The collapse of the world’s second-biggest cryptocurrency platform, FTX, in November 2022 was a failure of regulation. There were, of course, other factors at play, not least echoes of Theranos founder Elizabeth Holmes’s case where an infectious enthusiasm by the investment and media communities for the next big thing meant FTX’s millennial billionaire founder, Sam Bankman-Fried, was similarly taken at face value.
The irony cannot be lost on those who learned the news of Holmes’s 12-year jail sentence just a week after the collapse of FTX – no due diligence lessons seem to have been learned. Both Holmes and Bankman-Fried legitimised themselves and their businesses by seeking the support of establishment figures – in Holmes’s case political and business heavyweights and in Bankman-Fried’s case respected venture capital funds including Sequoia Capital and BlackRock.
Beware of geeks bearing gifts
Bankman-Fried curated a reputation as a well-meaning philanthropist, playing to the image of a humble geek prepared to donate millions to political campaigns, sponsor major sporting events and infiltrate the mainstream business community by raising legitimate funds from legitimate investors to fund an illegitimate business. Much of FTX’s balance sheet was made up of its own crytpo coin, FTT, which it created out of thin air and used to inflate the balance sheet of both FTX and its affiliated company, quantative trading firm Alameda Research.
Once the news of FTX’s business practices was out, a mighty surge of customer withdrawals meant the emperor’s clothes were revealed because FTX didn’t actually have the funds to cover the withdrawals. No one can claim piety in the machinations of Wall Street, but using retail customers’ money to essentially bankroll its deeply entwined sister crypto hedge fund Alameda Research was the kind of conflict of interest and commingling of funds that would have been a first, even for Wall Street.
FTX’s spectacular descent from $32bn company to bankruptcy in a matter of a week raises questions about how to shield the existing financial system from the repercussions of such instability within the cryptocurrency sector, given that crypto has entered mainstream institutional investor portfolios (exposure to FTX included a Canadian teachers pension fund through BlackRock’s investment).
Aside from a widespread compulsion for believing in the next unicorn company – particularly one with perfectly honed media messaging espousing the virtuous signals of philanthropy and global betterment – many believe that a failure to implement a regulatory framework for digital assets, including cryptocurrencies, lies at the heart of the biggest crypto-related bankruptcy in history. US lawmakers’ failure to keep pace with the development of crypto markets has been said to prompt US companies such as FTX to move their headquarters to jurisdictions with even less robust regulation – in FTX’s case the Bahamas. Losing domestic companies to overseas locations should be something policymakers examine very carefully, particularly in an industry that has the potential to underpin the future financial services industry.
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By GlobalDataThe world’s biggest crypto platform, FTX competitor Binance, is currently under investigation by UK and US regulators along with others, including failed crypto hedge fund Three Arrows Capital – another crypto company accused of misleading investors about the strength of its balance sheet. However, post-bankruptcy investigations are too far down the line in catastrophes such as the FTX case; what is needed are checks and balances before the event. A punitive approach where regulators are investigating domestic companies for breaches of rules without clarifying what those rules are, will not encourage good practice in the industry.
Crypto regulation needs to move faster to avoid another FTX
Global regulation needs to move faster. The US has been too slow to regulate considering its significance in the global crypto market. The US Securities and Exchange Commission is likely to lead on US regulation although pending congressional legislation has yet to clarify which agency will take the lead.
At its peak in 2021, the global crypto industry was said to be worth around $3trn. Despite estimates of this worth now sitting around the $900m mark in November 2022, what other billion-dollar sector exists in mature markets without a clear regulatory framework? More than 95% of crypto transactions take place on exchanges outside the US, leaving traders and retail customers at the mercy of unknown overseas regulatory frameworks. In addition, countries are losing valuable home-grown businesses to overseas jurisdictions.
The European Parliament has moved faster than the US by approving its Markets in Crypto-Assets Regulation in October 2022 – a pan-European framework that represents the most comprehensive attempt at crypto regulation so far. Other jurisdictions including Japan and the Netherlands are also progressive in exploring crypto regulation.
The repercussions of FTX’s collapse will unfold in the coming weeks and months. Companies highly entrenched within FTX’s balance sheet will no doubt collapse, but crypto is not going away. This makes regulation even more of a pressing issue. Exchanges should be required to disclose their balance sheet to include proof of reserves to cover their liabilities. Clarity of regulation rather than heavy-handed punitive regulation post-breaches is needed for the protections of citizens’ money – this is the only way the industry can gain the legitimacy it needs to develop.
