December 22, 2022 - 10:00am

With Sam Bankman-Fried, the founder and CEO of collapsed crypto exchange FTX, now in custody and facing charges of wire fraud, securities fraud, money laundering and a campaign finance violation, attention is turning to the health of his major rival, Binance.

The competitor exchange has been suffering billions of dollars of outflows over the last few days, amid growing concerns that the entire industry may be deeply undercapitalised and gripped by a deep contagion effect. There are also fears that Binance could be hit with a £2.1bn clawback if FTX bankruptcy proceedings conclude that Bankman-Fried used illicit gains to buy the shareholdings of Binance’s founder Changpeng Zhao, who is known as “CZ”.

Binance’s efforts to stop the bleeding with third-party assessments of its reserves, known as “proof of reserves”, have also started to backfire. This is down to a better public understanding of the limitations of such reports, which do little to assess the wider financial health of crypto companies or the scale of their liabilities. 

CZ has stated repeatedly that his exchange is fine, lauding its transparency. But such assertions are hard to square with reality. CZ refuses to confirm which jurisdiction governs Binance’s main trading operations. And very little is known about its full financial position. By all definitions, Binance appears to be purposefully operated as a black box. 

The fact that its true ledgers are not available for public digestion is also ironic given the sector it endorses was built on the promise of blockchain ledger transparency.

And yet, applying conventional financial analysis to assess the risk is arguably a wasted effort. A better understanding is likely to come from viewing these businesses as unregulated dealers engaged in turf wars over exclusive rights to financial flows from zero or negative sum activities, which in many jurisdictions would be highly controlled or considered illegal.  

In that case, the dynamics underpinning the rivalry between the two firms are closer to those that governed the Medellín and Cali cartels. 

This became apparent when financial personality turned FTX spokesman Kevin O’Leary testified before Congress last week. “These two behemoths who owned the unregulated market together,” he noted, “and grew these incredible businesses in terms of growth were at war with each other and one put the other out of business intentionally,” before adding that Binance had now become a massive global unregulated monopoly.

Underground turf wars of this variety only get more vicious when the underlying market begins to contract — whether due to crackdowns or other factors. 

What’s clear is that when CZ demanded the FTT token with which he was paid for his FTX shares by Bankman-Fried be exchanged into real dollars, he knew he risked bringing the whole thing down. 

Did he know the strategy could expose him as being equally naked in the market and ruin his own business? Chances are that he did, and that this behaviour was indicative of a scorched earth mentality.

The likely reality behind the desperation is that it’s not just a giant capital hole that’s spooking the crypto system. It could be the realisation that the confidence trick at the heart of the sector — underpinned by greater fool theory and easy Fed money — has finally run its course. 

That the industry is now fully embracing regulation certainly supports the idea that it believes its survival depends on the veneer of respectability that comes with government approval and oversight. Better to share the proceeds of an ongoing zero-sum business with the government and on the condition of giving up names and data than risk losing it all. 

But there is a risk here, too. If the share price of the biggest listed and regulated exchange Coinbase is anything to go by — down some 90% since it listed on the Nasdaq with great fanfare in April 2021 — it indicates that if your only competitive advantage is not being regulated, then being regulated is not necessarily a good recipe for survival either.

That makes the scorched earth dynamics at play all the more understandable.

Izabella Kaminska is the former editor of FT Alphaville and founder of The Blind Spot.