The authors are CEO and manager of the financial consulting company Complex
The factors in this column may invest in securities or instruments, including those mentioned therein. The aforementioned does not constitute investment advice or marketing, which takes into account the data and the special needs of each person
The crisis in the crypto market has reached the giant exchange Binance (Binance) and threatens to become a deep breaking point. At the end of the week, the French accounting firm Mezers announced that it is ceasing to operate in the crypto field and is withdrawing the reserve confirmation report it provided to Binance last week. This, on the grounds that it is not properly understood by the public.
● In one day: 3 billion dollars were withdrawn from the largest crypto exchange in the world
● Maintains ambiguity, and talks about transparency: meet the powerful man behind the Binance exchange
Mezers’ announcement is a fatal blow to Binance, which suffered $6 billion in redemptions last week, while the coin it issued, BNP, plunged 20%.
Binance has stated that it will publish a report from an alternative accounting firm within a few months. However, this is a long time for it to deal with waves of redemptions and crisis, without being able to rely on control and verification from a third party.
In addition, Binance is expected to encounter a refusal from the leading CPA firms, after the BDO firm also announced at the end of last week that it will examine the continuation of its work in the field of crypto, while the BIG 4 firms do not operate in the field.
Reserves report – what is it and is it sufficient?
Binance’s importance to the crypto market stems from being the largest crypto exchange, which currently holds about 53% of market trading and about 67% of derivatives trading.
Binance does not publish the total customer assets in its possession and the rate of withdrawals from it, but states that all customer funds are backed by full reserves, so that it can redeem any amount, and backs up its claim as stated in the reserves report. Similar reports are also provided by other crypto exchanges, such as Crypto.com and KuCoin.
However, a reserves report does not constitute a complete financial report, but shows a partial picture of the assets side only. The report shows that Binance has assets in an amount that slightly exceeds – at a ratio of 101% – the funds of its clients. However, the key point is that the reserves report does not specify whether the assets shown in it actually belong to the customers, and does not refer at all to the liabilities side of the exchange, that is, to the question of whether there are additional creditors who will claim entitlement to the funds. Thus, the report does not respond to the risk that the customers’ funds were used for other investment activities, making loans or transferring funds to third parties.
Here it is important to clarify that unlike the crypto exchanges, regular exchanges operate under strict global standards, maintain multiple controls, are closely monitored by regulators and publish full financial reports, audited by a CPA.
In addition, customer funds in regular exchanges are completely separated from the assets of the exchanges themselves, identified and protected in dedicated separate accounts, so that in the unlikely event of an exchange’s insolvency, the customer funds are protected from creditor claims, since they are not part of its assets.
On the other hand, in the case of insolvencies of a crypto exchange, where the aforementioned separation does not take place, there is a risk that the remaining funds will not be associated with the customers and will be swallowed up against additional obligations, and as a result, the customers will lose their right to the funds and become unsecured creditors.
In other words, customers of crypto exchanges should not be embarrassed by the mere statement that they have funds in their possession in a similar amount to those deposited there, since this is no proof that the funds belong to them and that there is a solvency towards them.
FTX events as an illustration of what is expected for the field
These risks have already materialized in the collapse of the FTX crypto exchange last month, which was estimated to be worth $32 billion in early 2022.
FTX also allegedly held sufficient reserves. However, the customers’ funds were not kept in designated accounts for them, but were used, among other things, for failed investments in various ventures, for the personal needs of the controlling owners, and to finance the trading needs of the Alameda Fund, a sister company to FTX, which dealt in trading in digital assets and crypto-currencies.
The same financing allowed Almeda to provide FTX with liquidity to increase trading on the stock exchange. In return, Almeda received unfair advantages in terms of trading such as faster execution of transactions, ability to trade without account balances or collateral and ease of liquidating loss transactions. In addition, Almeda received unlimited loans from FTX, which were financed from the customers’ money in the stock exchange. Since Almeda caused heavy losses, which did not allow her to repay the debts to FTX, these led to the loss of billions of dollars of customer money, which cannot yet be accurately estimated.
If FTX had published financial statements in accordance with generally accepted accounting rules, it would have been possible to see the additional uses made of the clients’ funds, properly measure the failed investments made and conclude that its liabilities significantly exceed its assets.
It is not for nothing that John Ray, the liquidator of the FTX stock exchange, who has 40 years of experience in the field of liquidations, claimed that he had never seen such an accounting mess and that FTX lacked corporate governance and basic control processes.
The crypto market crash is around the corner
In our opinion, the crypto exchanges are at a dead end today, and the next crash is only a matter of time. Binance’s only chance of being saved is in the event that the customers’ funds are indeed kept in full against the obligations towards them, or if there is a significant and unexpected change of direction in the crypto market, which will stop the redemptions from the exchanges.
The risk in Binance intensifies because $2.1 billion of its money was paid to it by FTX before its collapse, to repay a debt to it. The payment is in legal dispute and Binance may be required to return it, if for example it is determined that it is a prohibited creditor preference or payment of funds belonging to FTX customers. Due to the lack of a full financial report, it is not possible to know how these funds were classified and whether they are part of the assets attributed to Binance customers in the reserves report. But deleting the amount could drill a big hole in Binance’s balance sheet and lower the already fragile ratio of 101% assets against customer liabilities below the insolvency threshold.
The rational action of the investors in the crypto exchanges is to withdraw the funds from the collapsing exchanges. In our estimation, as redemptions increase, Binance will have no choice but to freeze withdrawals. First, this may be done with temporary technical arguments of the need to liquidate assets, but as long as it does not have full coverage to finance the repayments, there will be no escape from defaults. A similar situation may also occur in other remaining crypto exchanges, leading to their collapse.
In our opinion, from there the crisis may also permeate the largest stable currency, Tether, with a market value of 66 billion dollars, which claims a 1:1 backing in dollars, also through a reserves report. From here, the road to collapse of the entire crypto market is short.