FTX fiasco means coming consequences for crypto in Washington DC

On Nov. 11, while the rest of the country was celebrating Veteran’s Day, Sam Bankman-Fried announced that FTX — one of the world’s largest cryptocurrency exchanges by volume — had filed for bankruptcy. Lawmakers and pundits quickly latched onto the rapid disintegration of FTX to call for more regulation of the crypto industry. “The most recent news further underscores these concerns [about consumer harm] and highlights why prudent regulation of cryptocurrencies is indeed needed,” said White House Press Secretary Karine Jean-Pierre.

It remains unclear what exactly transpired at FTX. Reports indicating that between $1 billion and $2 billion of customer funds are unaccounted for are deeply troubling. Widespread consumer harm and indications of corporate impropriety only increase the likelihood that Congress will take action to regulate the crypto industry. As Congress looks toward overhauling the regulatory environment around crypto, it is important that lawmakers provide regulatory clarity without hindering positive innovation.

Anatomy of a collapse

Sam Bankman-Fried was once the golden boy of the crypto world. Launching his career in traditional proprietary trading at Jane Street, Bankman-Fried left Wall Street and founded a crypto-focused quantitative trading firm called Alameda Research in November 2017. Three months later, he rose to fame by being the first to significantly profit by arbitraging the difference in the price of Bitcoin in Japan and the United States, purportedly earning him and his team $25 million per day. Just over a year later, he founded FTX. One needs only read the laudatory, now-deleted profile of Bankman-Fried from Sequoia Capital (which invested $214 million in FTX) to see how many believed him to be a financial savant.

Bankman-Fried eventually left Alameda to focus on FTX while retaining a significant stake in the fund. FTX quickly grew to become one of the largest crypto exchanges in the world as revenues grew over 1000% between 2020 and 2021. In January, FTX was valued at $32 billion. But, on Nov. 2, leaked documents indicated that Alameda Research held a large about of FTX Tokens (FTT). Four days later, Changpeng “CZ” Zhao — CEO of rival exchange Binance — tweeted that his company would liquidate approximately $2.1 billion worth of FTT. CZ’s statements, coupled with fears of illiquidity, led to a classic bank run on FTX.

As part of Binance’s exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have came to light, we have decided to liquidate any remaining FTT on our books. 1/4

— CZ Binance (@cz_binance) November 6, 2022

Faced with a liquidity crisis, FTX and Binance agreed to an acquisition. But, “as a result of corporate due diligence,” Binance backed out of the deal. Over the next 48 hours, Bankman-Fried deleted assurances that “assets are fine,” asked investors for $8 billion to save his company and apologized.

1) I’m sorry. That’s the biggest thing.

I fucked up, and should have done better.

— SBF (@SBF_FTX) November 10, 2022

On Nov. 11, Bankman-Fried announced that FTX, FTX.US, Alameda Research and around 130 other affiliated companies had filed for Chapter 11 bankruptcy.

1) Hi all:

Today, I filed FTX, FTX US, and Alameda for voluntary Chapter 11 proceedings in the US.

— SBF (@SBF_FTX) November 11, 2022

The impact of FTX’s collapse on consumers is devastating. Court filings show that the FTX Group could have “over one million creditors in these Chapter 11 cases,” and legal experts have asserted that many customers may never get their money back. Following the departure of Bankman-Fried, FTX appointed John J. Ray III — the lawyer who managed the liquidation of Enron Corp. following its demise — to oversee the bankruptcy proceedings.

Fallout in Washington, D.C.

Over the last few years in Washington, crypto regulation has largely been considered a “pre-partisan” issue that cuts across political lines in ways that few issues can. It is widely acknowledged by lawmakers, regulators and the industry that crypto and blockchain technologies do not fit cleanly into existing regulatory structures, leaving much of the industry in a regulatory gray area and leading to what many have complained is regulation through enforcement. These complaints have led lawmakers to push for new legislation that aims at clarifying the rules of the road for crypto.

