FTX’s shocking demise proves it’s time to embrace regulation

The crypto space is still reeling after FTX's shocking collapse last week. Joe Davide recaps how the exchange fell... how a few basic safeguards could have protected investors... and why the crypto industry needs to embrace regulations.
Joe Davide
By Joe Davide Research Analyst

By now, you’ve surely read about crypto exchange FTX’s shocking collapse. Crypto investors and outsiders are wondering how it happened… and what the fallout will look like.

Put simply, FTX’s demise is a game-changer for the crypto industry. It’s too early to know if other big players will suffer the same fate… but regardless, investor confidence has been shattered.

As I’ll explain, this event proves the need for more regulations in crypto. Even a few basic safeguards would have helped the millions of investors who lost money when FTX and other exchanges collapsed in recent months. More importantly, regulations will help put the crypto industry back on solid footing. 

But first, we need to go over how one of the largest exchanges in the world crumbled in less than a week… and why no one saw it coming…  

A shocking one-week collapse

The chaos started when some of FTX’s financial documents were leaked…

No one knows who was behind the leak, but the documents came from Alameda, the hedge fund/trading firm owned by FTX’s (now former) CEO, Sam Bankman-Fried. Alameda is a sort of “sister company” to FTX… but the details are still hazy about how much overlap there was between the two companies.

The documents ended up in the hands of Coindesk, which published an eye-opening article on November 2 that revealed the details of the two companies’ financial ties. 

In short, Alameda had $14.6 billion in assets. The concerning part was that nearly $6 billion of those assets were linked to FTT, the native token of FTX. 

It turns out FTX was making loans to Alameda… and accepting its own token as collateral. In other words, the company put itself in an extremely risky position. If Alameda didn’t pay back the loans, FTX could end up being stuck holding a worthless asset… thereby leaving the company insolvent (which is exactly what happened).

Keep in mind, FTX was doing fine as long as no one noticed the precarious position it was in… and the value of FTT didn’t drop.

But everything changed once the financials were revealed… On November 6, ChangPeng Zhao, CEO of FTX’s biggest rival, Binance, said he was selling his company’s FTT holdings, worth about half a billion dollars.

This news created a panic, sending investors running for the exits… and FTT soon lost 87% of its value in less than 24 hours. 

Following the decline, FTX halted withdrawals… basically freezing customers’ accounts to prevent any more selling, which would cause the company to completely run out of cash.

On November 8, Binance stepped in to try to rescue FTX. It made a non-binding agreement to purchase FTX (aside from its U.S. operations)… but quickly retracted the offer after seeing the carnage. 

Binance probably saw there was no way to fix the massive hole in FTX’s balance sheet. Plus, its reputation was ruined… further damaging any long-term value that Binance would get from an acquisition. 

By the end of the week, FTX lost $8 billion in value, pushing the company into bankruptcy. Put simply, its assets weren’t worth anywhere near enough to cover the billions of dollars it would cost to keep the company afloat.

On Friday, November 11, FTX announced it would file for chapter 11 bankruptcy… and that Sam Bankman-Fried would step down as CEO. He tweeted, “I sincerely apologize,” causing his followers to make angry comments and question whether he was ever being honest.

SBF tweet: "I sincerely apologize"
Source: Twitter

Before last week, Bankman-Fried’s net worth was estimated to be around $16 billion. But with the collapse of FTX, that number has plunged by about 95%… an incredible $15 billion loss in just a few short days. It’s the largest sum of money lost by an individual in financial history… and it’s reported that the U.S. Justice Department will be investigating Bankman-Fried and FTX.  

It’s a stunning turn of events in such a short time.

Last month, I wrote about why FTX could become the “Goldman Sachs of crypto” because of its strategic purchasing of Voyager, LedgerX, and other assets. It’s disappointing to see a company that took years to build get wiped out in a matter of days.

This week’s top movers

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Crypto needs regulation

This isn’t the first such story in the crypto industry. Back in May, Three Arrows Capital, a crypto-focused hedge fund, failed under similar circumstances. 

Three Arrows ran into trouble because it invested a large sum in the Terra stablecoin. When Terra collapsed, the fund’s losses were compounded by its leverage. In short, Three Arrows had borrowed billions of dollars to fund its risky bets. And when Terra plunged, its losses were far more than it owed, forcing Three Arrows into bankruptcy.

