FTX[1] is a Bahamas-based cryptocurrency exchange founded in 2019 that, at its peak in 2021, had over 1 million users, making it the world’s third largest crypto exchange by volume. Since November 11, 2022, though, FTX has been in bankruptcy, having borrowed extensively and used the assets of its clients in a likely and spectacular fraud.

Why did the capital-markets system fail to provide the checks and balances that investors count on, leaving the crypto market in the hands of operators hostile to regulation? How can we avoid a system beholden to Sam Bankman-Fried, Mark Zuckerberg, Elon Musk, and other autocratic leaders who undermine the principles of our capital markets?

This post is not about drawing conclusions but about the numerous questions that made the crypto sphere – and particularly crypto exchanges – a $2 trillion market.

1. The Definition Divides Regulators

Regulators, lawyers, and central banks still struggle sometimes to put some crypto assets in a category but defining them is possible. Different crypto assets represent different things. Cryptocurrency is neither a currency, nor an object. Is it a financial asset? Deposits, stocks, bonds, notes, currencies, and other instruments possess value and give rise to claims, liabilities, or equity investment. Financial assets include bank loans, direct investments, and official private holdings of debt and equity securities and other instruments. When the holder resides in a country that is different from the issuer of the instrument, it is included in the international investment position of both countries, according to the U.S. Bureau of Economic Analysis. [2]

Why did President Biden have to force interagency cooperation and require a report from the various regulators to obtain a comprehensive regulation? [3]How have we not learned from the Great Financial Crisis of 2008 that the fragmentation and infighting among regulators is the best way to encourage unscrupulous market manipulators?

Key message

The responsibility for legitimizing crypto assets in their various forms falls under securities regulation while the legitimization of crypto exchanges falls under exchange regulation. Did the various regulators not see that it should have been, from day one, a cooperative undertaking once Bitcoin reached $ 100 million in June 2017? Why was international cooperation absent, whether at the Bank for International Settlement (BIS) or the International Organization of Securities Commissions (IOSCO), creating a new field of regulatory arbitrage on what was a global phenomenon?

2. The Pseudo “Crypto Exchanges”

The Securities and Exchange Commission waited to define crypto exchanges until April 2022, when it issued a proposal to, among other things, require “communication protocol systems” (or CPSs) to register with the agency and thereafter satisfy its many recordkeeping, transaction-monitoring and reporting obligations. These CPSs would be defined as systems or platforms that “make available” the means for buyers and sellers of securities to “interact.”[4]

• Why Did Authorities Accept that Definition?

There is a legal definition of an exchange in the context of financial assets. Rule 3b-16 of the Securities Exchange Act currently defines an exchange as a system that “brings together the orders for securities of multiple buyers and sellers” using non-discretionary methods.

Those of us with long memories know that advocates of electronic trading systems lobbied the SEC in the early 2000s to be considered as exchanges.[5] It was similar to the approach used by crypto-asset market makers. When the SEC adopted Regulation ATS, it established a framework for the regulation of trading venues that meet the definition of an “exchange” under Section 3(a)(1) of the Securities Exchange Act and SEA Rule 3b-16: They can either apply for registration as a national securities exchange, or they can register as a broker-dealer and comply with Regulation ATS.[6]

However, most exchange regulators allowed crypto exchanges to flourish without regulating them as broker dealers and requiring the reporting of their financial positions. For regulators, words matter. In the same way that the Federal Reserve legitimized the word “currency,” the SEC did not object to the “exchange” denomination of trading platforms.

• How Did Regulated Exchanges Avoid the Crypto Trap?

Would it have been better to require that trading should happen on a regulated exchange (something that was part of post-financial crisis reforms for some derivative products)? I vividly remember a conversation with the president of the Bombay Stock Exchange when the Reserve Bank of India was under pressure to approve crypto assets: “I will never trade on my exchange something that has no intrinsic value.” To their credit, most stock exchanges refused to trade cryptos or ETFs of cryptos or initial coin offerings (ICO). Their own listing standards were incompatible with such trading. That should have reinforced the prudence of exchange regulators.

I deeply respect that discipline, having witnessed the huge political, financial, and corporate pressure the exchanges were under to trade crypto assets on their markets without adequate regulatory framework.

