Crypto turbulence highlights need for due diligence

But the nascent sector presents numerous challenges

It has been a turbulent year for the cryptocurrency sector – even by turbulent crypto standards. Bitcoin has shed some 65% of its value since the beginning of the year, while numerous high-profile crypto firms have freefallen into bankruptcy. However, anyone familiar with the sector knows that extreme volatility is a prominent feature of this nascent industry. As a matter of perspective, in 2011 Bitcoin crashed from $32 to 1 cent. An untimely investor who bought the top still could have seen a more-than 2,000-fold gain over the next decade.

All the same, extreme risk is also a prominent feature of the cryptocurrency market. The recent collapse and apparent fraudulent activities of the cryptocurrency exchange FTX highlights this risk, given the number of prominent and respectable equity investors who got whitewashed.

Among those investors were Singapore’s Temasek Holdings, an investment arm of the Singaporean government. Before investing, Temasek said that it did eight months of due diligence on FTX, reviewing its audited financial statements, analyzing regulatory risk, and cyber security threats. Sequoia Capital, another FTX investor that lost $150 million, also said it had done proper due diligence prior to its investment. We are not sure what level of due diligence was performed, but at least one major red-flag was apparently missed: FTX did not have an accounting department.

On the other hand, when FTX’s founder and CEO Sam Bankman-Fried asked to be bailed out by Binance Exchange, the world’s largest crypto currency exchange initially agreed to acquire its rival but backed out of the deal some 24 hours later, citing problematic due diligence findings. Bankman-Fried has since been arrested and faces numerous charges, including fraud, money laundering and US election campaign finance violations. Ironically, his parents are compliance lawyers, which reportedly was viewed by some investors as a mitigating risk factor. As Canadian investor and TV personality Kevin O’Leary stated in an interview with CNBC’s Squawk Box:

“I obviously know all the institutional investors in this [FTX] deal. We all look like idiots. Let’s put that on the table. We relied on each other’s due diligence, but we also relied on another investment theme that I felt drove a lot of interest in FTX.

Sam Bankman-Fried is an American. His parents are American compliance lawyers. There were no other [large] American exchanges to invest in if you wanted to invest in crypto as an infrastructure play.”

To be sure, the collapse of FTX has negatively impacted the crypto market but it has also highlighted the need for more transparency and due diligence in the sector. “Following recent events, it is likely that investors will be preparing for contagion risks associated with crypto ecosystems and potentially deficient risk management processesTherefore, due diligence will become an indispensable measure for market participants to mitigate risk,” writes the International Financial Law Review in a piece called “Increased M&A due diligence the silver lining of FTX collapse.”

There are, however, a number of challenges for conducting due diligence in the crypto sector. For one, the industry is based on emerging and highly complex technology that is poorly understood by most people outside of the sector (and even many inside the sector). Performing a security audit on an exchange, for example, requires an extensive (and expensive) undertaking by a highly specialized team of blockchain and IT experts. Validating source of funds or proof of assets of a target firm can also be a murky area due to the complexity of crypto transactions and storage of digital assets. Moreover, as the regulatory environment is nascent and constantly evolving, evaluating and navigating regulatory compliance risks is much more challenging than in most other sectors. Lastly, there is a high degree of anonymity in the sector, partly a legacy of Bitcoin’s anonymous inception (to this day the identity of Bitcoin’s creator has never been revealed).

Even as crypto evolves into an increasingly mainstream industry, many start-up founders, crypto entrepreneurs and developers continue to insist on anonymity. “A growing number of crypto entrepreneurs, many of whom control hundreds of millions of dollars in investor funds, conduct business via mysterious internet avatars scrubbed of identifying information [while] some venture capital firms are backing founders without ever learning their real names,” writes tech journalist David Yaffe-Bellany in a New York Times article.

Obviously, this culture of anonymity undermines accountability and enables fraud, yet many crypto professionals have legitimate reasons for remaining anonymous. Once such developer that Access Asia closely follows due to his ground-breaking work in decentralized finance (DeFi), says staying anonymous is the most prudent way to develop his DeFi protocols because of “the current grey area of regulations.” In his words:

“I think with the current grey area of regulations and the continuing changing of regulations, being a doxed dev [a developer who has revealed their identity] is more of a vulnerability then a benefit. I think that someone like myself who stands on the merits of their work and their long history in the space operating under [a pseudonym] is more trustworthy than a [real] name. It is very easy to buy ID and get a KYC [Know your Customer]. I could spend a couple of thousand dollars right now for a [fake] ID and have a full KYC [done on myself]. And there would be no way anyone could confirm that person was actually me. So there has to be an element of trust if you’re going to put trust in the developer. I say put your trust in the [blockchain] contracts.”

Other crypto developers or entrepreneurs prefer to stay anonymous to avoid attention as they could become targets for hackers, thieves, or extortionists. Meanwhile, many others in the space are not anonymous, but reclusive, which also presents a challenge for due diligence practitioners to gather insight on their backgrounds, track records and reputations.

The challenges of undertaking due diligence in the crypto sector mean that risk consultants need to be uniquely placed. We believe that cryptocurrency and its underlying blockchain technology will likely be a major disrupter of business and finance in the years to come and Access Asia is in the process of making ourselves a better fit with this future.

We believe our experience in both the traditional and non-traditional / decentralized finance spaces, our well-established and growing network of contacts in the digital asset space, our familiarity with DeFi and crypto ecosystems, and our long track record in the due diligence business puts us in a strong position to serve the sector.