FTX’s Collapse and How It Will Impact the Regulatory Landscape and Future of the Crypto Industry

As 2022 wrapped up, people felt the coldest wave of “crypto winter,” sending chills down their spine. With what James Bromley, an attorney involved in the FTX bankruptcy proceedings, described as  “the most abrupt and difficult collapses of Corporate America,” the once crypto giant succumbed under a series of its own financial misdeeds.

Sam Bankman Fried’s cryptocurrency empire, FTX, collapsed in a lightning-fast series of events. Followed by Coindesk’s analysis report of Alameda’s balance sheet and the company’s desperate and unsuccessful attempts to secure emergency funding covering the shortcomings of around $8bn dollars, the now infamous SBF filed for bankruptcy on Nov 11. He was arrested on Nov 22 for the charges of wire fraud, securities fraud, and money laundering.

Though the collapse has brought up so many questions, the developments in the case leave two major ones looming: How far will the damage spread? And Is there a way to save cryptocurrency?

“The recent collapse of FTX is a loud warning bell that cryptocurrencies can fail, and just like we saw with over-the-counter derivatives that led to a financial crisis, these failures can have a ripple effect on consumers and other parts of our financial system. The cryptocurrency market’s continued turmoil is why we must think carefully about how to regulate cryptocurrencies and their role in our economy,” said Sen. Sherrod Brown (D-Ohio), the Chair of the Senate Banking, Housing, and Urban Affairs Committee.

Assessing the Damage

The immediate aftermath of the crash saw the value of many cryptocurrencies drops sharply. Bitcoin, the world’s largest cryptocurrency by market capitalization, saw its value fall over by 10% in the days following the incident. Other major cryptocurrencies, such as Ethereum and Litecoin, also experienced significant declines.

The collapse also caused a domino effect, with many investors liquidating their assets and several crypto exchanges filing for bankruptcy. The companies, due to “significant exposure” to FTX, took a page from their “biggest creditor’s” handbook and filed for Chapter 11. The latest one to join the list is Genesis after BlockFi, Celsius Network, and Voyager Digital.

In addition to the direct financial losses suffered by the investors, the fall led to a negative impact on the overall perception of cryptocurrency. The traditional financial institutions and mainstream investors saw the collapse as a failure of security and stability in holding digital assets.

In a joint statement on the crypto-asset risks, Federal Reserve System and Federal Deposit Insurance Corporation said, “It is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system. The agencies are supervising banking organizations that may be exposed to risks stemming from the crypto-asset sector and carefully reviewing any proposals from banking organizations to engage in activities that involve crypto-assets.”

The skepticism is not baseless; this cryptic world operates in a peer-to-peer network of blockchain, where the transactions are just a click away. Many mainstream economists like Christine Lagarde, Paul Krugman, Nouriel Roubini, and Kenneth Rogoff have come out against crypto in the past.

European Central Bank President Christine Lagarde said she is concerned about people “who have no understanding of the risks, who will lose it all and who will be terribly disappointed, which is why I believe that that should be regulated.”

A survey conducted back in 2021 showed that 1 in 3 people investing in cryptocurrency knows little to nothing about it. Data collected from about 750 investors showed that only 16.9% of them understood where their money was going.

With the traditional finance system, even if the people do not fully understand the system, stringent laws and regulations back it up, protecting customers’ interests. In the case of DeFi, the regulations are there, but the exercising authority and the political lines blur around the edges.

In a speech back in Aug 2021, the SEC chair Gary Gensler said, “There are some gaps in this(crypto) space, though: We need additional Congressional authorities to prevent transactions, products, and platforms from falling between regulatory cracks. We also need more resources to protect investors in this growing and volatile sector.”

More than 13 years since the release of Bitcoin and more than a year since this speech, there are still no centralized regulations backing the space up. The crypto industry has been in a cold war with regulators for quite some years now. The drill doesn’t amount to anything but reviewing potential bills to pass aimed at revolutionizing this uncertain digital market.

