Notes 12/12: Binance’s Problems Multiply

Over the weekend, the spotlight in cryptocurrencies shifted from FTX’s problems to those for Binance, the world’s biggest cryptocurrency exchange by trading volume. The exchange, which does not have a headquarters, is attempting to take charge of the crypto ecosystem after FTX’s shenanigans have left it without a representative. Binance CEO Changpeng Zhao (CZ) has replaced FTX’s Sam Bankman-Fried as the public face of cryptocurrencies.

Binance has its own set of problems. Some of them may be as serious and even bigger than those for FTX. For example, it is the exchange of choice for many illiquid tokens and is supposed to be home to “pump and dump” schemes. Tether, a controversial stablecoin, has propped up its operations and volumes for several years. It has its own version of FTT – the FTX token that caused its crash – in the form of BNB, a coin that has no utility outside of Binance’s ecosystem. Yet, it is valued in billions of dollars at Coinmarketcap, a data site owned by Binance.   

DoJ Considers Action Against Binance

Given the unregulated status of cryptocurrencies across most financial jurisdictions in the world, the exchange occupies slippery regulatory turf, one that makes it susceptible to crashes when regulatory authorities act against it. Up until now, they have chosen to ignore, or look the other way, its operations as the exchange expanded its geographic reach and trading volumes.

But that stance is changing.

The Department of Justice (DoJ) is now considering criminal charges against Binance, according to a Reuters report. The report states that the Department of Justice is considering filing criminal charges against CS for “non-compliance with U.S. anti-money laundering laws and sanctions.” The list of charges being considered are many: unlicensed money transmission, money laundering conspiracy, and criminal sanctions violations.

Apparently, Binance processed trades from crypto firms based in Iran – a country that has been sanctioned by the United States. Before 2021, it was also used by Russian drug firms and North Korean hackers to launder money across borders because it had lax or no KYC controls on its international site.   

More Problems with Proof of Reserves

I wrote about Binance’s “Proof of Reserves” report last week. The Wall Street Journal noticed things I’d missed in my earlier post. Specifically, I should have checked the report’s end where the “Customer Liability Report Balance” has a balance of 597,602 bitcoins while the “Asset Balance Report” adds up to 582,486 bitcoins.

Simply, this means that the company had more liabilities than assets. But Mazars, the firm that prepared Binance’s PoR report, “adjusted” its liabilities to 575,462, resulting in a shortfall of 21,860 bitcoins. The shortfall, according to a Binance spokesperson, was due to Bitcoin loans made to customers through Binance Loan programs.

In other words, the company is counting the bitcoin given to customers to conduct trades or stake on other platforms as part of reserves set aside for emergency purposes. Bitcoin is also listed as a collateral asset on the loan platform. In the past, the loan program has supported lending programs for LUNA, the controversial cryptocurrency of the Terra platform that crashed in spectacular fashion earlier this year.   

No Quality Controls

The report also quotes a former Financial Accounting Standards Board (FASB) member as saying that Binance’s PoR report is useless without information about its internal quality controls. He has a point.  

Recent events have already proved that the crypto ecosystem is a messy glob of interlinked relationships. The liabilities listed in Binance’s report do not provide information about relationships between these players.

How much of Binance’s loan book consists of crypto lending firms that are strategically important to the industry? Does Binance have adequate checks in place to determine the creditworthiness of its clients? What are the processes that the company has put in place to evaluate tokens listed on its platform?

Considering previous instances of crypto’s egregious interpretation of security and customer responsibility, it wouldn’t be surprising to know that Binance doesn’t have any rules to protect customers at all.

Can An Emergency Insurance Fund Protect Customers?  

One of the most popular acronyms in crypto is SAFU, which stands for Secure Asset Fund for Users. It emerged from the Binance stable and refers to an emergency insurance fund that the exchange says it maintains for customers in case of hacks or bank runs. The fund’s holdings consist of Binance USD, its stablecoin, BNB, and Bitcoin. The proportional holding of each token in the fund is not known.

On Nov. 9, it had holdings of more than a billion dollars. On that day, Bitcoin was trading in the range of $17,000. Since then, it has crashed to below $16,000 on account of a slew of bad news in crypto. Meanwhile, the BNB token crashed from $317.43 to $263.08 before eking out a slight price recovery on Nov. 9.

As with most cryptocurrencies, the token displays wild price fluctuations. Its market cap has fallen from $51.07 billion to $44.17 billion, as of this writing, based on data from Coinmarketcap – a Binance site. BUSD is a stablecoin whose price doesn’t fluctuate much beyond its $1 peg. However, its market capitalization has decreased from $23.07 billion on Nov. 9 to $22.05 billion, as of this writing.

A Volatile Crypto-Backed Fund

The effect of these price fluctuations on holdings in Binance’s so-called emergency fund is not known. Even more troubling is the fact that the fund’s contents do not have liquid markets. Bitcoin may have markets with liquidity comparable to those for mainstream assets but the market for BNB and BUSD is suspect.

If one were to believe Coinmarketcap, a site owned by Binance, BNB is the world’s fourth biggest cryptocurrency by market cap. But that perch rests on the shaky foundations of an unregulated exchange that has been accused of faking trading volumes and inflating market caps. Will the insurance fund make customers whole in case of a run? I think not.

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