The world of crypto has been wracked with one piece of bad news after another ever since the global economic downturn influenced by the Russia-Ukraine war. The newest fiasco which has now led to a near wipeout of the market values of major cryptocurrencies such as bitcoin was the fall of FTX, one of the largest cryptocurrency exchanges which filed for Chapter 11 bankruptcy in November 2022. This followed the collapse in the value of stablecoin Terra Luna thus continuing the perpetuating cycle of digital asset instability. The collapse of FTX was further followed by further industry churnings as multiple virtual asset exchanges were financially exposed to FTX due to FTX’s position as an industry leader with exchanges such as Bitfront and BlockFi declaring bankruptcy. These events have the potential to scare off prospective investors and further erode the value of existing stakeholders in the virtual asset world. These incidents also show that crypto exchanges which operate in a regulatory vacuum often indulge in financial improprieties to uphold their market values thus calling into question the business practices of the whole industry.

Understanding the FTX Collapse

FTX was the second largest cryptocurrency exchange in the world valued at approximately USD 32 billion at the time of its collapse. The Company originated from the trading firm Alameda Research whose founder Sam Bankman Fried with a desire to broaden the investing base established FTX in 2019 as an exchange for virtual currencies initially focusing on larger institutional investors. The Company also introduced its own token FTT in July 2019 with preferential access to its trading platform for FTT token holders. As the market value of the FTT token began to rise, FTX began to artificially support the token by purchasing FTT from the market using its funds. At this juncture, it is alleged that FTX began providing loans of fiat currency taken from customer funds to Alameda Research which was claimed to be a sister concern of FTX operating in an arm’s length manner in exchange for FTT as collateral which was operating as a sister concern of FTX and held large numbers of FTT which were acquired at low prices.

The fall started when the balance sheets of Alameda Research were leaked in November 2022 which demonstrated the high exposure of Alameda Research to FTX which effectively amounted to largely an unsecured debt. The debt of FTX which amounted to the tune of USD 8 billion would be largely affected in the instance that the value of FTT suddenly dropped which would significantly affect the financial health of FTX as a Company itself. The next significant event took place when Changpeng Zhao (“CZ”) the founder of crypto major Binance which was a former shareholder of FTX and held significant numbers of FTT publicly announced that he was selling off all the stocks of FTT which Binance held, thereby leading to an investor exodus and a significant wipeout of FTX finances to the tune of approximately USD 6 billion. This was followed by a public announcement by CZ of an intention to buy out FTX and the companies even signed an agreement to that effect following a corporate due diligence of the financial records of FTX by CZ. CZ later publicly called off the proposed takeover after a few days stating that there were many discrepancies in the records of FTX. This announcement led to a large number of existing investors at FTX attempting to pull out their funds from FTX simultaneously which stretched the company’s finances and led to the Company declaring bankruptcy and the company appointing John Jay Ray III who was the insolvency professional handling the Enron collapse took over as the CEO stating that there were significant lapses of corporate governance in the company’s finances including a significant amount of funds which cannot be tracked. FTX’s former position as the second largest crypto exchange was reiterated when the entire digital currency ecosystem was affected due to its exposure to FTX’s funds. Cryptocurrency exchanges Bitfront and BlockFi declared bankruptcy publicly stating their exposure to FTX as the reason for their insolvency as well as other companies tethering on the doldrums.

Shockwaves of the FTX Bankruptcy

The FTX bankruptcy was soon followed by an announcement by the cryptocurrency exchange Blockfi which declared that it was halting withdrawals considering its exposure to the debts of FTX and Alameda Research and that was soon followed by an announcement that Blockfi was filing for bankruptcy due to its financial exposure to FTX as FTX had bailed Blockfi out in an earlier in the year. Additionally, there were announcements from major cryptocurrency platforms such as Genesis, CoinShares, Coinbase, and Galaxy Digital that publicly announced that they struggling to stay afloat due to their exposure to FTX finances.

Bankruptcy of Bitfront

The next major announcement was when the cryptocurrency exchange Bitfront backed by Japan’s social media giant Line announced that they will be suspending the signing up of new users as well as credit card operations with the ultimate intention of ceasing operations in the following few months. Existing depositors will be able to withdraw funds till 31 March 2023 and that that interest for deposits made date will be paid in mid-December 2022. Though the announcement by Bitfront mentioned that their declaration of bankruptcy was not related to any instance of financial improprieties at other allied organizations it may be reasonably assumed that the economic headwinds created in the global cryptocurrency market caused by the FTX crash and its ensuing volatility in the crypto market hastened the bankruptcy. The operations of Bitfront as an exchange were declining with the firm halting its business in South Korea in 2021 and cryptocurrencies on average losing more than two-thirds of their previous market value in the last year.

