The collapse of FTX, the the second largest crypto exchange in the world, raises big questions about the viability of cryptocurrency and the state of America’s financial regulatory system. While the debate over whether the collapse of FTX means that crypto should be more regulated or kept further away from the regulatory safety net, we must ensure that those who may have broken the law in FTX are aggressively prosecuted. The inability to prosecute individuals who have broken the law is a key lesson from the last financial crisis that we must not forget as we enter the crypto crisis.
It’s clear that the global financial crisis of 2008 continues to shape the reaction to what some are calling crypto’s “Lehman Brothers moment.” More accurate analogies for FTX, however, are massive corporate frauds such as Enron, Tyco, and MCI WorldCom. These firms have prepared their books, as FTX appears likely to have done. FTX’s misdeeds seem closer to Bernie Madoff’s ponzi scheme and MF Global’s illegal use of client money to fund its own speculative investments.
For those who argue that more crypto regulation would have prevented the FTX implosion, remember that MF Global, Lehman Brothers and Bear Sterns were all regulated by the Securities and Exchange Commission (SEC). Similarly, Bernie Madoff, who ran the largest Ponzi scheme in American history at the time, was well known to regulators as was chairman of the NASDAQ stock exchange. FTX was also not outside the US financial regulatory system, was licensed and registered with the Commodity Futures Trading Commission (CFTC). There is no guarantee that if FTX had been more closely regulated it would not have stolen client funds like MF Global or possibly run a ponzi scheme like Madoff. After all, regulation alone cannot stop people from acting illegally and unethically. Laws define what is illegal, but law enforcement agencies have a duty to catch and prosecute criminals.
Congressional decision to hold hearings uncovering facts, exposing wrongdoing and gathering evidence for prosecution is the right first step. These hearings are likely to reveal more abuses in the crypto space. A potential domino contagion within crypto is entirely possible, witness another crypto exchange BlockFi suspends buybacks as a result of the collapse of FTX. When consumer confidence is shaken, investors will flee. The lack of regulatory safeguards and transparency in relation to other crypto exchanges and currencies may mean that FTX is not the last or even the biggest player to fail. Remember after Enron switched to MCIWorldComm, after Lehman switched to AIG.
How should the government respond? Enron executives went to jail. So Bernie Madoff did. Almost though no bank executive was personally prosecuted since the financial crisis, despite widespread misconduct. This was a major mistake in ensuring greater public trust and accountability in the way our financial system operates.
FTX is a critical opportunity for the government to get it right. Even if prosecution is more of a challenge because the status of crypto under the law is unclear and FTX operated through multiple offshore entities, it is critical that the government uses every possible mechanism to ensure personal accountability when there is illegal activity and the money of investors are stolen. One of the reasons given during the financial crisis for the lack of prosecutions was that prosecutors were afraid of losing cases. It is far better for the public to see the government try and fail a prosecution than to not try at all. If the laws are not enough to convict, then unsuccessful prosecutions will help build political support for changing the law.
Will Congress Act to Regulate Crypto? There was growing bipartisan support for draft law of stablecoins and for crypto exchanges. These proposals need to be fundamentally rethought as a result of the FTX implosion. a lot to the left and I want right to keep cryptocurrencies out of the regulatory system. FTX’s implosion could justify keeping crypto out of the regulated system, just as its implosion could be argued to mean regulation is more urgently needed.
Crypto remains in the underground world of financial regulation, caught between the traditional definitions of securities, commodities, assets, money and payments. As former CFTC Chairman Tim Massad pointed out the fragmentation problems of our regulatory system back in 2019, he wrote that while the Securities and Exchange Commission and the CFTC have: “some authority over crypto-assets, neither has sufficient jurisdiction nor together.” Although the cryptocurrency’s popularity exploded between Massad’s paper and the FTX implosion, no new regulatory powers were given to either agency. Federal banking regulators have generally tried to keep cryptocurrency out of the regulatory system, which so far appears to have limited the contagion from the FTX implosion to the broader financial system. New York’s financial regulator never gave FTX the necessary license to operate in the Empire State, a decision that saved New Yorkers a lot of money. Sometimes the correct answer to the regulator is no.
Congress should not rush to regulate cryptocurrencies, nor treat the industry broadly, assuming all crypto is as corrupt as FTX appears to be. As lawmakers take the time to figure out what the right regulatory system is, prosecutors need to step up. Americans lost a lot of money in FTX, just as they did in many other large corporations that broke the law. People must be held accountable to restore faith in the system. Let’s do a better job this time than we did in 2008.
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