In the second Investment section of the 2023 CMC Crypto Playbook, Dragonfly's Haseeb Qureshi and Tom Schmidt put forth the path forward for VCs, following the FTX collapse.
In November 2022, the crypto industry suffered arguably the biggest shock of the year, when the Bahamas-based cryptocurrency exchange FTX collapsed following the major mismanagement of funds.
In the aftermath of the collapse, close to a dozen other crypto firms have either buckled or are struggling to stay afloat, including BlockFi, Genesis Trading, Voyager Digital and Galois Capital.
In a recent episode of The Chopping Block on Laura Shin’s Unchained podcast, Dragonfly’s Haseeb Qureshi and Tom Schmidt analyzed the recent FTX fiasco and its impact on the way that VCs operate in crypto.
One of the Biggest Catastrophes in Crypto VC History
The collapse of FTX underscores a distinct lack of due diligence even at the highest levels of both crypto and traditional venture capital.
Backed by industry heavyweights like Paradigm, Sequoia Capital, and Blackrock, as well as the massive Singapore sovereign wealth fund Temasek, FTX managed to raise more than $1.5B at a valuation of $32 billion by January 2022.
Though it is now clear that FTX was operating on borrowed time and had an $8 billion hole in its balance sheet, it managed to fly under the radar for months before a wave of mass withdrawals exposed its insolvency. And just months before its collapse, it was reported that the exchange was still looking to raise a further $1 billion for acquisitions and industry bail-outs.It’s now clear that dozens of prominent VCs and backers are now set to record heavy losses on their books. For example, Sequoia Capital has already written off its $210 million investment in the company. What has gone wrong that would have caused the investors to be blindsided by this exchange? Weren’t there red flags?
Despite being backed by dozens of the most prominent funds in the world, none demanded a seat on the board, or financials audited by a reputable firm. Chamath Palihapitiya of Social Capital stated in a podcast that prior to a potential investment in FTX, he provided several reasonable suggestions on creating a board with external advisors but was told by Sam to “go f*ck yourself."
A Lesson Learned by Investors
Part of this boils down to the aura that Sam Bankman-Fried had developed over the last year — which was largely fueled by crypto media painting him as a savant. Many things that would be considered as odd/red flags, would become lionized as part of his genius. This was underscored by the horde of glowing profiles that appeared in mainstream media about SBF.
Unfortunately, this allowed him and FTX to simply shirk off investors who asked too many questions. With the media continually blowing up SBF’s ego, a mythology formed around him. This has crowded out the proper due diligence process that should have been carried out.
This wasn’t helped by the fact that VC firms in both the crypto and tech industries are now beginning to launch their own publications to enhance the marketing/PR efforts for their portfolio companies. This includes the likes of Sequoia Capital, which published a fawning puff piece about Sam. This, some believe, may have led to other less diligent investors getting caught up in the fiasco.
Despite the calamity of the FTX collapse, there is a silver lining. Both traditional and crypto VCs are now painfully aware that deception can occur at even the highest levels of venture finance, and that even the largest institutional investors can be blindsided by it.
The Way Forward
After FTX, diligence standards will almost certainly increase across the industry. We are likely to see more VCs demanding board seats and other corporate controls when investing into CeFi companies.
On the demand side, most institutional traders are now demanding Proof of Reserves (PoR), a cryptographic method by which exchanges can prove their assets on hand match their liabilities. Many exchanges have begun offering this already, and it’s likely this will become a standard industry practice going forward.
And finally, we’re likely to see more disaggregation of the exchange stack. Today, exchanges serve as custodians, brokerages, lenders, and exchanges, all in the same bundle. Going forward, we’re likely to see these different functions break out among different entities as they do in traditional finance; this makes it much more difficult for an exchange to steal a customer’s funds (since they don’t have access; the custodian does). In other words, eventually you will not need to custody your funds with Binance to trade on their exchange.
Altogether, these changes should help reduce the likelihood of the next FTX taking place on our watch. Although crypto is often chaotic, the learnings are always public, and it is ultimately up to the users of these platforms (and their investors) to demand these changes.