Jeffrey Hymen

Senior Editor

Loyola University Chicago School of Law, JD 2023

The rise of crypto

New investment vehicles and opportunities have flooded the financial services industry over the past few decades, but arguably none have grown in popularity at a rate comparable to cryptocurrency. A cryptocurrency is a digital or virtual currency typically based on a decentralized network that utilizes blockchain technology. In other words, this decentralized feature allows a network of users to verify and record transactions without relying on any central authority, which permits the cryptocurrency to exist without government interference.

While the concept of cryptocurrencies originated in the 1990s, the first major cryptocurrency to utilize blockchain, Bitcoin, entered the market in January 2009 and the first commercial Bitcoin transaction followed in May 2010. Popular digital assets such as Ethereum (ETH) and Tether (USDT) entered the market over the next couple of years, and the number of tradable cryptocurrencies subsequently skyrocketed to nearly 800 by the end of 2017. The proliferation of new cryptocurrencies has prompted the creation of large exchanges in order to facilitate the trading of digital assets in a safe and efficient manner. However, the involvement of major cryptocurrency exchanges, such as FTX, BlockFi, and Coinbase, have drawn the attention of regulators as digital asset trading volume increases. While the future of cryptocurrency remains bright, the recent collapse of FTX ought to prompt regulators to more closely monitor advances in the digital asset space to effectively protect investors from misconduct. A failure to adequately regulate the growth of cryptocurrency could be catastrophic for the future of digital assets and potentially the broader market.

The demise of FTX

The Securities and Exchange Commission (SEC) has charged FTX founder Sam Bankman-Fried with eight criminal counts, including wire fraud and conspiracy. Bankman-Fried raised at least $1.8 billion between May 2019 and November 2020 from investors who were falsely informed that FTX used effective controls and risk management protocols, according to the SEC’s complaint. The SEC alleges that Bankman-Fried regularly misappropriated customer funds to his privately-held crypto hedge fund, Alameda Research. Bankman-Fried then used the misappropriated funds to pay for real estate purchases, various venture investments, and corporate contributions to political candidates that exceeded the statutory $25,000 annual limit. Bankman-Fried also falsely represented to FTX customers that Alameda Research was merely another platform customer that did not hold any special privileges, according to the SEC.

FTX’s collapse arguably began in November 2022, when a CoinDesk publication released a report indicating that Alameda Research held an abnormally large amount of FTT tokens, which are issued by FTX. Bankman-Fried created FTX in 2019 in part to help financially support Alameda’s trading business, which meant that problems with one unit may negatively impact other areas of the business. Binance, a separate cryptocurrency exchange, announced a few days later that it would attempt to sell FTT tokens “due to recent revelations.” Binance’s announcement prompted FTT tokens to drastically drop in price as crypto traders raced to withdraw from FTX. FTX subsequently filed for bankruptcy as the company was unable to facilitate the mass amount of withdrawal requests due to its liquidity problem, which initially prompted the SEC to investigate Bankman-Fried and Alameda’s connection to FTX. FTX investors who were denied withdrawal requests are not expected to be able to recover their money.

Impact on the crypto space

FTX’s bankruptcy filing and the SEC’s subsequent investigation into Bankman-Fried has sent shockwaves across the crypto space. Amidst the FTX crisis, crypto investors have raced to withdraw invested funds from other major cryptocurrency exchanges, such as BlockFi. BlockFi filed for bankruptcy nearly two weeks after FTX with the company noting its “significant exposure” to FTX as well as the existence of at least 100,000 creditors. In an earlier attempt to help BlockFi evade bankruptcy, FTX provided a $400 million revolving credit line last July, which was accompanied by an option to eventually purchase the company. However, BlockFi’s connection to FTX ran far deeper than the revolving line of credit as evidenced by a report of uncensored financials that was supposedly uploaded by mistake. The uncensored financials indicated that BlockFi had $1.2 billion worth of assets exposed to FTX, including $415.9 million in assets linked to FTX as well as $831.3 million in loans to Alameda. While BlockFi is attempting to disassociate itself from FTX, the financial ties between the two companies will create challenges during bankruptcy proceedings.

Even though investors across the crypto space are feverishly rushing to withdraw after FTX’s collapse, BlockFi’s involvement with and reliance on FTX ought to serve as a lesson to cryptocurrency exchanges that enter the market in the future on how to structure their businesses. Furthermore, the SEC and other regulators should consider setting limits or standards pertaining to cross-exposure between crypto exchanges in order to avoid another domino effect leading to a crypto market upheaval if one major crypto exchange fails again.

Regulator response

Instead of initially attempting to more closely police the controls and risk management policies employed by crypto exchanges, regulators are focused on monitoring the financial advisory firms that recommend crypto products to investors. The Financial Industry Regulatory Authority (FINRA) has responded to FTX’s collapse by launching a targeted exam to obtain additional information as to how broker-dealers approached retail communications “concerning crypto asset products and services.” The targeted exam, as outlined on FINRA’s website, will probe communications pertaining to crypto assets at 20 separate broker-dealers that occurred between July 1 and the conclusion of September. Specifically, FINRA will request for production “all retail communications” relating to crypto products, which are defined by FINRA as “any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period.” While the definition commonly applies to written communications, the rule implicates alternative communication channels, such as video, social media, websites, and mobile applications. FINRA is expected to request additional information regarding each communication, including the initial date of dissemination to the public, whether a principal at the broker-dealer approved the communication, and whether it was submitted to FINRA’s Advertising Regulation Department (ARD).

While FINRA’s targeted exam is an encouraging start, the SEC and other regulators must act in order to restore the public’s perception of crypto and protect retail investors. Closely monitoring broker-dealers and their crypto-related communications will only do so much to shield investors as evidenced by Bankman-Fried’s intentional misconduct and FTX’s subsequent collapse. Emphasizing heightened regulation of the internal compliance policies, risk management protocols, and advertising practices employed by crypto exchanges will help to safeguard the investing public and potentially pave the path to another crypto boom in the future.