FTX bankruptcy will show importance of regulatory approach

Collapse highlighted relative strengths of different regulators

The collapse of crypto exchange FTX has burned the fingers of investors all over the world, but the stringent approaches taken by some regulators have meant their citizens are likely to be better protected than others.

FTX sought customers from around the world. Since different regulators place different restrictions and requirements on exchanges, FTX created FTX US, FTX Japan and FTX Australia, in addition to FTX Global. This practice is not unique – many reputable crypto exchanges have taken similar steps.

FTX’s bankruptcy has shone a light on the relative strengths of different regulators’ approaches. FTX Japan, in particular, required exchanges to segregate customer deposits, holding them with a third-party bank or trust. This makes it more difficult for funds to be fraudulently misused, as FTX Global is alleged to have done.

Japan had some crypto-specific requirements, ensuring that the vast majority of customer assets were held in ‘cold storage’ – offline and safe from cyber-attack – and that its ‘hot wallets’ – assets held online for swift exchange – were backed up by exchange-owned assets in cold storage. This meant that, if any funds were leaked from the less secure hot wallets, customers would be made whole from the exchange’s funds.

Japan also had an external watchdog that requires exchanges to be audited annually, ensuring that they are adhering to these requirements.

This comes in contrast with FTX US where state, rather than federal, law governs crypto exchanges. FTX US, which was based in Chicago, had no such restrictions and neither did Bahamas-based FTX Global.

Other regulators have already taken similar steps. Canada’s regulator announced in late 2022 that virtual asset service providers would be required to hold Canadian clients’ assets with an appropriate custodian, separate from the platform’s own assets.

In the US, President Joe Biden has published a roadmap to mitigate the risks of cryptocurrencies. The report focuses on ramping up enforcement and calls for Congress to step up its efforts ‘expanding regulators’ powers to prevent misuse of customers’ assets’. There are several bills in Congress at present that might address these concerns, but their path to becoming law is unlikely to be quick or straightforward.

Other jurisdictions, like the UK, had not authorised FTX to provide financial services in their jurisdiction. The Financial Conduct Authority has approved only 41 of the 300 applications made by crypto businesses for UK registration. Sadly for UK investors though, the fact that FTX was not registered in the UK did not prevent UK customers from signing up to the exchange and depositing money with it.

The FCA has come under criticism for its harsh and complex registration policy and has pledged to adopt a friendlier approach in alignment with the UK government’s stated ambitions to foster crypto innovation. The UK Treasury has announced plans to strengthen its rules on digital assets, opening a consultation to introduce new rules. A Treasury spokesperson was quoted saying that the standards would aim to avoid commingling of customer and business assets, adding that they would look to impose standards of bookkeeping and governance similar to those expected of institutions in traditional finance.

The problems affecting FTX were not solely caused by an absence of regulation. A deficit of oversight and enforcement of existing regulations was also an important contributing factor. But if, as seems likely, jurisdictions that had introduced strict controls for crypto businesses have, in doing so, protected their citizens more effectively from losing money in one of the biggest disasters to ever hit the crypto ecosystem, then you can be sure that other regulators will be quick to follow suit.

OMFIF’s Digital Assets Regulatory Policy Tracker, available here, offers a way to keep track of these developments and others in the crypto space, including regulation on stablecoins, crypto-derivatives, mining rules and tax. The tracker is updated quarterly, most recently in January.

Lewis McLellan is Editor of the Digital Monetary Institute, OMFIF.

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