While there are numerous smaller pieces of legislation that have been put forward, there are two major bills that seek to provide clarity for the crypto industry. The Lummis-Gillibrand Responsible Financial Innovation Act delineates the jurisdiction over digital assets between the Securities and Exchange Commission (SEC) and Commodities and Futures Trading Commission (CFTC), allow exchanges to register with the CFTC, and create new requirements for stablecoin providers, among other things. The Digital Commodities Consumer Protection Act (DCCPA) would grant the CFTC exclusive jurisdiction over digital commodity trades, mandate that exchanges register with the CFTC and create new disclosure requirements for digital commodity brokers, among other things.

Related: Sen. Lummis: My proposal with Sen. Gillibrand empowers the SEC to protect consumers

The DCCPA is sponsored by the chair and ranking member of both the House and Senate Agriculture Committees, which hold jurisdiction over commodities markets, and there are only slight differences between the House and Senate versions of the bill.

With Congress winding down, it is unlikely that either of these bills will pass before the end of the year. But, lawmakers have made clear their intent to revisit this issue next year, and the collapse of FTX has only increased the likelihood of legislative action on crypto.

In addition to comments from the White House and federal regulators, lawmakers have not pulled punches when it comes to FTX. Democratic Ohio Sen. Sherrod Brown said Bankman-Fried should be called to testify before the senate and urged regulators to “crack down” on the industry. Democratic Massachusetts Senator Elizabeth Warren, who has historically been critical of crypto, said the industry was mostly “smoke and mirrors” before calling for more regulation.

The implosion of FTX must be a wake up call for Congress and financial regulators to hold this industry and its executives accountable.
 
Too much of the crypto industry is smoke and mirrors. It’s time for stronger rules and stronger enforcement to protect ordinary people.

— Elizabeth Warren (@SenWarren) November 11, 2022

Other members of Congress were more nuanced in their comments surrounding FTX. “Oversight is one of Congress’ most critical functions and we must get to the bottom of this for FTX’s customers and the American people. It’s essential that we hold bad actors accountable so responsible players can harness technology to build a more inclusive financial system,” said Rep. Patrick McHenry of North Carolina. Sens. Debbie Stabenow of Michigan and John Boozman of Arizona, who are the original Senate sponsors of the DCCPA, pointed to the FTX collapse as evidence for why Congress should pass their bill.

The industry has also rallied around FTX to push for more regulatory clarity. The CEO of Coinbase, Brian Armstrong, penned an oped the day FTX filed for bankruptcy, calling for sensible regulation of exchanges. “It’s also important to be clear about why this happened — and what needs to change if we want to prevent something like it from happening again,” wrote Armstong. “Now, the U.S. has a choice: take the lead by providing clear, business-forward regulation, or risk losing out on a key driver of innovation and economic equality.”

Moving forward

It was already likely that Congress would take action to regulate crypto next year. The collapse of FTX makes it nearly certain.

As lawmakers weigh how to prevent the next FTX, it is critical that they avoid the pitfalls of panic-driven policy. As many have already pointed out, FTX’s impropriety and subsequent collapse are not unique to crypto. Pundits have been quick to make comparisons to Enron and Lehman Brothers. As happened following those incidents, Congress should first investigate FTX and then produce legislation that increases transparency and closes the loopholes that allowed FTX to operate as it did.

Related: Will SBF face consequences for mismanaging FTX? Don’t count on it

Thus far, Congress and federal regulators have been unable or unwilling to provide clear regulations for the crypto industry. But we have also seen instances where poorly drafted legislation created more confusion than clarity. The unworkably vague broker definition in the Infrastructure Invesment and Jobs Act is case and point and has yet to be fixed.

As lawmakers draft and redraft legislation targeted at crypto, it is essential that any proposal be narrowly tailored to solve specific issues in a specific context. For example, custodial and noncustodial wallet services operate differently and should be regulated differently. More importantly, lawmakers must not confuse applications and the protocols on which they run.

Hopefully, Congress will avoid a moral panic and will use the current momentum to produce legislation that provides regulatory clarity for crypto applications without hampering innovation. American customers and innovators should expect nothing less.

The opinions expressed are the author’s alone and do not necessarily reflect the views of Cointelegraph. This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice.