Trust vacuum in Web3 after FTX failure; regulations loom

A SHAKE-UP in consumer and investor confidence has rocked Web3 companies, following a year filled with scandals, contagion and a collapse in crypto prices. Industry players are preparing for a leaner year and trying to pre-empt tougher regulations.

Web3 is touted as the next evolution of the Internet, tapping blockchain technology and relying heavily on cryptocurrencies to incentivise use.

The industry boomed in recent years on the back of cheap capital and institutional interest. But the crypto turmoil over the past months has caused some businesses to collapse and left survivors wondering how to rebuild trust.

“It is a very painful time for the whole industry, as the collapses suck a tremendous amount of liquidity out of the crypto economy,” said Nathanael Lim, whose metaverse startup Avium helps studios produce, own and commercialise their intellectual property.

Avium managed to dodge losses from several crypto deposit-taking entities going bankrupt, as it held most of its funds in self-custodised wallets – over which they have complete control – or in fiat.

Still, the company has observed the ripple effects of the bust. Many of its peers in the Web3 startup space are controlling spending due to the liquidity crunch, for instance.

The biggest challenge for companies such as Avium is re-establishing trust in an industry that has seen scandals from even the most seemingly reputable organisations, said Lim.

“We’re going to see a demand for companies… with proper processes and systems of accountability. This will lead to a rise in secondary businesses that provide such support services,” he said.

The problem with many Web3 companies is they are still searching for their raison d’etre. There isn’t yet a “killer app” built that has captured the public’s imagination. Interest has so far been in the underlying technology instead.

Without a compelling product, Web3 will need a lot more time to rebuild its image, said Billy Naveed, chief strategy officer at venture builder Smile Group.

“The string of scandals has shaken trust in Web3 right to its very core,” he said.

About US$2.3 trillion was wiped from the crypto market this past year, according to data from CoinGecko. Bitcoin, the largest cryptocurrency by market capitalisation, has lost three quarters of its value since peaking at US$68,790 in November last year. It traded as low as US$16,756 on Thursday (Dec 22).

Among the events that have caused investors to retreat: The collapse in the value of supposedly dollar-pegged cryptocurrency Terra, which subsequently took down high-flying names including hedge fund Three Arrows Capital; and the bankruptcies of centralised deposit-taking entities, including crypto exchange FTX and crypto lender BlockFi.

“Many institutional players will be hesitant to continue deploying capital into crypto in the near term, pushing back the timeline of more smart money participation,” said Brandon Goh, chief executive of Treehouse, a decentralised finance (DeFi) analytics startup headquartered in Singapore.

Global standards

But Goh also believes events such as the FTX implosion have heightened awareness of financial malpractices in the crypto space and will help the industry mature.

Joshua Foo, regional director for Asean and Central Asia at Chainalysis, expects a slow emergence of globally coherent regulatory standards.

“We expect more discussions focused on consumer protection, including through custody, disclosure, and market structure requirements – for example, separating certain activities such as custody and trading from operating under one roof,” said Foo, whose blockchain analysis company is engaged in the FTX bankruptcy case.

Crypto exchanges often play multiple roles, for instance acting as both market maker and custodian, creating intermediary risks and conflicts of interest. And, they operate in an opaque environment with little to no regulatory supervision.

Some jurisdictions, including the European Union (EU) and South Korea, have proposed rules to protect consumer interests. But these have yet to be fully implemented.

FTX’s collapse last month has led EU officials to pursue the finalisation of crypto rules with greater urgency. In Singapore, the regulator is considering extending its scope to cover safety and soundness.

The Monetary Authority of Singapore began consultations in October on new measures, including the segregation of customers’ assets and restrictions on lending these assets out.

Platforms are preparing for tighter regulation by improving their own standards.

Australia-headquartered crypto exchange Independent Reserve, which is licensed in Singapore, said it has long adopted a conservative approach.

“(Among other measures, we) do not engage in any lending, borrowing or pledging assets as collateral for debt; maintain 1:1 reserves of all client assets; and store the vast majority of our client assets in offline cold storage vaults,” said chief operating officer Lasanka Perera.

The company has also engaged independent auditors for an annual audit of financial statements for the past three years.

Its next step is to show “proof of reserves”. This is an independent verification that an institution has sufficient reserves backing customer balances.

Such proof has become important after it emerged that FTX didn’t have the assets to back customer funds. Several other platforms, among them Binance and Crypto.com, have since begun publishing their proofs of reserves.

But market watchers have warned this process could lead to a false sense of security. Mazars, the auditor working with Binance and other exchanges, was forced to pause proof-of-reserves work for crypto clients over concerns about the way such reports are understood by the public.

Mazars on Dec 16 said the reports “do not constitute either an assurance or an audit opinion”. Instead, they report “limited findings based on the agreed procedures performed on the subject matter at a historical point in time”.

Silver linings

Some venture capitalists still appear bullish about Web3 in the long term. Embattled crypto platform Amber Group on Dec 16 said it raised US$300 million from investors to tackle the impact from the FTX fallout.

Chainalysis’ Foo sees potential for Web3 technologies to unlock new use cases in finance that currently aren’t possible due to the illiquidity of some traditional assets. Such technologies could also eliminate middlemen by building direct relationships between sellers and customers, which are already emerging in art and media.

Still, startups are likely to face difficulty building conviction around fledgling projects and explaining growth levers in a volatile market.

“This, coupled with the fact that macro valuations are on shaky grounds, essentially means we won’t see the same valuation climbs we witnessed in 2021 – which is a great thing in the long term,” said Cathay Innovation investment director Rajive Keshup, who is now looking to back DeFi regulation technology.

The string of collapses this year has also shone a spotlight on investor due diligence. Singapore state investor Temasek is in the midst of an internal review of its deal with FTX, which it backed alongside other blue-chip investors including Sequoia and BlackRock.

Market watchers have been stunned by how several red flags were missed at the crypto exchange, now revealed to have lacked basic internal controls.

“This space is super technical and very hard to do diligence on unless you know exactly what you are doing and what to look for,” said Keshup. “Unfortunately, many investors with limited (knowledge) got on the bandwagon last year, and it hasn’t been a smooth ride so far.”