Mike Belshe (BitGo) on FTX and the impact on crypto market structure (EP.375)

Hey Matt, great to be here.

We started way back in 2013. And one thing I like about BitGo is our mission statement has been something we've really been able to grow with. And in fact, even up to today's recent events, it still helps. It's delivering trust in digital assets. So our goal is to help make digital assets usable everywhere. And since 2013, people have been like, 'Wait a minute, can I trust this thing?' In those early days, the types of questions were like, 'Wait, what's Bitcoin backed by?' Of course, there are regulatory questions and lots of other questions. We focused in those early days on security. And in fact, I think that's where I met you at Fidelity was we had pioneered multi-sig. Today we do multi-sig plus MPC and a variety of blockchains. So I mean it's really scaled since then. But that particular era of trust was about can I trust the technology? Can I trust that I can either hold it myself without losing it, forget my password, lose my hard drive, etc. Can I use it on an exchange and know that if they're using weak operational security practices that they aren't going to get hacked and I lose all my money? So I think we've come a long way since then in terms of building that out. Now the second wave I think of delivering trust was around regulatory and compliance. We became a trust company. We closed out last year with 65 plus billion in assets under custody which is I think a pretty big number for a 2 and a half year old trust company in terms of growth. Today those numbers are way down just because asset prices have come down of course but delivering trust here is like how do fiduciaries participate? And one of the things I love about crypto, what got me into this space, decentralized nature of it, the idea that we can all be on the same playing field. We got transparency. So you hear a lot of this, not your keys, not your coins. Because so many people have been burned by somebody managing keys for them and then being dishonest about it, not having the trust factor, so to speak. Look, I totally get it and I agree. I think when you're not using a particular service, an exchange, heck, wrapped Bitcoin, you shouldn't be exposed to it if you don't need to be. Now, at an individual level, that works. And when it turns out, as the ecosystem gets bigger, invariably we want businesses to be able to participate as well. This isn't going to be a retail only thing. Some people are going to want to hold banks, use banks to hold their assets so that they can pass it on to their kids or they can invest it or have money managers or whatever. And anytime you've got management of other people's money, all of a sudden the not your keys, not your coins breaks down a little bit. You want the transparency. You want the safety and the trust, but you can't hold the keys yourself. You're intentionally wanting to hire someone to help you with your assets. And I think this is just destiny. Even just accepting payments in digital assets. Well, you don't want the CFO to unfortunately pass on or quit and oops, now you don't have your keys anymore. So, we do a lot of extra burden around how do we manage assets? And that's what becoming a trust company, a fiduciary was all about. Now for the last four or five years, we've been working on this market structure component and it's been difficult. It's hard to build a market structure. We got these vertical silos. We had this very engaging and charismatic young man, Sam Bankman-Fried, running all up and down Washington talking with the CFTC and others saying, 'Hey, I got it. I got the 12 key principles of crypto regulation. Just let me do all functions and manage my functions. I'll do it great.' Now, I have to admit, I actually thought Sam was generally a good actor. I didn't know him particularly well, but turns out he was the biggest charlatan of them all, and we now know why he was advocating for no market structure. I think as we think about delivering trust in digital assets, and everybody that's a Bitcoin holder, everybody that's a crypto holder, if you believe in the future of this space, of course, we want to have trust. I think we're all talking about this all the time. And I don't mean like trust other third parties. I mean building confidence so that people can understand they can use these assets safely and soundly and not have to worry about their economic futures. Market structure is going to be a big part of this. How do we put checks and balances in place so that you can't have a single party like a Sam Bankman-Fried, like a Bernie Madoff, act like a Bill Hwang that mess these things up and we got to do a lot better. It is pretty sobering actually to be in this market right now with this huge, huge failure. But we got to look at risk really hard right now. So anyway, that's a bit about what BitGo has been about.

