While the extent of the damage caused by the bankruptcy is still being evaluated, some are asking whether this is a death knell for the crypto asset market, while others suggest it is the harbinger of meaningful regulation necessary to facilitate the responsible existence and ultimate growth of the broader digital asset market.

In this article, we explore the events surrounding the FTX bankruptcy, as well as the market inefficiencies and failures revealed by the implosion that need to be addressed. We then explain how the magnitude of the event – as well as the not-so-surprising similarities to other storms that the market has weathered during this crypto winter, starting with the collapse of the TerraUSD stablecoin (UST) and its related Luna crypto asset in May 2022 – are galvanizing global regulators to take action to bring the regulatory oversight that is needed to achieve investor protection and market integrity.

What led to the downfall of FTX?
FTX was valued at over $32 billion in a $400 million financing round concluded in January 2022.¹ In mid-2022, FTX leveraged (no pun intended) its market-leading position to come to the rescue of a number of crypto firms, such as BlockFi, in the wake of the crypto market upheaval triggered by the collapse of the TerraUSD stablecoin (UST) and its related Luna crypto asset. Then, over the course of just nine days in November, which culminated with the company’s Chapter 11 bankruptcy filing on November 11, 2022, FTX’s value was destroyed.  

The public catalyst for FTX’s demise was an article published on November 2, 2022 by the website CoinDesk, which described the breadth and scope of the relationship between FTX and Alameda Research, a proprietary trading firm that was also owned by Sam Bankman-Fried, the principal owner of FTX.² According to the article, many of the assets of Alameda Research were in the form of FTT, tokens issued by FTX that were not backed by any reserve assets. This was reportedly a catalyst for Binance chief executive officer, Changpeng “CZ” Zhao, to tweet on November 6, 2022 that he planned to sell any remaining FTT from the $2.1 billion of assets Binance received in connection with their exit as an investor in FTX.³ Following this tweet, there was a precipitous drop in the price of FTT. As a result of the uncertainty over FTX’s financial position, customers started withdrawing their assets from FTX, triggering a “run on the bank” that ultimately led the company to file for bankruptcy on November 11, 2022.⁴

As the bankruptcy proceedings progress, details of the practices that precipitated the swift fall of this industry leader, as well as the consequences for its customers and other market players, have begun to emerge.⁵ According to a report in the New York Times, Alameda Research took out loans to make venture capital investments, and in the wake of the crypto market crash earlier this year, those loans began to be recalled by the lenders.⁶ Interestingly, there are reports that federal prosecutors are investigating whether FTX was involved in manipulating the market for UST and Luna, a watershed event that precipitated the crypto market crash in May 2022.⁷ In any event, due to a lack of liquidity, Alameda’s chief executive officer reportedly stated that FTX customer funds were used to cover those repayments.⁸ This would explain, in part, why sufficient funds to repay customers appear to be lacking. In his first day motion filing, John Jay Ray III, an insolvency expert who previously oversaw the liquidation of Enron and recently was appointed to restructure FTX, stated:

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”⁹

Similar to other fallen crypto market players during this crypto winter, this quote highlights how improper business practices are at the core of the crisis. Vertical integration of exchange trading, custody and proprietary trading operations within a single provider creates the potential, and arguably the incentives, for misuse of customer funds, particularly where appropriate segregation of assets does not occur.

What lessons can we learn from the downfall of FTX?
The FTX implosion shares many common themes with the other corporate failures during this crypto winter. One unmistakable lesson, however, is that while the crypto market was developed with aspirations of elimination of perceived exclusionary financial intermediaries, what has been created is a marketplace that relies on powerful, vertically integrated intermediaries in the form of exchanges, custodians and asset managers. Unlike traditional financial institutions, however, the crypto intermediaries are in large part not subject to a regulatory framework designed to ensure investor protection, segregation of proprietary and customer assets, or a control framework designed to ensure prudent business practices, the net effect of which is to increase consumer risk.

Custody banks, such as State Street, have a long history of providing safekeeping services for their clients on the basis of a clearly established body of law and regulation that defines and supports the client’s ownership rights over assets held in custody. In the banking industry, the safekeeping of client assets incorporates three core principles which are designed to effectively manage the potential risk of misappropriation or loss of assets. These principles can be summarized as follows:

• Separation of Financial Activities: Safekeeping operations must be functionally separated from trading and other similar market activities.
• Segregation of Client Assets: Client assets must be segregated at all times from the bank’s proprietary assets to help ensure that they are bankruptcy remote.
• Proper Control: The custodian must maintain proper control over client assets in order to identify the entitlement holder and to mitigate any “single point of failure” in the record of ownership.