• How Could FTX Be Allowed to Fuel Alameda’s Trading Activities?

As a trading platform, crypto exchanges were owning cryptos in their balance sheets. They needed to do so to create liquidity and allow trading. Since the assets were not widely owned by institutions, the market was limited to those “exchanges” and traders. It was easy to shuffle assets and transactions between the crypto trader and the crypto exchange.

Inevitably, the pricing of cryptos was decentralized and reflected the position of the trading platforms. One could not imagine the NYSE owning JP Morgan shares for liquidity purposes. How could this not lead to regulation by the market trading division of the regulators?

The absence of separation between the two companies allowed the comingling of assets and liabilities.

• Where Was the Transparency?

That structure led inevitably to a complete absence of reporting to a centralized point of price discovery. Transparency was absent. Who oversaw the financial statements of FTX U.S.? Nobody looked at the financial stability impact of those crypto “exchanges,” leaving the market dominated by one firm, Binance? Yes, it is a private company, but as an important market participant, could it truly operate without any form of oversight? What information did it give to its shareholders?

Key message

Not making clear that crypto exchanges were different from regulated exchanges helped confuse the public, which was already uncertain about the nature of those instruments. It was a form of legitimacy while none of the investor protections of an exchange were available. Will regulators strengthen their ability to avoid that confusion and reduce their complacency towards crypto assets? As the SEC is reexamining Reg NMS, this might be an element to consider.

3. Investor Protection: Dereliction of Duties

If FTX had more than 1 million accounts around the world, there is no doubt that, like all crypto products, retail investors had access to those products without any protection or transparency and were subject to profoundly dishonest marketing that made the cryptos tokens and crypto exchanges a gambling casino.

• Why Were Crypto Exchanges Accessible to Retail Investors? The QIB Question.

Did regulators ever look at the risks for retail investors, the core of their mission? This question raises another one:  The accredited investor definition limits what investors can participate in private placements undertaken in reliance on Rules 506(b) and 506(c) under the Securities Act (which forms part of the safe harbor from the registration requirements of Section 5 of the Securities Act pursuant to Regulation D). It also affects certain other exemptions from registration and plays an important role in other federal and state securities law exemptions.

Did regulators ever consider that crypto-assets – undefined, volatile, and explosive multibillion dollar securities sold through “private placements” – should be limited to “accredited investors”? Why did the SEC wait until August 2022 (six months after it started investigating FTX U.S.)?

• Why Was Nothing Done to Educate Retail Investors, Other than Generic Risk Warning?

We had several “surgeon general” warnings that cryptos could be volatile. Even with extensive media coverage, marketing campaigns by the crypto sphere, and the support of the metaverse and the tech world, those warnings quickly disappeared. We left education to marketeers.

When I published my first blog on cryptos, in January 2014, it had become clear to me that crypto was a Ponzi scheme[7]. The comments in responses were abundantly clear: I was a decadent financier who did not understand the transformational value added of products that are better than a fiat currency.

The Fed warned about crypto currencies for the first time in its Monetary Policy Report from July 2021. This is only one example of the way unscrupulous financiers mislead their customer: Don’t we remember that it is that behavior that triggered the huge retail losses during the financial crisis?

• Why Did It Take 10 Years to Start Serious Regulation?

It took July 2022 (six month after the investigation of FTX had started) for the Fed to release a supervisory letter recommending steps that lenders overseen by the Fed should take before getting involved in the digital-asset industry. As a starting point, the Fed said, firms should notify the regulator prior to engaging in crypto-related activities and ensure that they comply with the rules.

The same month, ahead of the United States, the European Council president and the European Parliament reached a provisional agreement on the Markets in Crypto-Assets (MiCA) proposal, which covers issuers of unbacked crypto-assets and so-called “stablecoins” as well as the trading venues and the wallets where crypto-assets are held. This regulatory framework should protect investors and preserve financial stability while allowing innovation and fostering the attractiveness of crypto assets. This will bring more clarity in the European Union, as some member states already have national legislation for crypto assets, but so far there has been no specific regulatory framework at the EU level.[8]

• Where Was the FSOC on Crypto Risks?

