What does the future hold for the cryptoasset market? More regulation is one certainty, and on that, nearly everyone seems to agree, writes Andrew Pimlott
The collapse of crypto exchange FTX in November 2022 sent shock waves through the digital asset world. Anyone who had deposits in, lent to, or bought shares in the exchange stands to lose everything. It went from a valuation of $32bn in October to $1 when it filed for bankruptcy on November 11, 2022.
Anyone holding FTX Tokens (FTT), FTX’s cryptocurrency, also suffered. They saw its value plunge from $26.26 on November 1, 2022, to $2.18 on November 12, 2022, to around $1.30 at the end of November.
Eleven years ago, I was seconded to New York to work on the collapse of MF Global (brokerage). MF Global and FTX have some similarities, both dipped into customers' funds to fill a financial black hole. The fallout from MF Global was huge. Lots of people lost everything and many businesses filed for bankruptcy. The fallout from FTX will follow a similar path. The wider crypto market has been damaged too. Before FTX went bankrupt, global cryptocurrency market capitalization stood at $0.95 trillion, already a huge drop from $3 trillion in November 2021, according to Binance, the world’s biggest crypto exchange. Now it has slipped even further to $0.84 trillion. Meanwhile, New Jersey-based crypto lender BlockFi, which had “significant” exposure to FTX, has become the latest casualty of the fallout from the debacle, filing for bankruptcy on November 28, 2022.
Investors, investment managers, exchanges, and others in the crypto ecosystem are now sifting through the wreckage, trying to figure out what went wrong with what was the world’s second or third-biggest crypto exchange. Most are putting a brave face on events, still convinced that the market as a whole offers great potential. FTX’s creditors may even get something back if the company’s bankruptcy lawyers recover some of the assets. BitGo, the custodian company given the job of tracking down the assets, says it has recovered $740m so far.
Crypto-philes are also encouraged by the resilience of Bitcoin, the biggest cryptocurrency by market capitalization, where 1 bitcoin at the end of November of 2022 was worth $16,422. Yet that is some distance below the $20,483 it was trading at just before FTX crashed, and dramatically lower than its $59,249 value exactly a year earlier.
Less impressed with the current situation and the future of crypto in general, are investors in traditional asset classes. They may not have lost any money, as the incident did not spill over into the wider financial markets, but they are in the same crypto-sceptic camp as financial regulators and governments. Officialdom is not only worried about consumers piling into cryptoassets and losing their money, it is concerned about the potential impact on financial stability if things carry on as they are.
That is why the U.S. House Financial Services Committee, for example, will hold a bipartisan hearing on December 16th into FTX’s collapse and the broader consequences for the digital asset ecosystem. The hearing will be live streamed on https://financialservices.house.gov/live/ and will capture the world’s attention as the committee says it expects to hear from the people concerned including Sam Bankman-Fried, the exchange’s former chief executive.
The demise of FTX – what happened?
FTX, based in the Bahamas, was used by investors and speculators to trade cryptocurrencies for other cryptocurrencies and fiat currencies. But concern about its stability surfaced when an article in Coindesk, a cryptocurrency news site, highlighted the inappropriate relationship between FTX and Almeda Research, a partner firm. The story prompted rival exchange Binance to announce it would sell its holdings of FTT, and FTT’s value fell. Other holders of FTT began to sell off their deposits held with FTX, creating a run on the exchange which it could not cope with. Binance stepped in to say it would acquire FTX to ensure depositors could withdraw their funds, but a day later withdrew from the acquisition because of doubts about FTX’s finances.
The situation quickly worsened. On November 10th, the Securities Commission of the Bahamas froze FTX’s assets and applied to the Supreme Court of The Bahamas for the appointment of a provisional liquidator. The next day FTX and its related companies applied for bankruptcy in the US state of Delaware. Bankman-Fried resigned as chief executive and was replaced by John J Ray III, the lawyer, and insolvency professional who oversaw the liquidation of Enron 20 years ago.
Secretary of the Treasury Janet Yellen was quick to make a statement, expressing the U.S. government’s concerns. “The recent failure of a major cryptocurrency exchange and the unfortunate impact that has resulted for holders and investors of crypto assets demonstrate the need for more effective oversight of cryptocurrency markets,” she said on November 16, 2022.
She added that for the past year the Treasury Department had been working with the President’s office and financial regulators to identify risks in crypto markets. Some of the risks identified – including commingling of customer assets, lack of transparency, and conflicts of interest – “were at the center of the crypto market stresses” observed in the past week, she said.
