Chapter 30 Quiz

Multiple Choice

1. Mt. Gox, at its peak, handled approximately what percentage of all global Bitcoin transactions?

(a) 20% (b) 40% (c) 70% (d) 95%

Answer: (c). Mt. Gox handled approximately 70% of all Bitcoin transactions worldwide at its peak. This extreme concentration in a single exchange — one that had no audits, no cold storage policy, and a single founder managing operations — is itself a cautionary tale about the risks of centralization.

2. The DAO hack exploited which specific type of smart contract vulnerability?

(a) Integer overflow (b) Reentrancy (c) Access control bypass (d) Oracle manipulation

Answer: (b). The DAO's splitDAO function was vulnerable to a reentrancy attack: it sent ETH to the caller before updating the caller's balance, allowing the attacker to recursively call the function and drain funds within a single transaction. This vulnerability was publicly identified before the attack but not patched.

3. In the QuadrigaCX case, the investigation ultimately concluded that:

(a) Gerald Cotten genuinely died with the only copies of the private keys, and the funds are permanently inaccessible (b) Gerald Cotten faked his death and absconded with the funds (c) The cold wallets had been emptied long before Cotten's death, and the "lost keys" narrative was a distraction from the real problem: customer funds had been misused (d) A third-party hacker stole the funds from QuadrigaCX's hot wallets, and Cotten's death was unrelated

Answer: (c). The Ernst & Young investigation and the Ontario Securities Commission's report found that the cold wallets were empty — they had been drained months or years before Cotten's death. Cotten had been trading with customer funds and transferring money to personal accounts. The exchange was operating as a fractional reserve, and the "lost keys" story was a smokescreen.

4. Terra/Luna's collapse was primarily caused by:

(a) A hacker exploiting a smart contract vulnerability (b) A design flaw in the algorithmic stablecoin mechanism — a reflexive death spiral triggered by loss of confidence (c) An exchange hack that drained Terra's reserves (d) A regulatory crackdown that forced Terraform Labs to halt operations

Answer: (b). Terra's algorithmic peg mechanism created a reflexive death spiral: as UST lost its peg, the redemption mechanism minted massive quantities of LUNA, crashing its price, which further undermined confidence in UST, which triggered more redemptions. The protocol executed exactly as designed — the design was the problem.

5. Three Arrows Capital's collapse was particularly damaging to the broader crypto ecosystem because:

(a) It was the largest single hack in crypto history (b) It had borrowed from numerous lending platforms, and its default triggered a cascade of insolvencies across its creditors (c) It operated the largest stablecoin, which lost its peg (d) It was a regulated entity whose failure undermined confidence in crypto regulation

Answer: (b). 3AC's significance was as a contagion catalyst. The fund had borrowed from Celsius, Voyager, BlockFi, Genesis, and others. When it defaulted, these lenders faced their own solvency crises, triggering a domino effect across the crypto lending industry. The mechanism was identical to contagion in traditional financial crises.

6. The CoinDesk article that triggered FTX's collapse revealed which critical piece of information?

(a) FTX had been hacked and customer funds were missing (b) Alameda Research's balance sheet was heavily concentrated in FTT tokens — tokens created by its sister company, FTX (c) Sam Bankman-Fried had a criminal record (d) FTX was operating without any software security measures

Answer: (b). The CoinDesk article, published on November 2, 2022, revealed that Alameda's balance sheet showed massive concentration in FTT, a token created by FTX. This exposed the circular, self-referential nature of the two entities' finances and implied that neither entity's "assets" were as valuable as claimed.

7. The core fraud at FTX can be most accurately described as:

(a) A Ponzi scheme in which new investor money was used to pay old investors (b) Customer deposits were lent to Alameda Research, which used them for trading, real estate, and personal expenses, with collateral consisting primarily of FTT tokens that FTX itself had created (c) FTX manipulated the price of Bitcoin to generate artificial profits (d) Bankman-Fried embezzled funds directly from FTX's cold wallets into his personal accounts

Answer: (b). The fraud was structural: customer deposits at FTX were funneled to Alameda Research through a software backdoor that exempted Alameda from risk controls. Alameda used the funds for trading, investments, real estate, political donations, and personal expenses. The "collateral" was primarily FTT tokens — tokens that FTX itself had created, making the arrangement circular and the collateral essentially worthless in a crisis.