Yes and no. So, first off, on Alameda, Alameda being a hedge fund, actually, that's a place where people are allowed to take crazy risk. And if you've got a completely isolated hedge fund, I mentioned Bill Hwang a moment ago, hey, those things can blow up. Those things can have contagion into the infrastructure providers. And it did happen in the traditional finance side in that case. But generally the infrastructure is supposed to be able to manage that risk, mitigate that risk, not carry that risk directly. So yeah, you're right. I think everybody was surprised by how bad the crossover between Alameda and FTX was. It never even occurred to me that he might be using the full balance sheet, the full customer funds of FTX straight into Alameda is absolutely criminal. So I think that one surprised us. Now, in terms of FTX growing, we did have a few things. They've been acquiring companies around the world. They had acquired I guess I don't want to say who it is, but one of the companies they acquired was actually looking hard at using BitGo and they pulled out of it at the last minute just a couple of months ago and we now know why. Now, there is a shining light here. FTX US derivatives, was formerly LedgerX. LedgerX has been a client of BitGo since 2016 or something like that. And the LedgerX team took the time to do it right. Those guys really struggled in those early days because they were waiting for regulatory approvals that were taking a very long time as they built that product out. They finally got it done. Became one of the first crypto derivatives companies available. Eventually got bought by FTX proper. But because they're heavily regulated, they're required to use segregated custody. They're fine. They're solvent. They do not have any issues. So, Zach Dexter over there deserves a lot of kudos for what he's built. BitGo being the custodian there. I know that they've had inquiries from the CFTC and they passed just fine even in the last week after all of this bad stuff happened. So, FTX generally has been growing. I didn't really have a lot of concern that they were stealing from the users. It just didn't occur to me that that was something Sam would do. But, it appears that I was in the same camp as pretty much everybody else.

Let's see. There's a bunch of problems here. A, there's been really bad risks being taken. Now, I think the most egregious of those, the Celsius's, Voyager's blew up earlier this year already. Then there's a little bit more subtle ones with weak forms of collateral that may not have been stress tested appropriately. For those of you that don't do lending, stress testing is where you basically look historically at a market and you look at a collateral type and you say, 'What's your exposure in terms of how the value of that collateral could change in the market?' And if you're using digital assets which are highly volatile, even if it's Bitcoin as collateral, you've got to really understand what stress factors you may be up against. I think also back in May there was a little bit of timing mismatch, which is sometimes you got assets which have lockups where they are not liquid for a certain amount of time. I think that's bit people a few times in this summer and now fall. Some of that is containable, some of it's not. If you were using GBTC as collateral, there's a lot of discussion about Grayscale, which as the trust company, which is what derives the GBTC value. I believe confidently that they actually do have the one-to-one backing of the Bitcoin. However, the ability to turn your GBTC into BTC is something that's locked up over an indefinite period of time. That seems to be consistent with what Barry Silbert has said about DCG's solvency and Genesis' solvency is that they have the assets. It's just they're not liquid right now. So, I think we're learning those lessons. But actually, I'm going to draw this back to market structure where there's risks being taken that cannot be measured because of the market structure. So, let's say you're lending in the space today. Who are you lending to? Who's borrowing as of right now? Like, nobody's borrowing. Nobody's lending. But a few weeks ago, who was borrowing? Well, traders like Alameda. Well, where do they trade? Well, they take it out to exchanges all over the planet. And of course, they're doing all kinds of arbitrage techniques. They're doing market making. They're doing all types of quant mathematics. And because the market structure is such that you have to pre-fund exchanges today, that means they're taking the assets they borrowed from you and then they're putting it on these exchanges. Some of them are rickety. Some of those exchanges run into trouble. Obviously, FTX just ran into more trouble than we expected, but we've seen this before. We've seen it at QuadrigaCX. We've seen it at Mt. Gox. We've seen another case on the tip of my tongue. There's a dozen of these. But BitMEX is solid today, but there was a huge scare just a couple years ago. The BitMEX founders were indicted and withdrawals stopped for a moment and everybody's like, 'Oh no, if I had 20 million bucks and I'm trading there, is that going to be locked up and gone?' That one had a happy ending, but it was a spook. Unfortunately, we as humans, we're going to get through this period. I think our biggest challenge right now is not forgetting what's happening to us right now. It's going to be so tempting in four weeks to go back to Christmas and holidays and come into the new year and go back to business as usual. And if we do that, we're just setting it up for the next failure. So the market structure where you have to put money on exchange is fundamentally flawed. It will never work in traditional assets. And I'm not a huge CeFi centralized finance advocate or anything like that, but there's some risk that they mitigated that we in crypto need to fundamentally learn. And exchanges never hold the asset. Never. NASDAQ walks into the SEC and says, 'Hey, we want to be our own custodian.' That's not a discussion that's going to happen. And same thing in the CFTC world. If you're a DCM, which is equivalent exchange, you have to use an external DCO, which is a clearing organization. Anyway, this is just a fundamental thing that we have to learn. The problem is you can have a great counterparty. Matt, you might be borrowing from me, but if I know you're trading, I can look at your balance sheet. Your balance sheet can be awesome. You have a billion dollars on that thing, but I know you're taking all these assets you're putting on these exchanges that are weak. And if those exchanges go belly up, whether it's FTX or others, that's going to hit your balance sheet, then now that's going to hit me. So, I can't possibly measure your counterparty risk because it's the sum of you plus whatever markets you're participating on and we're just not there yet. So, we need the market structure.

