As Binance walks away from bailing out rival crypto exchange FTX, the rapidly unfolding saga is putting crypto on U.S. regulators’ radars yet again.
“It does not matter that these are global exchanges. It feeds the narrative that crypto companies are taking excessive risks with no oversight,” said Cowen analyst Jaret Seiberg. “It increases the risk that crypto firms have to break up into separate entities rather than function as one-stop shops.”
Seiberg said he sees the failed bailout fueling a push next year to bar crypto platforms from serving as one-stop shops for all crypto services, including custody, trading, lending and market-making.
SEC Chair Gensler, who has warned about the risks of crypto for years, has repeatedly called on exchanges to register with the SEC and has said the agency is in talks with the biggest players.
Georgetown Professor James Angel pointed out that under rules for traditional brokerages like Fidelity and Charles Schwab, brokerage firms must keep assets separate from customer assets.
“If you have money in Schwab, they can’t invest it. Your money needs to remain separate,” Angel told Yahoo Finance. “Those rules don’t exist in the crypto exchange space. FTX is taking customer assets and investing them in some way in illiquid tokens that have lost value.
Analysts think the FTX liquidity crunch will further fuel Gensler’s thesis that most tokens should be treated like securities, requiring trading platforms to register as exchanges.
The SEC has not responded to Yahoo Finance’s request for comment.
Gensler suggested to Yahoo Finance in July that rules that apply to traditional brokerages to protect investors in the event of a brokerage failure could also apply to crypto. However, Gensler said tailoring the disclosure regime for stocks to crypto likely makes sense, given disclosures for stocks may not be the same as a crypto token.
The Federal Reserve has called for subjecting crypto to the same rules that apply to banks. Fed Vice Chair for Supervision Michael Barr said in a speech in October: “Crypto-asset-related activity, both outside and inside supervised banks, requires oversight that includes safeguards to ensure that crypto service providers are subject to similar regulations as other financial services providers.”
Barr believes that the same type of activity should be regulated in the same way.
“This principle holds even when the activity may look different from the typical activities we regulate, or when it involves an exciting new technology or a new way to provide traditional financial services,” he said.
FTX CEO Sam Bankman-Fried approached Binance to acquire his exchange after a surge in customer withdrawals fueled by a loss in confidence of its token FTT and links to Alameda Research — also majority owned by Bankman-Fried.
Confidence teetered after Binance CEO Changpeng Zhao tweeted that Binance would sell its more than $500 million holdings FTT, noting that he wouldn’t support those who lobby against other industry players behind their backs. The selling momentum picked up after CoinDesk published a report that indicated that much of Alameda’s balance sheet was made up of FTT, a token that’s not very liquid. Masses of users started pulling money and cryptocurrency out of their accounts.
While FTX’s issues surround its international unit, not its U.S. unit, analysts expect it will result in congressional hearings next year even with Republican gains on Capitol Hill.
“The recent events show the necessity of Congressional action,” House Financial Services Ranking Member Patrick McHenry said in a statement. “It’s imperative that Congress establish a framework that ensures Americans have adequate protections while also allowing innovation to thrive here in the U.S.”
Sen. Sherrod Brown (D-OH), chairman of the Senate Committee on Banking, Housing, and Urban Affairs, echoed those comments on Thursday.
“The cryptocurrency market’s continued turmoil is why we must think carefully about how to regulate cryptocurrencies and their role in our economy,” said Brown. “It is crucial that our financial watchdogs look into what led to FTX’s collapse so we can fully understand the misconduct and abuses that took place.”
Sens. Cynthia Lummis (R-WY) and Kirstin Gillbrand (D-NY), have put forth comprehensive legislation to regulate the crypto sector. Given that it’s a mammoth bill, it looked more likely that the bill would be broken up before consideration of passage. However, this event could make it harder to pass comprehensive legislation, according to some analysts.
“We believe it is now even more challenging to pass bills like Lummis/Gillibrand. Yet it could open the door for bills that take a more onerous approach to regulation,” Seiburg said.
Sen. Lummis said the potential bailout and loss of liquidity is another reason why new regulations are needed for crypto exchanges.
“Market manipulation, lending activity, and whether customer funds and assets were appropriately safeguarded are just a few of the many issues my colleagues and I need to consider in the coming days,” Lummis said in a statement.
Now that the deal has failed, it raises the question of what risks it poses to the U.S. financial system. Angel said so far it doesn’t look like it will spill into the traditional financial sector and that there aren’t that many trading institutions that are exposed. Though, he added, many thought the same thing with subprime mortgages leading up to the financial crisis in 2007.
“We’re in the same fog of war that we were in 2008 where we don’t know who is insolvent and who isn’t,” Angel said. This shows why we have to regulate financial services so carefully.”