FTX meltdown likely to spur crypto regulations, cool digital currency push

The crash last week of FTX, one of the world’s leading cryptocurrency exchanges, is likely to push lawmakers to create central oversight of an otherwise unregulated marketplace.

And while cryptocurrencies like those traded on FTX are different from others backed by fiat money or other assets, the meltdown of the exchange looks likely to cool a burgeoning number of efforts to adopt digital currencies by industries and governments.

Bahamas-based FTX Trading filed for bankruptcy last week after cryptocurrency prices dropped sharply and the company, once valued at $32 billion, found itself billions of dollars in debt. The exchange was founded in 2019 by MIT graduates Sam Bankman-Fried and Gary Wang. It quickly grew into the third-largest cryptocurrency trading platform, raising almost $2 billion in venture capital from high-profile investors.

FTX is not the first cryptocurrency exchange to fail. Some 42% of exchange failures have occurred without any explanation to consumers, while 9% were due to scams, according to one report. After FTX announced its bankruptcy filing, reports surfaced that the exchange and users of its online wallet services had been hacked.

“I sincerely hope that regulators finally take action,” said Martha Bennett, a principal analyst and vice president at Forrester Research. “Yes, it can be a challenge when the entities involved are specifically designed to evade regulatory oversight. But as the first steps in the insolvency process for FTX demonstrate, where there’s a will, there’s a way.” 

Howard Fischer, a former senior trial counsel at the US Securities and Exchange Commission (SEC), believes the cryptocurrency marketplace is at an “inflection point” where many want oversight to restore “some semblance of trust.”

“There [are] likely to be significant proposals aimed at both creating greater transparency into how crypto exchanges operate, including regulatory oversight into their balance sheets, calls to impose rules for segregation and protection of customer assets, and impetus to prohibit exchanges from operating jointly with investment operations,” Fischer said.

The regulations, Fischer said, are likely to be similar to the 1933 Glass-Steagall Act, which prohibited banks from using deposits to fund high-risk investments.

In the wake of such a high-profile crypto exchange failure, financial services and governments are also likely to take a second look at their own cryptocurrency and exchange projects.

“At this point, there is too much reputational risk from being associated with such a volatile asset — at least not until government regulation makes it a safer space, both reputationally and operationally,” Fischer said.

SEC Chairman Gary Gensler has been pushing for greater regulation of crypto assets over the past few years. In a similar way as stock exchanges, cryptocurrency exchanges such as FTX, Coinbase, and Binance, process trades for customers. But unlike the New York Stock Exchange or NASDAQ, crypto exchanges operate in a regulatory gray area and without explicit SEC approval.

Oversight of the exchanges and other crypto businesses has been an ongoing process, much of which is developed through court case precedence. For example, the SEC charged crypto exchange Coinbase with insider trading earlier this year. Earlier this month, the SEC won a case against blockchain-based payment network LBRY Inc. because it offered cryptocurrency as digital assets.

There are four main types of crypto currency, all of which are built atop a blockchain cryptographic ledger: cryptocurrency, such as bitcoin and Ether; stablecoins, or fiat-backed crypto such as Facebook’s Libra ; fungible and non-fungible digital tokens representing goods, financial assets, securities, and services; and central bank digital currency (CBDCs) or digital dollars created by governments.

Governments around the globe, including the US, are developing or already piloting CBDCs. Stablecoins are being created and piloted by financial services firms, such as JP Morgan’s JPM Coin and Wells Fargo Digital Cash, as well as companies such as Facebook’s Libra, for peer-to-peer transactions, which avoid slower and more expensive financial networks such as SWIFT.

In particular, stablecoins should eventually have to meet a number of regulatory conditions, according to Bennett.

“The backing of the coin has to be regulator-approved; attestations will have to be replaced by continuous audit, or the equivalent, of the backing assets; and consumer protections will have to be put in place,” she said.

Cryptocurrencies like bitcoin and Ether have no intrinsic value or backing of assets. They’re created “ex nihilo” or out of nothing. They’re “mined” by computers running special algorithms and their value is determined simply by the cost of producing them (i.e., the computer processing power) and market demand.

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Even before the FTX collapse, mainstream interest in cryptocurrencies was already cooling, both on the institutional side (including mainstream banking) and among consumers, due to a combination of continued regulatory uncertainty and the crypto crash earlier this year, according to Forrester’s Bennett.

“The FTX debacle will, in my view, pretty much keep away anybody who’s not already involved,” Bennett said. “This is unlikely to change until the implications and fall-out from the FTX bankruptcy are obvious, and there’s some clarity around regulatory action.”

Regulatory moves by Congress and the SEC will impact tokens, but the degree to which they’re affected will depend on the type of token (i.e., fungible or non-fungible), its provable backing (unless that backing is fiat currency), and the blockchain on which it runs, according to Bennett. For example, tokens on centrally managed or “permissioned blockchains” won’t be affected.

Bu stablecoin digital currencies will have to be regulated, “or be kept away from mainstream financial services,” Bennett said.

CBDC developments aren’t affected by the fall-out from FTX, as they don’t touch cryptocurrencies or public blockchains, according to Bennett.

“Put simply, we need to separate between digital currencies whose focus is on utility — whether issued by a central bank, government or a private entity — and those who function mainly as speculative assets, or the on-ramp to participating in speculative DeFi [decentralized finance] markets, which is what most stablecoins are used for today,” Bennett said.