BitGo's been advocating separation of trading and custody for a while and it's in part, I mean it sounds selfish, it's not selfish, it is our vantage point that we know how to do security in a regular way. So what is custody? Custody is segregated storage on behalf of the client and it provides bankruptcy remoteness which means that if BitGo goes bankrupt the regulator knows how to step in, knows what controls we have in place, we'll be able to return assets to the rightful owner in a very quick period so that's a positive. BitGo's been pushing for market structure to at least separate these two things because it provides a check and a balance. We need to know earlier if somebody's starting to go into a fractional reserve capacity. And I think the only way you can actually do that in light of outright liars like Sam Bankman-Fried is to have a second party involved. So the exchange can say, 'Hey, I got a billion dollars of this type of asset.' And then somebody else can say, 'Yep, I got a billion dollars for that guy.' Now, if they're in cahoots together, there's still potential for failure. Nothing's perfect, but you get these things regulated. You make sure you got jail time and known entities behind it. I think we can do a lot better than where we are today. But when I do look at what BitGo's been advocating, although it was a good first step, it is still a good first step. I think we now have to look deeper. If we had had this setup, let's say FTX was using BitGo as a custodian, the good news is we wouldn't have had any of this hacking and stealing of assets that happened after the bankruptcy. We would have had a lot more view on it. It could have been that there was somebody to raise their hand and say, 'Wait a minute, something doesn't look right here.' But at the end of the day, it means that the team at FTX would have been directing in and out of BitGo custody and we would have had a limited view as to what that means in terms of the overall balance sheet. The people that we're trying to protect here are the investors in FTX. And while FTX would have been protected in that model from BitGo's insolvency, what we wanted was for the investor to be protected from FTX's insolvency. So to get there, we have to go deeper. Starting with custody is still a key element, but now how do we make sure that the custodian has all the way visibility to the client's assets. So there's another product that we have at BitGo. It's called off-exchange settlement. It's about making it so that you can settle from direct custody as opposed to having to move the assets to the exchange. Now there's other things we're going to have to do. I think in terms of market participation, we need the custodians to be 100% rock solid safe with no possibility of exposure or taint. And here I think you have to look around and say, hey, what activities are allowed or not allowed? And so let me just be very clear. So BitGo has no exposure to Alameda or FTX insolvency at all at this point. But we have been doing borrowing and lending a little bit. Now we're doing a very conservative re-lend. As of right now, it's almost down to zero because the market has unwound positions. But should that activity be allowed and how do you do that activity? And although we do it through a different subsidiary away from BitGo Trust Company, I think we got to rethink kind of how we get the risk nailed on that. Prime brokerage is a real thing. It's going to come. I don't think anybody's solved it in crypto yet, but we got to nail this risk part first. And there's some building blocks that need to be laid, but all right, there's a lot of work for us to do. And I think every single infrastructure provider like BitGo needs to be really looking at every counterparty risk they have whether it's on trading which is generally a little bit easier especially with spot trading but still got real risk to lending and borrowing etc.

I don't think we can really count on the regulators to guide us through this. And I know if I were anybody listening to the podcast listening to the industry saying hey industry needs to fix it, I'd be like yeah right. But I actually do think our community, the digital asset space, those that are trying to build trust and make it so everybody in the world can use it, I think we have to demand it. I don't think we can expect the regulators going to fix it. There's also a lot of viewpoints going into the US regulatory. But maybe before I hit that, remember operating out of the Bahamas as FTX was doing, obviously it allows them to provide service and function that you wouldn't be able to do here in the US safely. Guess what? Every hedge fund in America has offshore feeder funds to allow them to a) access international clients and then b) to sell products that they otherwise couldn't sell here. Everybody operates that in traditional finance. So this isn't new. I mean I saw some of the crypto Twitter was surprised by the org chart of affiliate entities underneath FTX. I look at it I'm like yep looks like a hedge fund to me.