FTX: The Aftermath - New Regulations?

By JamesIrving | Legal Mongrel | 28 Nov 2022


 

Sam Bankman-Fried, Photo by Cointelegraph

In the immediate aftermath of the11 November 2022 filing for bankruptcy by Bahamas-based FTX, at the time one of the world’s largest cryptocurrency exchanges, there has been a lot of discussion about what will happen next. Some mainstream media commentators have taken the opportunity to express open hostility to the cryptocurrency economy generally, of the “See I told you so, crypto is poison” variety. Many people are suggesting that this spectacular failure will prompt governments around the world to regulate cryptocurrency exchanges more strongly in some as-yet unknown ways.

In this post, I will consider some of the possible forms that such regulation might take. At this early stage, however - only days after FTX’s collapse - it is impossible to know precisely what kinds of new regulations might be developed and implemented by governments. It is possible, however, to sketch out a number of the most likely areas that governments will consider during this process.

Before I look at these possibilities, let's acknowledge the pain that was inflicted on thousands of ordinary investors by the FTX collapse. If you have time, please check out the personal stories published anonymously by @coinfessions on Twitter. A lot of FTX customers did not have the sophistication to own and use hardware wallets to house their crypto keys, and left five- and six-figure amounts sitting in their trading wallets on FTX, in some cases their entire life savings, all of which is now inaccessible for most of these people. For many of these investors, the FTX collapse has been a devastating personal disaster. It will probably also scare many potential new customers away from the crypto scene, which will be a bad outcome for the crypto economy overall. There is a lesson here for everyone.

Possible areas of new/extended regulation

The first thing worth noting is that the regulatory problem does not lie only with cryptocurrency exchanges, but rather with cryptocurrency custodians, which includes exchanges like FTX which offer trading wallet services but also includes any other type of entity that holds a customer’s crypto coins for them. It is possible that governments will implement a number of new controls on cryptocurrency custodians (in countries where these don't yet exist), including:

  • requiring custodians to be insured;
  • requiring custodians to prepare and implement a loss mitigation strategy;
  • imposing accounting standards and random inspections by government auditors;
  • barring custodians from making loans to related parties;
  • requiring custodians to follow an industry code of practice;
  • requiring custodians to comply with security standards for business-related communications;
  • imposing minimum liquidity requirements; and
  • placing restrictions on the issuing of “native tokens” by custodians.

Many of these types of controls are already present in the banking and insurance sectors, which probably will be the models that governments will turn to when considering what might work in the crypto industry. Many of these things would have triggered warning signals in the FTX case, had they existed.

Time for a new approach by governments?

Governments could also change their approach to cryptocurrency regulation, in the wake of the FTX collapse. For example, instead of trying to regulate cryptocurrencies through securities or commodities regulators, and giving those agencies more things to do, governments could instead create dedicated cryptocurrency regulators. Such agencies could be staffed by personnel with industry experience, in which case they might be more suited to the job of understanding and regulating the crypto universe.

It is not possible to know exactly when new crypto exchange regulations will be prepared and implemented, but it is likely that some responses will be put into place as soon as possible, and others will be developed after FTX-related investigations and bankruptcy proceedings have been completed, so that any lessons that can be derived from that experience have been identified. Some governments, such as the Australian Government, have already announced that they plan to regulate cryptocurrency exchanges during 2023: see this article by Jody McDonald and Johanna Leggatt for Forbes Advisor. That is a likely timeframe for many new regulations: the next 12 months. Other governments have not yet made any official comments. The likelihood is that, as in any other area of regulation, once one government develops new regulations for cryptocurrency exchanges, other governments will follow suit.

Information and decentralization

Two other features of the FTX collapse are worth pointing out. One is that there was an information vacuum, with many ordinary investors not understanding what was happening to the crypto coins that were in their FTX trading wallets, which is bad for the crypto industry overall. The Guardian of Nigeria describes the situation in these words:

One thing is certain – these past few weeks have been a black one for the digital asset industry at large. Although that’s something we can all agree on, the random news breaks and the lack of a centralized source means that most individuals have still not gotten a vivid understanding of the causes, impacts, and future implications of the FTX collapse.

The other feature is that FTX was a centralized exchange, and its collapse may have boosted the value of the decentralized exchange model, which could be less susceptible to the problems that brought down FTX. A debate has started on whether decentralized solutions will work.

CryptoVantage, in an online article by Simon Chandler (16 Nov 2022), suggests that DEXs may have been the “big winners” of the FTX collapse, with a significant flow of crypto assets moving from centralized to decentralized exchanges in the days immediately following the FTX collapse. Other commentators are unenthusiastic about the practicality of decentralized custody solutions. Writing for NBC News, Rob Wile (22 Nov 2022) notes that having a offline wallet and generating your own keys is a well-known solution for crypto self-custody, but is “not particularly easy to do” and may be difficult for many people to implement.

Whatever happens next, it is obvious that the FTX collapse is a historical moment in the development of the crypto industry. And, while it is also obvious that governments cannot ignore the harm that has been inflicted on thousands of investors and must respond in some manner, it is also obvious - I think - that inappropriate regulation could also cause harm, and therefore that any government responses must be well crafted. Writing for The Globe and Mail - Opinion: Despite FTX implosion, overzealous crypto enforcement is not the answer - lawyer Adam Chisholm points out that poorly designed regulatory strategies will themselves result in new problems. He says:

Effective regulation of cryptocurrency and other blockchain activities, however, requires well-known rules and international co-operation – not just enforcement. Without these traits, even well-intentioned securities regulatory enforcement efforts with respect to cryptocurrency and blockchain activities are unduly discretionary, discriminatory and ineffective.

A smart way for governments to proceed with new crypto exchange regulations would be to publish white papers and create a forum for public comments. What actually happens will depend, as usual, on political pressures. Watch this space, as they say.

UPDATE [December 12, 2022] - In this post, I have focused on expected reactions by governments to the FTX collapse. I should add that both in the EU and the US (and in other jurisdictions), initiatives are already underway to regulate cryptocurrencies generally. In the US, President Biden issued Executive Order 14067 on March 9, 2022, setting out a policy priorities for "responsible development of digital assets". In the US Congress, there are a number of Bills that have been introduced which aspire to regulate crypto in some way. In the EU, the European Council on October 5, 2022 approved a regulation called MiCA (Markets in Crypto-Assets) which should come into force 18 months later: see this summary by WH Partners of Malta. All of these legislative approaches to crypto regulation, proposed or in the process of implementation, will probably now be reassessed by governments or their proponents to see if they address the problems identified with the FTX collapse.]

[Photo credit Sam Bankman-Fried (2021), the former FTX CEO, by Cointelegraph, a public domain image courtesy of Wikimedia Commons. The thumbnail image (prior to addition of the article title) is supplied for public use by FTX Exchange as part of its media kit: see https://help.ftx.com/hc/en-us/articles/360036096791-Media-Kit. This post is a an educational and informational discussion of legal concepts. It does not constitute legal advice for any person, nor does it create a lawyer/client relationship with any person. Although care has been taken to ensure that the law is described correctly at the time of publication, no guarantee of accuracy is provided. The author is a lawyer involved in blockchain projects.]

 

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JamesIrving
JamesIrving

I'm interested in new technology, especially blockchain. I'm a lawyer for some blockchain projects.


Legal Mongrel
Legal Mongrel

Commentary and analysis - legal and other.

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