How to prevent the next FTX

New Atlantean

Nov. 17, 2022 • 5:04 p.m. ET

How to prevent the next FTX

JP Snapper Casteras

The recent implosion of major cryptocurrency exchange FTX has reignited debates over how – and how heavily – cryptocurrencies should be regulated. While the fallout for everyone associated with FTX is likely to linger, there are steps policymakers and industry can take now to build transparency and trust, thereby protecting consumers and avoiding a repeat of this catastrophe.

Everyone is still trying to figure out what exactly went wrong and why. But the revelations so far are overwhelming. First of all, FTX was not only the third largest crypto exchange in the world – a website where customers deposit, buy and sell various types of tokens and derivatives – but also had close ties to an affiliated trading company run by FTX’s CEO called Alameda Research. To complicate matters further, FTX had also minted its own token called FTT.

It was with this overlap that the problems began. Sometime this year, FTX CEO Sam Bankman-Fried reportedly transferred $10 billion in customer funds to Alameda Research to offset trading losses incurred there. On November 6th, FTX’s main competitor, another exchange called Binance, announced that it owns a large amount of FTT tokens and wanted to sell them all, which could crash the price and threaten FTX’s balance sheet. Customers became unsettled and began withdrawing billions of dollars in funds from FTX. Binance briefly floated a plan to jump in and acquire FTX, but immediately abandoned it. It went downhill from there: FTX froze withdrawals and most of FTX’s legal and compliance teams resigned. Other serious allegations came to light, including that there may be a secret backdoor in the FTX software that eluded auditors and resulted in around $1.7 billion being lost. Adding to the drama was the person at the center, Bankman-Fried, who was once considered a crypto prodigy, testified before Congress and was an active political donor. He live-tweeted the entire episode (sometimes puzzling) and continues to give lengthy and disturbing interviews. All told, thousands of FTX clients have billions of funds they cannot withdraw and the crisis has spread to other businesses.

The fallout was rapid. In a single day, FTX filed for bankruptcy, Bankman-Fried officially resigned, and someone (possibly a hacker) disappeared with a fortune in excess of $300 million. Federal officials from the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission and the Manhattan U.S. Attorney’s Office are reportedly investigating the matter. Congressional hearings are scheduled, and US Senator Elizabeth Warren, a leading Democrat on the Banking Committee, called for “stronger rules and stronger enforcement.” Commentators suggest this is a death knell for crypto in general. Cryptocurrency advocates have faltered, and some blame regulators in part get no wind of irregularities earlier.

All of this litigation, investigation and regulation will take several years to unfold. And it seems unlikely that Congress will pass a bill any time soon — especially since a previously-scrutinized bill was backed by Bankman-Fried.

In the meantime, however, there are some measures that governments and industry can take to prevent such a disaster from happening again.

First, financial regulators and industry leaders should move to what is known as “proof of reserves,” which means that large, centralized exchanges and custodians must actually prove (and document) their assets and liabilities. In other words, they cannot simply claim that they own a billion dollars in client funds while tacitly using those funds for other risky investments and loans. A movement is already underway across the industry to voluntarily adopt this measure. Policy makers could strengthen them by promoting regular reporting, auditing standards and other guidelines to avoid gimmicks (eg. move money just before a report is due).

Second, the industry must strengthen its self-regulation. In traditional finance, there are groups known as self-regulatory organizations that have the power to set and enforce industry standards. Regarding cryptocurrencies, there is no such body yet, although several trade associations that have sprung up in Washington are doing a good job and could come together on this. Recent crises also underscore why the sector needs to be proactive in highlighting bad actors and not just pushing for favorable legislation.

Third, regulators should reaffirm – and clarify where necessary – that US regulations continue to apply to products and services regularly sold in the United States. Currently, some large, centralized cryptocurrency companies are essentially arguing that they are everywhere but nowhere. The CEO of the largest exchange, Binance, has repeatedly insisted that it has no headquarters whatsoever. It’s hard to imagine how that position is legally tenable for a centralized, for-profit entity—especially now. In the future, dizzying corporate structures and unproven claims of decentralization will not easily escape established principles of regulator jurisdiction. Already, we are likely to see agencies like the SEC doubling down on crypto enforcement activity. Existing federal laws might be sufficient to pursue claims of apparent fraud and extraordinary financial misconduct, and it is not yet clear that new legislation or new regulation would contain the root causes of FTX’s implosion.

In addition to causing significant damage to customers, the sad irony of the FTX crisis is that some prominent cryptocurrency projects have arisen out of a true desire to avoid the excesses and blunders of the 2008 financial collapse. In fact, the first bitcoin ever minted literally embedded a 2008 headline about big bank bailouts. If the industry is to keep that vision, it must improve transparency, restore trust and put its own house in order.

JP Schnapper-Casteras is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center and practicing attorney.

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Image: The FTX logo can be seen through the broken glass in this illustrative photo taken on November 14, 2022 in Krakow, Poland. Photo via Reuters by Jakub Porzycki/NurPhoto.


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