What Regulators Must Do Now in Light of FTX Scandal

How did we not see this coming? That’s the question many people are asking as the hyper-rapid, and potentially rabid, collapse of crypto trading platform FTX triggers a worldwide regulatory investigation.

Others may be taking their line of questioning a step further and asking: What could have been done to prevent this?

Calls for crypto regulations have grown louder following the collapse of the cryptocurrency exchange, which filed for bankruptcy on Nov. 11. The U.S. House Financial Services Committee is moving quickly to undertake a bipartisan hearing next month to investigate the cryptocurrency exchange’s collapse, the findings of which will likely have legislative repercussions for the entire industry.

In a recent court filing, the company’s new CEO John J. Ray III said FTX demonstrated “a complete failure of corporate controls,” which was helped along by “faulty regulatory oversight abroad.” Leaders in the public sector, including the former head of the Federal Deposit Insurance Corporation (FDIC), have joined the “regulation now” chorus in the wake of FTX’s failure.

Read more: Ex-FDIC Head: People ‘Getting Hurt’ by Lack of Crypto Rules

PYMNTS recently sat down with Saule T. Omarova, a professor of law at Cornell University, where she specializes in the regulation of financial institutions, banking law, international finance and corporate finance, to talk about the recent developments with FTX, and their implications for the broader financial and regulatory system. Omarova was President Joe Biden’s nominee for U.S. Comptroller of the Currency, before requesting that her own nomination be withdrawn.

“We should have seen something like this coming because of the incredible speed with which this market has grown and the lack of any legal or regulatory compliance culture in this new sector, run by a lot of interesting [sic] personalities who are not necessarily part of the financial establishment,” Omarova told PYMNTS’ Karen Webster. One of the most immediate and important failures in the whole FTX saga was the lack of “common sense internal controls.”

See also: SBF’s ‘Big Dumb Game’ Leaves ‘Worse than Enron’ Cleanup For CEO

In fact, much of the dubious detail surrounding FTX’s demise was apparent long before the final collapse — including the somewhat surprising reality that FTX operated with no CFO, and its board of directors consisted of only CEO Sam Bankman-Fried (SBF), another FTX employee and a lawyer.

Technology moves faster than regulators do

Most crypto crisis stories tend to result from solvency, rather than liquidity problems. The problem is not converting assets to money, the problem is that the underlying assets are themselves bad and that the money, when demanded by the parties it is owed to, simply isn’t there to be paid out. Crypto firms tend to have, and rely heavily upon, assets highly correlated to confidence in crypto as a whole — meaning a loss of confidence can often entail a corresponding loss of assets.

“Clearly these regulatory frameworks do not get us to where we need to be with respect to protecting the customers…or protecting the institutions themselves from failure,” Omarova said. “While it may be possible to institute a system of safeguards into a new regulatory framework, it is extremely difficult to get right and extremely difficult to enforce because the digital asset sphere is so dynamic and dependent on technology — and technology moves much faster than regulators do.”

This is the problem the industry faces coming out of FTX’s collapse, and it remains the main issue that needs to be addressed in order to shore up faith and trust in the long-term viability of cryptocurrency marketplaces as volatile, but reputable, places for investors to park their money.

Omarova said she was concerned that in the rush to address the industry’s apparent failures through comprehensive regulation, fueled by a politically motivated need to “do something quick,” public bodies could actually enact significant harm to the traditional financial system.

“For example, people who contribute to 401ks, or people who buy mutual fund shares, they would indirectly be much more exposed to digital assets,” she explained.

FTX’s collapse could point lawmakers toward deeper issues

Interestingly, Omarova saw the structural issues of the FTX collapse as not too dissimilar to the problem of the rise of secondary and tertiary exchanges in traditional financial markets, as “entirely synthetically created assets are [traded] for the sake of simply trading that have effectively overtaken the capital raising function of our financial system.”

There is a need to find more reliable and provably justifiable benchmarks for judging the value of financial claims and discerning the price of particular assets through objective and repeatable, context-agnostic methodologies.

“We really need to focus on the structure and dynamics of our financial markets to make sure investor money is not channeled or incentivized to go into purely speculative financial assets that bring no value to the real economy,” Omarova said.

This doesn’t mean we need to prevent the cryptocurrency markets from existing.

It just means that, perhaps, the general population needs to take a step or two back from the popular perspective that cryptocurrencies are the future of payments.

“As soon as you create that illusion that some private issue token is just as safe as the U.S. dollar issued by the Federal Reserve, you immediately put the Federal Reserve on the hook, and the entire federal government on the hook to back it up, should then the entire system come collapsing,” Omarova said.

The U.S. government and financial system went through a similar situation of regulatory and legislative need during the ‘80s and early ‘00s, as hybrid financial instruments such as derivatives and CDOs came on the market.

What is required now is the same degree of oversight that was needed then. Such oversight will require more resources and an expanded toolkit, one that empowers regulatory and enforcement agencies to properly protect both consumers and investors.