Regulation of Web3 in 2023 Part 1: Macro logics, and anatomy of mismanagement of Web3 companies

The Web3 industry has come a long way since the emergence of Bitcoin in 2008. In our Off the Record: Web3 brutal year event recap, we summarised how Web3 would take over the world in 2021, but what a year it faced in 2022! 

The latest scandal in 2022 was the bankruptcy of FTX in November and recently, it is in the news that Binance has also seen large outflow of funds in the following months after the FTX scandal.  

So will Binance survive 2023? 

To answer this, we need to understand customer elements and the fundamentals of Binance (and FTX) in the Web3 world. 

FTX and Binance are Centralised Finance (CeFi). CeFi refers to traditional financial systems, where the financial institutions such as banks or exchanges have central authorities with control over their entire system. The subset we are talking about is Centralised Exchange (CEX). When trading on CEX, our transactions are processed in their digital backend infrastructure, which happens near-instantaneously. CEXs have an obvious mandate, they are to act like custodians when investors deposit their money into the exchange, storing it securely and not do anything else without customer’s authorisation. They are not supposed to act like a bank, taking your deposits to use for other investments and operating on a fractional-reserve system.

 

From the 2020 Covid trough to its peak in 2021, the crypto industry grew by US$2.6 trillion dollars. However, after the events that happened throughout 2022, the total market cap dropped by US$2.0 trillion dollars, shedding much (~75%) of its previous gains. 

While the market cap is not the most accurate metric to judge by, it is still useful as a relative indicator of the growth of the entire crypto industry. The CeFi industry generally moves in tandem with the overall crypto industry and thus, one can extrapolate that they too, experienced explosive growth and subsequent decline over the past 2 years.

In 20/20 hindsight, the trust in the Web3 community, the inflation of several crypto assets and the lack of regulation were the reasons why CeFi was able to grow exponentially the past few years. 

 

However, as we are seeing now from the implosion of Web3 companies in 2022, human nature is greedy and maybe, should not be left to its own devices.

Two issues that were the underlying causes of the scandals we saw in 2022:  

Issue #1: Overleveraging

 

Now that the dust has settled on a few ex-reputable companies, we know that these companies were scarily over-leveraged. This was not an issue in 2021 when interest rate was low and expectation was (deliriously) high. 

However, in 2022 we saw that what goes up must come down. This is not new. As Warren Buffet said many years ago “Only when the tide goes out do you discover who’s been swimming naked.”

Issue #2: Fraud 

Whilst Sam Bankman-Fried pleads not guilty in the FTX fraud case, evidence implies otherwise; that FTX exchange (CeFi) committed fraud. 

As Vitalik mentioned in one of his tweets in the aftermath that “MtGox looked sketchy and never tried too hard to whitewash itself. Luna too. FTX was the opposite and did full-on compliance virtue signalling (not the same thing as compliance). The second kind of fraud cuts deeper than the first”.  

Some instances of FTX doing a full-on compliance virtue signalling include testifying at congress on crypto currency, donation to political parties and acquiring the naming rights of a sports arena: 

In the aftermath, there is a slew of knee jerk reactions from the public that we need to regulate the crypto industry. Even the crypto natives’ stance has shifted from “no regulation at any cost” to “Ok, maybe we do need some regulations?”.

But what exactly should be regulated, and how should we go about this? We will cover this in Part 2 of Macro logics, and anatomy of mismanagement of Web3 companies.

 

If you would like to learn more, feel free to check out these related articles – Event Recap: Off The Record: Web3’s brutal year and Two ways corporations are using blockchains without you noticing it.

You can download the full event deck of Off the Record: Web3’s Brutal Year as well as our other reports, such as The Future of NFTs, Who is Axie Infinity?, The Future of Ethereum, and Web3: The inevitable Next Step, for a behind-the-scenes look at Web3 applications and the future of the Web3 landscape.

If you want to watch a replay of the event on our YouTube channel, click here.