Jakub Porzycki/NurPhoto via AP
The most obvious and inevitable financial collapse in a while—the spectacular meltdown of the apparently fraud-riddled crypto exchange FTX—just keeps getting wilder. FTX had nearly ten times as many liabilities as liquid assets. Executives at FTX knew that the company had lent customer funds to its associated hedge fund Alameda Research to cover debts. Sam Bankman-Fried, FTX and Alameda’s founder and a future prison inmate, apparently installed a “back door” to move funds out of FTX without triggering accounting or compliance concerns. More than one million creditors are seeking restitution in bankruptcy. There was some sort of hack that appears to have been an inside job, among other efforts that look like insiders being allowed to abscond with cash.
It would be great if the FTX debacle was somehow unusual, and not just a badly run version of the kind of scams we’ve seen throughout financial history, particularly in the crypto space. A lot of focus is now going into how to properly regulate crypto, as if it’s a legitimate financial instrument that we need to standardize. The better way to look at it is as a vice or a deliberate fraud scheme, like cigarettes, illegal drugs, multilevel marketing operations, or gambling.
These products have vastly different regulatory environments, from law enforcement approaches, to sin taxes, to warning labels, to advertising bans, to assistance for the addicted. Some combination of that seems like a better idea than trying to maintain the fiction that crypto is a legitimate, productive wealth-building instrument.
What we have right now is a free-for-all over crypto regulation. FTX had been influential in pushing a bill that would move most of the oversight to the overworked and understaffed Commodity Futures Trading Commission (CFTC). Gary Gensler, chair of the Securities and Exchange Commission (SEC), which has filed lawsuits against crypto companies, has bashed the CFTC bill as “too light-touch,” noting that FTX helped consult on it.
CFTC’s chairman, Rostin Behnam, was a staffer for Sen. Debbie Stabenow (D-MI), co-author of the bill and the chair of the Senate Agriculture Committee, which has jurisdiction over the CFTC and whose members would benefit financially from adding free-spending crypto to their oversight roster. FTX’s chief D.C. lobbyist until this week, by the way, was a former CFTC commissioner. (It’s a classic case of greasy Washington corruption that makes me feel like I need a shower.)
Anyway, the Agriculture Committee was going to advance that CFTC oversight bill this week, but the FTX collapse ended that, and members are now giving back their FTX campaign donations. (How sad for them.)
Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY, and a holder of crypto) have a different industry-friendly bill that also gives the CFTC primary regulatory authority, and requires a study of the “opportunities and risks” of allowing digital assets into retirement accounts. Other industry wish list bills have been authored by Rep. Patrick McHenry (R-NC), the likely incoming chair of the House Financial Services Committee. A half-hearted effort to regulate stablecoins, which are digital tokens that are supposed to be pegged to the U.S. dollar like a money market fund, hasn’t gone anywhere.
The better way to look at crypto is as a vice or a deliberate fraud scheme, like cigarettes, illegal drugs, multilevel marketing operations, or gambling.
Sen. Elizabeth Warren (D-MA) seems to want the SEC in the lead, but also wants any crypto regulation to be “comprehensive,” including restrictions on Bitcoin mining and crypto-enabled money laundering. Sen. Sherrod Brown (D-OH), chair of the Senate Banking Committee, is leaning toward holding a hearing on FTX but hasn’t committed to any legislation, in part because of the expected pull of the industry toward watering down congressional action.
Out of everyone, Brown has the best of this argument. We’re hearing a “now more than ever” drumbeat right now—as in that Congress needs to regulate crypto, now more than ever, given all the scandals—but the truth is we typically police frauds through civil and criminal law enforcement. Rug pulls, pump-and-dumps, and other scams are rampant in crypto; the delightful website Web3isgoingjustgreat chronicles this on a daily basis. Stiffing customers who buy your investment product is illegal. FTX is already under investigation by the Justice Department and the SEC, and the SEC is also investigating Binance and Coinbase.
As usual with our regulators, the problem isn’t lack of laws but lack of will. FTX was already licensed and registered with the CFTC. They did nothing with the regulatory authority they had, and I’m not hopeful about what would happen if they get more.
By contrast, the SEC has demanded that crypto assets register as securities, which would force segregation between exchanges and brokerage sales. The industry has refused to do so and instead appealed to Congress to strip the SEC’s jurisdiction. With that stalled, the SEC can fine companies who don’t comply with their rules out of existence. This has been dismissively called “regulation by enforcement” by the industry; why, yes, that’s how you root out fraud.
Congress can get involved by fully funding the SEC’s effort to crack down on what can only be called a crime wave. New legislation doesn’t have to be part of that. It’s highly unlikely that anything coming out of the current legislative process would protect anyone. It would more likely hook crypto into the broader financial system, which regulators have resisted. That’s the only reason why the crypto collapse hasn’t infected the rest of the financial system.
If the government puts together a regulatory regime for a fraud scheme, the “too big to fail” conundrum can take hold, where they might feel obligated to bail out the crypto industry to protect investors. But law enforcement, and handcuffs, can perform that task of investor protection much more efficiently. Maybe if digital assets were serving some vital purpose, we would need to tailor some regime to allow it to blossom. But as Dean Baker explains, that does not really exist with crypto.
Arguments to ban digital assets fall along the lines of arguments to ban casinos, cigarettes, or alcohol. They usually are pretty unpopular. People are free to gamble, for example, though local governments offer services for gambling addiction. This is somewhat incongruous but consistent with the recognition that outright bans don’t work politically.
That said, the government doesn’t have to go in the opposite direction and devote resources to making crypto thrive. They could just toss anyone using crypto to defraud people in jail. Casinos are regulated at the state and federal level—they are defined as financial institutions under the Bank Secrecy Act—but the real forcing mechanism for compliance is the possibility of criminal indictment.
Regulators can facilitate this by loudly letting customers know that they are taking on huge risks by investing their money in digital assets. If you try to trade in penny stock markets, the website for those transactions warns you that it is reserved for “professional and sophisticated investors with a high risk-tolerance for trading companies that may have limited information available. Investors are strongly advised to proceed with caution and thoroughly research companies before making any investment decisions.”
There’s your regulation: a strong “let the buyer beware” warning. This is similar to the large warning labels on cigarettes, as well as the industry-funded public service announcements that smoking is harmful to human health. That ad campaign came out of a master settlement with the tobacco industry, and law enforcement officials should think about replicating that strategy.
Meanwhile, you don’t see pro-cigarette ads on television anymore, thanks to a ban enacted over 50 years ago. One actual legislative option is to do the same with crypto marketing. Larry David and Matt Damon have helped entice people into highly risky and fraudulent markets. This has been very lucrative for media and sports leagues—Miami is hastily changing the name of the FTX Arena where it plays home games—but if the harms outweigh the benefits, there’s ample precedent to limit advertising.
Even without such a law, the Federal Trade Commission has the authority to enforce truth-in-advertising laws, and can get involved here the same way that it does policing multilevel marketing schemes like Herbalife. Just this week, a private lawsuit was filed against celebrity endorsers of FTX on the grounds that they were pitching unregistered securities. Regulators and law enforcement can similarly pursue fraudulent marketing.
And if you really want to get into it, a large tax on crypto transactions, designed specifically to reduce the industry’s size and impact on the economy, would be appropriate.
I get antsy when I see the Federal Reserve’s vice chair for supervision Michael Barr—who himself has been tied up in crypto companies and trade groups—say that the FTX crash demonstrates the need for “strong guardrails,” and regulation akin to that of other financial services products. Crypto doesn’t share those qualities. We don’t need it for a functioning financial system. We should treat fraud like fraud.
