The demise of FTX should spur efforts to regulate cryptocurrency

The bankruptcy and fall of the digital asset exchange FTX provides stark examples of why regulations that are in place for traditional investments should also be in place for digital investments.

Sam Bankman-Fried launched FTX in 2019, and as of Nov. 6 it was one of the biggest digital asset exchanges in the world, with $16 billion in assets under its management. Following a week in which customers and investors sought to sell their FTX tokens (FTT) all at once and cash out their investments, the company declared bankruptcy on November 11.

Even for the cryptocurrency sector, which is used to extreme price swings, the rate at which FTX fell was startling. What took place?

The trading company Alameda Research's private balance sheet was linked to FTX's, according to a report by CoinDesk on Nov. 2. Bankman-Fried was the owner of two distinct organizations, Alameda Research and FTX.

According to the article, Alameda's balance sheet revealed that a sizeable chunk of the company's $15.8 billion valuation was based on FTT, the digital coin that FTX created. The news verified what most in the bitcoin sector had long suspected: Alameda and FTX had an abnormally strong financial relationship.

The law requires all companies subject to extensive regulation, including traditional investment vehicles, to declare apparent conflicts of interest. However, because cryptocurrencies and other digital investments are exempt from the laws and regulations that govern other types of investments, neither Bankman-Fried, FTX, nor Alameda were required to disclose the degree of interdependence between the two companies.

A massive run on the exchange ensued a few days later as investors and clients tried to sell their FTT and drain their FTX accounts.

The Wall Street Journal said that the Securities and Exchange Commission (SEC) and Department of Justice are currently looking into the finances of FTX and Alameda, with the CoinDesk story serving as the first in a series of revelations.

Additionally, according to the WSJ, FTX lent Alameda up to $10 billion in client funds, which may have led to both companies' demise.

Renato Mariotti, a former federal prosecutor and partner at Bryan Cave Leighton Paisner, tweeted: "If you’re an investor in Alameda, you expect that the fund managers are looking out for ‘your’ interests, not using your money to prop up the value of a token that will help a totally different business. When you’re told your money will be used for one purpose and instead the person uses it for another purpose, that’s fraud."

In its terms of service, FTX promised not to engage in these lending practices.

The terms of service for FTX stipulated that ownership of customers' assets would always remain with them and could not be given away or loaned. According to Philip Moustakis, a lawyer at Seward & Kissel and a former senior counsel in the SEC's Enforcement Division, it now appears billions of dollars in client assets were transferred to fill a massive hole in Alameda's balance sheet, in direct violation of these agreements. "If that is true, we’re talking about fraud with a capital F, meaning there may be serious criminal and regulatory exposure. The only question is who is responsible."

At the same time that FTX clients were clamoring for their money back and FTT's value was falling, almost $662 million worth of tokens went missing or were stolen. It is still hazy.

Another factor that could have an impact on FTX was the exchange's repeated attempts to acquire other struggling or bankrupt cryptocurrency businesses, such as BlockFi and Voyager Digital, which it signed options to purchase in July and September respectively. It is obvious that a company that would go out of business in a week should not be bailing out other failing businesses.

Regulators like the SEC and Commodity Futures Trading Commission (CFTC) have pushed for tighter regulation of the cryptocurrency market. The majority of cryptocurrency tokens are probably securities, according to SEC Chair Gary Gensler, and should be governed as such, along with the exchanges that sell them. While some legal proceedings—including one involving Ripple Labs—move through the courts, the SEC is now willing to regulate cryptocurrencies and cryptocurrency trading platforms through enforcement.

The CFTC was aware of FTX's financial situation at the time but took no action. The organization granted FTX Derivatives US a license and registered it as a derivatives clearing organization. In a news statement on Monday, the CFTC said that FTX had withdrawn a request to sell goods that were not sufficiently collateralized. The application, which was submitted in December 2021, was still pending.

The CFTC has been under fire for not adequately regulating FTX Derivatives.

Dennis Kelleher, president and CEO of Better Markets, a non-profit organization that advances the public interest in financial markets, said, "The CFTC appears to have failed miserably... and missed what now appears to be multiple failures at FTX to meet fundamental corporate governance standards."

The fact that Bankman-Fried has been a prominent advocate for cryptocurrency regulation is one of the ironies of this situation. He testified before Congress and lobbied lawmakers for the passage of legislation establishing a legal framework for cryptocurrencies in the United States. In some quarters of the cryptocurrency business, he received ridicule for his support of regulation.

Many of FTX's issues might be attributed to bad corporate governance, lax internal controls, and a concentration of crucial decision-making power in the hands of a select few executives under the direction of Bankman-Fried. In the end, FTX was not answerable to investors or authorities.

All digital investments have this basic problem. And that needs to change.

By fLEXI tEAM