Global Taxes

Cryptocurrencies: FTX collapse erodes sector’s ‘credibility and trustworthiness’

Neil Hodge Thursday 1 December 2022

The high-profile collapse of FTX – the world’s second largest cryptocurrency exchange – has demonstrated the need for better corporate governance standards in the nascent crypto industry, alongside increased oversight from regulators.

In early November documents leaked online showed that Alameda Research – a cryptocurrency trading company run by Sam Bankman-Fried, FTX’s CEO – was reliant on FTX’s own crypto coin, FTT, rather than a fiat currency or another cryptocurrency. After subsequent reports were published online, the major crypto exchange Binance announced on 6 November that it was selling its holdings in FTX-linked coins ‘due to recent revelations’, causing the value to plummet as customers rushed to take their cash out.

On 8 November FTX suspended withdrawals as Bankman-Fried attempted to raise emergency funding to plug an $8bn shortfall in finances. On 11 November Bankman-Fried resigned as the company filed for Chapter 11 bankruptcy. Following his departure, FTX’s new Chief Executive John Ray III, an insolvency expert, said he had ‘never seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information’ in filings before the Bankruptcy Court for the District of Delaware. The Bankruptcy Court also heard that the company – valued at $32bn back in January – lacked basic money controls.

Many customers used their FTX digital wallets like bank accounts, expecting their funds to be safe. More than one million investors are thought to have had cryptocurrency stored on the FTX exchange and are owed money, which they may not get back. Hackers are also thought to have stolen some of the funds.

The credibility and trustworthiness of crypto is being gradually eroded

Alexei Bonamin
Senior Vice-Chair, IBA Capital Markets Forum

Bankman-Fried tweeted in mid-November that his ‘one goal’ now is to ‘do right by customers […] And after that, investors’, including by meeting with regulators. His tweets reference FTX’s earlier success and later issues, with Bankman-Fried stating that ‘We got overconfident and careless […] And problems were brewing. Larger than I realized.’ In an interview at the end of November, he denied deliberately misleading investors and committing fraud, and argued that he lacked a full sense of what was happening within the various branches of FTX and its offshoots.

The lack of effective corporate governance has also shone a light on the capabilities of auditors to spot problems in the crypto sector. Experts say auditors are struggling to apply accounting rules to digital assets because those rules are still only half formed. High-risk audits also require more time and resources, but some crypto companies may view the audit as a ‘tick-box’ exercise and wish to pay the lowest fee for such processes.

Financial regulators worldwide have hinted that their regulatory stance is set to toughen, but to what extent and how effective regulation will be remains uncertain. As governments and central banks engage more with cryptocurrencies and release their own ‘stablecoins’ – digital currencies pegged to a ‘stable’ reserve asset such as the US dollar – it’s hoped that regulation and risk awareness within the sector will also improve.

In the wake of FTX’s collapse, Sir Jon Cunliffe, Deputy Governor for Financial Stability at the Bank of England, said while digital currencies are still too small to pose a threat, better regulations are needed to protect the financial system as cryptocurrencies continue to gain ground. He added that recent volatility in the value of cryptocurrencies is an issue: the value of Bitcoin, the world’s largest digital currency, has dived by almost 70 per cent in the last year.

Speaking at the UK’s Warwick Business School in late November, Sir Cunliffe told his audience that ‘we should not wait until [the crypto world] is large and connected to develop the regulatory frameworks necessary to prevent a crypto shock that could have a much greater destabilising impact. The experience in other areas of digitalisation has demonstrated the difficulty of retrofitting regulation on new technologies and new business models after they have reached systemic scale.’

Alexei Bonamin, Senior Vice-Chair of the IBA Capital Markets Forum and a partner at Brazilian law firm TozziniFreire Advogados, says ‘the credibility and trustworthiness of crypto is being gradually eroded’ by events such as the FTX collapse. He adds that in-house lawyers, specifically, should be aware that crypto companies and crypto intermediaries in general don’t have specific compliance requirements or regulation on key areas such as know-your-customer and anti-money laundering controls, cyber security or credit and liquidity risks. As such, ‘risks arising from the lack of such controls cannot be disregarded and must be taken into account. As mitigating measures, in-house lawyers should rely on tightly-written agreements with crypto intermediaries, as well as on audits of the internal controls of such companies.’

Pedro Eroles, also a partner at TozziniFreire Advogados, calls for greater regulatory oversight of the crypto sector as investors appear either unconcerned about risks that have an impact on traditional financial services companies, such as liquidity, solvency and capital market risks, or assume that the crypto companies have the same compliance requirements as banks and insurers. Tighter regulation, he says, ‘would better coordinate the soundness and good functioning of the crypto markets.’

For Anurag Bana, a senior project lawyer in the IBA’s Legal Policy & Research Unit, the ‘global ramifications’ of FTX’s collapse will raise questions about the governance of crypto companies and their future oversight by regulators. He says financial regulators will need to get more actively involved in supervision. ‘In future, financial regulators will need to re-examine how crypto companies operate; how they attract customers; and how they should be more closely monitored, held to account and sanctioned,’ he says. ‘Regulators need to step up and be prepared to step in when they see signs that crypto companies are going to fail.’

Bana adds that regulators may also need to consider the appeal of crypto companies and the impact on customers if they’re based in countries where such companies don’t have authorisation to operate. ‘An unauthorised company does not mean that it is doing anything illegal, nor does it mean that it cannot operate or try to attract customers from countries where it is not granted authorisation. Perhaps these are issues that financial regulators need to think about in future, because it suggests a limit of their regulatory oversight and powers,’ he says.

Image credit: Rafael Henrique/AdobeStock.com

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