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FTX Disaster & the Importance of Obsessing Over Crypto Risk

Posted by Marcelo Sampaio on Nov 25, 2022 10:30:00 AM

This content is shared by Marcelo Sampaio, CEO at Hashdex

Financial markets are built on trust. Everyone, from investors to entrepreneurs, needs to believe the system works and the rules are respected. Last week, this trust was damaged by one of crypto’s most influential players.

The relative stability of the crypto market of recent months was interrupted on November 6 by a run on deposits at one of the world’s largest digital asset exchanges, FTX. This was triggered by Binance's plans to sell its holdings of ~23 million FTT tokens (~$529 million at the time) issued by FTX.

It has since emerged that FTX potentially has a hole in its balance sheet worth $8 billion that could be associated with a loan or loans to Alameda Research (owned by the founder of FTX) pledged with FTT as collateral and using client deposits.

As we noted in a November 9 email to our clients, Hashdex had no exposure to FTX, FTT, or Alameda. But unsurprisingly, these events hurt investor sentiment, contributing to worsening liquidity and falling market value for other crypto assets.

In recent years, Sam Bankman-Fried (SBF), the founder of FTX, became a poster child for the crypto industry's efforts to find legitimacy around the world. The implosion of his exchange has been a major setback for the crypto industry, which has been making tremendous strides with investors and policymakers.

However, it’s important to understand two things from these recent events: crypto fundamentals remain intact and regulated investment funds—like our suite of Hashdex offerings—remain a secure and simple way to access the crypto ecosystem.

Confidence in Crypto Fundamentals

Since early 2020, all major crypto assets have maintained their operation functionality and no random protocol changes were needed in response to the government lockdowns or the liquidity crisis and asset bubble that followed. There were no changes when the Fed changed course or when 3AC and Celsius failed. And there were no changes when FTX came under pressure and FTT’s price sank.

Each of these decentralized networks continued to produce blocks of transactions for anyone in the world to access. Any user with an internet connection and with physical or legal controls over their private keys, was able to transfer value to someone else without needing a third party’s permission. Bitcoin’s investment case is as strong as ever, Ethereum is becoming more scalable, and decentralized finance (DeFi) projects continue to prove their worth in a challenging investment environment.

So, despite a lack of trust in financial markets, crypto asset networks have done nothing to lose our trust. This reliability is a core promise of crypto. We must remember why we are here.

The Built-In Trust of our Regulated Framework

Our industry cannot afford to wait for regulators to force change. Since 2018, Hashdex has demonstrated that a regulated framework with strong governance standards has tremendous value. Eliminating risk and removing friction for crypto investing has been, and still is, at the core of our mission. We have never strayed from this mission, which today is more valid and important than ever.

This commitment includes our intense focus on making counterparty risk front and center when building institutional infrastructure. It also includes partnering only with best-in-class custodians, exchanges, and other service providers. And, an essential component of this structure are the fund auditors that validate portfolios and confirm we are operating with the highest governance and management standards.

For all of our investment products, our operational journey begins with strict criteria for choosing the counterparties with which funds are authorized to trade crypto assets. We have dedicated processes that rely ultimately on the approval of a committee with members independent from the manager to evaluate the choice of exchanges, custodians, OTCs, and—more recently—staking validators.

In addition to understanding in detail each service provider’s technology, we delve deeply into its organizational structure. This includes proving the existence of the controls needed to ensure the service provider’s regulation is aligned with the local requirements of the funds. Among the list of requirements to be a service provider for Hashdex funds, the four most important criteria we apply are:

