The bankruptcy of major cryptocurrency platform FTX is causing massive fallout in this evolving financial industry. On Monday, U.S. prosecutors charged the founder and former CEO of FTX with several financial crimes and campaign finance violations including wire fraud and money laundering. According to the complaint released by the U.S. Securities and Exchange Commission, Sam Bankman-Fried orchestrated years of fraud by diverting investor funds to his private hedge fund and used those funds to make venture investments, lavish real estate purchases, and large political donations.
The charges came one day before the U.S. House Financial Services Committee held a hearing on the collapse of FTX.
Rutgers Law School Vice Dean Yuliya Guseva, co-author of Regulation of Cryptoassets, and Distinguished Professor Douglas Eakeley, founder and co-director of the Rutgers Center for Corporate Law and Governance, explain the significance of the bankruptcy, its potential consequences, and why Congress needs to step in now.
Douglas Eakeley, Distinguished Professor and Founder/Co-director of the Rutgers Center for Corporate Law and Governance
Why is the bankruptcy and unraveling of FTX such a major event in the financial world?
Eakeley: FTX was one of the largest cryptocurrency exchanges in the world. Its founder and CEO, Sam Bankman-Fried, enjoyed celebrity status as the “paragon of crypto.” FTX operated through a network of over 130 affiliated entities, almost all of which have filed for bankruptcy – including Alameda Research, its trading arm. The bankruptcy petition reported that FTX may have more than 100,000 creditors and estimated its assets and liabilities were in the range of $10 billion to $50 billion.
The bankruptcy proceedings promise to be nightmarish, involving novel issues of law and multiple challenges to achieving an accurate accounting of the underlying facts. John J. Ray, the new FTX CEO (an experienced bankruptcy expert) has disclosed that the books and records of the FTX conglomerate are in disarray and unreliable. The Wall Street Journal has reported that FTX may have loaned billions of its customers’ deposits to Alameda. FTX has also reported that it has been hacked. And there is a significant jurisdictional dispute: much of FTX’s operations were conducted in the Bahamas through FTX Digital Markets Ltd. The Securities Commission of the Bahamas has launched a liquidation proceeding to recover assets and deposits that may or may not be subject to the U.S. bankruptcy court. (Digital Markets is not part of the U.S. proceeding because the Bahamas had already put it in liquidation.)
Yuliya Guseva, Rutgers Law Vice Dean
Crypto companies Celsius Network, BlockFi, and Voyager Digital have also recently filed for bankruptcy. How are these bankruptcies affecting other currencies, investors, and other companies?
Guseva: The bankruptcies of several crypto-lenders are directly related to the collapse of FTX. On the one hand, before going under, FTX offered to serve as a white knight, with its CEO acting as if he were a reincarnation of JP Morgan in the crypto world. On the other hand, companies such as BlockFi had direct exposure to FTX and affiliated entities. FTX seems to be one of BlockFi’s largest creditors. These interconnections within the crypto industry and their opaque nature exacerbate financial, operational, and liquidity risks. Hypothetically, had cryptoasset prices been going up, these problems would have been less severe. The reality, however, is that the collapse of FTX coincided with a downturn in the crypto market.
If a crypto-lender’s prospects are bleak, this adversely affects the users of its lending products. Depending on the nature of the custodial accounts of the lender, users and investors may be severely affected. For example, a bankruptcy judge recently allowed only a small group of the users of Celsius access their deposits.
A broader question is how to regulate crypto-lenders. The SEC, for example, reached a settlement with BlockFi in early 2022. In the order, BlockFi agreed to seek registration under the Investment Company Act. It also filed Form T-3 for its interest-bearing accounts. The underlying problem, however, is that when a business model is based on an inherently volatile and novel asset class, our securities regulation and registration do not prevent companies from collapsing.
The bankruptcies of the crypto-lenders demonstrate the need for a better and different regulatory approach.
Even through cryptocurrency regulations are still in its early stages, have there been any changes to regulations because of the bankruptcies? If not, what should federal regulators do next?
Eakeley: There have been no changes to regulations because what is required is action by the Congress to authorize those changes. As recently as October 3, 2022, the Financial Stability Oversight Council pointed out that one of the most critical three gaps in the regulation of crypto-asset activities in the United States was “limited direct federal oversight of the spot market for crypto-assets that are not securities.” A debate has raged for years about whether cryptocurrencies and the platforms on which they are traded should be regulated as commodities by the Commodities and Futures Trading Commission (CFTC) or the Securities Exchange Commission (SEC). Both regulators have repeatedly asked Congress to extend their jurisdictions to regulate this “spot” market for cryptocurrencies. Two bipartisan bills pending in Congress (the Digital Commodities Consumer Protection Act of 2022 (DCCPA) and the Responsible Financial Innovation Act) would confer jurisdiction on the CFTC to regulate that market.
Those bills will die at the end of the year. It is difficult to predict what, if anything, we will see by way of legislative action in the new Congress, with the Republicans in control of the House of Representatives and the Democrats in control of the Senate. Given that Mr. Bankman-Fried (and others in the crypto industry) publicly supported the DCCPA (and the potentially less stringent regulatory approach of the CFTC compared with the SEC), there may be less appetite for granting the CFTC jurisdiction to regulate the spot market. SEC Chair Gary Gensler has publicly stated that he believes many cryptocurrencies are securities subject to the jurisdiction of the SEC, and the SEC has been under increased pressure since the FTX debacle to increase its enforcement actions in this area, despite questions about its authority to do so under the 1933 Securities Act and 1934 Securities Exchange Act.
U.S. Senator Elizabeth Warren (RLAW ’76) says that the FTX collapse “shows crypto may be more integrated into the banking system than regulators are aware.” She and other Senate Democrats are pushing for regulators to examine links between cryptocurrency firms and banks. What are the implications of recent events for people who don’t invest in cryptocurrency?
Guseva: It is important for Congress not to overreact in an economic downturn, to provide solutions to the actual problems of the crypto industry, and to develop a better framework for proactive regulation. FTX is an example of abject mismanagement, a complete lack of financial discipline, insufficient internal controls, and profound conflicts of interest. Looking for linkages with U.S. banks, however, is not what is needed in the wake of its bankruptcy.
FTX and other crypto-related bankruptcies demonstrate that our views on regulation should evolve and cover broader and amalgamated types of financial services. Congress needs to design new approaches to financial regulation and let regulatory agencies do their job, which they already do very well for the most part.
Note that most of the questionable activities of FTX took place abroad. Within the U.S., investment banks have been relatively cautious in their crypto-related activities. This caution is even more evident in the case of national banks which are highly regulated financial institutions. In fact, their entry into the crypto world has been slow. The Office of the Comptroller of the Currency has deliberately required that banks have ex-ante controls in place before they can provide crypto-related support and engage in stablecoin and other activities. For instance, a non-objection letter is required before certain crypto activities may be conducted.
Even though states’ approaches to crypto vary, with some states introducing special purpose depository institution charters, the level of this financial activity has been relatively low.
To summarize, with all due respect to Senator Warren, who is a preeminent expert in bankruptcy and finance, it is important to thoughtfully focus legislative resources on the actual problems of the crypto economy and future technological innovations. One area where the markets and investors need Congress is providing regulatory clarity and introducing a workable framework for the cryptoasset market and relevant services. Today, the United States does not have a uniform approach. It is imperative that legislators develop a comprehensive whole-of-government policy regarding financial innovations such as blockchain-related services and cryptoassets.