Application of these principles to all crypto intermediaries would help ensure customer protection and limit the likelihood of “bank runs” and the contagion in the crypto marketplace that we have seen this crypto winter. While they may not have prevented the downfall of FTX, they almost surely would have positively impacted the manner in which FTX grew, the development of an appropriate risk oversight and control function, and the protection of customer funds.

Regulatory imperative strengthens globally
Across the globe, the response from lawmakers and regulators has been one of identifying an increased urgency in the need for appropriate regulation.

In the United States, calls for action amongst legislators has increased. Senator Cynthia Lummis (R-WY) used the FTX debacle as an opportunity to explain how a bill that she recently sponsored, the Responsible Financial Innovation Act, would have banned a number of the practices that were allegedly conducted at FTX.¹⁰ The bill proposes, among other things, to provide legal clarity around the classification of a digital asset as a commodity or a security, include a new disclosure regime for certain digital assets to increase financial stability, expand the remit of the Commodity Futures Trading Commission (CFTC) to include regulation of spot digital asset commodity trading and exchanges, and codify the legal framework for custodial services offered by banks, including clarification that custodied assets are not assets or liabilities of the custodian and should not be recorded on the balance sheet of the custodian.¹¹ Another bill that was introduced in August 2022 by US Senators Debbie Stabenow (D-MI) and John Boozman (R-AR), the Digital Commodities Consumer Protection Act,¹² would expand the authority of the CFTC to include spot “digital commodities” transactions, which are defined as including “property commonly known as cryptocurrency or virtual currency, such as Bitcoin and Ether”, but excludes securities, physical commodities or anything else the CFTC determines not to be a digital commodity. This bill was supported by Sam Bankman-Fried, however, which may cloud its future. Senate Banking Committee chairman, Sherrod Brown (D-OH), has also urged the Treasury to work with Congress to create legislation for the crypto industry in the wake of FTX.¹³

The prudential regulators in the United States have taken a more cautious approach, but have also indicated that the topic of crypto assets and related bank activities continues to be high on their list of priorities. Federal Reserve Vice Chair of Supervision, Michael Barr, stated in testimony to the Senate Banking Committee that the ability to strike a balance between supporting innovation and managing risks is quite challenging, but also noted that “it would be ‘useful’ to provide more guidance on how financial institutions can safely hold crypto assets."¹⁴ In December, the Office of the Comptroller of the Currency (OCC) published its Semiannual Risk Perspective, Fall 2022,¹⁵ in which it identified crypto assets as a special topic in emerging risks and noted that it “continues to maintain a careful and cautious approach to crypto-assets in the federal banking system”. The OCC stated that it was continuing to focus on evaluating whether banks were operating in a safe, sound and fair manner.

In Europe, the governor for financial stability at the Bank of England, Sir Jon Cunliffe, called for better regulations to protect the financial system in the wake of FTX, noting that the links between the crypto world and traditional finance were developing rapidly.¹⁶ In the European Union, the president of the European Central Bank, Christine Lagarde, also called for increased regulation in the wake of FTX during a November 28th hearing of the Committee on Economic and Monetary Affairs of the European Parliament.¹⁷ While the EU has made significant legislative progress in the form of the Markets in Crypto Assets regulation (MiCA), which is expected to have a final vote for approval in February 2023,¹⁸ Lagarde also noted the potential need for a supplementary regulation, MiCA II, that would further regulate crypto asset staking and lending.

In Australia, the Treasury reportedly confirmed that it is planning on introducing regulations to improve investor protection with respect to crypto assets in 2023.¹⁹ In South Korea, regulators from the country’s Financial Supervisory Service (FSS) stressed the need to implement a regulatory framework during a South Korean National Assembly meeting.²⁰ This comes as the South Korean government is reportedly working on comprehensive digital assets legislation, referred to as the Digital Asset Basic Act, which is expected to be in force in 2023.²¹ Work on this act was initially reported to have commenced in the wake of the TerraUSD/Luna crash at the beginning of the crypto winter, and it is said to encompass both a broad range of digital assets as well as the role of banks in the sector.

Continued relevance, reduced hype and strengthened regulation
While the failure of FTX is the latest in a string of crises during this crypto winter, it is not correct to view it as a death knell for the crypto industry. There are certainly some legislators who see it as validating concerns they previously raised about crypto, but a significant number of legislators and regulators continue to view the digital asset class, which is broader than cryptocurrencies, as more than a fad and something that lawmakers need to more urgently address to ensure investor protection as well as market integrity. On a global basis, from North America to Europe to Asia, senior lawmakers are calling for accelerated legislation and rule-making. It remains to be seen exactly how comprehensive the regulatory framework will be, but to the extent it can effectively address the business conduct issues demonstrated during the crypto winter, the focus can shift to using cryptographic technology to revolutionize the investment lifecycle for all digital assets.