Would Crypto Regulation Have Prevented FTX Collapse?

December 19, 2022 Profitable Investing Tips

First of all, a large crypto exchange, FTX, experiences the equivalent of a run on a bank, loses money, and files for Chapter 11 bankruptcy. Then, as the story progresses, we find that the owner may have been playing fast and loose with client money and has been arrested on charges of fraud. In the background is the issue of regulation of cryptocurrencies and President Biden’s executive order to Federal agencies to get their houses in order so that an efficient and effective system of cryptocurrency regulation can be devised.

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FTX Collapse vs FTX Fraud and Whether Regulation Would Have Helped

Crypto regulation is coming but would crypto regulation have prevented the FTX collapse and, for that matter, would crypto regulation have prevented fraud allegedly committed by Sam Bankman-Fried and others with client assets? These are two separate issues as we see it. Today we are concerned about regulation and the FTX collapse and in our next article we will address the issue of FTX fraud allegations and whether or not regulation would have made any difference.

Regulation after the Financial Crisis as a Model for Crypto Regulation

During and following the 2008 Financial Crisis President Bush and then President Obama signed into law measures to help deal with the crisis and prevent its recurrence. These were the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Emergency Economic Stabilization Act. Subsequently many have complained about the “undue burden” imposed by such regulation. But if these laws had been in place before 2008 the worst economic collapse since the Great Depression would have been avoided. One of the Dodd-Frank measures is stress tests for banks and large insurance companies. These yearly assessments carried out by the Federal Reserve test possible scenarios to see if these institutions could survive likely financial shocks. The Consumer Financial Protection Bureau was formed to protect consumers from risky financial products. Both of these approaches seem likely candidates as crypto regulation goes forward.

FTX and the Shape of Crypto Regulation to Come

The crypto world has unraveled over the last year and fallen into a severe crypto winter. Aside from the drastic fall in crypto token values, the first hint of major problems came with the collapse of the Luna and TerraUSD cryptocurrencies followed by the Three Arrows crypto hedge fund. Because the crypto world is very closely interconnected, this may actually have been the start and primary source of the FTX collapse. It remains to be seen if Bankman-Fried and others siphoned off enough wealth to make a difference in the collapse of the company. While financial issues can come on rapidly, longer term issues can be picked up by financial audits. All publicly traded companies must submit to a yearly audit of their financial statements by an independent auditor. Because the new CEO of FTX who is shepherding the company through bankruptcy says that bookkeeping was virtually nonexistent for years, this simple requirement of all companies listed on US stock exchanges could perhaps have helped avoid the problems that evolved at FTX. It would not have helped FTX so much as investors who would not have lent them money and customers who would have avoided their tokens!

Does the Crypto Realm Need a Volcker Rule?

Another thing that came online after 2008 was the Volcker rule which bars banks from speculative trading activities. It was named after former Fed Chair Paul Volcker. It bars banks from what is called proprietary trading. Their agents cannot buy and sell commodity futures, options, derivatives, or securities within the bank’s accounts. Doing exactly this is a large part of what brought on the Financial Crisis. In the case of FTX, their Alameda arm was engaged in crypto trading. They were not firewalled by the rest of the company and, in fact, crypto assets from FTX found their way into Alameda and were said to be part of their collection of assets instead of “in-house” loans. Regulators need to decide if crypto exchanges are more like banks in which case, they should not be doing any trading or more like companies that trade risky assets in which case they need to be regulated as such.

It is our opinion that proper regulation would have at least softened the blow to FTX even if it had not prevented the collapse of the company in the midst of the crypto winter.