FTX Disaster
FTX: The relative stability observed in the crypto market in recent months was interrupted on November 6 by a run on deposits by one of the largest digital asset exchanges, FTX. The trigger for this event was Binance’s announcement revealing its intention to sell 23 million FTT tokens ($529 million at the time of announcement), issued by FTX.
It has since been revealed that FTX may have an $8 billion shortfall on its balance sheet resulting from a loan made to Alameda Research (from the same owner as FTX) backed by FTT collateral, using its customers’ deposits. As we highlighted in an email to our customers on the 9th of November, Hashdex does not have any exposure to FTX, FTT, or Alameda.
However, as expected, these events shook investor confidence, compromising market liquidity and causing a drop in the value of crypto assets. In recent years, Sam Bankman-Fried (SBF), the founder of FTX, has established himself as one of the greatest spokespersons for the legitimacy of the crypto industry in the world.
The implosion of its exchange represents a huge setback for the crypto industry, which has been making huge strides in the eyes of investors and policymakers. However, it is important to stress two points after these events: the fundamentals of the crypto world remain intact and regulated investment funds — such as Hashdex’s product offering — remain the simplest and most secure way to access the crypto ecosystem.
Confidence in crypto fundamentals As of early 2020, all major crypto assets remain operational and no random protocol changes have been required in response to lockdowns during the pandemic, the liquidity crisis or the ensuing bubble. There were no changes after the Fed swerved or when the 3AC fund or the Celsius lending platform crashed.
And there were no changes when FTX was pressured and the FTT token price plummeted. Each of these decentralized networks continues to produce transaction blocks accessible by anyone in the world. Any individual with an internet connection and physical or legal control over their private keys was able to transfer value to anyone else without third-party permission.
Bitcoin’s investment thesis remains stronger than ever, Ethereum is gaining scalability, and decentralized finance (DeFi) projects continue to demonstrate their worth in a challenging investment environment. So despite the lack of trust in financial markets, nothing has happened in the major cryptocurrency networks that could shake trust in the technology.
Trust is the essence of the promise of crypto. We can’t forget why we’re here. The trust built into our regulated framework Our industry cannot wait passively for regulators to impose change. Since 2018, Hashdex has demonstrated that a regulatory framework with strict governance standards is of great value. Eliminating risk and reducing friction from investing in crypto has always been, and remains, our core mission.
We never set aside this mission, which today is more important and valid than ever. This commitment includes our intense focus on minimizing counterparty risk when building our institutional infrastructure, and our insistence on only having the highest standard of custodians, exchanges, and other providers as partners. In addition, an essential component of this structure is the fund auditors who validate our portfolios and confirm that our operation adheres to the highest standards of governance and management.
For all of our investment products, our operational journey begins with strict standards for selecting counterparties with whom funds are authorized to trade crypto assets. We have a dedicated process, which depends on committee approval and has members who are independent of the manager to evaluate the choice of exchanges, custodians, OTCs, and—most recently— staking validators.
In addition to the detailed understanding of each technology behind the service provider, we delve into its organizational structure. This process includes demonstrating the existence of necessary controls to ensure that the service provider’s regulation is in line with the legal obligations of the jurisdiction where the fund is located.
Among the list of requirements to become a service provider for Hashdex funds, the most important criteria are: Service providers must use the highest available standard of escrow practices. Qualified custodians must present a certificate of segregation of the fund’s assets, as well as structures disconnected from the internet.
The storage must contemplate multiple signatures and the geographic distribution of keys to mitigate the existence of a single point of failure and risk of the key man. These barriers guarantee the highest degree of security against hacker attacks that could compromise private keys. To date, there are no documented cases of an account being compromised to this degree of security.
Custodians using independent auditors. The quality and effectiveness of a custodian’s operational process must be confirmed. This audit process generally follows an AICPA SOC 2 (Service Organization Control Reports) process and includes an insurance policy against the loss or theft of private keys, as well as fraud and internal theft. Limited exposure to exchanges. Cryptocurrency exchanges have always been the biggest vector for cyberattacks.
Therefore, we adhere to a general rule that assets can only be held in a brokerage environment immediately before their sale. In these cases, the sale or exchange operation must be carried out within a maximum of 24 hours. After this period, the asset must be returned to the custodian and the balance held on the exchange must be reset to zero.
Strict OTC standards must be followed. Over-the-counter exchanges (OTCs) must have a license to operate in their respective jurisdictions, in addition to submitting their corporate structure and balance sheet for our review and adjusting our counterparty risk policy on trade settlements. In addition to these priorities, we have additional safeguards built into our due diligence processes.
For the approval and maintenance of counterparties, Hashdex analyzes criteria related to the financial health of the institution and the prevention of money laundering and terrorist financing, including the following requirements: The entity must be regulated in the jurisdiction in which it operates; the exchange in question must utilize strict KYC and AML/terrorist financing prevention processes; and the institution must adhere to the recommendations of the Financial Action Task Force (FATF).
Cryptocurrency Scrutiny—Trust but Verify All of the individual crypto assets we invest in are part of an index that adheres to its own strict set of standards. For example, the Nasdaq Crypto Index™ (NCI™) has what we believe is the highest standard of methodology that dictates its eligibility criteria. Before any asset can join the index, it must be backed by major exchanges and central custodians.
Each exchange and custodian must follow institutional standards and regulated service provider that adheres to compliance practices (Including AML and KYC) that have gone through Nasdaq’s strict due diligence process.
Individual crypto assets selected for the benchmark must: Be listed on several major exchanges, allowing investors to trade constituent assets with regulated counterparties of the highest standard, as well as accessing trusted pricing sources to calculate index value; be supported by leading custodians to ensure that investors are confident that their assets are held to the highest standard of security available; Holding liquidity on the main exchanges that exceeds 0.5% of the most liquid asset, a fact that minimizes transaction costs and the impact of negotiations on prices; Have a free-float price, which eliminates priced assets backed by another asset, such as stablecoins .
For all of our product offerings, we go beyond the index providers’ eligibility criteria. Our team analyzes custodians and exchanges independently, in addition to releasing a “Know your Token” report with a detailed description of each asset. This report includes analysis from our research, risk, compliance, legal, and operations teams.
This analysis is submitted to our Risk and Compliance Committee and can only be included in the Hashdex Portfolio upon its approval. Finally, all of our operating systems and processes have been carefully designed to not depend on any specific Hashdex employee, thus ensuring the physical integrity of our taxpayers and investors.
Approvals must originate from various Hashdex employees, the administrator, and the custodian. This makes it virtually impossible for a single person to inappropriately initiate or approve transactions. Furthermore, as cryptocurrency transactions are irreversible, we have established whitelisting policies, transaction limits, anomaly detection, and panic codes on all of our accounts. A reliable partner in challenging times Hashdex has spent the past five years building the necessary infrastructure and processes to protect our investors from the fallout of events like the FTX.
The processes described above prevented our exposure to the FTT token, FTX, and Alameda. And they will help us avoid exposure to future events initiated by third parties who do not share our obsession and discipline when it comes to risk management and operations. When an investor allocates his money to a Hashdex fund, we want him to feel completely confident in the value of his investment.
Therefore, our highest priority remains the security of our customers’ assets. As such, we will continue to be a voice for best due diligence practices in the crypto ecosystem. Trust is earned over time. While we are disappointed that some evil actors have tarnished the crypto industry’s image, we remain confident that trust will be restored as more market participants adopt the best practices needed for this industry to evolve.
While we don’t know how long it will take the industry to regain confidence after these events, our commitment to our values and our mission remains unchanged: giving investors access to crypto through simple, secure, and regulated products.
