HomeBlogFinanceFTX’s collapse underscores the need for regulating crypto

FTX’s collapse underscores the need for regulating crypto

Never let a good crisis go to waste. A near-existential disaster seems to have hit the cryptosphere: FTX, a big exchange that enjoyed a $32bn valuation in January, has collapsed with an $8bn hole. FTX’s founder, Sam Bankman-Fried — hitherto crypto’s friendly face — is mired in allegations that his firm misplaced or misused client money. Confidence in the wider crypto market — its stock-in-trade — has been badly hit, with bitcoin tumbling in value. The time for politicians, policymakers and regulators to put protections in place is now.

There is an attractive simplicity around crypto’s largely unregulated status: do not invest unless you are prepared to lose your shirt. It is a message easy for punters to understand. Whether they follow the advice is another question, faced with the siren call of easy wins promised by supermodels and sports stars in primetime adverts. Arguably, the current approach has helped ringfence crypto’s crisis from the rest of the financial system.

To improve on the status quo, there can be no half-measures. A spate of retail investment scandals have shown that regulating only parts of a firm’s business confers the sheen of respectability with none of the benefits. It is confusing for ordinary customers, who see that a firm may hold certain authorisations and wrongly assume that their investments are safe should things go wrong. Crypto investors should not be bailed out if bets on an asset with no intrinsic value go sour. Existing criminal laws can be applied to instances of fraud and theft. But there are simple improvements that could and should be made to protect consumers and the wider financial system against crypto’s riskiness.

The parts of the crypto ecosystem that touch the real world ought to have the most effective guardrails. This means that stablecoins, which claim to be underpinned by real-world assets as a way for traders to park their cash safely between bets, and exchanges such as FTX, ought both to be brought within regulators’ purview. At the very least, stablecoins should have to publish audited reserves to show that their claims are true.

Similar transparency should be imposed on exchanges. The head of Binance, FTX’s arch-rival and one-time mooted saviour, has said exchanges should now publish their proof of reserves. But that is of little use without also disclosing the other side of the ledger. Binance has so far declined to publish its liabilities.

Beyond its exchange services, FTX was busy lending, issuing tokens and brokering. Regulating crypto exchanges should stop intertwined functions that can lead to conflicts of interest and “hyper-correlated” risk, as Bankman-Fried described it. Regulation should also impose segregation of client assets to prevent the kind of lending out of other people’s money that FTX extended to its sister hedge fund.

The US, UK and EU have draft legislation to try to fill some of the gaps. But political gridlock and turf wars have stalled progress, certainly in the US. The heft of US markets and the long arm of its white-collar laws mean it is imperative that momentum is not lost.

It will be hard to impose rules on an industry that has purposefully set itself up outside them, out of principle and sometimes for more nefarious reasons. Smaller jurisdictions with light-touch regimes have provided a safe harbour, as they have with other areas of finance. That is undoubtedly problematic. But without steps from the largest and most powerful jurisdictions, arbitrage, charlatans and outright fraudsters will continue to proliferate. Waiting for the next, more consequential, crisis before acting may be too late.

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