The U.S. Government’s Regulatory Response to the Failure of FTX
December 14, 2022

The recent collapse of FTX has been among this year’s biggest headlines both inside and outside the cryptocurrency space. Sam Bankman-Fried’s (SBF) descent from golden boy to alleged fraudster has been met with all manner of responses from the public. But now we enter a more interesting phase: the regulatory response.

Right now, there are hearings scheduled and investigations underway, but no one has been arrested. For anyone who remembers Bernie Madoff’s perp walk in 2008, this is somewhat of a shock. In fact, it’s an even greater shock that SBF has been able to participate in interviews with the likes of the New York Times.

As the market tries to figure out what will happen next with the regulatory landscape for cryptocurrencies, it helps to look at what has happened so far.

Summary of Events

Countless summaries of the events have already been made, but there are some important points that are relevant to the regulatory response. It started in early November 2022, when Alameda’s balance sheet was leaked and showed that FTX’s proprietary token, FTT, made up a large portion of the balance sheet. This led to widespread speculation over the financial stability of Alameda, culminating in a thread from Binance’s Changpeng Zhao, where he said he would be selling his FTT token.

This triggered complete chaos and a bank run on FTX. Soon after, FTX stopped being able to handle redemptions, FTT, SOL, SRM, and any other tokens associated with Alameda and FTX. SBF attempted to quell fears in a thread saying that FTX was fully solvent, but more and more details emerged that indicated otherwise.

For a time, Binance was going to purchase FTX and cover their liabilities, but they pulled out after less than 24 hours, citing too many regulatory and legal issues to make the deal feasible.

Then on November 11, FTX declared bankruptcy. In the aftermath, it became clear that FTX and Alameda were intermingling customer funds illegally and taking immense risks in an attempt to maximize returns. FTX had been using their own tokens as collateral to get large loans from centralized lenders like BlockFi, Celsius, and many others. Since then, centralized crypto lender BlockFi has declared bankruptcy and many other companies are expected to go under before this is done.

The Legal Implications of FTX’s Collapse

Even assuming a best-case scenario where this was a trading loss and not theft, this would be in the top 5 trading losses of all time. Very few people know the full truth right now, but the main point is that unlike banks, crypto exchanges are not permitted to lend out assets unless users have opted-in to a specific lending product.

Spot holdings are meant to remain spot holdings. So the fact that FTX has allegedly lent out or even traded with customer funds is both unethical and illegal.

In short, the balances reported by FTX to customers should be held in their possession at all times at a 1-to-1 ratio. They used convoluted financial engineering to keep their company alive longer, and the user deposits lost may end up being clawed back in legal proceedings, but this will take time to execute.

There are some things that were done that seemed illegal, and other acts that live in a gray zone. For example, when FTX raised $420 million in October 2021, it now looks like $300 million of those funds were used to cash out SBF. Additionally, there are no records as to how the money was spent. It was meant to be used to expand FTX business, engage more regulators, and improve user experience.

Limited Investigations So Far

As of the time of publication, no one has been arrested yet in association with the alleged fraud by FTX. SBF is still in the Bahamas and seems to be living freely at this point.

One thing that is clear is that embarrassment is a factor here. Regulators and politicians alike were fooled by FTX and SBF. Optics are a major factor and we are seeing FTX try to paint itself as a victim in real-time. On one hand, regulators may make an example of him. On the other hand, politicians want this to go away.

Bahamian regulators have confirmed that they are holding onto some of FTX’s assets right now. There is now a debate over whether FTX’s Chapter 11 filing applies to assets that were held in the Bahamas, and the Supreme Court of the Bahamas may have to weigh in.

The House Financial Services Committee will be investigating the FTX collapse at a hearing on December 13th. There’s already a lawsuit filed against FTX, SBF, and prominent celebrities who helped promote the company. In mid-November, the FBI floated the idea of extraditing SBF back to the U.S. but no other news has surfaced on the topic, suggesting that it is no longer a priority.

One of the most interesting narratives to emerge to do with the FTX debacle is that there was a turf war between the SEC and CFTC, and SBF exploited it in order to avoid issues with either organization. The CFTC argues that it should be regulating Bitcoin as a commodity, whereas the SEC claims most cryptocurrencies are securities.

What Will Future Regulation Bring?

The alarming part of the whole FTX scandal is that SBF had been in talks with regulators and was pushing his own ideas through them. When a copy of the draft of the Digital Commodities Consumer Protection Act (DCCPA) leaked, there was outrage over the proposed restrictions on DeFi. It largely seemed as if SBF was pulling up the ladder behind him and ensuring FTX’s ability to thrive while regulating their decentralized competitors.

Supporters of both bills are pushing forward with their own bills. A notable difference between these bills is who would have oversight of the crypto market. In the DCCPA, the Commodity Futures Trading Commission would have oversight. With the Lummis-Gillibrand bill, the SEC and CFTC would have joint oversight. The CFTC aspect is controversial because of the widespread belief that they do not have the necessary resources to regulate crypto effectively.

A competing bill, the Lummis-Gillibrand bill, is also being touted as having the answers. Inside, it specifies that an exchange not use customer assets for proprietary trading and maintain 100% of customer assets for immediate withdrawal.

The main question we are left with is:

If FTX’s top priority was putting more assets in FTX custody, was this a Ponzi scheme or just customer fund intermingling?

For the sake of the cryptocurrency community, we hope regulators can get to the bottom of this sooner than later.

Secure Digital Markets (SDM) is a digital asset brokerage operating on a global scale providing OTC cryptocurrency spot trading and crypto-backed lending services to institutional, high net-worth, and corporate clients across 60+ international markets. We offer a custom pathway to digital asset liquidity and off-exchange transactions. SDM streamlines the acquisition, storage, and liquidation of digital assets in a secure and compliant manner.

Our clients use our services to unlock liquidity and take advantage of current opportunities in the market. Visit our website today to learn more about our services and how SDM can help you to maximize your digital assets.

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