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Op-Ed | The New Republic | November 23, 2022

Don’t Fall for FTX’s Final Con

Congressional OversightcryptocurrencyFinancial RegulationIndependent Agencies
Don’t Fall for FTX’s Final Con

Embracing the bitcoin industry’s regulatory agenda is not the answer to the crypto crash.

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This month’s collapse of FTX, the world’s second-largest cryptocurrency exchange, has sparked a media frenzy and a reinvigorated call for new regulation of the crypto industry. But this renewed push ignores two key questions: What exactly is a cryptocurrency, and what is its fundamental value? To build appropriate guardrails for the industry, it’s important to first identify the real socioeconomic value of this asset class. In this case, bespoke regulations for crypto would offer little beyond an opportunity to circumvent current banking regulations.

Disappointingly, crypto-aligned legislators from both sides of the aisle, such as Senators Debbie Stabenow of Michigan, Cynthia Lummis of Wyoming, John Boozman of Arkansas, and Kirsten Gillibrand of New York, have for months been pushing for a light-touch regime that would establish the Commodity Futures Trading Commission, or CFTC, as the primary regulator of digital assets. This would effectively sideline industry foe Gary Gensler, the chair of the Securities and Exchange Commission.

This crypto caucus appears to be capitalizing on FTX’s downfall in order to swiftly ram through the failed company’s preferred regulations: that is to say, virtually none. They’re trusting that the general public doesn’t understand crypto or the financial regulatory system well enough to discern the obvious trick they’re attempting to play. But if there’s one thing Washington should learn from FTX’s downfall, it’s to not trust hype and to think independently about how much online coins are really worth.

Crypto’s explosive growth is a tale as old as time—a speculative mania fed by predatory advertisements promising wild returns. (Some of FTX’s celebrity endorsers are now facing a lawsuit.) FTX in particular was supposed to be the industry’s shining ethical light. As it happened, however, its bankruptcy has revealed that the company put on a clinic on autopiloting a business into bankruptcy. At FTX, there was no centralized management of cash flows, and “less liquid” crypto assets on the firm’s balance sheet were worth less than 1 percent of what was being told to the public, to the tune of $659,000 versus $5.5 billion. (Those with scars from the 2008 financial crash might note that FTX’s undercapitalization makes the brigand banks from that collapse look positively saintly by comparison.)

It’s important to note, however, that suspect accounting practices aren’t unique to FTX; it’s an industry-wide issue. The fundamental problem that caused FTX’s collapse is that there are no fundamentals to offer any stability for a crypto token’s value. Ephemeral pricing that’s frequently manipulated by opaque market participants in a new product without meaningful historical parameters makes the accounting shenanigans of the “traditional” financial sector seem quaint. To maintain the illusion of solvency, the brokerages, exchanges, and investment firms peddling crypto need to make sure that there are enough purchase orders to simulate demand and that there are few enough sell orders to keep supply from flooding the market. The way that most crypto hucksters achieve this feat is by relying on market makers (such as Alameda in FTX’s case) to buy and hold large amounts of tokens.

The crypto market is in dire need of a regulator with experience looking into suspicious accounting practices, after speculation and hype causes an investment product to trade for more than it’s worth, and most importantly, the credibility to crack down on bad financial actors. It needs a regulator skeptical that existing investor protection regimes should be weakened, or exceptions made, because crypto bros refuse to play by the rules—or refrain from breaking existing law. The SEC is the regulatory agency with all of these characteristics.

Enshrining the CFTC as crypto’s primary regulator instead would reflect the success of the industry’s well-funded Washington lobbying strategy in the past couple years. In fact, Stabenow and Boozman’s proposed CFTC-centering legislation, the Digital Commodities Consumer Protection Act, was endorsed by none other than FTX founder Sam Bankman-Fried

There are a few reasons why handing full oversight responsibility to the CFTC would constitute an industry giveaway. First, the CFTC, which has historically interacted with large, sophisticated market actors, does not have an investor protection mandate. The agency also has minimal experience developing investor protection rules, especially for retail investors. The SEC, by contrast, boasts a well-developed investor protection regime which includes rules on brokers’ execution of client orders, fair and accurate advertising, segregating customer assets, as well as disclosure and compliance requirements.

