The FTX Downfall: What It Means for the Future of Cryptocurrency

While cryptocurrencies have made their mark in earnest since October 2008, the year 2022 has seen the crypto market expand and contract, with total market capitalization dropping from $3 trillion in 2021 to shy of $890 billion as of December 2022. From its ever-increasing popularity to the November collapse of the cryptocurrency exchange FTX, it has been a whirlwind year in the crypto industry.

The year ahead will be important for cryptocurrencies as Congress and the relevant regulatory agencies consider whether to exercise additional oversight, and the Department of Justice attempts to ensure that consumers are protected from harm. If government agencies or investors successfully compel increased transparency in the crypto asset space, the coming years could bring additional investment and resources in all things blockchain, despite the FTX debacle.

What Happened with the Cryptocurrency Platform FTX and What Does It Mean for the Future of Cryptocurrency?

With the rise of cryptocurrency investing, companies and individuals turned to crypto exchanges to purchase cryptocurrencies, such as Bitcoin, ether (ETH), and Solana. As the interest in such investing increased, so did the popularity of the cryptocurrency exchange platform FTX. Investors could use FTX to make deposits and trade various forms of cryptocurrency. And, for a while, all was well until investors learned that Alameda Research, a hedge fund founded and operated by FTX founder Sam Bankman-Fried, had a significant amount of FTT—the native FTX token—on its books.

When CoinDesk published a report in early November 2022 that nearly 40 percent of Alameda’s balance sheet was tied to FTT tokens, rival cryptocurrency exchange platform, Binance, which held millions in FTT tokens, announced that it would liquidate its FTT holdings. As a result of this announcement, the price of FTT plummeted, FTX customers panicked and attempted to withdraw their assets, and both Alameda Research and FTX entered a loss spiral from which they could not recover. Binance considered purchasing FTX before abandoning the deal, citing “mishandled customer funds.”

It was soon discovered that Bankman-Fried had been using FTX customer deposits to plug holes in the balance sheet of Alameda (unbeknownst to customers) and had also taken out a $1 billion personal loan from Alameda’s reserves. As a result, nearly 2.7 million account holders may now find themselves unable to access their funds.

On December 13, 2022, the Office of the U.S. Attorney for the Southern District of New York unsealed an eight-count indictment charging Bankman-Fried with conspiracy to commit wire fraud, wire fraud, conspiracy to commit commodities fraud, conspiracy to commit securities fraud, conspiracy to commit money laundering, and conspiracy to defraud the Federal Election Commission and commit campaign finance violations. The same day, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) brought related lawsuits against Bankman-Fried. In less than a month, FTX went from an industry leader in Washington, D.C. and a backer of mega sports sponsorships to upending the entire crypto ecosystem.

In a post-FTX world, cryptocurrency companies must take steps to effectively manage risk, including: (i) the use of robust cybersecurity protocols; (ii) proper storing of private keys using effective controls or encryption; (iii) ensuring assets are not improperly comingled among related entities; and (iv) hiring reliable auditors and financial officers. The total lack of corporate governance within FTX is a warning to all companies in the crypto space that effective corporate compliance is more important than ever. Additionally, ensuring that investors are tax-compliant with regard to their holdings and any cross-border transactions, including related party transactions, has never been more important. This also means appropriately dealing with potential losses at both the entity and shareholder level(s).

An Industry-Wide Issue: Lack of Corporate Governance

The FTX crisis may not be the most well-known example of corporate malfeasance, but according to some estimates, the scale of investor losses could eclipse the Enron scandal. Some of the most egregious issues at FTX included:

• Use of corporate funds to purchase homes for employees;
• Failure to keep records of employees and employment status;
• Approval of expenses via emojis on an online chat program;
• A total lack of document retention, including a practice that saw documents and applications set to auto-delete after a certain period of time;
• Failure to keep meeting minutes and hold regular board meetings;
• Use of unsecured group email accounts;
• Deficient customer wallet/crypto key confidentiality mechanisms, exposing sensitive customer information;
• Secret, backdoor bookkeeping systems that allowed Bankman-Fried to move customer funds from FTX into Alameda without notifying those customers or senior-level FTX employees; and
• Failure to implement oversight mechanisms such as an independent advisory board.

