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FTX collapse fans flames of crypto regulation debate

Bitcoin crypto currency burning under fire value diminishing 3D

The wildfire provoked by the exchange's downfall last week demonstrates yet again the pressing need for regulators to act

If you haven’t heard of the FTX crash last week, you’ve probably been living under a rock. The consequences of this unprecedented fiasco are many and varied, but a key aspect is the extent to which it has evidenced once more the soaring need for better regulation and transparency in the digital asset space.

Multiple US regulators have already come forward and expressed views to that effect – including the Federal Reserve’s vice chair for supervision Michael Barr, who yesterday told the Senate committee on banking, housing and urban affairs that tougher supervision of digital assets was imminent. “[The sector] requires effective oversight that includes safeguards to ensure that crypto companies are subject to similar regulatory safeguards as other financial services providers,” he said during the hearing.

Speaking of his organisation’s priorities before the same committee, acting comptroller of the currency Michael Hsu said that as the digitalisation of banking accelerates and bank-fintech partnerships grow, the Office of the Comptroller of the Currency (OCC) should focus on adapting its expertise and regulatory framework to ensure that the safety, soundness, and fairness of banking are maintained, or in fact strengthened.

“With regards to crypto, the OCC has adopted a ‘careful and cautious’ approach,” he said. “Last November, we issued guidance which reminds the banks we supervise that they are not permitted to engage in certain crypto activities unless they can perform those activities in a safe and sound manner.”

This approach, Hsu added, has helped to mitigate the risk of contagion from crypto to the federal banking system following the Terra/Luna collapse earlier this year, as well as limit the fallout from the FTX bankruptcy. He also reiterated that the OCC would establish an Office of Financial Technology early next year, building on the work of the Office of Innovation launched in 2016.

“This change will enable us to engage more substantively with non-bank technology firms and to better supervise bank-fintech partnerships so that we can help ensure that consumers of banking services are treated fairly, as well as help maintain a level playing field as the industry evolves,” he added.

Meanwhile, in Europe, Germany’s Federal Financial Supervisory Authority (BaFin) president Mark Branson spoke of the need for a set of rules to be adopted globally before crypto becomes too intertwined with traditional finance and starts posing serious financial stability threats. “The recent crash in digital assets was well-timed given [those] ties are still limited, [but] crypto assets need to be subject to global rules if they’re adopted by mainstream finance and expose banks and a wider swathe of investors to risk,” he said during an industry event in Frankfurt.

On the day of FTX’s official collapse, the Financial Stability Board published a note saying its consultative group for Europe had met in Lisbon to discuss global and regional economic and financial market developments, including the need to promote consistent and effective regulation of crypto assets and stablecoins.

“The Binance/FTX situation demonstrates that these new kinds of financial institutions have the same challenges as existing ones,” said Mercedes Tunstall, partner at Cadwalader. “Maintaining the faith of your customers, investors, and the public at large, is more important than just about anything else, and even a suggestion that the trust is misplaced can cause catastrophic problems.”

These kinds of public lessons show that the cryptocurrency market is beginning to mature, which will likely produce increased scrutiny, Tunstall argued. “Regulators are going to come under increasing pressure to act,” agreed firm co-partner Peter Malyshev.

Capitalising on the moment

Yet, for all the talk, many items in the digital asset regulatory framework debate remain at a standstill – especially in the US, where regulators are still trying to make up their mind on which agency should take the lead.

"The crypto asset market is overdue an effective and proportionate system of regulation, yet policymakers are again sleep walking into this crisis, either through ignorance or a slow pace of reaction,” said Etay Katz, partner at Ashurst. “This crisis should be the catalyst to structural changes in global regulation of the sector. Ultimately, crypto exchanges and brokers would benefit hugely from the legitimacy associated with a proportionate regulatory framework."

In the US, several draft bills have been floated over the past few months to address the issue, including the Lummis-Gillibrand bill – which one of its authors said in a Tweet this week would have helped to avoid the FTX disaster, had it been implemented.

“The Gensler SEC [Securities and Exchange Commission] has spent years saying there was no need for clarifying law and regulation in the space, as most crypto tokens are securities and firms such as FTX are essentially unlicensed securities exchanges,” said James Lovely, consultant at FPExpert. “To the extent that this is true, the SEC owns much of the cascading problems as to US investors and crypto. You can’t have it both ways: saying that these assets are securities and then when things fall apart, denying that you’re at least partially responsible for the rampant wave of securities fraud.”

Much of the serial collapses that have occurred in 2022, Lovely added, can be attributed to a paucity of enforcement from the SEC.

Defending his track record as SEC chair, Gary Gensler said in a CNBC interview last week that the agency had conducted 100 enforcement actions in the space under his and his predecessor’s leadership. The key issue, he argued, wasn't lack of regulation to regiment the space – but that many crypto asset firms fail to comply with existing rules.

“This is an industry that has regulation, which is often very clear, but it also an industry that is significantly non-compliant,” he said. “We have multiple paths, one of which is to work with crypto exchanges and lending platforms to get them properly registered so that the public is protected.”

Another path, Gensler added, is investor education. Agreeing nonetheless that the space should be more regulated, he called on industry participants to engage with the agency, saying that “the runway is getting shorter”.

“The American public and investors around the global are getting hurt by a field that has benefited from a lot of fancy talk [from] celebrities and celebrity CEOs and entrepreneurs,” he said. “The public can fall prey to promotions and marketing, but it is highly speculative. We have been very clear with folks in this industry that non-compliance is not going to work, and will continue on these paths if we need to, [being] the cop on the beat, going into court and putting the facts and law in front of judges.”

In an exemplary enforcement action, the SEC recently fined Kim Kardashian a whopping $1.26 million in penalties for promoting an EthereumMax crypto asset security on her social media channels without disclosing the payment she had received for doing so.

Some industry members, however, do agree that more regulation isn’t the answer to all woes in the crypto space.

“The whole reason [the FTX collapse] happened is because of unlawful, and quite possibly unethical, practices,” said a director at a crypto derivatives exchange. “When an investor deposits money into an exchange, that’s where the money should stay – this is already written in contracts, and regulation wouldn't help in that respect. However, more transparency on the company’s operations and practices most certainly would have made a difference, as people would have seen from the get-go that it wasn't safe to place their money in it.”

Whether or not further regulation is the key missing piece of the crypto puzzle, the cascade of events that unfolded over the past 10 days is, if nothing else, an indication that there should be some form of reckoning in the space.

“Cryptocurrencies in one form or another are here to stay and the crypto market is only set to grow, so it must come into the regulatory tent and be held to the same standards as the rest of the financial system,” said Nigel Green, CEO at financial advisory group DeVere. “Crypto doesn’t need saviours in the form of business leaders with their own interests at stake. What it does need, however, is for a robust and enforceable regulatory framework to be established and approved at an international level.”

Although crypto cynics and Bitcoin bashers may use the latest events to attack the booming sector, future-focused investors will understand that the inevitable destiny of finance is digital, Green argued. As such, regulators should use the momentum created by the FTX crash to truly advance the debate, or are the saying goes: they shouldn’t let a good crisis go to waste.

“Investors should appreciate the intrinsic value of digital, borderless, global currencies, which have already changed the way the world handles money, does business, makes transactions and manages assets,” said Green. “Industry participants and financial watchdogs must now seize this moment as a point of inflection and work together to further shore up the sector, and instill trust and transparency by means of sensible, workable regulation.”