Yu Zhe'an's Perspective: What we truly want is not a reserve currency, but to achieve financial stability.

The author of this article is researcher Nathan Yu, who has over ten years of experience in trading Taiwan and U.S. stocks, specializing in financial analysis and monetary policy analysis. He is currently engaged in fixed income product development and research at a cryptocurrency company in Taiwan. Authorized publication.

Ever since FTX was forced into bankruptcy and ceased operations at lightning speed, people have begun to contemplate how to solve the issue of bankruptcy and how other exchanges can achieve trustworthy self-validation.

We Neglect the Real Business of Exchanges

FTX being run on the verge of bankruptcy is fundamentally no different from traditional financial banks being run on the verge of bankruptcy. Although FTX and other peers in the cryptocurrency exchange industry claim to be "certain exchanges," it is easy for people to misunderstand that they are conducting "securities business." However, their true core of profit-making activities usually involves using user funds to engage in lending and investment, which is "banking business." It is precisely because they are engaged in banking business that FTX's collapse has been so rapid.

After this painful lesson, it is also time to pay attention to how to achieve "financial stability of cryptocurrencies."

Without financial stability, the widespread application of cryptocurrency finance is impossible. Without financial stability, there is no trust from the general public. Without trust from the general public, what are we talking about in terms of development and innovation? It doesn't matter whether you are a user of a centralized exchange or a player in on-chain protocols. Don't think that your play is not CeFi, so it's not your business. Everyone is interconnected. Regulators and the general public don't care whether you are DeFi or CeFi. They only know how we, as a group, keep messing things up.

FTX's Bankruptcy Situation is Far More Serious than Traditional Banks

If it is inevitable for these cryptocurrency exchanges to use user assets for investments, what should we demand from these operators?

The risk of a cryptocurrency exchange facing bankruptcy is because the cryptocurrency exchange's real business is banking business, not just the securities business of buying and selling cryptocurrencies. Since these cryptocurrency exchanges are engaged in banking business, we should demand from them by examining the regulatory indicators of banks, rather than just using the regulatory indicators of securities business or various self-created indicators to demand from them.

So, if we apply the regulatory indicators of traditional banks directly to FTX without modifying any parameters, FTX still cannot survive. This is because the bankruptcy faced by FTX this time is about 20 times more severe on average than the ten recorded traditional bank bankruptcy events in 2008, in terms of the average daily rate of outflow.

SBF claimed that before the bankruptcy, he prepared around $6 billion in cash to meet the daily demand of about $250 million, so the $6 billion in cash reserves could normally buy SBF about 24 days to find new funds or sell assets for cash. However, this $6 billion in cash reserves was almost depleted by FTX users' bankruptcy, which actually took only about three days.

Possible Reasons for FTX's Bankruptcy: 5+1

What are the reasons that caused FTX's bankruptcy to be so massive? What led to SBF, despite having prepared 25 times the daily withdrawal amount in liquid assets, still not enough to cope with user bankruptcies?

Here are some characteristics that I currently think can amplify the scale of a cryptocurrency exchange bankruptcy:

1. The vast majority of non-operational deposits. Currently, users' deposits are for speculation or earning interest, unlike commercial banks, the proportion of using deposits from cryptocurrency exchange accounts for their own business operations is extremely low.
2. Users have no loyalty to cryptocurrency exchanges. As soon as users are offered higher interest rates, they will immediately move their funds to earn interest.
3. The spread of information in the cryptocurrency industry is extremely fast. Panic causes the scale of bankruptcy in a short time to be much higher than that of traditional financial banks.
4. Through on-chain data, the flow of funds of the exchange can be observed. There is clear evidence that amplifies users' inner fears.
5. There is a severe mismatch of liquidity between investments and financing.

All these five unique factors in the cryptocurrency circle combined will make the rumor of insolvency very easy to self-realize.

Moreover, malicious competition between peers in the cryptocurrency exchange industry is the sixth point.

In addition to spreading news attacks through the media, threatening to sell tokens issued by competitors to create market panic, perhaps the most damaging means is to spread rumors first and then cooperate with multiple institutions holding a large amount of assets to carry out malicious bankruptcies at a designated time together. The vast majority of users first see the rumors and then confirm from on-chain data that funds are indeed accelerating outflow, usually causing panic, and this operating method almost guarantees that the cryptocurrency exchange will definitely be bankrupt and cease operations. Every industry indeed needs to eliminate the weak and retain the strong, but using this method to eliminate the weak and retain the strong undoubtedly kills the industry's prospects, destroying the trust of both insiders and outsiders in this industry.

In the case of FTX, the reason for the insolvency is, of course, due to many unethical financial operations. However, what is important now is not FTX, but what other cryptocurrency exchanges that aim to do banking business should do next.

The Six Steps that Exchanges Should Take for Soundness

The top priority is to solve the bankruptcy problem.

In the following sections, I will propose a series of steps to briefly introduce a regulatory indicator in "Basel III" that aims to enhance a bank's ability to cope with short-term liquidity risks.

