How Better Compliance Will Prevent the Next FTX Catastrophe
By Sandy Fliderman, Co-Founder & President — Industry FinTech
There are a number of reasons why cryptocurrency is a risky investment, some of which — like its volatility — are inherent and will likely never go away. Other reasons, however, are avoidable.
A lack of compliance with applicable laws and regulations is one of the avoidable reasons that crypto is risky, as was shown by the collapse of the FTX cryptocurrency exchange. FTX, which at its peak was a $32 billion crypto exchange, quickly plummeted in November 2022, taking the crypto market with it. Allegations of a number of compliance violations surfaced following the FTX collapse, eventually leading to the criminal indictment of FTX’s founder and CEO Sam Bankman-Fried.
In the aftermath of the FTX crisis, crypto critics quickly highlighted the lack of compliance in the industry; even US Securities and Exchange Commission (SEC) Chair Gary Gensler described the crypto space as “significantly non-compliant.” The charges levied against Bankman-Fried reveal a number of compliance issues that must be addressed if crypto is to earn the trust of the followers it needs to enter the mainstream.
Compliance with transparency requirements
One of the charges brought by the SEC against Bankman-Fried involves violations of the anti-fraud provisions of the Securities Act of 1933. This law, which was put in place in response to the historic stock market crash of 1929, calls for a high level of transparency in the statements provided by investment platforms. The law springs from the belief that increasing the amount of information available to investors lowers the risk level of their investing.
In the case of FTX, the SEC argues that Bankman-Fried intentionally defrauded investors by misrepresenting how the funds they entrusted to FTX were being handled. In its press release on the charges, the SEC specifically states that Bankman-Fried concealed:
- The “undisclosed diversion” of funds from FTX to Alameda Research, which the SEC describes as Bankman-Fried’s “privately-held crypto hedge fund;”
- The “undisclosed special treatment” that Alameda received from FTX, which the SEC says included “a virtually unlimited ‘line of credit’” that FTX’s assets funded and that was exempt from “certain key FTX risk mitigation measures,” and;
- The “undisclosed risk” assumed by FTX as a result of its investments in Alameda, which the SEC says had “significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens.”
When Bankman-Fried stepped down as CEO following the FTX failure, John Ray III stepped in to manage the platform’s operations. In December 2022, Ray responded to some of the SEC’s allegations while testifying before the US House of Representatives Financial Services Committee. Ray revealed that FTX had “literally, no record-keeping whatsoever,” highlighting the overall lack of value that FTX placed on creating documentation and making that documentation available to its stakeholders.
Investors must accept the volatility inherent in crypto markets. And yet, without access to information on additional risks such as those presented by FTX’s investment in Alameda, investors cannot be expected to understand or appreciate the full risk level they are assuming. Unless crypto exchanges comply with regulations that ensure that level of disclosure, crises like those experienced by FTX can be expected.
Compliance with liquidity best practices
Liquidity is the term that is used in the financial realm to explain the ease with which assets, like cryptocurrencies, can be converted to cash. Some reports on the FTX collapse point to issues with liquidity as a contributing factor, saying that FTX did not have the cash reserves necessary to cover the volume of withdrawals prompted by early rumors of trouble at the exchange.
US regulations require banks to have a certain level of liquidity, but crypto exchanges do not have similar rules. However, comments made by regulators in the aftermath of the FTX collapse indicate that liquidity requirements may be a part of future regulations.
US Senator Sherrod Brown, who chairs the Senate Banking Committee, reached out to US Department of the Treasury Secretary Janet Yellen following the FTX crisis regarding the need for crypto legislation. Brown’s letter to Yellen stated that FTX suffered from “three of the most common hazards in financial markets — leverage, illiquid holdings, and extreme concentration.”
The volatility in the crypto market means the values of particular assets can fall suddenly and unexpectedly. To address that reality, crypto markets must have high levels of liquidity. While that practice is not a regulatory requirement at this point, it is nonetheless a clear best practice that should be applied to avoid the type of “run on the bank” that FTX suffered.
Cryptocurrency has created a world of inexpensive and ubiquitous access to advanced payment options, spurring record growth. As a result, the industry now needs to be concerned about managing the downside risks of the incredible platform that has been built. Understanding compliance requirements and enforcing them should be central to any exchange’s efforts to protect its customers and their investments.
Sandy Fliderman is an experienced CTO and Entrepreneur with expertise in cutting-edge technology, big data analytics and large-scale operational systems. He has been involved in all levels of technology firms from start-ups to publicly traded companies with areas of focus across multiple industries. Sandy has expertise in developing new technology platforms including holding several patents in the cybersecurity space. Most importantly, Sandy is passionate about innovation and how technology can be used to improve and modernize outdated ways of doing things. Sandy is currently a member of the 2022 Forbes Technology Council as well as the Florida Business Journals Leadership Trust. Sandy is the Co-Founder and President of Industry FinTech (“IFT”), an innovative, digital back-office platform supporting Funds, SPVs, REITs, Deals and Private Companies.