The FTX horror show could have a silver lining for the crypto industry

The FTX horror show could have a silver lining for the crypto industry

From all the reports now flowing about the workings of FTX, it’s pretty clear that its management was chaotic and arguably incompetent, its risk management illusory, its accounting erratic at best, and its protection of its clients’ funds non-existent.

Indeed, the commingling of client funds held on the FTX platform with Bankman-Fried’s own hedge fund, Alameda Research – it appears that billions of those dollars have been handed over to Alameda to essentially play crypto assets with it Bankman-Fried was trying to climb out of a hole in Alameda’s balance sheet — speaks to something far worse than the lack of systems to separate customer funds from the company’s own operations.

As contagion spreads across the sector – other companies face liquidity and potential solvency problems as investors flee – the interconnectedness and vulnerability of some of the larger participants to runs is becoming clear.

The collapse of FTX will bring some much-needed change.Recognition:Getty

The fact that, as with many of the traded crypto assets, much of the “value” on FTX and Alameda’s balance sheets came from digital tokens that Bankman-Fried essentially created out of thin air speaks to the downside’s potential the level of leverage – financial and structural – in the key segment of the crypto sector and the magnitude of the potential losses that investors could face. It’s messy and inedible.

In some jurisdictions, regulation is already on the drawing board.

European Union legislation on “markets in crypto assets” has been drafted and approved but has yet to be enacted.

After a comprehensive Senate investigation last year, the federal government wants to introduce a law next year.

In the US, there is an ongoing dispute over how restrictive regulation should be and which regulator – the Securities and Exchange Commission or (as Bankman-Fried preferred and has aggressively lobbied and donated) the Commodity Futures Trading Commission.

This reflects the tension between regulating crypto companies as if they were mainstream financial institutions (in which case the SEC would be chosen as the primary regulator) or using a minimalist approach (the CFTC) to try and capture the entrepreneurial spirit and potential of the sector not to suffocate .

The thrust of their proposals is similar, if not identical, in all major jurisdictions, drawing on their experience in regulating traditional financial institutions.

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Senate recommendations effectively focus on regulating crypto exchanges. They would need to be licensed, meet minimum capital adequacy requirements, be audited, segregate client funds from their own, be subject to anti-money laundering and know-your-customer requirements, and their key employees would need to be screened under the “responsible person” regime .

Proposed EU legislation would be broader and more intrusive, but has similar focuses on customer protection, custody arrangements and anti-money laundering provisions.

Drawing on lessons learned from the FTX experience – and other industry crashes, hacks and scams – it is clear that more transparency is needed if investors are to maintain their own ability to assess the stability of the organizations they trust funds.

That alone is not a perfect solution. We have seen that in the securities traded markets, where companies are subject to disclosure rules, they are scrutinized, scrutinized by professional analysts and investors and scandals still emerge.

However, it is a starting point. It could also help what are in many cases very immature companies run by fairly inexperienced people who are more focused on their IT systems than on managing financial risk. Bankman-Fried is a 30-year-old who couldn’t handle his own balance sheet.

Others in the industry are urgently commissioning their own reviews, mainly to reassure investors and lenders, but also suspected to reassure themselves in an environment where underlying assets – crypto assets – are extremely volatile and number in the hundreds millions of “value” have evaporated.

If the collapse of FTX means introducing regulation that can bring more sunlight to the crypto markets and bringing forward some basic investor protections, it would be a good thing for investors and the credibility of the digital asset sector in general.

External audits and regulatory oversight are essential parts of any regulatory architecture, although experience with conventional companies shows that they offer no guarantees.

Segregation of client funds should be another non-negotiable point. Client funds held by exchanges or other trading entities must be held in escrow and their use monitored by an authorized custodian to avoid what happened in FTX.

It is not clear that using FTX customer funds to play within Alameda is even illegal as FTX is registered in the Bahamas.

This suggests that consideration may also need to be given to how to regulate offshore-based companies operating in regulated jurisdictions and is likely leading to possible international harmonization of regulatory efforts.

The anti-money laundering and “know your customer” requirements common in proposed regulatory frameworks are an attempt to remove the anonymity that obscures and facilitates some of the sector’s less legitimate activities. They should not interfere with legitimate activities.

The immaturity and volatility of traded crypto assets is such that no level of regulation insures against loss or wrongdoing, but centuries of regulatory experience in traditional markets do not do that anyway.

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If the collapse of FTX means introducing regulation that can bring more sunlight to the crypto markets and bringing some basic investor protections forward, it would be a good thing for investors and the credibility of the digital asset sector in general.

Bankman-Fried may have ignited billions of investor funds and destabilized and discredited the entire crypto sector, but the collapse of his group and paper fortune — once valued at more than $26 billion — could ultimately do something positive for the sector’s survivors.

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