FTX or no FTX, more exchange regulation was always coming

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To the surprise of almost nobody, governments are ramping up efforts to regulate digital asset exchanges. The recent collapse of FTX came with all the usual revelations about missing reserves, “loans” between related entities, and general rule-breaking. Such is the outrage that a regulatory response is almost mandatory, and United States Senators Ron Wyden (D-OR) and Sherrod Brown (D-OH) this week started the ball rolling.

Sherrod Brown chairs the Senate Banking Committee and has been vocal in the past about protecting customers from digital asset scams. Post-FTX, he sent a written request to Treasury Secretary Janet Yellen for assistance in drafting new digital asset legislation covering exchanges. He also called to speed up action on the Financial Stability Oversight Council’s recommendations from a report on digital assets published in October 2022 and promised to use his position on the Banking Committee.

The Financial Stability Oversight Council was established under the Dodd-Frank Wall Street Reform and Consumer Protection Act and (as its name suggests) looks for risks that could affect the stability of the U.S. financial system. Its October report identified a number of “regulatory gaps” specific to the digital asset space, particularly “stablecoins” and regulators’ ability to examine and supervise “affiliates and subsidiaries of crypto-asset entities.”

Ron Wyden is the Senate Finance Committee Chairman. His response to the FTX debacle was to send letters to six of the largest digital asset exchanges (Binance, Coinbase, Bitfinex, Gemini, Kraken, and KuCoin) asking them to provide information on their organizational structures, balance sheets, customer protection policies, insurance, and affiliate/subsidiary companies, along with non-digital-asset-related activities such as real estate acquisitions made by the company or key personnel.

Sen. Wyden’s questions seem to relate directly to accusations against FTX, probing the exchanges about what assets make up their reserves, how they intend to prove/audit them, and whether managers consider their exchanges to be highly leveraged. As polite requests (as opposed to court orders), the letters don’t have deadlines or set rules about how the exchanges should answer, so Wyden could be waiting a while for satisfactory answers to questions like the ones in this example.

FTX brought mainstream attention to digital asset exchanges

That more scrutiny and regulation would follow FTX’s collapse was inevitable. Indeed we have predicted for some time now that the rules would tighten regardless, simply because digital asset exchanges have become far more prominent in recent years. The general public lack of understanding of blockchain and “crypto” meant exchange implosions of the past could still slip under the radar, but that’s no longer the case.

The above-mentioned revelations about FTX and the way exchanges really operate have become familiar to anyone with more than a few years of experience in the industry. But FTX was supposed to be different. It targeted the mainstream market, sought photo-ops with regulators instead of hiding from them, and worked hard on a “we’re the good guys” image.

CEO Sam Bankman-Fried has even tried to maintain that good-guy image as his business and reputation crumble around him, setting out on a media mea culpa tour and claiming it was all just the result of mistakes and naivety. As he reiterated in a much-publicized Q&A with Andrew Ross Sorkin of the New York Times, he’s really sorry he failed his stakeholders and wants nothing more than to make it up to everyone. Despite all appearances to the contrary, he was never aware of any wrongdoing as FTX comingled funds, over-leveraged its reserves, and miscalculated its liabilities.

Perhaps this is all part of the act, or perhaps SBF really believes he did his best. As Matt Damon said in “The Talented Mr. Ripley”: “You never meet anybody that thinks they’re a bad person.” Responses on social media suggest few of his former customers are buying it, or at best, they don’t care. So we shouldn’t be surprised if even some of the most hardened ‘crypto-veterans’ start baying for more regulation—anything’s better than losing your life savings.

Exchanges are really fiat money gambling casino businesses, after all

No one should panic at the thought of the government seeking new means and opportunities to increase its regulatory reach into the “crypto industry.” It’s important to remember that digital asset exchanges are, at their core, really fiat money gambling casino businesses and not the innovative blockchain applications everyone wanted ten years ago. Their business has little or nothing to do with “real world” digital asset usage or economic benefits. A large proportion of their customers never move their digital assets out of exchange wallets, depositing and withdrawing only in USD or other national currencies.

This is the kind of activity governments are seeking to regulate, and all they’re doing is asking exchanges to follow the same rules as every other regulated market. As the Financial Stability Oversight Council’s report noted, most exchange/trading activity already falls under existing laws, and it’s just a matter of determining who should enforce them.

Follow CoinGeek’s Crypto Crime Cartel series, which delves into the stream of groups—from BitMEX to Binance, Bitcoin.com, Blockstream, ShapeShift, Coinbase, Ripple,
Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.