[News] FTX collapse will lead to change for cryptocurrencies

It is pretty clear from all the reports now flowing about the way FTX operated that its management was shambolic and arguably incompetent, its risk-management illusory, its bookkeeping erratic at best and its protection of its clients’ funds non-existent.

Indeed the co-mingling of client funds held on the FTX platform with Bankman-Fried’s own hedge fund, Alameda Research – it appears that billions of those dollars were handed over the Alameda to essentially gamble on crypto assets so that Bankman-Fried could try to climb out of a hole within Alameda’s balance sheet – speaks to something far worse than an absence of systems to segregate customer funds from the company’s own operations.

As contagion spreads through the sector – other entities are experiencing liquidity and potentially solvency issues as investors flee – the interconnectedness and vulnerability to “runs” of some of the larger participants is becoming apparent.

The fact that, as is the case with a lot of the traded crypto assets, much of the “value” in the FTX and Alameda balance sheets was attributable to digital tokens that Bankman-Fried essentially created out of thin air, speaks to the downside potential of the leverage – financial and structural – in key segment of the crypto sector and the scale of the potential losses investors could face. Its chaotic and unpalatable.

In some jurisdictions regulation is already on the drawing boards.

The European Union’s “Markets in Crypto Assets” legislation has been drafted and approved but has yet to be enacted.

Here, after a comprehensive Senate inquiry last year, the federal government plans to introduce legislation next year.

The collapse of FTX will lead to much-needed change.Credit:Getty

In the US there is ongoing wrangling over how intrusive any regulation should be and which regulator – the Securities and Exchange Commission or (as Bankman-Fried favoured and lobbied and donated aggressively for) the Commodity Futures Trading Commission.

That reflects the tension between regulating crypto entities as if they were mainstream financial institutions (in which case it would be the SEC chosen as the primary regulator) or using a minimalist approach (the CFTC) to try to avoid choking the sector’s entrepreneurial spirit and potential.

In all the key jurisdictions the thrust of their proposals is similar, albeit not the same, and draws on their experiences in regulating conventional financial institutions.

Loading

The Senate’s recommendations effectively focus on regulating the crypto exchanges. They would need to be licensed, meet minimum capital adequacy standards, be audited, would have to segregate customers’ funds from their own, be subject to the anti-money laundering and “know your customer” requirements and their key staff would be vetted under the “responsible person” regime.

The proposed EU legislation would be more extensive and more intrusive but has similar emphases on customer protection, custodial arrangements and anti-money laundering provisions.

Drawing on what has been learned from the FTX experience – and other collapses, hacks and frauds in the sector – it is clear that more transparency is required if investors are to be given their own ability to assess the stability of the organisations to which they trust their funds.

That’s not by itself a perfect solution. We have that in traded security markets, where the companies are subject to disclosure regimes, are audited, are scrutinised by professional analysts and investors and scandals still emerge.

It is, however, a starting point. It might also help what are in many cases very immature businesses led by quite inexperienced people more focused on their IT systems than financial risk-management. Bankman-Fried is a 30-year-old who had no grasp of his own balance sheet.

Others in the sector are urgently commissioning their own audits, largely to reassure investors and lenders but also, one suspects, to reassure themselves in an environment where the underlying assets – crypto assets – is extremely volatile and hundreds of millions of “value” has evaporated.

If FTX’s collapse means regulation that can bring more sunlight to bear on crypto markets and impose some core investor protections will be brought forward, that would be a good thing for investors and the credibility of the digital assets sector more broadly.

External audits and regulatory oversight are essential pieces of any regulatory architecture, albeit that experience with conventional companies says they provide no guarantees.

Segregation of customer funds should be another non-negotiable. Customer funds held by exchanges or other trading entities need to be held in trust and their use monitored by an authorised custodian to avoid what has occurred in FTX.

It is not clear that the use of FTX client monies to essentially gamble within Alameda is even illegal, given that FTX is registered in the Bahamas.

That suggests some thought might also have to be given to how to regulate offshore-based entities operating within regulated jurisdictions and probably leads towards eventual international harmonisation of regulatory efforts.

The anti-money laundering and “know your customer” requirements that are common in proposed regulatory frameworks are an attempt to remove the anonymity that cloaks and facilitates some of the sector’s less legitimate activities. They oughtn’t impact legitimate activity.

The immaturity and volatility of traded crypto assets is such that no level of regulation will insure against losses or malpractices but centuries of regulatory experience in traditional markets doesn’t do that anyway.

Loading

If FTX’s collapse means regulation that can bring more sunlight to bear on crypto markets and impose some core investor protections will be brought forward, that would be a good thing for investors and the credibility of the digital assets sector more broadly.

Bankman-Fried might have torched billions of investor funds and destabilised and discredited the entire crypto sector but the collapse of his group and his paper wealth – once estimated at more than $US26 billion – might ultimately produce something positive for the sector’s survivors.

The Business Briefing newsletter delivers major stories, exclusive coverage and expert opinion. Sign up to get it every weekday morning.

Source link