Where were the overseers of systemic risk?

The Financial Stability Oversight Council (FSOC) is charged with identifying risks to the financial stability of the United States, promoting market discipline, and responding to emerging risks to the stability of the U.S. financial system. The council consists of 10 voting members and 5 nonvoting members and brings together the expertise of federal financial regulators, state regulators, and an independent insurance expert appointed by the president.

Did those officials believe that a $2 trillion, volatile asset would not be a possible financial stability risk? Did it take Senator Elizabeth Warren’s letter of July 2021 to the Secretary of the Treasury, as the chair of the FSOC? The letter warned, “I have become increasingly concerned about the dangers cryptocurrencies pose to investors, consumers, and the environment in the absence of sufficient regulation in the United States. However, as the demand for cryptocurrencies continues to grow and these assets become more embedded in our financial system, the Council must determine whether these trends raise concerns beyond investor and consumer protection and extend to broader systemic vulnerabilities that could threaten financial stability.”[9]

Why was the FSOC report on Digital Asset Financial Stability and Regulation only published in October 2022?[10]

• Will 1 million Investors Have Any Recourse?

Listening to a webinar organized by the law firm of Davis Polk & Wardwell, I was struck by the complexity of the resolution of the FTX bankruptcy, whether it is under Chapter 11 or Chapter 15. Determining whether retail investors or clients will get any of their money back will take a few years. The complexity of the chart below suggests that this bankruptcy case will be as intricate as that of Lehman Brothers.

Key message

Regulators left retail investors without information or protection. They could have protected them by limiting the access to crypto assets to accredited investors. They could have warned the public. They could have explicitly disavowed the use of exchanges for cryptos. They did not.

4. Investors and Banks Embraced an Inspiring Leader Instead of Due Diligence

I have become increasingly concerned about the impact of the cult of toxic CEOs. In the case of cryptos, three key influencers, Masayoshi Son, Mark Zuckerberg and Elon Musk, have completely failed in their crypto strategies. However, as influencers, they gave credibility to crypto markets.[11]

Billions of dollars have been lost because we prefer to believe in charismatic leaders more than in facts and reality. As regulators put serious limitations on broker dealers’ messages, should they not do the same for those who influence capital markets outside of their sphere of influence?

• Was It Wise to Invest Billions of Dollars with an Inexperienced Trader?

Where did fiduciary duty go?

An interesting twist is the relationship between Sam Bankman-Fried and venture capital firm Sequoia Capital. Bankman-Fried put $300 million in Sequoia, which invested $210 million in FTX.  Sequoia says it will mark down to zero its investment FTX, as possibilities of bankruptcy loom. But Sequoia was a key promoter of FTX.   Venture capital firm Sequoia Capital apologized to its limited partners for its investment in collapsed crypto exchange FTX and said it would improve its due diligence process for future investments, the Wall Street Journal reported, citing people familiar with the matter.[12]

What did Temasek, Ontario Teachers, or BlackRock do in this adventure? They are known to be conservative investors, attentive to due diligence and oversight.

Now investors are under scrutiny, too, for enabling Bankman-Fried with so little oversight. It was the most dramatic example in recent history of what happens when so-called visionary founders are given lots of money with few strings attached.

• What Due Diligence Did Leading Investors Perform Before and After Their Investment?

Not only was there little oversight, but due diligence, which is a duty and needs to be thorough, was also lacking. The fraternity of Silicon Valley hates it.

Now the relationship between Alameda Research and Bankman-Fried’s cryptocurrency exchange, FTX – and how the two propped each other up – is coming under scrutiny as prosecutors and regulators investigate the collapse of one of the best-known trading platforms in the crypto universe.[13]

• How Could a $9 Billion Debt Build Up on the “Collateral” of Cryptos?

This empire was built on sand. FTX has less than $1 billion of liquid assets and $9 billion of debt, according to the Financial Times.[14] Who were the lenders and what was their collateral?