Existing regulations applying to cryptoassets “must be enforced rigorously”, she said, the government “needs to move quickly to fill the regulatory gaps” and action must be taken to prevent “spillovers from the events in crypto markets” threatening financial stability in the wider market.
Legal and political reactions
Although FTX was based in the Bahamas, the liquidators there agreed to consolidate proceedings in the US. A lawyer at law firm Sullivan & Cromwell acting for FTX in its bankruptcy case told the U.S. Bankruptcy Court for the District of Delaware that Sam Bankman-Fried ran the exchange as his “personal fiefdom”. He spent “substantial amounts of money” on items unrelated to the business before it imploded, said James Bromley on the first day of the hearing in late November 2022.
“We have witnessed one of the most abrupt and difficult collapses in the history of corporate America,” said Bromley, whose team is winding down the company and trying to unravel its web of assets to repay creditors.
The next significant public discussion on the case is likely to be the US House Financial Services Committee’s bipartisan hearing on December 16. The committee says it “expects to hear from the companies and individuals involved, including Sam Bankman-Fried, Alameda Research, Binance, FTX, and related entities, among others”.
Committee chairwoman Congresswoman Maxine Waters, a democrat representing part of California, said “the fall of FTX has posed tremendous harm to over one million users, many of whom were everyday people who invested their hard-earned savings into the FTX cryptocurrency exchange, only to watch it all disappear within a matter of seconds”.
“This event is just one out of many examples of cryptocurrency platforms that have collapsed in the past year [which is why] we need legislative action to ensure that digital assets entities cannot operate in the shadows outside of robust federal oversight and clear rules of the road.”
Industry reaction
Although crypto investors and other industry players have been hit hard by the scandal, they are battling on grim-faced. They might be secretly worried, but outwardly they are confident about the future. The first session of a cryptoassets inquiry held by the UK Parliament’s Treasury Committee on November 14, 2022 featured evidence from several leading figures in the crypto sector including Ian Taylor, Executive Director at CryptoUK; Daniel Trinder, Vice President Government Affairs, Europe and MENA at Binance; and Tim Grant, Head of Europe, Middle East, and Africa at Galaxy Digital.
Committee Chairman Harriett Baldwin MP got straight to the point with her first question: “With the collapse in so many different cryptoassets in 2022, and the news last week, which we will drill into in greater detail as we go through, would you say that cryptoassets are the tulip bulbs of the 21st century?”
Binance’s Daniel Trinder was the first to respond to the comparison with the Dutch tulip bulb market bubble-and-burst of the 1600s. “I would not say that they are tulip bulbs,” replied. “The key failure last week, plus the ones earlier in May, are largely down to issues relating to failures around governance, risk management, excessive leverage, and if we believe the reports, inappropriate use of clients’ assets. These are traditional failures that have plagued traditional finance. I do not think that there is anything inherent around the failures that I am aware of around crypto or the technology per se at this moment.”
Tim Grant of Galaxy Digital – an investment company specializing in cryptoassets and blockchain technology company – was just as forthright in his convictions about the potential of the crypto market. “It would be wrong to throw the baby out with the bathwater and say that all cryptoassets are purely speculative, do not have some economic value, and do not have some element of value creation built into them.”
Ian Taylor of CryptoUK, the self-regulatory trade association for the country’s cryptoasset industry, accepted that it “is a highly risky and volatile asset class [but] we always advise people who want to invest to do their homework and perhaps be prepared to lose 100% of their investment”. He went on to say that if the market were regulated more closely, “some of these events may not have taken place”. What this shows, he added, “is that we need some regulation around these central actors, such as audits and proofs of reserves on assets and liabilities”.
One of the main criticisms leveled at the market by crypto-phobe investors and regulators is that it is under-regulated. Yet, as Ian Taylor’s comments show, many crypto-philes are asking for more regulation to put their industry on a sounder footing.
More regulation is certainly the UK authorities’ intention. City Minister Andrew Griffiths has proposed an amendment to the financial services and markets bill which would widen the scope of crytpoasset regulation. The U.S. government and regulators have similar intentions, as illustrated by Secretary of the Treasury Janet Yellen’s comments mentioned earlier. So does the European Union – its Regulation on Markets in Crypto-Assets (MiCA) will into force in 2024, giving financial regulators powers over companies providing cryptoasset services such as trading, lending, and custody.
Financial firms do not usually welcome, never mind request, greater regulatory and legislative intervention, but this time it is different. Crypto firms realize that if the rules and laws governing their activities are not tightened up they may not have a future.
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Andrew Pimlott is Senior Managing Director, Financial Services, Data and Technology, EMEIA, Ankura Consulting.
© Copyright 2023. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.