8. John J. Ray III, the CEO appointed to manage FTX's bankruptcy, had previously overseen the liquidation of which major corporate fraud?

(a) WorldCom (b) Enron (c) Bernie Madoff's fund (d) Lehman Brothers

Answer: (b). Ray had previously managed the Enron liquidation. His statement that he had "never in my career" seen "such a complete failure of corporate controls" as at FTX — coming from the man who had seen Enron — became the most cited assessment of the FTX disaster.

9. Which of the following systems continued operating without interruption during the 2022 crypto crisis (Terra collapse through FTX collapse)?

(a) Celsius Network (b) Uniswap (c) Three Arrows Capital (d) Voyager Digital

Answer: (b). Uniswap, a decentralized exchange, continued facilitating trades throughout the crisis. No withdrawal freezes, no frozen accounts, no missing funds. Celsius, 3AC, and Voyager were all centralized entities that froze customer funds and eventually filed for bankruptcy.

10. The chapter identifies a central pattern across crypto failures. Which statement best captures this pattern?

(a) Blockchain technology is fundamentally flawed and cannot be trusted with financial assets (b) Centralized entities (exchanges, hedge funds, lending platforms) failed, while decentralized protocols (Bitcoin, Ethereum, Uniswap, Aave) continued operating as designed (c) Every crypto failure was caused by government regulation stifling innovation (d) Decentralized systems are immune to all forms of failure and fraud

Answer: (b). Five of six failures examined in the chapter were primarily failures of centralized entities. The underlying blockchain protocols continued operating throughout each crisis. The pattern is not that decentralization is a panacea — it is that centralized intermediaries introduce the same risks in crypto that they introduce in traditional finance, and those risks are exactly what blockchain technology was designed to eliminate.

Short Answer

11. Sam Bankman-Fried was sentenced to 25 years in federal prison. Three of his former colleagues — Caroline Ellison, Gary Wang, and Nishad Singh — received significantly shorter sentences after cooperating with prosecutors. Why do prosecutorial cooperation agreements play such an important role in fraud cases? What are the potential problems with relying on cooperating witnesses?

Model Answer: Fraud cases often depend on insider testimony because the fraudulent activity occurs behind closed doors — in private communications, internal systems, and closed meetings. External evidence (like financial statements) shows what happened but not who decided it. Cooperation agreements incentivize insiders to testify truthfully in exchange for reduced sentences, providing the jury with a narrative of intent and decision-making.

The primary risk is that cooperating witnesses have a powerful incentive to tell prosecutors what they want to hear and to minimize their own culpability while maximizing the defendant's. Defense attorneys will always argue that cooperators are "buying" lighter sentences with their testimony. The prosecution's burden is to corroborate cooperator testimony with documentary evidence — emails, chat logs, financial records — so that the testimony is credible even accounting for the cooperator's self-interest. In the FTX trial, the prosecution presented extensive documentary evidence alongside cooperator testimony.

12. The chapter argues that FTX's collapse was "a fraud, not a crypto failure." A skeptic might respond: "It happened in the crypto industry, it involved crypto assets, and it was enabled by the lack of regulation in crypto. How is this not a crypto failure?" Construct a response to this skeptic that is honest about crypto's role while maintaining the distinction between technology failure and institutional failure.

Model Answer: The skeptic is partially right — FTX could not have existed in its specific form outside the crypto industry. The lack of regulation, the ease of creating exchange tokens (FTT), and the absence of mandatory audits all reflect weaknesses in the crypto ecosystem's institutional infrastructure. In that sense, the crypto industry enabled FTX.