In the world of finance, everything tends to be connected. So it’s no surprise that Three Arrows’ problems spread to other firms. One of its biggest lenders was Celsius, a platform that allowed its users to take collateralized loans on crypto. When Celsius began failing, it halted client withdrawals… and soon filed for bankruptcy, as well.

Things settled down over the past five months… and it looked like the crypto space was back on solid footing. 

But the collapse of FTX proves that the May/June 2022 problems weren’t just a one-time event for the crypto industry.

Even if the FTX saga finishes without taking down more firms… we’re bound to see more problems in the crypto space as long as it keeps avoiding the typical regulations used in the traditional financial sector.

The most obvious examples (that would have helped users who had their accounts frozen on exchanges like FTX and Celsius) are FDIC and SIPC insurance…

You’re probably familiar with the FDIC (Federal Deposit Insurance Corporation)… it’s what keeps your bank account safe in case of a bank failure. While the FDIC doesn’t technically cover brokerages, regulated U.S. brokerages typically keep your cash holdings at an FDIC-insured financial institution, which means they qualify for FDIC “pass-through” insurance. For example, Gemini provides the details of its custodial banks on this helpful page

The other important protection for investors comes from the SIPC (Securities Investor Protection Corporation). This is basically the same thing as FDIC insurance, except it protects your assets in case of a brokerage failure. But right now, SIPC protection does not apply to crypto brokerages because crypto is not considered a security for legal purposes.

Keep in mind, FDIC and SIPC insurance do not apply to losses you take on your investments. But they ensure investors’ deposits and/or assets are safe even if their bank/brokerage collapses.

These basic regulatory protections wouldn’t immediately solve the biggest problems in the crypto space… but they could have helped millions of customers who lost their assets on FTX, Celsius, and other failed exchanges this year.

The other major piece of regulation I want to mention is the Securities Exchange Act of 1934 (SEA), which created the Securities and Exchange Commision (SEC)… and gave it regulatory power over exchanges, brokerage firms, and other key players involved in securities. 

In short, the Securities Exchange Act of 1934 is the basic framework for regulations that prohibit a range of financial misconduct like fraud and insider trading. Most importantly, it “requires periodic reporting of information by companies with publicly traded securities.”

I don’t want to get lost in the details of this ancient piece of regulation. The important thing to understand is that it forces big companies to disclose their financials on a regular basis, so everyone can see their condition.

This kind of transparency is almost non-existent across most of the crypto space. Only a few U.S.-based public companies (like Coinbase and Silvergate Capital) are 100% regulated and provide up-to-date financial statements each quarter.

Increased regulations wouldn’t prevent every future crypto crisis. (For example, there are no laws to stop the failure of a hedge fund like Three Arrows Capital.) 

But most of us just want to be able to invest without the fear of losing our money (and crypto) when an exchange collapses. And even the most basic regulatory protection would be a huge step in the right direction.

It’s time to embrace regulation

Like it or not… regulations are coming. 

After last week, the crypto industry might not have much say about what happens next. On November 10, White House Press Secretary Karine Jean-Pierre commented on the FTX collapse, saying, “The most recent news further underscores these concerns and highlights why prudent regulation of cryptocurrencies is indeed needed.” 

I’m not a huge fan of regulations… but they’re needed in the crypto industry. 

After the FTX collapse, investors don’t trust most exchanges or brokerages. Regulations will help restore confidence in the industry… and add important safeguards to ensure these kinds of crises aren’t a regular feature of the crypto sector.

Keep in mind, regulation is super-important to institutional investors. If you’re a crypto investor, you should be rooting for any changes that will help draw more institutional money into the space. As I explained last month, BlackRock and other big asset managers could pour billions of dollars into crypto… but they need to see a healthy regulatory framework to prevent these kinds of disasters.

I’m looking forward to more regulations in the crypto industry… as it will help stabilize the markets and will create more transparency for investors.

Editor’s note:

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Joe Davide
Joe Davide is a research analyst with a passion for all things crypto. He contributes to Crypto Intelligence, Wall Street Unplugged, and Curzio Crypto. When he’s not researching tokens, NFTs, and metaverse tech, Joe’s usually playing a round of golf.

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