Step One: Implement Business Separation

The financial and non-financial operations of the exchange need to be separated. Subsidiaries engaged in financial operations should not operate non-financial operations, and subsidiaries engaged in non-financial operations should not hold shares of subsidiaries engaged in financial operations. Different financial operations need to be separated, such as securities trading operations, custody operations, banking operations, etc., all need to be independently operated by different subsidiaries to execute their business, each having its own financial statements to achieve financial independence, and various financial services should not share the same wallet address to serve as a common window for customer withdrawals and deposits.

Securities trading operations are suitable for using methods such as merkle trees to prove that operators are not misappropriating assets for trading, while banking operations and investment operations are not suitable. Different regulatory indicators for different financial operations need to be tailored according to their business characteristics.

Step Two: Establish Priority of Use of Deposits

After separating banking operations from other operations through business separation, we can start to address the bankruptcy problem in banking operations.

Deposits collected in banking operations must be invested in safe projects first to strengthen the bank's ability to withstand risks in all aspects. Among them, using high-quality liquid assets to cope with short-term liquidity issues in banking bankruptcies to enhance the bank's ability to recover short-term liquidity under pressure.

After all regulatory indicators related to safe project funds have been met, deposits can then be invested in projects for free use.

Step Three: Define Qualified High-Quality Liquid Assets

Since high-quality liquid assets (HQLA) are an asset portfolio created to address short-term liquidity crises, certain characteristics need to be met to be included in this category, which can be divided into general characteristics and market characteristics.

Step Four: Calculate Qualified High-Quality Liquid Assets

Here is a reference table. The design of the table includes three aspects: risk weights, credit ratings, and asset distribution limits.

After reading this table, readers may start to wonder that the assets I mentioned currently almost do not exist in the cryptocurrency circle. How can we execute them? It is currently impossible to implement it effectively, but it will definitely be realized in the near future. The cryptocurrency circle needs high-quality bonds or government bonds as high-quality fixed-income tools to serve as the underlying assets of the bank's balance sheet. The sooner the high-quality fixed-income tools in the cryptocurrency circle are introduced, the more opportunities we will have to achieve financial stability.

Of course, we can also use a large number of stablecoins as qualified high-quality liquid assets, but directly holding these stablecoins currently does not bring any benefits to banking operations that need to make money, as well as to depositors.

Step Five: Calculate Reasonable Funds Outflow Rate and Expected Current Outflow Amount for Each Liability

After initially calculating the safe assets to cope with short-term bankruptcies, we certainly also need to calculate the factors that will cause bankruptcies and fund outflows. Here we divide them into three categories: unsecured financing, secured financing, and derivative instruments. The most critical issue is how to determine the coefficients. Due to the lack of deposit protection mechanisms in the cryptocurrency circle, and the characteristics of the deposits collected by cryptocurrency exchanges are different from banks in traditional finance, this evaluation needs to be addressed with a more cautious attitude.

Step Six: Calculate Liquidity Coverage Ratio

After calculating the total amount of HQLA assets and net cash outflows through the previous steps, we can calculate the liquidity coverage ratio.

At this point, we have explained in the simplest way the spirit behind the liquidity coverage ratio indicator. Due to space constraints, I skipped defining the baseline for calculating cash outflows, adjusting HQLA assets, calculating cash inflows, the impact of ISDA contracts on collateral when institutions are downgraded, etc., and this indicator is just the tip of the iceberg among the many regulatory indicators in banking operations.

Realizing Financial Stability is the Solution

The reason I spent so much space introducing a regulatory indicator used in banking operations is mainly to promote a few concepts:

First, securities trading operations can be proven through asset reserves or other means. This is actually a simple problem, the key lies in whether there is a will to do it.

Second, if we want to do more than just securities trading operations and also want to try to do banking operations well, then the problem cannot be solved by asset reserve proof. Financial risk management methods should not continue to be developed in isolation. They should refer to the effective management methods already proven in traditional finance and combine them with the unique characteristics of cryptocurrencies for design.

Third, as the saying goes, "you cannot make bricks without straw." It is also unlikely to do various financial operations well without high-quality fixed-income tools, short-term repo tools, derivative instruments, and other important financial tools. This also depends on the advanced developers in the cryptocurrency circle developing in the above directions.

Fourth, regardless of whether the service architecture is decentralized, financial services will never escape trust. If everyone easily redeems their assets to their own wallet addresses, this is actually similar to nationals in underdeveloped countries not trusting their national financial system, which is definitely not the way an industry with highly developed finance should be. What we should do is to re-establish trust and protection for users through various reliable and responsible operating methods, rather than treating various offline wallets or pure on-chain protocols as long-term solutions.

Cryptocurrencies have always evolved at a very fast pace. Currently, the progress can be compared to about a hundred years ago in traditional finance. However, I believe that developers and users will reach a similar level of understanding as traditional finance in the next five to ten years, and I also believe that the increasingly mature cryptocurrencies can bring some new ideas and contributions to financial services worldwide.

Let's all work together.