The implosion of US cryptocurrency exchange FTX has led to a renewed interrogation of regulation in the sector. But what is being done to address the inherent risks in this volatile and fast-moving market?
On 11 November 2022, the cryptocurrency exchange giant and hedge fund FTX filed for bankruptcy in the US.
In his declaration in support of the petitions to start bankruptcy proceedings, John J Ray III, the insolvency practitioner in the case, starkly set out his views on FTX's corporate governance and structures:
"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. 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." (paragraph 5)
The fallout for FTX has been substantial. Its former CEO, Sam Bankman-Fried, was arrested in December 2022 on fraud charges. Further charges are being brought by prosecutors amid allegations that Bankman-Fried stole billions in customer funds from FTX, to try and cover losses in its sister company, Alameda Research. Following its bankruptcy, substantial and serious questions have been asked about failures of corporate governance within the organisation. Meanwhile, further documentation provided to the bankruptcy court estimates that FTX and its associated entities have more than one hundred thousand creditors, with the number potentially reaching up to one million.
The case has led to renewed focus on the risks associated with the volatile crypto industry, and the potential for the turmoil within the sector to impact on the financial world more broadly. On 9 March 2023, it was announced that Silvergate Bank, a US financial institution which in recent years has increasingly focused on services for the cryptocurrency sector, would be going into voluntary liquidation, following the impact of FTX's collapse on its financial position. In a speech in the wake of FTX's bankruptcy filing, Deputy Governor of the Bank of England, Sir Jon Cunliffe, warned that the increasing integration of the crypto sector and the conventional financial sector would heighten the risk that the instability of the crypto industry will have a damaging impact on broader financial stability.
In particular, the collapse of FTX, and the number of creditors potentially put at risk by these developments, has prompted increased scrutiny on the way in which the crypto sector operates and increased discussion on the need for greater regulation. But what went wrong at FTX, what has been the regulatory response, and what might the future look like for the regulation of crypto?
What went wrong at FTX?
What precisely happened with FTX is still being untangled. The collapse started with the revelation from CoinDesk that the assets of Alameda Research, the crypto trading firm also owned by Bankman-Fried, largely consisted of 'FTT tokens', a cryptocurrency issued by FTX. This led to a run on FTT tokens, and a proposed buyout of FTX's non-US business by Binance was cancelled after corporate due diligence raised substantial concerns, leading to the ultimate bankruptcy filing.
Investigations since have flagged significant corporate governance issues, including a lack of appropriate separation between FTX and its sister company Alameda Research and the repeated granting of large personal loans to executives. There are allegations of misappropriation of customer funds on a huge scale: FTX has identified $8.9 billion in missing customer funds, and seemingly cannot account for this deficit.
The aftermath of FTX's collapse has highlighted the importance of regulation generally. Customers of FTX Japan have been able to withdraw their assets, benefiting from the local regulations to which the subsidiary was subject: customer deposits were segregated and required to be mostly held in offline 'cold storage'. In contrast, the relative lack of regulation in other jurisdictions has left investors exposed to potentially significant losses.
Current regulatory regimes for the crypto industry are limited, with inconsistency across jurisdictions.
In the UK, the FCA's regulation of cryptoassets presently requires UK-based crypto-asset exchanges to be registered for anti-money laundering purposes. The FCA's guidance on cryptocurrency advises extreme caution, warning investors that they are unlikely to be protected if things go wrong and that they should be prepared to lose their money if they invest in cryptoassets. In September 2022, the FCA issued a specific warning that FTX "may be providing financial services or products in the UK without our authorisation… you are unlikely to get your money back if things go wrong”.
In recent months, this caution has been supplemented by proactive measures by the FCA to crack down on unlawful practices in the crypto sector. In February, the FCA worked with the West Yorkshire Police's Digital Intelligence and Investigation Unit to inspect sites in Leeds suspected of being home to unregistered crypto ATMs. This has been followed by similar inspections in East London in March. While it is not currently clear whether enforcement action will be taken following these inspections, they do suggest that the FCA is taking a harder line against those in the crypto sector who don't comply with their regulatory requirements.
Alongside this are growing calls for greater regulation of the crypto industry. In the EU, the Markets in Crypto-Assets (MiCA) Regulation has been developed, with a deferred vote on the regulation now scheduled for April 2023. In advance of this, some EU countries have already started to tighten their regulation of the crypto sector. The French National Assembly recently voted in favour of tougher licensing rules for new cryptocurrency firms, following interventions by figures such as the Bank of France Governor Francois Villeroy de Galhau. In the US, the FTX collapse led to the establishment of a House Subcommittee on Digital Assets, Financial Technology, and Inclusion, and the signing of an Executive Order on Ensuring Responsible Development of Digital Assets. The US Securities and Exchange Commission has also launched a number of investigations against other entities involved in crypto.
The future of crypto regulation
There are concerns that, despite the renewed focus on regulation, progress has generally been piecemeal and slow. President of the European Central Bank Christine Lagarde expressed concern in the wake of the FTX collapse that, while they would represent an improvement, existing regulatory proposals would not capture all of the issues in the rapidly changing crypto sector and stated "there will have to be a MiCA II".
A more comprehensive strategy for regulating the crypto industry may be needed in order to provide the necessary safeguards for investors. As Japan has shown, these can be invaluable in ensuring there are proper protections within this growing sector. In the UK, the Financial Services and Markets Bill 2022-23 was amended at committee stage to bring crypto assets within the scope of the regulatory framework of the Financial Services and Markets Act 2000 (FSMA) (clause 65 of the Bill). This could lead to a requirement that crypto asset firms be fully authorised by the FCA, and potentially subject to the extensive regulations set out in the FCA Handbook.
As well as providing more protection, this could also open up new opportunities: as Sir Jon Cunliffe noted in his speech in November 2022, regulation of those operating in the crypto currency is an important step, not just for protecting consumers and investors, but also for exploring ways in which technological innovations seen in the crypto sector can be harnessed by the conventional financial sector. The Bank of England and the European Central Bank are in the process of exploring options for digital currencies. With greater regulation, it might be hoped that these developments can yield benefits without the substantial risks which currently exist for those investing in the crypto sector.
This article has been co-written by Rebecca Wyke (Solicitor) and Rebecca Durkin (Trainee Solicitor).