Regulation with Hindsight: Will the FTX Turmoil Cause Regulators to Rethink?

The collapse of FTX started when Binance made an announcement on November 10, stating that the firm officially abandoned the intent to acquire FTX​. After that, worse news about the company kept coming. Last Friday, FTX filed for bankruptcy protection​, and its Cheif Executive Sam Bankman-Fried resigned. FTX US, FTX's crypto hedge fund Alameda and about 130 other sister companies are included in the Chapter 11 proceedings.

Companies are in a rush to disassociate themselves from FTX. Payments company Visa has elected to terminate global agreements with FTX. Kraken has taken steps to freeze verified accounts on its platform belonging to FTX Group​, Alameda Research and their executives. Even the bankrupt crypto lender Voyager Digital is ending the deal to sell itself to FTX US.

Moreover, regulators are also taking actions against the beleaguered cryptocurrency exchange. Although these actions are to some extent an afterthought for cryptocurrency investors.

Bahamas, Japan and Cyprus Take Actions, But with Hindsight

On November 10, the financial market regulator of the Bahamas has frozen the assets of FTX Digital Markets, the Bahamian subsidiary of FTX Trading and operates as the global crypto trading platform, FTX.com.

"The commission is aware of public statements suggesting that clients' assets were mishandled, mismanaged and/or transferred to Alameda Research. Based on the commission's information, any such actions would have been contrary to normal governance, without client consent and potentially unlawful," the Bahamian regulator stated.

In addition, the Financial Services Agency, or FSA, of Japan has requested FTX Japan suspend business orders​. In a Nov. 10 announcement, the FSA said it had taken administrative actions against FTX Japan following FTX Trading Limited's suspension of withdrawals "without explaining the reasons clearly to investors."

The financial regulator said it had issued suspension orders and business improvement orders in accordance with Japan's Payment Services Act and Financial Instruments and Exchange Act. It has ordered the local subsidiary of FTX to suspend operations until 9 December.

Cyprus's Securities and Exchange Commission also asked FTX EU to suspend its operations. FTX had announced in September that it had received approval from the Cypriot regulator to operate as a Cyprus Investment Firm.

"The company is regulated by CySEC under the provision of Investment Services Law and is authorised to provide investment services in Derivatives and/or other financial instruments. However, it is not licensed by CySEC to engage in the direct trading of crypto assets," CySEC said.

These regulators moved quickly, taking measures less than a day after the FTX crisis. But does these ex post facto actions make sense to investors? 

For example, Japanese authorities have been deregulating the cryptocurrency industry in an effort to spur economic growth. The consequence, however, is that FTX's Japanese investors will have to accept the fact that their assets, approximately 19.6 billion yen ($140 million) in cash and deposits owned by FTX Japan, could disappear forever.

In fact, back in September this year, the British financial market supervisor, the Financial Conduct Authority (FCA), has flagged FTX​, which may be more protective for investors.

Too Little, Too Late—Actions Against Cryptocurrency Companies

We have already witnessed a lot of crypto platforms suffering from the tolls taken by the crypto winter this year, which caused huge losses for crypto investors. Particularly, crypto hedge fund Three Arrows Capital, which is also known as 3AC, received billions of dollars in loans without providing audited financial reports and then collapsed for failure to pay back the loan. Its failure then contributed to a broader liquidity crisis that has rippled through crypto markets.

What's worse than institutions taking excessive risk with client money is that investors don't know the risk. Investors often do not understand the basic information they need to protect themselves.

This stems from the fact that some regulators do not explicitly require crypto companies in terms of transparency, such as timely public disclosure of price, volume and other transaction data about crypto assets, establishing risk control systems, having good financial standing and management capabilities, and having at least the financial resources needed to meet eventual orderly wind-down.

As we all know, the quick death of FTX is essentially attributed to the exposure of the Alameda Research crisis​, where people found out that most of Alameda's assets were FTTs. After FTX issued FTT, Alameda acquired FTT coins at a low price, used them for financing, and then loaned money from FTX where the loan was actually the customer funds. In this way, FTX transferred 10 billion customer funds to Alameda, which finally led to the bankruptcy situation.

However, this might not have happened if regulators had imposed restrictions on the improper use of customer funds by exchanges, required that customer assets held in custody by crypto-asset exchanges be managed separately from self-held assets, and prohibited the use of customer assets as margin, collateral or security to others or for other purposes.

Regulation Should be a Firewall Rather than an Afterthought

Pairing the opportunities of the asset with forward-looking regulation is a hurdle not yet tackled by many governments. But the recent crypto turmoil has forced them to start taking it seriously.

"The administration has consistently maintained that without proper oversight, cryptocurrencies risk harming everyday Americans," White House Press Secretary Karine Jean-Pierre said. "The most recent news further underscores these concerns and highlights why prudent regulation of cryptocurrencies is indeed needed."

To rebuild investor confidence, what the crypto industry needs to do is not promising super high yields, recreating the opaqueness that exists in traditional banking, or adopting traditional measures such as Chapter 11 bankruptcy. The most promising way forward is to use the lessons learned from the crises in traditional finance and crypto to drive adoption through risk management and transparency, leaving the failing companies behind. The implementation of strict policies by regulators is the fastest and most effective way to achieve this goal.

Some countries, such as China, the Unites States, South Korea and UK ,have strict rules and regulations pertaining to the cryptocurrency exchanges.

We should probably say there is no cryptocurrency regulation whatsoever in China (excluding two SARs, Hong Kong and Macau, where financial regulations are different and independent), because the digital assets are completely outlawed within its border. In June 2021, China banned all domestic cryptocurrency mining, and followed-up by outlawing cryptocurrencies outright in September 2021. The new regulation effectively banned the use of all cryptocurrency exchanges (foreign and domestic).

In the US, the Commodities Futures Trading Commission (CFTC) regulate crypto by continuing seeing it as a type of commodities. In addition, the US Securities and Exchange Commission (SEC) requires that all virtual currencies being traded within the U.S. shall be lawfully registered. Both the Financial Crimes Enforcement Network (FinCEN), affiliated to the Treasury, and the Internal Revenue Service (IRS), have laid out transparency and taxation requirements.

In South Korea, cryptocurrency exchange regulations are strict​ and involve government registration and other measures overseen by the South Korean Financial Supervisory Service (FSS). In 2017, the South Korean government prohibited the use of anonymous accounts in cryptocurrency trading and banned local financial institutes from hosting trades of Bitcoin futures. Similarly, the Financial Services Commission (FSC) imposes strict reporting obligations on banks with accounts held by crypto exchanges.

In the UK, cryptocurrencies are not classified as legal tender, and exchanges and other providers must register with the FCA to be allowed to operate in the jurisdiction. In addition, the regulator remains strict about crypto promotions to retail investors and continues to warn of the dangers the industry poses to consumers.