Bloomberg Interview Part 1: FTX Founder Reveals Regulatory Compliance Policies for the First Time, Discusses Whether Equity Tokens Will Be Delisted

FTX Exchange founder Sam Bankman-Fried recently sat down for an interview with Bloomberg's "Odd Lot," along with Bloomberg columnist and author of "Money Stuff" with 150,000 subscribers, Matt Levine, to discuss the structure of the crypto industry and the potential future developments of FTX.

Compared to mid-May, the cryptocurrency market has cooled off slightly, but the industry continues to develop rapidly. It is not difficult to see that the main theme of the crypto industry in 2021 is the integration of crypto finance and traditional finance. Host Joe Weisenthal believes that the most significant difference between the crypto market and 2018 is that the industry's development speed has not been affected by the bursting of the bubble.

The integration of crypto and traditional finance can be broadly divided into two categories: traditional institutions incorporating cryptocurrencies or integrating blockchain technology, and the crypto industry actively expanding its territory or acquiring traditional financial companies to infiltrate traditional financial services.

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FTX's Next Step: Acquiring More Traditional Finance Companies in Preparation for Regulation

When discussing industry trends, it's inevitable to inquire about FTX's next steps. And SBF's standard answer is "acquiring more companies."

SBF believes that as cryptocurrencies and traditional finance gradually converge, the ecosystem will undergo a qualitative change, with overlapping services indicating integration and innovation. Through acquisitions and partnerships, more potential in the industry can be unleashed. Indeed, acquisitions are currently taking place, as Joe Weisenthal mentioned that news of acquisitions or funding is heard every other day.

"So far, some highly regulated traditional financial institutions have begun to enter the crypto field, including fintech companies, but most (acquisitions or additions of crypto services) have nothing to do with fintech."

SBF explained that the pressure on these companies mainly comes from customers: "Assuming an institution does not offer Bitcoin services, it can be easily imagined that the most common user feedback received is to add Bitcoin services."

Market Structure Flaws and FTX's Explosive Growth

For traditional investors like Matt Levine, FTX is relatively unfamiliar, so curiosity about FTX's rise process arises, which, from the subsequent conversation, is related to the flaws in the crypto market structure before 2018 and even now.

Prior to 2018, there were more "spot exchanges" like Coinbase or Binance in the market, with fewer exchanges for crypto derivatives, which had issues with "user experience" and "capital efficiency." SBF gave an example that if a user wants to trade ETH/USD contracts, the user needs to first purchase ETH and then transfer it to the exchange as collateral for the contract.

"As a result, exchanges need to manage hundreds of wallets on the same exchange, with each wallet supporting only one currency. This is inefficient in terms of margin utilization, and low capital efficiency leads to the ineffective clearing of the clearing engine. So whenever the market fluctuates, the clearing system collapses."

This situation causes excessive price volatility in the market, leading to more users' margin calls being liquidated, which is not a good customer experience.
Liquidation Issues Are Not Server Issues
Next, the recent surge in trading volume resulting in "liquidation issues" was mentioned. Joe Weisenthal pointed out that during the peak trading periods in Q1 and Q2, price fluctuations causing liquidations and exchange crashes sparked discussions.

The reason for the large number of liquidations is the interaction of two forces, one of which is the "margin system."

SBF stated that most exchanges now have isolated margin, meaning, for example, if Xiao Ming buys BTC/USD and ETH/USD contracts, the margins for the two are calculated separately, which means that when liquidating the BTC contract, the ETH contract is not affected. The advantage of this system is the ability to differentiate between different products, meaning contracts do not interact with each other.

For exchanges, under this system, margin checks, risk management, and order books are independent, so by purchasing more servers, they can quickly introduce more products and significantly expand their business.

However, if the process encounters a bottleneck (meaning trades), the exchange cannot accept any more orders because it cannot confirm if users have sufficient margin, which then triggers a series of liquidations due to trade crashes.

How Do Traditional Exchanges Solve This Problem?

