lent its users’ funds to Alameda Research, a crypto hedge fund that Mr. Bankman-Fried also founded and owned.

The implosion has been described as a “Lehman moment” for crypto, a reference to the investment bank whose implosion helped set off the 2008 financial crisis. Other companies with ties to FTX started to teeter. Last Monday, the crypto lender BlockFi, one of the companies that FTX had bailed out in the spring, filed for bankruptcy, citing its entanglements with Mr. Bankman-Fried.

Some prominent figures in crypto have tried spinning FTX’s downfall as a positive development, arguing that it will redirect energy toward finding practical uses for the technology.

“For us, this is actually a great moment,” said Jeremy Allaire, the chief executive of the crypto payments company Circle. “We’re delivering real value, and the people who focused on building giant speculative trading casinos are not so happy.”

Binance operates essentially the same type of business as FTX, but Mr. Zhao, the chief executive, has recently been careful to differentiate himself from Mr. Bankman-Fried, calling his one-time rival a liar and criticizing FTX’s most dangerous practices. On Nov. 25, Binance announced a new “proof of reserves system,” promising to keep users informed about the amount of cryptocurrency in its accounts and to dispel fears that it might be vulnerable to the type of run on deposits that destroyed FTX. (But Binance’s plans were heavily criticized for lackingkey information.)

Coinbase has also tried to alleviate fears of a collapse, publishing a blog post that said it always holds the same amount of money that customers deposited. “There can’t be a ‘run on the bank’ at Coinbase,” the post said.

Still, the mere existence of large companies like Binance, Coinbase and FTX is antithetical to the ideals of crypto, some industry experts argue. Since FTX’s collapse, some crypto enthusiasts have flocked to smaller firms in the experimental field of decentralized finance, which allows traders to borrow, lend and conduct transactions without banks or brokers, relying instead on a publicly viewable system governed by code.

But DeFi has its own problems, including vulnerability to hackers, who have drained billions of dollars this year from the experimental projects.

“They’ve based it on clunky technology that is very inefficient,” said Hilary Allen, a finance expert at American University. “They’re operationally very fragile.”

Scrutiny in Washington has also intensified. Gary Gensler, the chair of the S.E.C., has vowed to pursue crypto companies for violations of securities law. The House Financial Services Committee is scheduled to hold a hearing on Dec. 13 examining FTX’s collapse.

Mr. Bankman-Fried has been asked to testify. In interviews with The New York Times, he has at times seemed agonized over FTX’s bankruptcy — and at times been strikingly flippant.

“You know,” he said in one interview, “the crypto winter has been officially extended.”

Wasn’t that a bit of an understatement? “Yep,” he replied. “Alas.”