Ever since Bitcoin’s electrifying launch in 2009, the crypto market has evolved into a new frontier of wealth, generating a boom of cryptocurrencies, elaborate exchanges, and even a whole new universe built upon the blockchain. The new industry seemed immune to the financial pressures caused by the COVID-19 pandemic in 2020; people don’t need to leave their homes to buy and invest crypto. Indeed, the crypto market hit an all-time high in January 2021, and then again in November of the same year. For investors and a niche subset of the public, there appeared to be no end in sight. Reddit and Discord became a breeding ground for a new generation of young adults seeking the rush of asset trading, with real-time advice and discussion on market trends and even informational videos for those who decided that the alluring modern market was an attractive entry into the world of trading.
Unfortunately, for every boom there must be a bust. On November 7, 2021, the second largest cryptocurrency exchange in the world—FTX—announced a liquidity crisis and sought a bailout by venture capitalists and Binance, its top market rival. In a run likened to that of 1929, spooked investors rushed to the site seeking $6 billion in withdrawals. Over the next seven days, a whirlwind of events would unfold: Binance’s announcement—and then abandonment of—a plan to acquire FTX after diligence revealed evidence of mishandled funds; FTX’s foreign assets were frozen; and reports surfaced that millions of dollars in customer deposits were funneled into hedge funds eerily acquainted with FTX founder Sam Bankman-Fried mere days before the crash.
So what went wrong? It turns out that the SEC was wrestling with a “will they or won’t they” regulation dilemma on cryptocurrency for months leading up to the FTX crash. The agency, in deciding whether to launch into a lengthy and complicated research period to find the right regulatory balance, found itself grappling with a fear of restricting a growing and potentially lucrative industry while remaining worried of illegal cryptocurrency payments and a black-market ecosystem rife with cybercrime.
In fact, about a month prior to the run on FTX, the SEC began to toss around the idea of seriously cracking down on the crypto market. There was only one problem: the agency could not decide whether cryptocurrency counted as a security. SEC Chairman Gensler certainly made his views clear over the past year, citing the Securities Act of 1933, the Securities Exchange Act of 1934, and the “Howey Test” as put forth by the Supreme Court in SEC v. W.J. Howey Co.[1] Under the Howey Test, a transaction is considered a security if it meets the following four criteria:
- Money is invested.
- There is an expectation that the investor will earn a profit.
- The investment is in a common enterprise.
- Profits are generated via the efforts of others.
If deemed a security and registered with the SEC, crypto exchanges would be forced to adopt technology systems to make their order books audit-compliant. They would also face strict rules on order execution to prevent market manipulation. From Gensler’s perspective, crypto intermediaries that engage in the business of effecting transactions in security tokens are brokers. And those that buy, sell, or swap crypto security tokens for their own accounts are dealers. Because of this, crypto investors “should get the protections they receive from regulated broker-dealers,” Gensler said.
With FTX handling billions in consumer funds, it seems striking that the crypto exchange giant went wholly unregulated by the SEC for two years—and it’s not because FTX simply wasn’t on their radar. If the SEC was under the impression that it possessed authority to regulate crypto exchanges, it could have done so a long time ago. Chairman Gensler actually met with Mr. Bankman-Fried and FTX executives repeatedly in the months preceding FTX’s failure. Earlier that year, the SEC also inquired into documents and information on FTX’s practices related to its handling of customer assets—the heart of the alleged fraud—but evidently turned up with nothing. Whether this was just an unfortunate oversight, or the result of Bankman-Fried’s reputation on Capitol Hill as a friendly face with a deep wallet, remains to be seen.
Forging ahead, there continues to be pervasive uncertainty in the world of crypto. Many are wondering if the FTX scandal will result in a slew of legislation and regulation as did the last known financial scandal in recent history: Enron. It turns out the two are scarily linked in more ways than one. John Ray III, the leader in recouping billions for Enron’s creditors back in the early 2000s, has stepped in as CEO of FTX. Ray, however, seems to view the two on different levels, stating about the crypto exchange, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” In fact, the parallels between the two companies continue to reveal themselves. Enron painted itself as an advanced tech pioneer through its energy trading platform Enron Online. That very guise of modernity actually acted to shield dodgy accounting practices and related-party self-dealing while capturing institutional and regulatory actors to keep the wheel spinning. Here, the glamour of a new market built entirely upon the shiny new technological advancements of the last two decades resulted in a regulatory failure that allowed the FTXs to flourish domestically and internationally.
It does at least seem as though the SEC has learned from its mistakes. In late January 2023, the agency charged two digital asset giants — Gemini Trust and Genesis Global Capital — with selling unregistered products to individual investors. Congress announced that it would raise the agency’s budget this fiscal year. And a late 2022 court victory has finally given the SEC the go-ahead to fully treat crypto tokens as securities subject to regulation whether or not they are sold through initial coin offerings. Unsurprisingly, crypto companies are poised to fight back. Armed with internet conspiracists and Twitter “trolls,” the millennial and gen-z crypto community’s resistance to the SEC is centered around a doubt that the agency, comprised of mostly middle-aged civil servants, possess the knowledge and authority to try and regulate the market. The SEC, meanwhile, is standing strong on its desire to bring crypto middlemen like FTX into the existing securities regulatory regime.
Over the next few weeks, months, and years, the SEC will have an opportunity to redeem itself as long as it continues to deliver on its threats to crack down on the crypto market (and whatever other shiny new financial development that is sure to come). Should the SEC choose to regard it as so, FTX and crypto’s flashy rise and fall could serve as a final wake-up call for its continued history of leaving financial markets largely unchecked. But this isn’t the first time that writing has been on the wall. From Bernie Madoff cheating rich, sophisticated investors, to Enron’s hidden accounting practices and now Sam Bankman-Fried’s transfer of customer assets to small subsidiary venture funds, one can’t help but notice a larger pattern. Post dramatic newsworthy implosion, the agency likes to go public with its retaliatory measures for a few weeks. However, once the press dies down and the ringleaders go through prosecution, all public statements and efforts to regulate financial markets seem to fade away. If the SEC is serious this time about cracking down on consumer-oriented regulations, I hope that their recent actions and inquiries into the crypto market don’t turn out to be hollow. Moving forward, the questions remain—can the cryptocurrency industry remain afloat? Can the SEC rebuild the public’s trust? And more importantly: what lessons will the agency glean to prevent the next generation’s financial scandal?