  • The service provider must use the highest available custody practices. Qualified custody must include certification of segregation of the fund's assets as well as structures disconnected from the internet. Storage must require multiple signatures and geographic distribution of cryptographic keys to mitigate the existence of a single point of failure and key-man risk. This makes it as difficult as possible for hacker attacks that could compromise private keys. To date, there have been no known cases of compromised accounts with this type of security.
  • Custodians must use independent auditors. The quality and effectiveness of a custodian’s operational processes must be attested. This audit generally follows the AICPA SOC 2 procedures (Service Organization Control reports) and includes the provision of an insurance policy against private key theft and loss, as well as against fraud and internal theft.
  • There must be limited exchange exposure. Crypto asset exchanges have always been the biggest vectors of cyber attacks. Because of this, we have a general rule that an asset can only be in the exchange environment when necessary to sell that asset. In these cases, the sale or exchange operation must be carried out within a maximum period of 24 hours. After this period, the asset must be returned to the custodians and the balance on the exchange must be reset to zero.
  • Strict OTC standards must be followed. Over-the-counter exchanges (OTCs) need to have a license to operate in their jurisdiction and submit their corporate structure and balance sheet for us to analyze and adjust our internal counterparty risk policies in trade settlements.

In addition to these priorities, we have additional protections built into our due diligence process. For the approval and maintenance of counterparties, Hashdex analyzes criteria related to the financial health of the institution and the prevention of money laundering and terrorist financing, including the following requirements:

  • the entity must be regulated in the jurisdictions in which it operates;
  • the exchange in question must have strict KYC and AML / terrorist financing prevention processes; and
  • the institution must follow Financial Action Task Force (FATF) recommendations.

Crypto Asset Scrutiny—Trust but Verify

All of the individual crypto assets we invest in are part of indices that also have their own strict standards. For example, the Nasdaq Crypto Index™ (NCI™) has what we believe is a best-in-class methodology for eligibility criteria. For any asset to make its way into the NCI™, it must be supported by core exchanges and core custodians. Each exchange or custodian must be an institutional-grade and regulated service provider with compliance practices (including AML and KYC) that meet Nasdaq’s strict due diligence process. Individual crypto assets selected for benchmark inclusion must:

  • be listed on multiple core exchanges, allowing investors to trade index constituents with top-tier regulated counterparties and access reliable pricing sources for calculating the value of the index;
  • be supported by multiple core custodians to ensure that investors will be confident their assets are held using the most secure means available;
  • have liquidity on core exchanges greater than 0.5% of the most liquid asset, which minimizes transaction costs and the impact on prices from trading;
  • have a free-floating price, which eliminates assets that have their value pegged to another asset, such as stablecoins.

For all of our product offerings, we go beyond the eligibility criteria of the index providers. Our team independently analyzes custodians and exchanges and issues a “Know Your Token” analysis with a detailed description of each asset. This includes the perspectives from our research, risk, compliance, legal, and operations teams. This review is submitted for approval by our Risk and Compliance Committee before the asset is allowed in any Hashdex portfolio.

Finally, all our systems and operational processes have been carefully designed to not depend on any specific person at Hashdex, thus guaranteeing the physical integrity of our employees and investors. Approvals must come from multiple Hashdex employees, the administrator, and the custodian. This makes it virtually impossible for a single person to improperly initiate and approve transactions. Additionally, as cryptocurrency transactions are irreversible, we have established in all our accounts whitelisting policies, transaction limits, anomaly detection, and panic codes.

A Trusted Partner in Challenging Times

Hashdex has spent the last five years building the necessary infrastructure and processes to protect our investors from events like FTX. The processes described above are what protected us from holding FTT or having exposure to Alameda and FTX. And they will help us avoid exposure to any future events sparked by third parties that don’t share our obsession for risk and operational discipline.

When an investor commits their money to a Hashdex fund, we want them to feel completely confident in the security of their investment. That’s why our highest priority remains ensuring that client assets are secure. And it is why we will continue to be a voice for the best due diligence and crypto investment practices.

Trust is built over time. While we are disappointed that a few bad actors have given the broader crypto industry a black eye, we remain confident trust will be regained as more market participants adopt the best practices necessary for this incredibly promising industry to evolve. While it’s unclear how long it will take the industry to recover confidence from these events, nothing has changed with our commitment to our values and our mission: giving investors access to crypto through simple, secure, and regulated products.

 
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