Capacity is another issue: The CFTC’s budget and staffing numbers pale in comparison to its sister agency. The CFTC has $811 million, while the SEC has $2.69 billion. The SEC’s staff, as measured in full time equivalent positions, is nearly seven times larger than the CFTC’s (4,658 to 676, according to each agency’s 2022 performance report). Capacity constraints limit the CFTC and all other government agencies’ abilities to function properly and, in this case, would leave room for industry players to step in to influence the CFTC’s rulemaking process. It is absolutely the case that both commissions deserve greater resources, but the CFTC is obviously starting with a weaker hand. 

The past decade has illustrated just how weak it is. Take the CFTC’s self-certification program—the agency’s process for approving futures contracts, for example. The agency happily assented to proposals from the Chicago Mercantile Exchange, or CME, and the Chicago Board Options Exchange, or CBOE, to list bitcoin futures contracts in late 2017. (The SEC has continued to reject the exchanges’ proposals to offer bitcoin exchange–traded funds, which would similarly track bitcoin prices, citing concerns about potential fraud and manipulation.)

As law professor Lee Reiners has chronicled, bitcoin is an illiquid market. This makes its derivatives, such as the futures contracts CME and CBOE listed, especially sensitive to manipulative schemes such as large trades on the spot market. Moreover, fraud—pump and dumps, wash trading, rug pulls—is part and parcel of the crypto industry. In short, this is a market with plenty of potential to screw people out of their money. Yet, the CFTC argued that only instances such as filing false statements in the self-certification would warrant its intervention.

It’s worth noting that even in this regard, the crypto industry failed in its compliance obligations. To the surprise of no one with any passing familiarity, the CFTC found earlier this year that in the months leading up to CBOE Futures Exchange, Gemini (a crypto exchange) made “false or misleading statements of material facts …  to the CFTC in connection with the self-certification of a bitcoin futures product.”

But there’s an even better example of the CFTC being too lax with the crypto industry—FTX itself. The CFTC was FTX’s primary regulator (via FTX subsidiary LedgerX). Before the collapse, the agency eagerly embraced FTX’s dangerous proposal to eliminate intermediaries and fully automate crypto margin trades, which would have allowed FTX to complete crypto futures trades 24 hours a day, seven days a week, 365 days a year.

This embrace of the crypto industry is a trend that current CFTC chair Rostin Behnam seems intent on continuing. Behnam, a former Stabenow staffer, has openly supported both his former boss’s proposal, as well as Lummis and Gillibrand’s proposal to extend his agency’s reach. Behnam has even claimed that the price of bitcoin could double under his watch—an outrageous remark for a regulator. Regulators should discourage bubbles, not seek to inflate them,

Assenting to the crypto industry’s wishes to incorporate it into the broader financial sector is a recipe for disaster. We’re incredibly lucky that the broader financial system was mostly isolated from FTX’s face-plant. What happens when banks and major asset managers are more directly invested in crypto? It will create more financial sector bloat and put the government (and by extension, the public) on the hook for future downturns. Additionally, there is simply no way to prevent other actors from exploiting loopholes that any digital asset legislation would introduce to the system. Truthfully, the mere existence of a delineated digital asset regime would likely push traditional financial firms to move their assets and take advantage of lighter regulations.

The simple truth is that crypto doesn’t do anything useful enough for the world to justify a particularized regulatory scheme. The only reason to treat it differently from existing financial products would be to shield its leaders from the host of anti-fraud rules they’re flaunting already.

The FTX disaster should be all the impetus needed to kill off any new crypto industry–approved legislation. Instead, we need Congress to provide material support for financial regulators in the form of increased appropriations to guard against the next collapse. Much of the crypto industry is already subject to laws—the very ones that the SEC seeks to enforce and that the crypto industry broadly (not just Sam Bankman-Fried) seeks to evade by reducing the SEC’s jurisdiction ex post facto. Both the CFTC and SEC urgently need funds to fulfill their mandates. Crypto stretches these needs even further, but the need has existed for years. For decades, financial crimes have too often gone unpunished. This wasn’t for a lack of rules, but a lack of will, funds, and people willing to enforce them. Crypto doesn’t need special treatment, it needs to face the music.

Congressional OversightcryptocurrencyFinancial RegulationIndependent Agencies

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