Update 657 — Investors Ask FTX, WTF?
Fraud Ignites Hill Debate on Crypto Reg.
In recent weeks, Americans have seen the air begin to go out of two of the biggest political and financial balloons of recent years. Ex-President Trump suddenly trails Florida Gov. DeSantis in GOP 2024 polls by as much as 23 points; “I can’t do this anymore,” Steve Bannon said on his “War Room” podcast. And the cryptocurrency environment went from year-long winter to toxic overnight, in the wake of FTX’s precipitous collapse last month.
The FTX fraud scandal — allegedly, roughly $10 billion in customer funds, gone — got full attention in Congress this week. Also long gone: the crypto-euphoria of Super Bowl halftime. The FTX scandal has sobered Democrats and Republicans. The hearings this week in House Financial Services and Senate Banking suggest that the existing bills, drafted before the scandal to address regulation of the crypto industry, may have been overtaken by events: they got virtually no mention.
In today’s update, we review these hearings and explore their implications for cryptocurrency regulation going forward.
Good weekends all…
Dana
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The House Financial Services Committee and Senate Banking Committee held their respective hearings this week to investigate the collapse of crypto trading platform FTX. The overarching objectives for the hearings; to uncover the grueling truths behind the company’s internal operations and to figure out how to approach crypto policy and regulations going forward. The crypto market has faced troubling times, with November data reporting Bitcoin down 65 percent year to date.
Bitcoin Valuation Year to Date
Source: Coin Market Cap
The hearings, while investigative in nature,reflected bipartisan desire to find a comprehensive, investor-protection based framework around the nascent industry, with members working diligently to draw a road map of exactly how we arrived here. While it is clear that Democrats and Republicans alike want to get to the bottom of what happened, the future remains unclear. Disagreements remain over who should regulate crypto and if a new regulatory framework is necessary after all.
Fraud Aplenty to Fuel Reform
The sudden collapse of FTX sent shockwaves throughout the crypto industry last month, emerging as the latest scandal in a series of mass digital asset related fallouts. Until a few months ago, the $32 billion crypto exchange was considered the largest and most popular of its kind, securing investments from major venture capital firms both in the US and abroad. The mastermind behind the operation, 30-year-old Sam Bankman-Fried, had painted himself as Washington’s model crypto prodigy. He donated more than $70 million to election campaigns and gave at least $40 million to politicians and political action committees leading up to the 2022 midterm elections. Aside from his friendly checkbook, he successfully maintained a well-known presence in the halls of Congress, and, perhaps most importantly, formed trusting relationships with the regulators charged with overseeing his self-made empire.
All of this changed on November 11th when the company filed for Chapter 11 Bankruptcy proceedings, a code generally known to provide companies with reorganization tools to keep its business alive and pay creditors back over time. This move, while otherwise not uncommon in the digital asset industry, would go on to reveal a disturbing truth; an $8 billion hole in company accounts and over 1 million customers locked out of their FTX accounts, wondering if they’ll ever recover from this likely irreversible financial loss.
House: Bipartisan Chorus Supporting Reform
The Waters-McHenry-led House Financial Services Committee was the first of the two committees to convene this week, but saying it did not go as planned would be an understatement. The Committee had successfully convinced Bankman-Fried to testify – persuaded by threat of a subpoena – but the night before the crypto tycoon was due to appear, he was apprehended by Bahamian authorities upon the request of the U.S. Attorney for the Southern District of New York and the Department of Justice.
Here, he was met with a litany of charges, including wire fraud on both customers and lenders, conspiracy to commit money laundering, and conspiracy to defraud the United States and violate campaign finance laws. Though Bankman-Fried himself was unable to attend the hearing, the committee proceeded as planned in what was a pleasantly bipartisan hearing.