SBF explained that the way crypto exchanges operate is completely different from traditional exchanges because the primary business of traditional exchanges is not clearing; clearing and risk control are the responsibilities of brokers. They are more like periodic checks to ensure that the margin is sufficient. This is why traditional exchanges do not need to have as high throughput as crypto exchanges to handle a large number of trades in a short period.
Viewing Crypto Exchanges from a Traditional Capital Perspective
Matt Levine believes that both crypto exchanges and traditional exchanges are not particularly capitalized. In traditional finance, if a user experiences significant losses, the main broker responsible for clearing will compensate, a role typically held by investment banks.

Matt Levine asked:

"If something were to happen, does FTX have billions of dollars to pay for user losses? Or can FTX's technology quickly complete the clearing?"

SBF stated that different exchanges would have different answers. However, if the clearing system collapses, resulting in negative balances in user accounts, exchanges usually consider this as users leveraging too high and not managing risks properly. Trading is a zero-sum game, where if someone's assets are negative, someone else's are positive. Sometimes exchanges use part of a user's profit to compensate for losses.

"However, this is not a good business strategy because if this situation occurs day after day, millions of users will lose money, which is not the result exchanges want. In case of unforeseen events, such as hacking attacks, the most irresponsible way is to declare bankruptcy." - SBF stated.

In SBF's view, declaring bankruptcy is often an unavoidable choice for many exchanges with smaller capital, but for FTX, capital is the best backing. FTX raised $900 million in Series B funding, and this capital represents the implied "equity value" behind FTX, effectively guaranteeing FTX's reputation.

Of course, compared to 2018, almost all mainstream exchanges have made significant progress in clearing, but the liquidation stampede caused by price fluctuations still occurs, leading to sudden large-scale liquidations. SBF mentioned that this is why FTX adopts a three-tier liquidation system. When approaching liquidation, a portion of the margin is liquidated first to avoid negative balances in user accounts.

Discussing Regulation: Equity Tokens

The conversation then shifted to "equity tokens." Equity tokens are a product introduced by FTX at the end of October last year, which involves collaborating with stock custodians and token issuers to launch 1:1 tokenized trading of stocks.

The new chairman of the U.S. Securities and Exchange Commission (SEC), Gary Gensler, reiterated his conservative stance last week, believing that the crypto market is chaotic and should consider cryptocurrencies as securities, subject to SEC regulation. Host Tracy Alloway pointed out that Gary Gensler specifically mentioned "equity tokens" and "synthetic assets."

"I'm curious, would you (referring to SBF) be very worried? Would you consider delisting equity tokens as a product?"

SBF clarified that equity tokens are still within the regulatory framework, especially as FTX's equity token product is in collaboration with CM-Equity and Digital Assets AG. CM-Equity holds an operating license from the German Federal Financial Supervisory Authority (BaFin), so contrary to external perceptions, equity tokens are indeed regulated products.

He emphasized that the definition of being unregulated is providing unregistered securities to users, and the broker (exchange) failing to fulfill KYC and AML responsibilities.

"FTX is completely different from the situations described above. We diligently perform KYC and AML obligations for every user. Furthermore, we ensure that U.S. citizens and individuals from other jurisdictions cannot use FTX. Most importantly, we ensure that every equity token is fully reserved and provided by CM-Equity, licensed by BaFin."

SBF also expressed the hope that FTX.US could offer equity tokens in the future, but this is a long-term goal. Although FTX.US recently obtained a "broker-dealer license," regulation in the U.S. is more complex, and issues such as defining equity tokens, their operations, and insured parties remain to be resolved. Additionally, SBF also hopes to enable cryptocurrency payments through exchange-linked financial cards in the future.

Having such a vision is not surprising; for SBF, capital efficiency is crucial, so apart from trading cryptocurrencies and equity tokens, funds in FTX can also serve as collateral and be used for daily payments.

"We have obtained a broker-dealer license, so this is our long-term vision. You can place your funds there, use them to trade cryptocurrencies, and buy bread," SBF concluded.