Need for a regulatory framework

An analysis of the FTX collapse and the subsequent bankruptcies at exposed cryptocurrency exchanges such as Bitfront only shows that a robust regulatory framework is required for the sector to ensure that such events may be minimised in the future. These safeguards are required to be provided to ensure that no virtual asset exchange is singularly exposed to any organisation financially and mechanisms are instituted to require sound corporate governance practices at organisations. While some jurisdictions such as the USA still have a regulatory vacuum regarding cryptocurrencies and some others such as India has adopted a legal framework aimed at discouraging investment in any kind of virtual assets primarily by way of punitive taxation jurisdictions such as the special economic zones Dubai International Financial Centre (DIFC) and the Abu Dhabi Global Markets (ADGM) in the UAE as well as Hong Kong have introduced preliminary regulatory frameworks in an attempt to cushion and ringfence the burgeoning industry and the greater financial system as a whole from such arbitrary shocks.

DIFC

The financial regulator for the DIFC the Dubai Financial Services Authority (DFSA) has introduced a regulatory regime for a crypto token which focuses on countering money laundering, consumer protection, market protection and ensuring safe custody of their tokens. DFSA as per their regime aims to publish an initial list of crypto tokens that will be readily available for financial firms in the DIFC to use for their activities. For other tokens, the trading entity will have to seek prior permission from the DIFC for purposes of trading in such tokens. DFSA reserves the right to disallow the trading in any token if there is insufficient transparency behind the background of such token or the underlying systems involved in their distribution such as protocol, the background of key managerial persons, governance mechanism, etc. Cryptocurrency exchanges must be registered as designated non-financial businesses or professions to operate out of the DIFC to ensure that anti-money laundering norms are followed, and such entities are effectively monitored by the regulatory authorities. Financial promotion of tokens not recognised by the DFSA is prohibited in the DIFC. DIFC is home to an exclusive venture studio platform focused on digital asset technologies named Studio Launchpad.

ADGM

The financial regulator for ADGM, the Financial Services Regulatory Authority (FSRA), has introduced regulations on cryptocurrency trading activities along the same lines as DIFC with similar aims of preventing money laundering and protecting retail investors. The regulations classify cryptocurrencies as commodities and require cryptocurrency exchanges to be licensed entities that may be existing regulated entities operating out of ADGM or new entrants and must possess a Financial Service Permission (FSP) license as granted by the FSRA. FSP license holders are only required to trade in virtual currencies which are accepted by the FSRA. Recognised cryptocurrency exchanges are also required to adhere to specific guidelines on corporate governance requirements including commercial, technical, and human resources requirements. For most purposes, the regulations follow a similar thread as those imposed by the DIFC. Virtual asset firms such as Matrix, Midchains, Hayvn, Seba Bank and Yoshi Assets are operating out of ADGM as of date.

Hong Kong

Hong Kong has issued guidelines which are due to come into effect from 1 March 2023 and applies to Virtual Asset Service Providers (VASP) which includes cryptocurrency exchanges. The main purpose of these regulations is to prevent money laundering as the major amendments have been made primarily to the applicable laws on money laundering in Hong Kong SAR. Under the regulations, VASPs must be licensed by the Securities and Futures Commission (SFC) which is the financial regulator for the territory. Overseas exchanges, currently the only form of VASP covered under the regulations, will not be allowed to operate in the territory. The regulations also will not cover peer-to-peer platforms, provided that the actual transaction is conducted off the exchange and the exchange does not come into possession of any client money or virtual assets. Licensed VASPs must be entities incorporated or registered in Hong Kong with at least two key personnel termed as “Responsible Officers” for operations and regulatory compliance one of whom must be an executive director. Individuals offering services on behalf of VASPs must be licensed by SFC as well. Additionally, the SFC is required to approve the VASP’s premises for the storage of data and the ultimate owner of the VASP apart from ensuring that VASP services are only available to professional investors for the time being. The regulations also set out certain licensing conditions which cover issues such as risk management, prevention of market abuse, asset management etc which must be adhered to by the VASP apart from broader requirements under the money laundering laws of Hong Kong.

Conclusion

The FTX fiasco and its ripple effects show that the world of cryptocurrencies with its immense popularity considering the global economic doldrums; cannot operate in a regulatory vacuum any longer. The FTX bankruptcy occurred in the absence of robust risk management policies and sound asset management policies of the Company. If the company operated in a regulated environment like the rest of the conventional financial services industry, then the company would have been required to provide adequate provisions for an economic downturn and would have been penalised for unsound investment strategies and the lack of an arm’s length relationship with its sister entity. The regulations as introduced by DIFC, ADGM and proposed by Hong Kong are all attempts to ensure that such mishaps do not occur under their regulatory frameworks by focusing on corporate management policies of exchanges, licensing requirements as well as recognition of the tokens which may be traded in their respective jurisdictions as in case of ADGM and DIFC. These steps merely attempt to ringfence investor funds and ensure a strong regulatory framework to ensure sound corporate governance amongst firms involved in the trading of digital assets. These steps promise to show the positive beginnings for the institution of a strong regulatory framework for digital assets as a whole and will only seek to prevent fiascos such as the FTX collapse and the accompanying economic shocks in the future.

Authors: Sumit Kochar and Upamanyu Banerjee