“ If you wanted to build a new system for trading crypto, you could kind of just code it up and see what happened. Then you could go to the regulators and say, “Here’s how the rules for crypto should work,” and they might listen to you. (Or they might not. They might argue, as many regulators did, that crypto is largely covered by existing rules and that you were breaking them. But you might go ahead anyway or move to a different country with friendlier regulators.).” Matt Levine wrote in an article titled “How to not play the game.”

End number of new digital currencies and companies have been launched, and the policing authorities have struggled to keep up. There are 240+ crypto exchanges with 8870 cryptocurrencies to trade, according to CoinMarketCap.

In the months following the crash, a majority of these exchanges have been actively taking steps to reinstate the faith of investors and protect themselves from the same fate as FTX, including exercising regulations and providing publicly accessible reserve proofs.

Regulation and Decentralization’s Impact on the Future of Cryptocurrency

“2023 for us could be a real inflection point in policy, and a regulatory framework could be one of those things that help to accelerate the accelerator side of the crypto downturn,” said Tom Duff Gordon, VP of international policy at Coinbase.

The FTX breach had a detrimental effect, yet despite this, the cryptocurrency industry has proven to be quite resilient. Prices have recovered, and trading volume has reached pre-contagion levels. The episode, however, serves as a warning of the dangers involved with investing in digital assets and the demand for more security and transparency in the sector.

“It’s frustrating to see what a lot of people in crypto see as a built-in bias against the industry, which many of us understand because this space does have a side to it that deserves and requires scrutiny,” says Rachael Horwitz, the chief marketing officer for crypto investor Haun Ventures.

Cryptocurrency exchanges are constantly evolving, and a lack of regulations in this volatile space makes it easier for these institutions to engage in fraudulent and illegal activities. The lawmakers now have an impetus to get the proposed legislative laws finalized and set up a widespread regulatory framework.

The demise of this crypto giant did not help those who were building their trust in cryptocurrencies. However, they are missing the argument that FTX was not “Crypto” itself; it was a centralized medium that let you borrow, buy, and sell crypto.  The convolutional framework of “real” cryptocurrencies is based upon a decentralized financial system(DeFi).

“The major benefits (of DeFi) are we're looking at transparency. We're looking at the automation of risk management. We're looking at trustless reporting. You don't need to trust a third party, person, auditor, SBF, or anybody to understand the NAV and the valuation of a certain protocol. You can use things like subgraph technology. You can use things like Chainlink Oracle, and you don't have to trust a human being. You have to trust decentralized code, which is much easier to buy into.”  Mona El Isa, the CEO and founder of Avantgarde Finance and founder of Enzyme, said in an interview while talking about how DeFi can save cryptocurrency.

In their BIS working papers, the members of the Monetary and Economic Department of the Bank for International Settlements: Igor Makarov and Antoinette Schoar, explained how decentralized exchanges (DEXs) have gained a lot of attention and are now the DeFi industry segment with the quickest rate of growth. Users' ownership over their private keys is one of the fundamental benefits of decentralized exchanges versus centralized exchanges. Market participants cede ownership of their crypto tokens to the exchange when they deposit them with a centralized exchange. This exposes them to exchange risk; investors may suffer large losses if the platform is compromised and their funds are misused.

However, they also pointed out how we still have a long way to go since “the new financial architecture proposed by cryptocurrencies and decentralized finance presents formidable challenges for regulators.”

The biggest challenge in regulating the crypto architecture comes from the jurisdiction-free nature of the currency originating from the use of permissionless blockchain protocols and smart contracts. A common framework of regulations is needed to protect the interests of global investors and to ensure that exchanges do not exercise free will when it comes to operating across different countries.

“There also really needs to be coordination on enforcement to ensure that countries are not a safe haven and that there’s that level of global cooperation,” said Wharton’s Kevin Werbach, a longtime advocate of stronger oversight.