Will the FTX Collapse Lead to Better Cryptocurrency Regulation?

On Tuesday, November 22nd, the first hearing was held in the bankruptcy case of the cryptocurrency exchange FTX. One of the attorneys representing the company, James Bromley, was blunt. “You have witnessed probably one of the most abrupt and difficult collapses in the history of corporate America,” he told a Delaware courtroom. He described FTX as having been run like “the personal fiefdom” of its co-founder and former chief executive, Sam Bankman-Fried, and said that a significant amount of FTX’s assets had either been “stolen or are missing.” The comments came five days after John J. Ray III, FTX’s new C.E.O., filed a document with the federal bankruptcy court of Delaware in which he echoed the same sentiment. “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,” Ray wrote in the filing. “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” (“I wish that I had been more careful,” Bankman-Fried wrote in a letter to former employees on the day of the hearing, apologizing for FTX’s collapse. “I deeply regret my oversight failure.” Still, the former C.E.O. argued that, had he not given in to the pressure to file for bankruptcy, he could have saved the company.)

The assessment carries enormous weight coming from Ray, who, throughout the course of his forty-plus-year career, has overseen some of the most high-profile company bankruptcies in recent history. He managed the liquidation of the energy-trading firm Enron after its collapse, in 2001, and supervised the bankruptcies of the Canadian telecom company Nortel and the subprime-mortgage company Residential Capital. His report is a harsh indictment of FTX’s leaders, including Bankman-Fried, but it might also be taken as an indictment of the safeguards that are supposed to keep the markets secure for regular people. It will take months, even years, to fully understand what went wrong at FTX and its related companies, and why. But two things could emerge from the FTX crisis, which might transform a tragic situation into a learning opportunity, and might also make similar corporate collapses less likely to occur in the future. For one thing, investors may, going forward, be more wary of potential crypto investments, and the aggressive marketing and false promises that often accompany them. For another, regulation of digital assets might finally become clearer and more stringent. “Whenever you have a business that fails, as the facts emerge, there are typically lessons learned that can inform other companies in that industry, as well as the broader public, about where risks lie and how similar risks could be avoided in the future,” Deborah Meshulam, a partner at D.L.A. Piper and a former official with the Securities and Exchange Commission, said. “We’re in very early days.”

The crypto industry and its U.S. regulators have been in something of a cold war for several years. Dozens of new digital currencies and companies have launched, and the agencies responsible for policing the markets have struggled to keep up. More than thirteen years after Bitcoin was first released, there is still no centralized regime to regulate the industry. “The state of regulation in the U.S. is multifaceted,” Meshulam told me, sounding diplomatic. “You really have a number of different regulatory regimes that address different aspects of digital-asset activity. And you have them at the federal and the state level.”

Digital assets consist primarily of coins, tokens, and currencies, such as Bitcoin and Ether, which are created using cryptography technology and whose transactions are recorded on a blockchain, a decentralized electronic ledger that is, in theory, transparent to everyone—sort of like a giant spreadsheet in the sky. Many cryptocurrencies trade on specialized platforms, such as FTX. The best-known of the regulatory agencies overseeing cryptocurrencies and other digital assets is the S.E.C., which has taken the position that most digital assets are offered as securities, making them subject to U.S. securities laws, and typically requiring that they be registered with the S.E.C. before being sold to the public. Rather than publishing a list of attributes that the S.E.C. believes cause an asset to be categorized as a security, though, the agency’s views have been communicated through myriad channels in a less than precise fashion, at least according to some in the crypto industry. And, anytime something isn’t clearly defined, it creates space for different actors in the market to argue that the regulations don’t apply to them.

One way in which the S.E.C. communicates its interpretation of existing regulations to the public is by bringing enforcement actions, usually by suing companies or individuals and charging them with conducting an “unregistered securities offering,” or with committing fraud. The agency has brought a number of charges against crypto firms in recent years, including one against Kik Interactive, which the agency accused, in 2019, of violating securities laws when it issued unregistered tokens. (The agency won the case, and Kik had to pay a five-million-dollar penalty.) The S.E.C. prevailed in a similar case against the messaging app Telegram, which it accused of issuing unregistered tokens when it issued 2.9 billion “Grams” to a hundred and seventy-one initial purchasers around the world, in an effort to raise money. (In a settlement, the company agreed to return $1.2 billion to investors and pay a $18.5-million civil penalty.) A high-profile case involving similar charges against Ripple Labs, which issued a token called XRP, is still unresolved. (“​​Like a hammer wanting everything to be a nail, the SEC is keeping everything murky so it can argue every crypto is a security,” Stu Alderoty, Ripple’s general counsel, wrote this summer.) If the S.E.C. loses the Ripple case, it will be a major setback in its efforts to establish that most tokens are securities that it should oversee.

