Georgetown Law
Technology Review

The so-called “crypto winter” got a good bit colder last week as one of the crypto industry’s titans, Sam Bankman-Fried, saw his empire crumble.  The crypto-exchange founder’s net worth was reportedly $16 billion on Monday; by Friday, it had fallen to zero.  This is just the latest in a series of crashes that crypto-industry leaders say are akin to the 2008 financial crisis.

The crash of Bankman-Fried’s exchange, FTX—and the greater crypto winter overall—proves that federal legislation is necessary to establish who regulates the crypto industry.  Rather than leaving it up to the discretion of SEC and CFTC officials, the government should create a regulatory agency dedicated to blockchain-based digital assets. Providing regulatory clarity by resolving these issues would go a long way towards preventing another meltdown like this.

What happened to Bankman-Fried’s FTX?

Bankman-Fried founded FTX, which was, until recently, the world’s third-largest crypto exchange.  Although just three-years old, his exchange had over a million users.  FTX had a presence that permeated into American culture: the company held naming rights to the Miami Heat’s home stadium, signed a branding deal with Major League Baseball, and ran Super Bowl Commercials featuring Matt Damon and Tom Brady.  Bankman-Fried also founded Alameda Research, a large cryptocurrency trading firm.

Bankman-Fried intermingled his two firms, which brought them both down. Last week, CoinDesk reported that a significant portion of Alameda’s balance sheet was made up of FTT, the token issued by FTX.  In fact, Alameda and FTX itself together held the majority of all FTT in circulation. If at any point Bankman-Fried’s two firms decided to sell those tokens, the price would have crashed. Thus, the FTT in Alameda’s balance sheet was significantly overvalued.  Additionally, Alameda had been borrowing against its FTT holdings, prompting unconfirmed rumors that FTX was loaning user-deposited funds to Alameda with illiquid FTT as collateral.

Those rumors—although unconfirmed—caused a significant holder, Binance, the world’s largest crypto asset exchange platform, to begin dumping their FTX tokens. Binance CEO Changpeng Zhao (“CZ”) referenced the Alameda news when he announced the liquidation of the company’s FTT holdings. Given the size of these holdings, the announcement prompted a sell-off of the token as FTT holders began to withdraw funds at a rapid clip.  This happened at such an overwhelming rate that FTX was forced to pause withdrawals.

FTX then reached a tentative deal to be acquired by Binance, after failing to secure other funding to close the balance sheet hole that resulted from the run on its exchange.  But Binance backed out of the deal a day later, citing the size of FTX’s balance sheet hole. Sam Bankman-Fried told investors later that day that the exchange would need $8 billion in emergency funding to cover its shortfall and could file for bankruptcy.

 FTX’s crash highlights the shortcomings of current crypto regulation

Crypto-exchanges like FTX are difficult to regulate, because (1) they are often based on foreign soil, ensuring they’re outside the reach of U.S. regulators.  But even when they are subject to U.S. regulation by the SEC and CFTC, the regulation itself lacks structure and enforceability because (2) these agencies have not clarified what qualifies as a security, or how that applies to digital asset companies, and (3) there is no clear division of regulatory authority between the SEC and CFTC.

First, as is often the case with crypto-exchanges, FTX is a Bahamas-based company and therefore outside of the reach of U.S. regulators. Even though U.S. citizens should not be able to use it, many Americans surely found their way around these roadblocks.  But beyond its effect on individual American users, the United States feels the repercussion of these crashes in other ways; FTX’s collapse hurts U.S.-based investors in ensuing market crashes, even if they use regulated exchanges like Coinbase.

Second—and according to the founder of CoinBase, the main driving force behind these exchanges’ move to foreign soil—the U.S. crypto regulatory regime lacks clarity.  The current process for determining whether other digital assets are securities is no process at all. There are essentially two options. The first is simply waiting to see if the SEC will (or won’t) pursue an enforcement action against an individual issuer. The second is attempting to read tea leaves based on what SEC Chairman Gary Gensler says in interviews. While well-resourced companies can afford to move slowly through this quagmire and play by the SEC’s ever-changing rules, start-ups cannot. As a result, innovation is stifled and new companies are pushed offshore. When, like FTX, those start-ups find success offshore, they become unregulated behemoths that put U.S. investors at risk upon collapse.

Third, this lack of clarity produces infighting between regulatory agencies. Cryptocurrencies share some characteristics of securities and some of commodities, but they are not fully either one. As a result, the two agencies tasked with regulating these different asset classes, the SEC and the CFTC, are both trying to push the other out of what they see as their own regulatory turf. This infighting produces more uncertainty, with digital asset companies caught in the feedback loop, unsure of which regulatory rules they should follow. 

How the industry should be regulated

As the dust settles on the FTX crash and the Justice Department begins its probe, the question becomes “what now?” Given the murky waters, heeding calls for more heavy-handed regulation of the crypto industry or stricter enforcement of existing regulation would be a mistake; the crypto industry does not need more regulation, it needs better regulation. The asset regulations currently in place were written at a time before cryptocurrencies existed. Their writers did not contemplate such an asset class. So, attempting to more strictly enforce regulations that are not fit for purpose would only make matters worse.

Given that cryptocurrencies do not fit neatly into any existing asset class, the simplest solution would be for Congress to define them as a separate asset class. Congress could then create a new regulatory agency dedicated to crypto—or a sub-agency within either the SEC or the CFTC—to enforce these regulations. Unless and until Congress steps in to provide this clarity, crypto companies will continue to grow overseas and the extreme boom-and-bust cycle will spin on.