At the press conference announcing the criminal charges against Bankman-Fried and parallel SEC and CFTC actions, the U.S. Attorney for the Southern District of New York, Damian Williams, said that while only Bankman-Fried has been charged, “we are not done.” At the same time, Gurbir Grewal, the Director of the SEC Division of Enforcement, said that unregistered cryptocurrency exchanges “don’t provide [investors and customers] with the same robust level of disclosures and protections against fraud and conflicts of interest. That’s what traditional, US-registered securities exchanges provide. So it’s imperative that non-compliant platforms come into compliance.” The comments from U.S. Attorney Williams and Director Grewal make clear that the government will continue to examine the conduct of other actors moving forward in the crypto space.  

The Future of Crypto – Congressional Action and Regulation on the Horizon?

The impact of FTX’s bankruptcy on crypto investors set off a firestorm that may prompt the federal government to increase oversight of the crypto industry. There are three main areas where change could take place.

Congressional Action

In the 118th Congress, the FTX failure could breathe new life into a bill introduced this year in the Senate Agriculture Committee, which would provide the CFTC with a greater ability to oversee cryptocurrencies. The bill, introduced by Agriculture Chairwoman  Sen. Debbie Stabenow (D-MI), and co-sponsored by ranking member, Sen. John Boozman (R-AR), would require crypto firms involved in the trading of digital commodities, such as Bitcoin and ether (ETH), to register with the CFTC as their primary regulator. Earlier this year, CFTC Chair Rostin Behnam commented that the CFTC would need approximately $100 million in additional funding to fulfill his regulatory responsibilities on crypto oversight – a 33 percent increase on his current budget.

On December 14, 2022, Senator Elizabeth Warren (D-MA) announced a bill that would designate providers of digital asset wallets as money service businesses, which, in turn, would require them to comply with the Bank Secrecy Act. The bill would require that cryptocurrency companies comply with know-your-customer requirements and would also prohibit financial institutions from dealing with services that commingle users’ cryptocurrencies together, obscuring their origin.

Regulatory Turf War

The ambiguity around whether cryptocurrencies should be defined as commodities or securities has resulted in a regulatory regime that is often unclear. The Chairperson of the SEC,  Gary Gensler, has been clear that he believes most crypto assets are securities and his agency should therefore be the lead crypto regulator. However, the CFTC has maintained that virtual currencies, including Bitcoin, are a commodities and, therefore, under the purview of the CFTC. Given slight differences in crypto assets, this confusion complicates regulation in this space.

Cryptocurrency Accounting

One area where there is likely to be increased clarity in the next year is with respect to accounting standards for crypto assets. The volatility of the cryptocurrency market is, in part, due to its lack of transparency, and it is more important than ever for investors in any cryptocurrency to know as much as possible about how much of any given crypto asset is in circulation, who owns it, and how much of it they own. The collapse of FTX has shown what can happen when these questions are unanswered, and the consequences can be devastating to investors.

While it remains to be seen if the federal government will take any legislative action, on December 14, 2022, the Financial Accounting Standards Board (FASB) released a tentative decision requiring an entity that holds crypto assets to (i) disclose the aggregate amount of crypto assets it holds separately from other assets; (ii) present gains and losses on crypto assets in the entity’s net income and separate from the income statement effects of its other intangible assets (such as amortization or impairments); and (iii) classify crypto assets it received as noncash consideration during the ordinary course of business and converted into cash as operating cash flows. Among other specific recommendations, the FASB Board also decided that crypto tokens should be reported at fair value and that an entity should disclose, both annually and at interim periods, the units held and the corresponding cost basis. Although FASB is not a regulator, it sets Generally Accepted Accounting Principles (GAAP), the accounting standard accepted by the SEC. FASB is also considering whether to issue guidance on how to appropriately value the native tokens that cryptocurrency companies create themselves, which was a key issue in FTX’s demise.

The Need for Counsel Well-Versed in Cryptocurrency Issues

Buchanan Ingersoll & Rooney has developed a team of attorneys and government relations professionals focused on helping companies and individuals navigate cryptocurrency issues and assess the impact on their industry, clients, business, and personal investments. Our firm’s Blockchain and Crypto Assets Practice Group is prepared to guide any individual or organization through the opportunities and challenges this fascinating space presents.