FTX, which collapsed over a 10-day period in November 2022, was not the first cryptocurrency exchange to fail — exchanges fail all the time. In 2020 and 2021, nearly 100 exchanges shut down.

FTX, however, was not a normal exchange. It was the third-largest cryptocurrency exchange in the world, providing services to more than one million users. In early 2022, it was valued at $32 billion. 

When FTX fell, it sent ripples throughout the crypto space. Bitcoin dropped to a two-year low, and many other crypto projects were negatively affected as well.

Among US regulators, the FTX collapse prompted a fresh wave of complaints regarding the lack of compliance in the crypto space. In comments prompted by the FTX crisis, US Securities and Exchange Commission (SEC) Chair Gary Gensler described those operating in the crypto space as “significantly non-compliant.” Allegations directed at FTX regarding compliance violations eventually led to the criminal indictment of Sam Bankman-Fried, FTX’s founder and CEO.

Crypto’s exposure to financial regulations is a confusing topic. While some say crypto lies outside of serious regulatory purview, others, like the SEC’s Gensler, argue that there are a number of financial regulations that apply to crypto. The case against Bankman-Fried provides an illustration of compliance issues that led to the FTX collapse, pointing those in the crypto space to compliance duties they must address to avoid future failures.

Providing Investors with Greater Transparency

The Securities Act of 1933 is one of the laws that Bankman-Fried is charged with violating in his operations involving FTX. The Securities Act was enacted following the historic stock market crash that occurred in 1929. It requires investment platforms to provide a high degree of transparency to prospective investors. It is based on the logic that more information regarding investments helps investors to better understand the risk that they are assuming.

The SEC says Bankman-Fried misrepresented to FTX investors the way in which their money was being handled, thus intentionally defrauding them and violating the anti-fraud provisions of the Securities Act. The SEC stated in a press release on its charges that Bankman-Fried concealed:

• The “undisclosed diversion” of funds from FTX to Alameda Research, a cryptocurrency trading firm that Bankman-Fried co-founded in September 2017 and which the SEC described as Bankman-Fried’s “privately-held crypto hedge fund;”
• The “undisclosed risk” that FTX assumed by investing in Alameda, which the SEC described as having “significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens,” and;
• The “undisclosed special treatment” that Alameda received in its relationship with FTX, which the SEC says included “a virtually unlimited ‘line of credit’” that was funded by FTX’s assets and that was exempt from “certain key FTX risk mitigation measures.”

The risks inherent in crypto markets is something that investors must accept. However, the information provided by crypto platforms empowers investors to better navigate those risks. When platforms withhold or falsify information on their operations, as FTX is charged with doing, it puts investors at an extreme disadvantage. Crises like those experienced by FTX can be expected when crypto exchanges fail to comply with regulations that require disclosure that is intended to aid investors.

John Ray III assumed the position of CEO at FTX after it declared bankruptcy and Bankman-Fried stepped down. He was called to testify before the US House of Representatives Financial Services Committee in December 2022 on the events that led to FTX’s failure. Ray explained to the Committee that FTX had “literally, no record-keeping whatsoever,” pointing to an overall lack of commitment to creating documentation and making it available to FTX’s investors and other stakeholders.\

Protecting Investors by Ensuring Liquidity

For investors, regardless of the asset, liquidity is an important consideration. Liquidity refers to the ease with which assets can be converted to cash. Some reports claim that liquidity was a contributing factor in the FTX collapse, saying that the exchange’s cash reserves were not sufficient to support the volume of withdrawals that occurred after reports of issues at the exchange began to surface.

Regulations applying to banks in the US require that they have a certain level of liquidity, but there are no regulations requiring the same precautions for crypto exchanges. Following the FTX collapse, however, that could change.

In a letter to US Treasury Secretary Janet Yellen encouraging a fresh look at crypto legislation, US Senator Sherrod Brown highlighted the role that a lack of liquidity may have played in the FTX collapse. In the letter, Brown argued that FTX suffered from “three of the most common hazards in financial markets — leverage, illiquid holdings, and extreme concentration.” While speaking to the Senate about FTX, Brown said that the US should look to “existing banking and securities laws for time-tested approaches” for overseeing and examining investment platforms.

Providing high levels of liquidity would seem to be a critical issue in crypto markets, where high volatility can lead to sudden and unexpected changes in value, though it remains unclear whether regulators will take the steps necessary to impose liquidity requirements. In the meantime, crypto markets should consider ensuring liquidity to be a best practice that is important to avoid the type of crisis that FTX suffered.

The cryptocurrency space has grown at a record pace by creating a world of inexpensive and ubiquitous access to advanced payment options. The next logical step is increasing efforts to manage the risks on the incredible platform that has emerged. Central to those efforts should be developing a deep understanding of compliance requirements and a strong commitment to enforcing them with the goal of protecting consumers and their investments.

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