As always when the music stops playing, this latest downturn exposed a number of exchanges who were swimming naked all this time. Though a few were masters of disguise, there’s still a number of red flags that you can check to avoid falling victim to another exchange bankruptcy.
Besides nearly all crypto lenders getting wiped out, several exchanges went under in the last year, including FTX, Coinflex, Zipmex and Hotbit. The crypto space has always seen shady exchanges come and go, but it hasn’t been since the days of Mt.Gox that we’ve seen such “sudden” collapses.
Exchanges can fail gracefully, but as the space took on way too much systemic leverage, sudden rug pulls became more likely. Though the leadership in these exchanges will always point to external factors, the reality is that the failures are entirely due to reckless management that allowed the exchange to be brought down by these stresses. Oftentimes, there’s also crime involved.
Why lending is the downfall of the crypto exchange
In the case of Zipmex, they chalked their collapse to Celsius and Babel Finance. With the lenders going out of business, the exchange had apparently placed a significant amount of customer funds through its ZipUp lending program for customers.
With the partner companies collapsing, the exchange suddenly found itself with at least a $100 million hole in its books that it had no way of filling up.
Offering lending services to retail or small scale investors is the #1 red flag to avoid. Lending is an incredibly complex risk management business that almost nobody, not even dedicated firms, managed to master.
The temptation to co-mingle user deposits with these rehypothecation schemes is also very strong, which would further expose the exchange. The Zipmex case had a bittersweet side in that only ZipUp funds were lost, while regulations prevented the company from doing the same with exchange deposits.
Crypto lending is essentially operating a bank, and companies that do this should be regulated as such. This is quite ironic considering that Celsius built its marketing campaign on “hating” banks, while being the literal definition of a wildcat bank itself.
So, for the future, it’s important to apply high due diligence and make no trust assumptions on exchanges offering some form of lending and earn program. Better to just avoid them, even if the exchange is otherwise reputable — FTX was also considered “solid”.
Exchange tokens and creative accounting practices
One of the things that allowed FTX to keep the charade going is their “mark to market” trick of valuing illiquid, low float “Samcoins” at their current market price. It’s easy to see how trying to realize 500% of the circulating supply of an asset would impact prices heavily. But if these tokens are used as collateral, then anything becomes possible.
More conservative accounting practices would include projected discounts from selling large amounts, or just using cost valuation methods (where the asset is valued at its purchase price).
In practice, this is harder to see from the outside, as most exchanges don’t publish their books. However, a good litmus test is whether the exchange token is used in some form of lending platform, be it centralized or decentralized. If there is a large supply of exchange tokens in a money market, that’s a huge red flag. You can be sure that the platform is levering up on them, and collapse is just around the corner.
If you don’t know how it makes money, run
The exchange business should be quite simple: each time a trade occurs, the exchange takes a relatively small fee. Because volumes are usually much larger than the liquidity or open interest, even small fees can generate tremendous revenue.
But what if the exchange is struggling to attract any kind of volume? Alternative tactics come into play.
A good example is a launchpad. When hosting such an IEO or ICO, the project will usually give some of their tokens to the platform. But since these types of projects struggle to maintain a long term outlook, the exchange has to sell these tokens as soon as possible, or otherwise it’ll get stuck with illiquid and low quality tokens on their books.
The solution is simply to dump as soon as the token is listed, thus ensuring that the exchange has paid itself.
If volumes are low or look manipulated, and if the exchange holds a lot of IEOs, this is certainly a red flag. It means that these sales have become the platform’s primary source of income, and trading against its customers can’t possibly be a good long-term strategy. This red flag is quite easy to spot.
Overall, it’s important to trust your gut and challenge all your assumptions about how the exchange’s team is “honorable” and “competent.” That makes it easy to see and digest red flags, and potentially avoid losing all your money to another crash.