FTX’s Implosion Should Spur Policymakers to Get Serious About Regulating Crypto Exchanges… But Not Rush It
FTX—the Bahamas-based cryptocurrency exchange made famous in ads from celebrities like Larry David and Tom Brady—dramatically collapsed earlier this month, resulting in financial losses not only for investors in the company itself but also for millions of consumers who traded on the company’s platform. It will likely be months (at least) before a full accounting shows whether the ultimate causes of FTX’s downfall were simply abysmal corporate governance or outright fraud. But regardless of the cause, the result shows why policymakers should get serious about regulating crypto exchanges.
More than six years ago, ITIF published a report on how policymakers should address emerging fintech innovations, including nascent cryptocurrency services, such as by establishing national regulations, creating regulatory parity with incumbents, promoting cybersecurity, and heavily penalizing companies that act negligently and harm consumers. Unfortunately, progress on the regulatory front has moved slowly with existing regulators locked in a turf war based on a debate about whether various digital assets are securities or commodities—the answer to this question determining whether the Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC) is the lead regulator.
The leading bill in Congress to address this issue, at least until recently, was the Digital Commodities Consumer Protection Act, sponsored by Senators Stabenow (D-MI) and Boozman (R-AR). This legislation would grant the CFTC authority to regulate a broad set of platforms involved in trading digital assets, including by establishing adequate finances, cybersecurity standards, transparency disclosures, and reporting requirements. Platforms, such as crypto exchanges, would have to register with the CFTC, and the agency could impose fees on these platforms to fund its oversight activities.
Had this legislation been in place a few years ago, would it have prevented the FTX debacle? Maybe. One of the goals of regulating the crypto industry is to prevent and deter fraud, including the type of misuse of customer funds that appears to have occurred at FTX. But there are already laws against fraud, so the deterrent effect of new laws aimed specifically at crypto could be minimal. And regulators do not catch everything. The SEC famously missed the Bernie Madoff Ponzi scheme, despite having received warnings about for a decade. Still, an effective regulatory regime for digital assets could help deter fraud, such as by giving regulators more authority and resources to investigate misuse of customer funds and improper corporate governance.
Crypto regulation should also have in place other regulations designed to protect consumers and avoid excessive risk, such as liquidity requirements, cybersecurity standards, and restrictions on shady accounting gimmicks that overinflate balance sheets. Regulating crypto exchanges will not protect traders from the significant losses that can come from speculating in various cryptocurrencies, but it will help ensure that crypto exchanges do not vanish into the night with those digital assets or other customer funds.
Finally, regulation should centralize and coordinate the various financial transparency requirements designed to prevent criminal use of digital assets. Anti-money laundering provisions, including know-your-customer and customer due diligence requirements, are necessary to prevent criminals and terrorists from using digital assets to move funds for illicit purposes, such as financing terrorist acts and avoiding sanctions.
And how might policymakers get crypto industry regulation wrong? First, they might use regulation as a backdoor attempt to enact environmental standards. Sen. Warren (D-MA), for example, has stated that any regulation should include restrictions on mining. As ITIF has previously argued, policymakers should address the environmental and energy concerns for digital assets, but heavy-handed regulatory policies that attempt to restrict how operators use data centers are likely to be unsuccessful. Instead, government should lead by example by setting procurement standards for energy-efficient blockchain technology and supporting research and development of energy-efficient blockchain protocols.
Second, they might create rules that unfairly favor particular crypto technologies. Indeed, some in the decentralized finance (DeFi) community have argued that the Stabenow-Boozman legislation would favor incumbents (like FTX), leaving DeFi with either improper or insufficient regulation. Here too, ITIF’s principles on fintech regulation are useful, as we’ve noted the importance of “creating tech-neutral rules” and “create a level playing field between incumbents and new entrants.” One way to strike a balance, especially to the extent that DeFi systems are less mature, would be to create a regulatory sandbox for DeFi projects so that regulators can have oversight while also working in partnership with the DeFi community to create a comparable regulatory framework.
Finally, Congress might take too long to pass legislation creating a regulatory framework for the crypto industry. Not only will this expose buyers to potentially avoidable risk, but it will cede the U.S. government’s regulatory leadership as other countries enact their preferred rules, potentially hurting many legitimate U.S. crypto startups and businesses.
The crypto industry still has a long way to go to establish itself as more than a volatile market for digital speculators. But, even with all of its problems, crypto still holds tremendous potential to increase efficiency and transparency in financial systems. Transactions on the blockchain can clear nearly instantly with full transparency for all parties, reducing uncertainty and risk, and minimizing intermediaries and fees. Users can move funds quickly, anywhere, anytime and use smart contracts to automate transactions. Congress should not sit on the sidelines any longer, but instead should act carefully but swiftly to regulate the crypto industry.
