The regulatory gaps that enabled the disastrous failure of FTX — which was one of the most respected crypto companies in the world until just weeks ago before being exposed as a house of cards — underscore the high risks of trading on unregulated digital currency exchanges. It has prompted policymakers in Congress and federal agencies to consider new legislation and more aggressive penalties to avert a future meltdown. Crypto has evolved in a regulatory gray area where even activities resembling traditional financial products have evaded oversight.
A big question is whether regulators have sufficient powers or need more powers. Two key financial markets regulators — the SEC and the Commodity Futures Trading Commission — are facing scrutiny as to why they haven’t done more to shield consumers.
“Part of what we’re seeing is a sign that the financial regulatory system isn’t evolving as fast as it needs to to address emerging threats,” said Kate Judge, a professor at Columbia Law School.
FTX’s bankruptcy filings include outrageous allegations by top executives – including Bankman-Fried, a former political mega-donor – that they are treating FTX and its 130 subsidiaries like a slush fund. Behind its slick facade, FTX was actually a loosely organized network of investment firms, crypto companies, and holding companies with no centralized accounting system, little oversight of staff, and few internal controls to prevent Bankman-Fried and other employees from dipping into the company’s coffers.
“Never in my career have I seen such a complete failure of corporate controls and a complete lack of trustworthy financial information as here,” FTX’s new CEO John Ray III, who previously led Enron’s restructuring, wrote in a bankruptcy filing Thursday . “This situation is unprecedented.”
Because FTX’s Bahamas-based parent never registered with the SEC or the Commodity Futures Trading Commission — and spent tens of millions of dollars campaigning in Washington to ward off any arguments that it was necessary — internal operations have been tightened never scrutinized by FTX like Wall Street banks or traditional exchanges.
The SEC and CFTC have the power to investigate companies that are not registered with them, but there must be evidence of potential fraud or manipulation affecting the securities and derivatives markets they regulate.
“You can never stop fraud,” CFTC Chairman Rostin Behnam said in a Nov. 14 interview. “A regulated entity will certainly be in a much better position to avoid issues related to illegal activity or the use of client funds for illegal reasons.”
This is one of the reasons SEC Chairman Gary Gensler has called for crypto exchanges to be registered with his agency, according to sources familiar with the commission’s mindset. Registered stock exchanges must give up their books on request.
Gensler, who headed the CFTC during the Obama administration, has argued for the past two years that securities laws cover most crypto activity.
But the SEC’s efforts to investigate unregistered digital currency companies often face stiff opposition — including costly industry litigation and broadsides from crypto-friendly lawmakers in Congress.
In March, Gensler even spoke to Bankman-Fried, other FTX executives and exchange operator IEX about IEX’s plans to enter the crypto market, according to people familiar with the meeting. FTX’s US subsidiary later announced an investment in IEX.
Before the executives could get far into their presentation, Gensler paused and spent the rest of the meeting talking about how crypto exchanges should meet exchange standards, people said, asking not to be named while they were private talks discussed.
“I don’t think there was – within our framework – any way for the SEC to intervene in this case,” Rep said. Stephen Lynch (D-Mass.), chair of the Financial Technology Task Force of the House Financial Services Committee, in an interview.
Senate Banking Chairman Sherrod Brown (D-Ohio) said the SEC chief “believes he has the authority to do many things, but Gensler’s problem was that he inherited an agency that essentially opened the door for these crypto companies.”
The CFTC oversaw a component of Bankman-Fried’s empire, LedgerX, a derivatives exchange that was registered with the agency for about four years before it was acquired by FTX’s U.S. subsidiary in 2021.
Critics such as consumer group Better Markets have complained in recent days that the CFTC should have been following red flags surrounding FTX.
But Behnam said the only option the CFTC has is to look at LedgerX — one of the FTX entities that is not bankrupt and continues to operate.
“Any sane person would assume that regulation worked,” said Behnam, who has repeatedly urged Congress to give his agency more authority over exchanges that facilitate trading in bitcoin and other crypto commodities.
Behnam has thrown his support behind a Senate bill that would enable its agency to monitor digital assets, but the legislation now faces political headwinds because it also had FTX’s backing.
Treasury Secretary Janet Yellen on Wednesday called on Congress to fill loopholes in crypto regulation identified in an Oct. 3 report Financial Stability Oversight Council report Identifying the dangers that could result from the unregulated growth of the industry. The council is chaired by the Treasury Department and includes other leading financial regulators, including the heads of the SEC and the CFTC.
In the meantime, with Congress likely to squabble for months on how to monitor the market, Yellen wants regulators to start expanding their authority.
“We have very strong investor and consumer protection laws for most of our financial products and markets designed to address these risks,” she said in a statement. “Where existing regulations apply, they must be rigorously enforced so that the same protections and principles apply to crypto assets and services.”
Zach Warmbrodt contributed coverage.