28 Nov 2022

FTX and the need to be careful regarding crypto regulation

Syed Rahman advises against a knee-jerk regulatory response to the collapse of the world's second-largest crypto exchange

The cryptocurrency world has often been compared to the wild west, thanks largely to an image of anything goes that has been fuelled by a number of high-profile controversies. 

The latest of these is the collapse of FTX – which had been the world’s second-largest crypto exchange – which has left billions unaccounted for, FTX plus 130 associated companies in liquidation and heavy law enforcement interest from a number of countries. And while it is early days in this particular tale from the wild west, it has already boosted previously-voiced arguments that the crypto world is in urgent need of a strong sheriff.

John Ray III, a hugely-experienced insolvency professional who oversaw the liquidation of Enron, said in a US court filing on 17 November that FTX was the worst case of corporate failure that he had seen in more than 40 years. 

Ray, who took over as CEO after the $32 billion crypto exchange’s collapse, made it clear he had never seen “such a complete failure of corporate controls and such a complete absence of trustworthy financial information’’. He has cited “compromised systems integrity”, “faulty regulatory oversight” and a “concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals” in the filing to the federal bankruptcy court in Delaware. Not to mention a lack of proper bookkeeping, records or security controls for the digital assets it held for customers, the use of software to “conceal the misuse of customer funds” and a failure to have accurate lists of even its bank accounts or staff.

The contents of the court filing read like evidence in a criminal case rather than the procedural paperwork in a civil law matter. Which is, lest we forget, what the FTX catastrophe is at this stage. The filing is, therefore, the perfect ammunition for those who argue that there needs to be more regulatory oversight of cryptocurrencies.

Huge legal and financial problems are followed quickly by very strong opinions being voiced on what could have been done to prevent them

Many huge legal and financial problems are followed quickly by very strong opinions being voiced on what could have been done to prevent them and what actions have to be taken now to ensure there is no repeat. It is perfectly understandable that this happens in the wake of FTX’s multi-billion collapse – and I am one of those who has opinions on what needs to be done. But any action that is taken regarding the crypto sector needs to be considered and carried out very carefully.

Any rushed introduction of sweeping regulation for cryptocurrency may be seen by many as likely to have a number of positive effects. The markets may be bolstered. Some all-important trust may be regained by the products on offer and, by implication, by those promoting them and the exchanges and other institutions that facilitate such activity. 

But regulators will need to be careful in their approach. Any knee-jerk reaction to the problems or a one-size-fits-all approach may risk damaging the cryptocurrency sector at a time when it already has a challenge on its hands to convince many that it deserves their attention and investment. 

Crypto is a fast-evolving space. While there may be a need to counter the rogue elements within it, any regulation that acts as a hindrance to innovation will not help at all. Regulation that strips the crypto ecosystem of the creativity that has brought it this far would be doing it a great disservice. While there are clear problems that need to be addressed, a ham-fisted regulatory approach that is ushered in as a panic measure and/or as a need to be seen to be doing something would be a classic case of one step forwards, two steps back. 

What also needs to be recognised is that adopting new legislation to deal with crypto could well be a double-edged sword. Any legislation that creates a crypto regulatory framework could create opportunities where traditional finance ends up migrating into the new regime. This could result in the large-scale sidestepping of existing financial regulation, which would create its own problems – and may have a larger damaging effect on the broader economy than any crypto-related crisis.

Make no mistake, what has happened at FTX has come as a shock to many (although not all) observers. But it should not be used as a big stick to clumsily beat the whole cryptocurrency sector. The consequences of that could be even more shocking.

Syed Rahman is a partner at London financial crime specialists firm Rahman Ravelli
 

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