Sam Bankman Fried’s FTX and how to curb crypto’s self-destructive urge

FTX, which had been world’s second-largest cryptocurrency exchange, suffered a major liquidity crisis last week, as hedge funds and other customers lost confidence.

In what was tantamount to an old-fashioned bank run, FTX was hit with massive withdrawal requests, including $US5 billion ($7.5 billion) of withdrawals the Sunday before its collapse which forced the exchange to pause withdrawals.

Risky trading

The funds outflow was driven by growing concerns about FTX’s close links with Alameda, which had a reputation both for pursuing risky trading strategies and for the large stakes it held in illiquid venture investments.

According to the Wall Street Journal, FTX lent some $US10 billion to Alameda, using money that customers had deposited on the crypto exchange for trading purposes. In total, FTX had $US16 billion in customer assets.

Traditional brokerages and exchanges are forced to keep customers’ funds separate from the capital they use for trading.

But in the unregulated world of crypto, it is far from clear that FTX customers will ever get their money back, or even that Bankman-Fried and FTX will face any legal consequences for losing customer funds.

FTX customers aren’t the only ones facing huge losses. FTX’s investors included big name venture capital firms, pension funds and hedge funds, like Sequoia Capital, Tiger Global Management, Ontario Teachers’ Pension Plan, and Singapore’s state-owned fund Temasek, some of whom invested in FTX at a valuation of $US32 billion several months ago.

With the crypto exchange now having filed for bankruptcy, some investors, including Sequoia, have slashed the value of their investment in the FTX to zero.

But the big question for regulators is how zealous should they be in trying to impose order on the crypto Wild West?

One approach would be for regulators to do very little by way of imposing controls.

After all, the whole ideological appeal of bitcoin and other digital assets – and the crypto industry more broadly – is that it represents an escape from the clutches of governments and central banks.

Indeed, the very fact that Bankman-Fried ran his crypto empire from the Bahamas is proof that the crypto market has been able to achieve its libertarian goal of creating an operating environment outside any government interference.

Similarly, the high-flying hedge funds and pension funds that invest in crypto firms have more than enough resources to conduct their own detailed due diligence on crypto firms, and enough financial muscle to force these businesses to be more transparent about their finances.

Curbing excesses

What’s more, the market cap of the entire crypto market has now shrunk to below $US1 trillion, and there are limited linkages between crypto and the traditional financial system. That means these periodic meltdowns in the crypto world pose few concerns from a financial stability perspective.

People who invest their savings in crypto know that they’re making a highly speculative investment – that’s part of its appeal. They’re simply hoping that the price of bitcoin or ether, or whatever digital currency they buy will move higher, which means they’ll be able to sell their stake at a profit.

Still, Yellen’s comments point to a strong desire on the part of authorities to do something to curb crypto’s excesses, which often leave investors without the same protections from fraud or market manipulation that come with other types of investments.

The collapse in May of the supposedly safe stablecoins, luna and its sister token terraUSD, saddled investors will billions of dollars in losses and forced policy-makers to focus on the lack of crypto regulation.

Regulators in the European Union have come up with new rules which would force crypto issuers to publish a white paper describing the characteristics and risks of their tokens, including what they intend to do with the funds they raise.

In addition, issuers of stablecoins, which have a value pegged to that of other assets, like the US dollar or the euro, also face tighter reserve requirements.

Meanwhile, in the United States, the Financial Stability Oversight Council (FSOC) – which comprises the heads of the Treasury Department, the SEC, and the Commodity Futures Trading Commission and other agencies – last month released a 120-page report that argued that crypto appears “to be primarily driven by speculation”, rather than meeting real-world needs.

The report noted that crypto firms “lack basic risk controls” and “have risky business profiles and opaque capital and liquidity positions”.

Still, the FSOC report argued that existing laws already address many of crypto’s issues, and it urged regulators to continue taking action against rule breakers, and for US Congress to pass legislation to regulate stablecoins.

But some believe that US and European regulators aren’t going far enough to protect investors.

They believe that crypto assets should be subject to the same type of regulations as other securities, so that anyone buying, say, bitcoin, would receive the same legal protection as if they purchased shares or bonds.

But this more rigorous regulation is much more difficult to achieve, given the huge range of digital assets and platforms, and the ease with which crypto firms can shift domicile to escape rules.

Indeed, the big risk is that authorities respond to the FTX bankruptcy by talking tough about increased regulation, even though they lack any detailed plans for improving investor protection.

Such a response would likely give inexperienced investors the impression that tighter rules are being implemented, which will only increase their sense of confidence about investing in crypto.

Instead, regulators should use FTX as an opportunity for educating customers about the huge risks they’re running when they invest in an unregulated market such as crypto.

They should be extremely wary of holding out unrealistic hopes that those who deposit money or buy crypto assets on these exchanges will be somehow protected, unless they genuinely intend to implement much tougher controls on the crypto industry.

It’s extremely important for investors to realise that even if the scrutiny of stablecoin issuers is increased, vast swaths of the crypto industry will remain unregulated, and that investors will remain largely unprotected.

Because the illusion that regulators will somehow make investing in crypto safer is an extremely dangerous one.

It’s telling that one of Bankman-Fried’s strategems for winning the support of high-end professional investors was to depict himself as someone who wanted the crypto industry to shed its Wild West, unregulated image.