Cryptocurrency Regulation Post FTX
R Tamara de Silva
The fall of the FTX Exchange and its affiliate Alameda Research from having a valuation of $32 billion to bankruptcy, rapidly followed by the indictment of its founder, Sam Bankman-Fried (SBF), and principals, has been nothing short of spectacular. Skeptics of cryptocurrency, along with those with little knowledge of digital assets have been vindicated in cynicism of all things cryptocurrency. The events of FTX have also affected lawmakers and regulators’ view of cryptocurrency and digital assets. Despite the events at FTX, any future regulation of cryptocurrency, if it is to occur at all, must take place with caution given the complexity of what effective regulation will require, and the decentralized nature of cryptocurrency.
If we were to take every allegation in the indictment of the U.S. Attorney for the Southern District of New York, the complaints of the U.S. Securities and Exchange Commission (SEC) and that of the U.S. Commodity Futures Trading Commission (CFTC) as true, (though Mr. Bankman-Fried remains entitled to the presumption of innocence), the facts alleged point to a conspiracy to defraud the customers of FTX. The fall of FTX and Alameda Research is due not to the inherent nature of cryptocurrency but, as stated in the goverment’s charging instruments, misconduct on the part of the principals of FTX and Alameda Research. It could also be caused, in addition to the fraudulent conduct alleged and the lack of internal controls, to a fundamental mismanagement of risk and a gross misunderstanding of market risk. The latter seems plausible by Mr. Bankman-Fried’s own words in an interview with Andrew Ross-Sorkin, days before his arrest. Listening to SBF’s interview one is reminded of other financial crises where large institutions, with internal risk departments and multiple risk controls, unlike in the case of FTX, were caught flat footed when faced with market scenarios their risk models did not anticipate. Like in the FTX, all of these failures were endogenous to the management of FTX and not a reflection on digital assets or cryptocurrency writ large.
Infact, the operations of FTX have none of the characteristics of transactions on a decentralized network that offer transparency, immutability and no single point of failure. FTX’s transactions were not on a blockchain but tracked on FTX and Alameda’s internal ledgers.
What is a blockchain
A blockchain is simple terms is a shared accounting ledger that uses cryptography and a network of computers to store assets and secure the ledger from tampering. Bitcoin transactions, before Bitcoin was tradable on regulated U.S. trading exchanges, were the first cryptocurrency transactions to occur on a blockchain. Through a mix of game theory and cryptography, Bitcoin replicates the financial system’s ability to transfer value, but without any of the labor typically involved in settling and running transactions and without the costs of having third party intermediaries like a bank and financial firm.
Transactions on a blockchain are transparent, immutable and nearly impossible to tamper with. While no regulation can wholly prevent a bad actor determined to commit fraud, had transactions at FTX been on an auditable and transparent decentralized platform, the fall of FTX may not have happened. Had FTX held customer deposits on a blockchain, their customers would know at all times where their assets were.
Another alternative to this, is presented in the case of FTX’s affiliated U.S. exchange, LedgerX, LLC (LedgerX). LedgerX was registered and regulated by the CFTC as a designated contract market (DCM), swap execution facility (SEF), and derivatives clearing organization (DCO). It remains solvent after the bankruptcy of FTX and 130 affiliated entities. LedgerX, because of its compliance with the bedrock fundamentals of the commodity markets, kept customer funds segregated and securely walled off from other assets. Alameda Research was never able to use customer funds in LedgerX to fund its trading and market maker activities.
Many public reports indicate that segregation and customer security failures at the bankrupt FTX entities resulted in huge amounts of FTX customer funds being misappropriated by Alameda for its proprietary trading. But the customer property at LedgerX –the CFTC regulated entity – has remained exactly where it should be, segregated and secure. This is regulation working.
CFTC regulations further require that LedgerX be completely walled off from the otherunregulated FTX entities in order to properly protect customer property. To that end, as part of the ongoing bankruptcy, FTX has reported that LedgerX holds more cash than all the other FTX debtor entities combined.
Testimony of Rostin Behnam, Chairman of the CFTC before the U.S. Senate Committee on Agriculture, Nutrition and Forestry 12/1/22
LedgerX was also subject to CFTC regulations of contract markets such as the maintenance of accurate records and books that are subject to audit and inspection by the National Futures Association (NFA) at any time, an annual independent certified audit, and the maintenance and posting of adequate capital to cover a year’s worth of the firm’s operating expenses. The CFTC also required that LedgerX was completely walled off from other non-regulated FTX entities.
What LedgerX illustrates is how well the derivatives markets, regulated by the CFTC function and how well they have historically protected customer funds (other than the isolated case of Jon Corzine at MF Global, which again was one bad actor who deliberately decided to break the law).