The Commodity Futures Trading Commission, which regulates the derivatives markets, has also exerted some authority over digital assets that it classifies as “commodities” rather than securities. Within the crypto industry, the C.F.T.C. has, so far, been considered more lenient than the S.E.C., and many in the industry would prefer to see authority over the business consolidated under the C.F.T.C. A bill that’s seen as fairly friendly to the crypto industry, called the Responsible Financial Innovation Act, was introduced in Congress last June, and it proposes to clarify and streamline the division of responsibilities between the two agencies. Senator Cynthia Lummis, a Republican from Wyoming who co-sponsored the bill with Senator Kirsten Gillibrand, a Democrat from New York, recently tweeted that the FTX collapse wouldn’t have happened if their legislation had already been passed.

According to the bankruptcy court filing, FTX was composed of four groups of businesses: the unit containing FTX U.S., an exchange registered in the United States where U.S. residents could trade digital assets and tokens; Alameda Research L.L.C., essentially a crypto-oriented hedge fund; a group of venture-capital investment vehicles; and another group based around FTX.com, a crypto exchange situated outside the U.S. All of them were controlled by Bankman-Fried, with small minority interests held by the FTX co-founder Zixiao (Gary) Wang and the former director of engineering, Nishad Singh.

As more details emerge about Bankman-Fried’s empire and the way it was run, the argument for taking stronger regulatory and legislative action may garner more support. There were no appropriate “disbursement controls” over FTX’s expenditures, Ray wrote in the court filing, noting that FTX employees “submitted payment requests through an on-line ‘chat’ platform where a disparate group of supervisors approved disbursements by responding with personalized emojis.” There was no centralized control of the company’s cash. FTX Group corporate funds were used to purchase real-estate properties in the Bahamas, where the company had its headquarters, for employees and advisers. Reuters has reported that FTX, Bankman-Fried’s parents, and company executives bought a hundred and twenty one million dollars’ worth of real estate, mainly “luxury beachfront homes.” (FTX, Bankman-Fried, and the company executives did not respond to Reuters’ requests for comment. A spokesman for Bankman-Fried’s parents said that they had been trying to return the property to FTX before the bankruptcy proceedings. Separately, James Bromley, the FTX attorney, said on Tuesday that the company spent three hundred million dollars in the Bahamas buying homes and vacation properties for its senior staff.)

The FTX Group did not keep appropriate books and records, or security controls, with respect to its digital assets, according to Ray. Bankman-Fried used an auto-deleting application to communicate with employees, and encouraged them to do the same. Those managing the bankruptcy have been unable to figure out who even worked at the company, owing to its “unclear records and lines of responsibility.” Ray also said that the company’s financial statements that were available—the company had not been able to find statements for two of its four business groups—should not be trusted; one of the auditing firms that worked on them is called Prager Metis, and its Web site describes it as the “first CPA firm to officially open its Metaverse headquarters in the metaverse platform Decentraland.” (In a statement to Bloomberg Tax, Prager Metis defended its financial statements, saying they were “fairly stated.”) To add further bleak comedy to the situation, Ray says that at least three hundred and seventy-two million dollars in “unauthorized transfers” of FTX digital assets and another three hundred million dollars of unauthorized minting of an FTX-issued token called FTT occurred on the day of the bankruptcy filing, suggesting that other actors in the crypto market were poised to take advantage of FTX’s disarray. In response, the company has hired forensic analysts, investigators, and cybersecurity experts to try to identify those responsible for potential thefts of assets, as well as to sort out what may be “very substantial transfers” of FTX property in the days leading up to the bankruptcy. According to estimates, FTX owes nearly $3.1 billion to its largest fifty creditors, including to customers who lost money they had in their accounts. But the real numbers could turn out to be even larger. According to Ray, “the Debtors have located and secured only a fraction of the digital assets of the FTX Group that they hope to recover.” ♦