FTX failure resets US crypto legislative program

The dramatic failure of FTX could send draft US legislation to regulate digital assets right back to the starting line, ex-regulators say.

“The collapse of FTX underscores the need for a much stronger regulatory framework around crypto generally and in particular for trading platforms,” says Timothy Massad, former chairman of the Commodity Futures Trading Commission (CFTC).

Lee Reiners, policy director at the Duke Financial Economics Centre and a former Federal Reserve supervisor, agrees: “Everything is on the table right now when it comes to how this industry and how this asset should be regulated.”

But Massad warns that isn’t necessarily a good thing in terms of providing regulatory clarity. The FTX fallout may complicate consensus-building in Congress and further delay legislation.

“You will have some people in Congress and in regulatory positions who are very skeptical of the entire industry and will be reluctant to do anything that legitimizes it, and they will favor just very strong enforcement,” he says.

Those delays could impede US efforts to be a rule-maker, rather than a rule-taker, on crypto. The EU already has its Markets in Crypto-Assets regulation on the statute books.

“The US should be a leader, as it has been in many areas of financial regulation. That’s why I am a little concerned that this is going to arguably delay getting there,” says Massad.

However, the crypto industry may now be less hostile to regulation, says Gregory Hopper, an independent consultant and former global head of emerging risks at Goldman Sachs.

“There’s going to be more of a consensus in the crypto community and the regulatory and legislative communities that something needs to be done in terms of bringing regulation forward,” Hopper says.

Current CFTC chair Rostin Behnam is set to face questions from the US Senate Agriculture Committee on December 1 about the failure of FTX, which held a CFTC license as a derivatives clearing organization following its acquisition of LedgerX in August 2021.

Reiners says the findings from congressional hearings should be used to stress test future legislation.

“We have to look at these various proposals, starting with the Senate Ag bill and ask: ‘If this bill was passed as is and had been in effect, would it have made a lick of difference?’” Reiners says.

Blame game

A large part of the congressional review will ascertain whether regulatory agencies could have prevented the loss of US retail customer funds in FTX. Those findings are likely to influence lawmakers’ thinking on which agency should be given authority over cryptocurrency markets going forward.

Sources agree that FTX-related entities were inconsistently regulated in the US, partly owing to the ongoing tension between the main markets regulators on whether digital assets are commodities and therefore regulated by the CFTC, or securities and therefore regulated by the SEC.

Already the battle lines are being drawn. The SEC has been criticized by prominent Republicans for a March 2022 staff note on how companies should account for custodial services of crypto assets. SEC staff recommended that crypto should be recorded on custodians’ balance sheets at fair value, even though in legal terms it belongs to the owner, not the custodian. But Massad believes the Republican criticism is unfair given the lack of a proper legislative framework.

“Unless you pass a law that says crypto exchanges can custody their customer assets, that’s not going to happen in crypto, just because of the nature of the assets and the nature of the trading. Why would you have a bank do it in the absence of a requirement that you do that?” says Massad.

Cryptocurrency market participants point out that full segregated custody in cold wallets may be difficult because exchanges need a minimum amount of assets in the hot wallet to enable rapid repayment to customers.

Reiners says criticism of the SEC is rooted in Republican antipathy towards SEC chairman Gary Gensler and his aggressive positions on issues like climate risk and private fund disclosures.

Instead, Reiners believes the CFTC lent “wholly undeserved” credibility to crypto, notably through its consideration of FTX’s direct clearing proposal.

“The CFTC deserves some scrutiny here given that it does have fraud and manipulation enforcement authority over commodity spot markets,” he says. FTX is now facing fraud investigations in New York and the Bahamas, where it was headquartered.

Massad, however, thinks it is a “totally unreasonable proposition” that the CFTC should have investigated offshore entities connected to disgraced former FTX chief executive Sam Bankman-Fried, given the commission’s modest enforcement budget and the relatively small size of the US crypto derivatives market compared with the overall derivatives market.

‘Toxic’ legislation

The Digital Commodities Consumer Protection Act (DCCPA), which would have given the CFTC primary authority to regulate cryptocurrency spot and derivatives markets, had bipartisan support in Congress. It was proposed by Democratic senator Debbie Stabenow (the Agriculture Committee chair) and Republican senator John Boozman, ranking member on the committee.

But Reiners says the bill is now considered “toxic” because Bankman-Fried was a keen supporter and is perceived to have influenced its drafting. Legislators may now review its central tenets, including the legal definition of digital assets and the purview of the CFTC.

“It hits the reset button on these policy debates and proposals, largely because Sam Bankman-Fried was so active on Capitol Hill, pushing for very specific policies and pieces of legislation,” says Reiners.

Indeed, progressive Democratic senator Elizabeth Warren, who had previously signaled support for the DCCPA provided certain changes were made, is now said to be working on stronger digital asset legislation. Reiners expects Warren and Democratic Senate Banking Committee chair Sherrod Brown to table their own alternative bill, because “the political calculus has changed.”

It hits the reset button on these policy debates and proposals, largely because Sam Bankman-Fried was so active on Capitol Hill, pushing for very specific policies and pieces of legislation

Lee Reiners, Duke Financial Economics Centre

Massad agrees that the Stabenow-Boozman bill is very unlikely to progress, “in part because I think people will want hearings and investigations, and I think that’s a good thing”.

For Massad, the DCCPA didn’t go far enough. He is neutral on whether the CFTC or SEC should have jurisdiction over the market—but what matters is imposing a set of standards for crypto exchanges akin to the securities and derivatives markets.

These standards would cover governance, conflicts of interest, risk management, operational resilience and protection of customer assets to specify that they cannot be loaned out without permission—FTX allegedly lent customer funds to its proprietary trading entity, Alameda Research.

“What we needed was a framework that required protection of customer assets that had regular examinations, that had rules preventing conflicts of interest, and that required good governance and boards of directors and risk management,” says Massad.

Second chance for DeFi?

Although the DCCPA was supported by FTX and Coinbase, it was opposed by large parts of the crypto community because it was designed around centralized exchanges like FTX, Coinbase and Crypto.com, but was not compatible with decentralized finance built on smart contracts.

“It would have effectively destroyed DeFi,” Goldman’s Hopper says.

He thinks a leaked second draft, which includes exemptions for an individual who “validates digital commodity transactions” or “develops or publishes software” could make things easier for decentralized venues that run on the blockchain rather than through human intermediation.

However, he would like legislation to go further, providing a clearer definition of cryptocurrencies that are not securities—the original draft gave bitcoin and ether as examples, but this would not provide certainty to those who issue or trade other coins.

In addition, Hopper says the legislation should line up with amendments to the Uniform Commercial Code “to accommodate emerging technologies”, which were approved by state uniform law commissioners in July 2022. As contract law is governed at state level, the UCC is designed to ensure the harmonization of laws governing cross-state contracts.

“That bill should make sure that its definitions are really consistent with the definitions that are in the updated universal uniform commercial code,” says Hopper.