Where the analogy ceases to apply to other crytocurrency exchanges and other cryptocurrencies is decentralization itself. There is a complexity of regulating the cryptocurrency market that the existing regulatory regimes of the CFTC and SEC do not address. The technology behind decentralized assets is still relatively nascent and neither the SEC not the CFTC has a comprehensive regulatory regime established to regulate them.
Preserving the Nature of Decentralization
In tradition markets, the functions of trading, establishing margin, issuing securities, their clearing and settlement are all performed by separate entities in different silos. In a peer to peer Bitcoin transaction, the trading and settlement and clearing of the transaction takes place without any of the above mentioned third party intermediaries without either party knowing or needing to know the other. To break apart a decentralized transaction in order to make it fit into the separate silos of tradition market structures would be to destroy its decentralized nature and the benefits offered by decentralization (ie.the security, the lack of intermediaries; less labor, time, and costs/fees).
The challenge for regulation is to regulate cryptocurrency without making it something it is not and thereby either destroying it, or outlawing an entire technology because you cannot think of a way to regulate it. No regulation is better than destruction of the industry or outlawing it completely because digital assets have value. You cannot at a moments notice pick up and travel with $100,000 million in gold or real estate, but you can take that amount of Bitcoin with you wherever you go. Blockchain and decentralized technology has the potential to make all financial transactions cheaper and safer by getting rid of all third party intermediaries- among its many other use cases.
Regulation by Enforcement
The way cryptocurrency is currently regulated, through a patchwork of regulation amongst competing federal agencies is not the answer either. A full discussion of the regulatory framework and its history is outside the scope of this article so I will skip to highly abbreviated summation of the state of the law. At the federal level, there are three regulators, the SEC, the CFTC and the Financial Crimes Enforcement Network, a bureau of the U.S. Department of Treasury (FinCEN). There is wide variance between the states regarding cryptocurrencies and crypto firms ranging from having no regulation, some regulation, to active regulation. The SEC and the CFTC have been having an argument about what constitutes a currency and is subject to regulation by the CFTC, and what constitutes a security and is subject to regulation by the SEC. This argument retains ambiguity about one of the most used cryptocurrencies, ether. The lack a comprehensive framework and ambiguity have not stopped the SEC from taking enforcement actions against industry participants.
Instead the Commission has tried to cobble together a regulatory framework through enforcement actions. Enforcement is the appropriate tool to address the rampant fraud in the crypto space. One-off enforcement actions that represent the first time the Commission has addressed a particular issue publicly, however, are not the right way to build a regulatory framework.
This lack of clarity has not only created uncertainty in the industry, but is also no substitute for a regulatory framework that would protect the investing American public. The industry has long been asking for guidance.
The SEC relies on a U.S. Supreme Court case concerning the sale of parcels of citrus grove in Florida, to determine if the sale of a cryptocurrency constitutes the creation of an “investment contract.” This determination is made by the scrutiny of 4 factors called the Howey test (after the case). Under the Howey test, an investment contract exists when there is the investment of money, in a common enterprise, with a reasonable expectation of profits to be derived, from the efforts of others. There is substantial ambiguity in the application of this test for issuers of digital assets and marketers to determine if the digital asset is a security.
For cryptocurrency exchanges, there is no clear path forward for registration with the SEC. Currently the most widely used cryptocurrency exchanges; Coinbase, Kraken and Binance.US are regulated on a state by state level as money transmitters and required by FinCEN to register as money service businesses (MBSs). PayPal is also a money transmitter as are Western Union and MoneyGram.
The problem with this is money transmitters lack the safeguards of CFTC and SEC regulated brokerage firms. Money centers take custody of client assets but they lack the powerful regulatory protections of customer segregated funds that futures commission merchants (FCMs) have under the CFTC. There are not necessarily adequately capitalized or independently audited, and otherwise lack the regulatory safeguards of traditionally regulated brokerage firms.
A Path Forward
What may arguably be worse than a regulation by enforcement, is the creation of a regulatory framework of an already complex industry and technology, written by lawmakers who do not understand the industry or its nuances. One way to start would be to ask all industry participants to enact best practices that would seek to emulate the protections of customer funds and the avoidance of conflicts of interests seen in their CFTC and SEC regulated counterparts. For example, cryptocurrency exchanges that have custody of client funds, should try to mimick the custodial practices of brokerage firms in the futures industry.
Users of crypto exchanges should always ask and understand what they are allowing an exchange to do with their money. As a general principal exchanges that have custodial functions should not also borrow and lend with customers. Proprietary firm trading should be ring-fenced from customer accounts. Enable proof of reserves that takes into account a firm’s liabilities. Educate independent auditors on how to audit cryptocurrency exchanges-this may take time. And perhaps in the long run, use blockchain technology itself to form a regulatory framework-after taking into account the guidance of the industry participants. Above all, no regulation by haste.