The difference between a centralized exchange like FTX and a decentralized exchange is who is ultimately in control of the digital asset. (ddp)

There is plenty of speculation in the media about where the firm went wrong, but rather than churn the rumor mill, let's turn to a few likely implications for the asset class after its tough week:

1. Reevaluation of exchanges, with an emphasis on decentralized options. As the FTX collapse was occurring, network activity spiked with transactions. The majority of these were customers moving funds off of other exchanges in an effort to avoid potential contagion risk. These other exchanges were direct competitors to FTX, and given the fear in the market, are currently working on efforts to provide proof that their customers funds are safe and secure. While this drama will not mark the end of centralized exchange operations, in our view it will shift activity towards decentralized options at the margin. As a reminder, the difference between a centralized exchange like FTX and a decentralized exchange is who is ultimately in control of the digital asset. When using a centralized exchange, the exchange is the ultimate owner of the keys and therefore the assets, not the customer, while with a decentralized exchange the customer maintains full ownership of their assets via control of the keys.

2. Legislation and regulation will be a theme for 2023. Digital asset legislation has been one of the few topic areas to see substantial and meaningful bipartisan legislation formation in the US Congress. Given the close balance of power in the upcoming Congress, we expect this to be one area that sees renewed focus. The Lummis-Gillibrand bill introduced in the current Congress will provide a template for what we expect to see, though it is likely that the turmoil around TerraUSD in the spring and now FTX will drive larger focus to specific areas like stablecoins and centralized spot exchanges. Similarly, we would expect regulatory action in 2023 to be a point of focus. How the digital asset regulatory structure will come together remains to be seen, but regardless of whether it is the SEC or CFTC driving action, we expect regulation to be a major focus for governments, users, and ecosystem participants.

3. Legal systems will grapple with novel concepts. The latest pain in digital asset markets will certainly spur numerous legal claims, many of which will look similar to settled law, but many others are likely to have novel components. Consider a hypothetical example where courts may hear complaints from customers who had funds custodied with the FTX exchange. Now, if FTX had been a regulated broker, the courts would know how to handle the complaint and award the assets back to the owner, which is the customer. In the digital asset space there is no equivalent and the courts could find that the assets are not in fact the property of the customer, but are the property of the exchange. This is just one illustrative hypothetical of the new concepts the judicial system will have to grapple with as a result of this new asset class and technology. And without meaningful regulation or legislation to look to, the courts may have to answer some thorny questions on their own.

Main contributor: Michael Gourd, Asset Allocation Strategist

Content is a product of the Chief Investment Office (CIO).

Original report - Crypto markets under stress, 14 November, 2022.