What Are the True Ramifications of the FTX Collapse?

Shock Waves from FTX

According to US attorney Damian Williams, the sinking of the FTX crypto exchange in November 2022 signified one of the worst financial crimes in American history. The nature of the crime, according to acting FTX CEO John Ray, was “old-fashioned embezzlement”, but, by the end of March this year, FTX co-founder Sam Bankman-Fried had been charged with 13 separate offences, generally divisible into the categories of money laundering, illegal campaign donations, bribery, and fraud. Bankman-Fried could receive a 155-year jail term if convicted on all counts. The federal judge in charge of his case could decide to be lenient, but we have seen white-collar criminals dealt huge jail-terms in the past, for instance in the case of Ponzi schemer Bernie Madoff, who was slapped with a hefty 150 years behind bars.

Aside from the impact on the former CEO’s physical freedom, the incident has set a shock wave rippling out to all parts of the crypto sector and the economy. FTX was involved in the operations of 130 other firms, most of which had to fold last December. The list of FTX’s creditors extends beyond 100,000. Indeed, explains Yuliya Guseva of Rutger’s Law School, “These interconnections within the crypto industry and their opaque nature exacerbate financial, operational, and liquidity risks”.

Analysts seem to agree that the full circumference of FTX’s ripple effect cannot yet be gauged, so we’ll have to wait and see, but we can already see direct effects in the arena of popular culture, where cryptocurrencies used to be openly promoted by celebrities and influencers. In mid-November, the Florida federal court hosted a class-action lawsuit against celebrities Shaquille O’Neal, Kevin O’Leary, and Steph Curry for assisting FTX in operating a fraudulent crypto scheme, aimed at duping the unwary out of their hard-earned money. The halo surrounding crypto – the one that suggested it was a taste of the inevitable future, the bandwagon you should jump on before it’s too late – had definitely dimmed.

What will the future of the crypto industry look like? We’ll try to sketch some broad outlines but, firstly, let’s update you on legal developments in the case.

Wang, Singh and Ellison

FTX co-founder Gary Wang knew Bankman-Fried since their days together at the Massachusetts Institute of Technology. The two friends started up the Alameda Research trading firm at Berkeley and then relocated to Hong Kong where FTX got off the ground. Later on, when they moved to Nassau, FTX snowballed to the enormous value of $32 billion. The FTX collapse, culminating in their filing for bankruptcy on November 11 last year, took even less than a week, which shows you how fragile the crypto ecosystem can be.

After that happened, in December, Wang pled guilty to charges of wire fraud and conspiracy to commit commodities fraud, cooperating with prosecutors and accusing Bankman-Fried of trying to delay the FTX bankruptcy. More damning for Bankman-Fried was Wang’s revelation that the CEO himself had asked for the firm’s computer code to be changed, so as to allow Alameda Research to illegally borrow customers’ money. This testimony could knock the nail in the coffin of the CEO with regard to his embezzlement charges.

Another senior FTX man who went along with the authorities was Nishad Singh, who was in charge of the firm’s engineering. Singh actually created the software code that made it possible to illegally transfer FTX client funds to Alameda, according to the SEC (Securities and Exchange Commission). Singh was also blamed by Damian Williams for “[corrupting] our politics with tens of millions of dollars in illegal straw campaign contributions” to Democratic nominees. Caroline Ellison, the former chief of Alameda, also pled guilty to the charges laid against her last year. Bankman-Fried, for his part, pled not guilty to all the charges he faced in federal court on January 3rd, 2023.

Crackdown

“Digital assets… are speculative products run by reckless companies that put Americans’ hard-earned money at risk”, said Senator Sherrod Brown in mid-February, summing up regulators’ fed-up attitude toward the sector. One of the preferred stablecoins, Paxos, was told by authorities to stop issuing their Binance USD (BUSD) token at the time. The SEC also wanted to sue Paxos for not registering their products under federal securities law. In response, the Binance crypto exchange saw $873 million in withdrawals from their platform in a single day.