But the fraud itself — taking customer deposits, lending them to a related party, falsifying financial records, and spending the money on personal expenses — is not specific to crypto. MF Global did the same thing with customer commodity trading accounts in 2011. Bernie Madoff did it with investor capital for decades. The mechanism of the fraud requires no blockchain, no tokens, and no smart contracts. It requires only a custodian who has access to customer funds and the willingness to misuse them.

The distinction matters because the prescription differs. If FTX is a "crypto failure," the solution is to restrict or ban crypto. If FTX is a "fraud enabled by weak regulation," the solution is to regulate custodians — require audits, mandate segregation of customer funds, and enforce transparency. The technology itself provides the tools (proof of reserves, on-chain auditing, decentralized exchanges) to prevent the specific kind of fraud FTX committed.

13. Anchor Protocol offered 20% yield on UST deposits, which attracted approximately $14 billion in deposits. Explain why this yield was unsustainable and why, despite widespread warnings, investors continued depositing funds.

Model Answer: The 20% yield was unsustainable because it was subsidized by Terraform Labs — the protocol's reserves were being depleted to pay it, and the underlying lending activity did not generate sufficient returns to support the rate. The subsidy would eventually run out, at which point the yield would have to drop dramatically or cease.

Investors continued depositing for several overlapping reasons: (1) Yield hunger — in a low-interest-rate environment, 20% on a "stablecoin" was enormously attractive. (2) Greater fool theory — some investors knew the yield was unsustainable but believed they could earn it in the short term and exit before the collapse. (3) Complexity as camouflage — the mechanism was complex enough that many retail investors genuinely did not understand the risks. (4) Social proof — the more money flowed in, the more legitimate the protocol appeared. (5) Do Kwon's charisma and aggression — his combative dismissal of critics created a tribal dynamic in which questioning the yield was treated as disloyalty or ignorance.

14. The Ethereum hard fork in 2016 reversed The DAO attack but created Ethereum Classic (ETC) as a minority chain. In your own words, explain why the existence of ETC is philosophically important, even though it has a small fraction of Ethereum's market cap.

Model Answer: Ethereum Classic exists as a permanent reminder that "code is law" has a constituency — that some participants in the blockchain ecosystem genuinely believe immutability should not be overridden, even to correct a $60 million theft. ETC's continued operation demonstrates that the Ethereum fork was not a consensus decision but a majority decision, and that a meaningful minority preferred to accept the exploit's consequences rather than compromise the principle of immutability.

This matters because it keeps the philosophical debate alive. If the fork had been unanimous and ETC had immediately died, it would have been easy to conclude that the community had settled the "code is law" question permanently. The fact that ETC survives — with miners, developers, and a market cap — means the question remains open. Any future proposal to alter Ethereum's state for non-technical reasons will face this precedent and this counterexample.

15. Design a simple "proof of reserves" system for a hypothetical crypto exchange. Your design should specify: (1) what the exchange publishes, (2) how individual users verify their inclusion, and (3) what the system proves and what it does NOT prove. Be honest about the limitations.

Model Answer: The exchange constructs a Merkle tree where each leaf represents a customer account (containing a hash of the customer's ID and their balance). The exchange publishes: (a) the Merkle root, (b) the total claimed liabilities (sum of all customer balances), and (c) the on-chain addresses holding the exchange's reserves, along with signed messages proving the exchange controls those addresses.

Individual users verify their inclusion by requesting a Merkle proof from the exchange — a set of intermediate hashes that allows them to verify that their specific balance is included in the published Merkle root.

What it proves: (1) The exchange controls at least the on-chain assets visible at the published addresses. (2) The user's balance is included in the claimed total liabilities (assuming the Merkle proof verifies). (3) The total claimed liabilities can be compared against total visible assets.

What it does NOT prove: (1) That the exchange has no hidden liabilities (e.g., loans, legal claims, or obligations not in the Merkle tree). (2) That the assets shown are not borrowed for the snapshot and returned afterward. (3) That the exchange's non-crypto liabilities (rent, salaries, legal obligations) are covered. (4) That the reserves are not encumbered (pledged as collateral elsewhere). A proof of reserves is a necessary but not sufficient condition for solvency.