Cryptocurrency exchanges have been making headlines lately, and not for the right reasons. The recent collapse of FTX, once valued at a staggering $32 billion, highlights the dire need for better solvency assessment methods in this rapidly evolving industry. Sam Bankman-Fried, the founder of FTX, was recently found guilty of money laundering and fraud, among other charges. It is alleged that he diverted around $14 billion of FTX customer funds to his own investment fund, Alameda Research.
Traditionally, financial institutions are subject to established solvency assessment procedures. However, the evaluation of solvency among cryptocurrency exchanges, known as Virtual Asset Service Providers (VASPs), is a different story. The process lacks a systematic approach and is often conducted ad-hoc. One of the main reasons for this is the nature of cryptocurrency assets, which are held in pseudonymous wallets on different blockchains and are only partially disclosed in available reports.
Recognizing the urgent need for change, researchers from the Complexity Science Hub (CSH), in collaboration with the Financial Market Authority (FMA) and the Austrian National Bank (OeNB), have proposed a new approach to assess the solvency of VASPs. Their working paper, titled “Assessing the Solvency of Virtual Asset Service Providers: Are Current Standards Sufficient?”, outlines two key suggestions.
Disclosure of Wallet Addresses
The researchers propose that VASPs should disclose their crypto asset wallet addresses and provide additional metadata describing the use of these wallets. This would allow independent auditors to verify if a VASP has access to the funds associated with its on-chain wallets. By increasing transparency, the industry can ensure that customer funds are adequately protected.
Separating Balance Reports
Another crucial recommendation is for VASPs to separate their balance reports into crypto and fiat assets and submit them at appropriate intervals. This would enable a clearer understanding of the proportion of assets held in traditional currencies versus crypto assets. By improving the reporting standards, regulators and auditors can better evaluate the financial health of cryptocurrency exchanges.
To support their proposals, the researchers conducted an analysis of 24 VASPs registered with the Financial Market Authority in Austria. They compared data from multiple sources, including known crypto asset wallets, balance data from the trade register, and information from regulatory authorities. The findings were revealing.
Inconsistencies in Balance Sheets
The researchers discovered that the known crypto asset holdings and the balance data provided by the VASPs were only partially consistent. This inconsistency can be attributed to three main factors. Firstly, not all VASPs separate their balance sheets for crypto and fiat assets, making it challenging to assess the proportion of each. Secondly, VASPs manage their crypto asset transactions differently, leading to discrepancies in reporting. Thirdly, the crypto asset holdings of VASPs are not easily visible to third parties.
The collapse of FTX serves as a stark reminder that even large cryptocurrency companies can fall into insolvency, potentially resulting in substantial losses for customers. The research conducted by the Complexity Science Hub, in collaboration with regulatory authorities, presents crucial insights into the solvency assessment of VASPs. By implementing the proposed recommendations, the industry can take a step towards improving the analysis and evaluation of VASP solvency, thus enhancing the overall stability of the cryptocurrency ecosystem.
The collapse of FTX highlights the need for more robust solvency assessment methods in the cryptocurrency industry. The proposals put forth by researchers offer viable solutions to enhance transparency and accountability among VASPs. By embracing these recommendations, regulators and auditors can work towards creating a more secure and trustworthy environment for cryptocurrency investors and users.