The sole witness who appeared before the committee was John J. Ray lll, an experienced lawyer who specializes in restructuring troubled companies. Ray became a known commodity when he took over the bankruptcy proceedings for Enron in 2001. His testimony, while partially limited in scope due to the ongoing nature of the investigation, was clear in acknowledging the “complete failure of corporate controls” and a “complete absence of trustworthy financial information” that went on behind closed doors. He stated the collapse stemmed from the “absolute concentration of control in the hands of a small group of grossly inexperienced, unsophisticated individuals who failed to implement any systems or controls necessary for a company entrusted with people’s money or assets,” and cited specific mismanagement practices, including but not limited to :
- The use of computer infrastructure that gave individuals and senior management access to systems that stored customer assets without security controls to prevent them from redirecting those assets;
- The ability for Alameda Research to borrow funds held at FTX to be used for its own trading or investments;
- The commingling of assets;
- The lack of documentation for transactions involving nearly 500 separate investments made with FTX funds;
- And the absence of an independent governance throughout the FTX group.
Ray had no recommendations for how a regulatory regime should look in regard to digital assets, but did highlight the need for record keeping, internal controls, transparency and most importantly, the need to segregate customers’ money. He presented an open and transparent attitude with the committee and cited his intention to share any and all information with the group going forward. Although no solution was declared point-blank, his testimony undoubtedly aided in the investigation and helped lawmakers get a better idea how FTX came to a crash. It is clear that both parties in the House want to come together to enact solutions, but there is not yet a broad agreement on what those solutions look like.
Senate: Debates Broad Regulation
The Senate Banking hearing involved a greater focus on regulation and less on Sam, with members exhibiting greater familiarity and more granularity in the facts and policy implications of the FTX scandal. The members of Senate Banking and the hearing witnesses provided a variety of perspectives. This meeting was designed to focus on overall policy goals rather than the specifics of the FTX collapse itself, and succeeded in that objective.
Chairman Brown, a long-time crypto skeptic, was vocal about the need for a comprehensive framework that “looks at crypto products for what they are, not looking at these products the way crypto executives want them to be.” Brown’s stance aligns with advocates and policy experts who argue for existing securities law to be applied to crypto. Ranking Member Toomey also agreed on the need for regulation in general, but advocated for rules tailored specifically to the sector, arguing that “decades-old legislation that deals with traditional instruments” would be “very problematic.”
The worry around most members of the committee, however, was striking a proper balance between protecting investors while also protecting our traditional financial institutions from crypto’s inherent and volatile risks. A number of skeptical Democrats expressed concerns that new regulations to digital assets could result in the intertwining of crypto and our traditional markets, exposing more banks, asset managers and retail investors to new risks. Among the most skeptical comes Senator Elizabeth Warren, who used Wednesday’s hearing as an opportunity to introduce her new bipartisan bill that cracks down on money laundering in the crypto industry.
Witness testimonies also ranged; Professor Hilary Allen argued the collapse of FTX was not an isolated incident but rather is symptomatic of many broader problems in the crypto industry. She noted that several prosecutors are referring to this incident as a tale as old as time, citing classic embezzlement made slightly different from innovative technology, and agreed they are not necessarily wrong. This case of “good old fashioned embezzlement,” however, was able to “reach such a scale and go undetected for so long- all because it was crypto.” In her eyes, and those of many others, active enforcement of the SECs existing securities regulation framework would make it more difficult to make crypto out of thin air, and that is certainly a great place to start.
A New Years Resolution
While policymakers remain divided on what solutions to proceed with, the Bankman-Fried fallout emphasized the increasingly urgent need to instill comprehensive guardrails that can adequately protect investors and hold bad actors accountable. Although time has all but run out on the 117th Congress, conversations and legislative proposals will continue into the new year with new players and new faces involved in the game. We hope the 118th Congress will be able to work across party lines to legislate in this space — necessary for passage of the bill and durability of the law — to forestall another crypto-catastrophe of this magnitude. Until then, we risk putting millions of innocent investors in harm’s way, all because of Congress’ indifferences.