Date first published: 10/01/2023
Key sectors: technology; finance
Key risks: credit risks; market contagion
Risk development
In November 2022 FTX, the cryptocurrency exchange specializing in derivatives and leveraged products, filed for bankruptcy. FTX was once valued at US$32bln and its founder Sam Bankman-Fried was the most prominent name in crypto. Its failure highlights serious issues that arise due to the lack of regulation of the crypto space and the profile of its collapse will likely push policymakers in Washington to create a formal and extensive regulatory structure.
Why it matters
Crypto assets are partly regulated, with the Securities and Exchange Commission previously took action against fraudulent crypto operators. However, securities laws were largely designed before the widespread use of digital assets – and are not specifically designed for that new class.
The US based Commodity Futures Trading Commission (CFTC) is likely best placed to regulate crypto going forward. However, the CFTC has focused on institutional markets – that means areas where there are few individual retail investors. Institutional investors are generally expected to have greater capacity to analyse information, while markets dominated by smaller retail investors require different disclosure and transparency rules. The market is also global, and without international cooperation other jurisdictions could impose weaker rules.
Background
The FTX collapse highlighted serious issues with the crypto market. While the trigger for the company’s collapse was depositors trying to withdraw their funds, FTX was particularly suspectable given serious fraud and management issues. The most charitable read is that FTX suffered from a complete failure of corporate control, with reports indicating that there was no record of who worked for the company and the no process for monitor expenses.
However, the reality is that FTX engaged in serious fraud. Customer funds were transferred to FTX-affiliated hedge fund Alameda Research. The US Attorney for the Southern District of New York claimed that FTX is one of the ‘biggest frauds in financial history’. Around US$8bln in customer funds are believed to be missing, with little prospect for recoveries.
FTX collapse raises some questions about the due diligence of some of the world’s largest funds. Major investors put more than US$2bln in FTX, with little evidence that they carefully audited the company’s operations, Furthermore, the company’s collapse also comes as crypto assets are facing a free fall. While they reached a peak over the pandemic, rising rates have money flee risker assets. While investment into crypto slowed since 2021 and largely stopped in May 2022, when TerraUSD stable coin collapsed, FTX’s bankruptcy will also hamper confidence in the future of most crypto assets. That is particular problem given that its value had little to do with fundamentals.
Investors in FTX lost significantly – although that does not mean that the company’s collapse will have a large impact become the crypto market. The market even its peal was relatively small compared to other financial assets, and major investors holdings were relatively small. That means that there is unlikely to be systemic impact on financial markets.
Risk outlook
It is easy to see FTX as heralding the end of crypto. That is likely too dramatic of a conclusion. Improved regulation could partially help restore confidence in exchanges, and crypto has been relatively robust to push scares. However, it is likely that there will be greater scrutiny by investors in the year ahead. The most likely outcome is that a few cryptocurrencies, Bitcoin and Ethereum amongst them, and regulated exchanges like Coinbase will still survive – but the sector is likely to evolve considerable in the coming years.