The sudden demise of FTX cryptocurrency exchange had elevated the risks in the sector to top priority in regulatory circles, especially because of the hundreds of outraged FTX clients who had lost their money, perhaps never to recover it. The threat to stablecoins was particularly painful for the industry because they form a crucial hinge in the crypto infrastructure, receiving institutional funds meant ultimately for other crypto assets.

Another threat to the industry emerged in February, this time to the “staking” services offered by crypto firms, which allow people to earn passive income from their hoarded cryptocurrency. The SEC forced crypto platform Kraken to put an end to their staking products and fined them $30 million. Since this service is heavily relied upon by many digital tokens, the worry generated was real. The general mood of confusion and helplessness was captured by Marcus Sotiriou of GlobalBlock, who said, “People are desperately trying to figure out how to offer a product legally while getting zero guidance”.

Senator Brown was grateful the “crypto contagion didn’t infect the broader financial system”, but remained concerned because “we saw glimpses of the damage it could have done if crypto migrated into the banking system”. Next month, however, it would seem trouble did indeed manifest from the interconnections between traditional finance and crypto.

Silvergate, Signature, and Silicon Valley

In March, three US banks that worked together with digital asset firms were shut down: Silvergate, Signature, and Silicon Valley Bank. Signature, for instance, held $240 million of corporate funds from the Coinbase crypto exchange. When Circle announced they had $3 billion stored at Silicon Valley, their USDC stablecoin lost its peg to the US dollar, (although the token later recovered). Since stablecoins are touted as the “stable” incarnations of cryptocurrency, the depegging set off yet more alarm bells throughout the sector.

When Barney Frank, a board member at Signature, was asked why all this had happened, he answered it was because of “the nervousness and beyond nervousness from [Silicon Valley Bank] and crypto”. Indeed, agreed Ryan Selkis of Messari, “It’s hard to look at this and not see a coordinated effort to choke off the industry”. Many likeminded people viewed the events as symptomatic of a new intolerance brewing among lawmakers toward the industry. It’s not 100% clear this is the case, though. According to Mark Williams of Boston University, the real reasons the banks went under had to do with the macroeconomic backdrop and some bad risk management on the banks’ parts.

What Kind of Response?

Senator Elizabeth Warren, like her colleague Senator Brown, is worried about dangerous ties between traditional finance and crypto. She and other Democratic officials are focusing their energies on questioning the validity of many of these ties. Yuliya Guseva disagrees with her approach, however, because “Looking for linkages with US banks… is not what is needed in the wake of [the FTX] bankruptcy”. Rather, Guseva suggests, Congress should devote themselves to “providing regulatory clarity and introducing a workable framework for the crypto-asset market and relevant services”. Generally speaking, the Democratic approach to the FTX meltdown has been to rush to defend consumers against the dangers of crypto, while Republicans have urged that individual actors be blamed and the underlying technology be left intact.

In terms of concrete action, regulators have honed in most closely on stablecoins like Tether (USDT) and Circle’s USDC, which are pegged to the USD. The agenda has been to ensure that their disclosures are up to scratch and their reserves sufficient. Looking down the road, one of the most enduring legacies of the FTX failure may be in the field of new legislation. “Nothing spurs legislation like a crisis”, says Ron Hammond of the Blockchain Association. Indeed, new accounting laws emerged after Enron went belly up, back in 2001. New laws in the crypto industry could help it along, ultimately, in setting clear guidelines that could re-inspire institutional confidence.

Summing Up

Crypto enthusiasts point to its mushrooming prices over the years and its potential to store value in inflationary times and grow people’s wealth. One of Bitcoin’s claims to fame is being truly scarce, in the sense that only 21 million tokens will ever exist. Bloomberg’s Merryn Somerset Webb answers, however, that, “while scarcity combined with usefulness or desirability creates intrinsic value, scarcity in itself does not”. She also points out that we already have an inflation hedge that works: it’s called gold.

It remains for proponents of crypto to prove it can do things we couldn’t get done otherwise. In the meantime, we can only watch as the regulatory landscape in which it will have to thrive starts to take shape around us.