Bankman-Fried was using client assets as collateral for the debt. With $5 billion of withdrawals in one day, FTX and the 139 companies in its group had to file for bankruptcy. Using client money as collateral, Alameda Research was trading billions of dollars from FTX accounts and leveraging the exchange’s native token as collateral. Three sources familiar with the company told CNBC that they were blindsided by FTX’s missteps and that only a small cohort knew about the potential misuse of customer deposits.[15]

What has been done since the bankruptcy of MF Global in 2011 to ensure that the use of banking assets as collateral for leverage is no longer possible? How to avoid such a major fraud in contravention of securities regulations?

Key message

The lack of audit and supervision has created a situation where leverage and fraud made FTX’s growth and collapse possible. Its investors did not exercise the minimum oversight that would have made them realize what the new CEO of FTX, John J. Ray, realized in three days. “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 said in a court. “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.”[16]

An inspiring leader can overwhelm the authorities who abstain from due diligence. It is a trend in a society where the show supersedes the substance. The media are particularly susceptible to fawning over and promoting controversial leaders, just because they are controversial. Should regulators have a say in the huge advertising and marketing campaigns that perpetuate the financial narrative and mislead investors?

Conclusion: Regulators Need Preemptive Rights

Over the past 10 years we have seen financial frauds or scandals of all sorts. They are concentrated in the technology world and capital markets.  Acting after the fact is insufficient.  Should the authorities act preemptively to block unproven and undefined projects? Should regulators have the right to investigate new products and require the promoters to present their financial innovations, including their risks and benefits?  Should a duty of due diligence and oversight be imposed on institutional investors that receive money from the public?  How can we justify the lack of protection of investors facing experimental actions that remain unregulated until it is too late?

The time has come to collectively recognize that the complexity of financial markets has made it extremely challenging to regulate them and achieve financial stability. It is those who claim that regulation is too strict who committed the frauds or scandals that regulators are supposed to mitigate or avoid.

ENDNOTES

[1] FTX Crypto Exchange, built by traders, for everyone…https://ftx.com

[2] https://www.bea.gov/help/glossary/financial-assets#:~:text=Deposits%2C%20stocks%2C%20bonds%2C%20notes,equity%20securities%20and%20other%20instruments.

[3] https://www.whitehouse.gov/briefing-room/statements-releases/2022/03/09/fact-sheet-president-biden-to-sign-executive-order-on-ensuring-responsible-innovation-in-digital-assets/

[4] https://www.coindesk.com/layer2/2022/04/05/a-new-sec-definition-for-exchanges-has-big-implications-for-crypto/

[5]https://www.sec.gov/foia/docs/atslist#:~:text=Regulation%20ATS%20establishes%20a%20regulatory%20framework%20for%20%E2%80%9Calternative,exemption%20provided%20under%20Exchange%20Act%20Rule%203a1-1%20%28a%29.

[6] https://www.finra.org/rules-guidance/notices/18-25

[7] https://www.huffpost.com/entry/the-bitcoin-is-victim-of_b_4676132

[8] https://www.consilium.europa.eu/en/press/press-releases/2022/06/30/digital-finance-agreement-reached-on-european-crypto-assets-regulation-mica/

[9] https://www.warren.senate.gov/imo/media/doc/FSOC%20Crypto%20Letter%2007.26.2021.pdf

[10] https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf

[11]  https://gugeux.medium.com/masa-mark-and-elon-the-crypto-influencers-2314a2924c8b

[12] https://www.wsj.com/articles/sequoia-capital-apologizes-to-limited-partners-for-ftx-investment-11669144914

[13]https://www.nytimes.com/2022/11/18/business/ftx-alameda-ties.html?action=click&block=storyline_top_links_recirc&module=styln-ftx&pgtype=Article&region=MAIN_CONTENT_1&state=default&variant=show

[14] https://www.ft.com/content/f05fe9f8-ca0a-48d5-8ef2-7a4d813af558

[15]  https://www.cnbc.com/2022/11/13/sam-bankman-frieds-alameda-quietly-used-ftx-customer-funds-without-raising-alarm-bells-say-sources.html

[16] https://www.coindesk.com/business/2022/11/17/new-ftx-boss-condemns-management-of-the-crypto-exchange-during-sam-bankman-frieds-tenure/

This post comes to us from Georges Ugeux, who is the chairman and CEO of Galileo Global Advisors and teaches international finance at Columbia Law School.