How to Curb Self-Destructing Crypto Envy

FTX, which used to be the second-largest cryptocurrency exchange in the world, suffered a major liquidity crunch last week as hedge funds and other clients lost confidence.

In what amounted to an old-school banking race, FTX was hit by massive withdrawal requests, including $5 billion ($7.5 billion) in withdrawals on the Sunday before its collapse, which forced the exchange to suspend withdrawals.

Risky trade

The outflow was prompted by growing concerns over FTX’s close ties to Alameda, which had a reputation for both pursuing risky business strategies and large stakes it held in illiquid venture capital investments.

According to the wall street journal, FTX loaned some $10 billion to Alameda, using the money customers had deposited on the crypto exchange for trading purposes. In total, FTX had $16 billion in client assets.

Traditional brokers and exchanges are forced to separate client funds from the capital they use for trading.

But in the unregulated world of crypto, it’s far from clear that FTX clients will ever get their money back, or even that Bankman-Fried and FTX will face legal consequences for losing client funds.

FTX clients are not the only ones suffering huge losses. FTX investors included major venture capital firms, pension funds and hedge funds, such as Sequoia Capital, Tiger Global Management, Ontario Teachers’ Pension Plan and Singapore State Fund Temasek, some of which invested in FTX at a valuation of $32 billion. many months ago.

With the crypto exchange having now filed for bankruptcy, some investors, including Sequoia, have reduced the value of their investment in FTX to zero.

But the big question for regulators is how zealous they should be in trying to impose order on Wild West Crypto?

One approach would be for regulators to do very little by imposing controls.

After all, the whole ideological appeal of bitcoin and other digital assets – and the crypto industry more broadly – ​​is that it represents an escape from the clutches of governments and central banks.

Indeed, the very fact that Bankman-Fried ran his crypto empire from the Bahamas is proof that the crypto market was able to achieve its libertarian goal of creating an operating environment free from government interference.

Similarly, hedge funds and high-flying pension funds that invest in crypto companies have more than enough resources to conduct their own detailed due diligence on crypto companies, and enough financial muscle to force those companies to be more transparent about their finances.

Limit the excesses

Additionally, the market capitalization of the entire crypto market has now fallen to less than $1 trillion, and there are limited connections between crypto and the traditional financial system. This means that these periodic crashes in the crypto world pose little problem from a financial stability perspective.

People who invest their life savings in crypto know they are making a highly speculative investment – ​​that is part of its appeal. They just hope that the price of bitcoin or ether, or whatever digital currency they buy, will rise, which means they can sell their stake for a profit.

Still, Yellen’s comments underscore a strong willingness on the part of authorities to do something to curb crypto excesses, which often leave investors without the same protections against fraud or market manipulation that come with other types. of investments.

The May collapse of supposedly safe stablecoins luna and its sister token terraUSD has burdened investors with billions of dollars in losses and forced policymakers to focus on the lack of crypto regulation.

European Union regulators have crafted new rules that would require crypto issuers to publish a white paper outlining the characteristics and risks of their tokens, including what they intend to do with the funds they they rise.

In addition, issuers of stablecoins, whose value is pegged to that of other assets, such as the US dollar or the euro, also face tighter reserve requirements.

Meanwhile, in the US, the Financial Stability Oversight Council (FSOC) – which includes the heads of the Treasury Department, SEC, Commodity Futures Trading Commission and other agencies – released the month last a 120-page report claiming that crypto appears to be “primarily driven by speculation,” rather than addressing real-world needs.

The report notes that crypto firms “lack basic risk controls” and “have risky business profiles and opaque capital and liquidity positions.”

Still, the FSOC report argued that existing laws already solve many crypto problems, and it urged regulators to continue to take action against rule breakers, and the US Congress to pass legislation to regulate stablecoins.

But some believe that US and European regulators are not going far enough to protect investors.

They believe that crypto-assets should be subject to the same kind of regulation as other securities, so that anyone buying, for example, bitcoin has the same legal protection as if they were buying stocks or bonds.

But this tighter regulation is much more difficult to achieve, given the wide range of digital assets and platforms, and the ease with which crypto firms can change domiciles to evade the rules.

Indeed, the big risk is that the authorities will react to FTX’s bankruptcy by talking strongly about increased regulation, even if they lack detailed plans to improve investor protection.

Such a response would likely give inexperienced investors the impression that stricter rules are being implemented, which will only increase their sense of confidence about investing in crypto.

Instead, regulators should use FTX as an opportunity to educate clients about the huge risks they face when investing in an unregulated market such as crypto.

They should be extremely cautious about the unrealistic expectation that those who deposit money or buy crypto assets on these exchanges will be somehow protected, unless they genuinely have the intention to implement much tighter controls on the crypto industry.

It is extremely important for investors to realize that even if the scrutiny of stablecoin issuers is heightened, large swaths of the crypto industry will remain unregulated and investors will remain largely unprotected.

Because the illusion that regulators will somehow make crypto investing safer is extremely dangerous.

It’s telling that one of Bankman-Fried’s ploys to win the backing of high-end professional investors was to portray himself as someone who wanted the crypto industry to shed its unregulated image of Far West.

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