Rory Doyle, Financial Crime Policy Manager, Fenergo
The sorry tale of FTX’s collapse is not so much a story of the crypto industry but more about the need for even tighter regulation. How could a company the size of FTX, which had more than one million users at its peak, operate for so long with no clear record of money in and out? How could it collapse in less than two weeks?
FTX was able to raise billions of dollars in venture capital (VC) funding, yet failed in less than two weeks. Its collapse is an example of what happens when there’s a lack of governance and risk management and validates growing calls for tougher regulation of the digital assets market. It is not yet clear if the FTX scandal will damage long-term confidence in the digital assets industry, but it is a nervous time for crypto exchanges and investors as they watch and wait to see what happens next.
In this post, I reflect on what we’ve learned so far from the FTX case, what it means for global financial regulation and Financial Institutions (FIs), and the role technology should play in meeting changing compliance requirements.
A quick recap on the demise of FTX
FTX was founded in 2019 and collapsed just three and a half years later. As news reports emerged of alleged financial mismanagement between FTX’s various branches, including sister company, Alameda Research, spooked investors and customers pulled their money from the platform, causing its rapid implosion. FTX reportedly created its regulatory framework by acquiring companies that already had licenses, meaning it could give VCs the impression that FTX was a well-regulated company while bypassing lengthy and diligent applications processes.
FTX applied for Chapter 11 bankruptcy in November 2022.
John Ray III, who famously steered Enron through its bankruptcy, was brought in as FTX CEO to replace co-founder Sam Bankman-Fried. Ray’s role is to stabilize the company and recover as many assets as possible for investors, creditors, and customers. Ray said the former FTX leadership had “failed to implement virtually any of the systems or controls” required for managing investors’ money and that there was “an absence of recordkeeping”.
The fall of FTX is a lesson on the value of a prudent, regulated financial system. Without effective controls and policies in place, money can be moved around unchecked and illegally while creating opportunities for money laundering. This can have dire wider consequences on society as customers struggle to recover their losses.
Regulation around digital assets has been tightened, but the industry is likely to see further scandals like the collapse of FTX if crypto-related FIs are not continuously monitored and reviewed.
Tighter regulation and technology are key to sound compliance
Digital assets can cross borders a lot easier and quicker than traditional money flows. Therefore, crypto needs solid governance from an Anti-Money Laundering (AML) and Know Your Customer (KYC) perspective for those running crypto operations and also from a due diligence point of view for those investing. There are signs that regulators are getting tougher on crypto-regulated issues. In 2022, we saw significant AML-related fines from US regulators served on BlockFi, Robinhood, Bittrex and Kraken, which totalled $193 million.
The FTX collapse is a reminder that we need to see more regulations to prevent similar failures in the future, especially around the disclosure and reporting of assets. Regulation must evolve at the same pace as the established financial industry and we also need more regulatory inspections.
Digital asset exchanges must invest in compliance technology to survive. They need to satisfy not only regulators but also creditors, investors, and customers. Deploying compliance technology ensures good governance and good KYC. At a time when budgets are tight, FIs must continue to invest in compliance technology; automating reporting can provide long-term savings by reducing the resources required, avoiding costly penalties and the potential for lost business resulting from the reputational damage of a fine.
Lessons in due diligence
The FTX case is also a reminder to institutional and individual investors to do their due diligence on any organization in which they entrust their money. Read annual reports, listen to what external auditors are saying about liquidity positions, take a risk-based approach.
Without increased regulation, there will be further scandals and confidence in the crypto industry will erode. In short, the cryptocurrency market needs regulation more than regulation needs the crypto market. Nothing should stop cryptocurrencies from being easily regulated; the whole point of Blockchain is the ability to see the full trail of transactions. Cryptocurrencies are even being explored seriously by several national governments, with some – such as Japan and Sweden - even trialling Central Bank Digital Currencies (CBDCs). As the industry keeps evolving regulators will need to keep pace, both at a national and international level.
Digital assets could play a significant role in the future of finance and technology has a key role to play as FIs managing those digital assets seek to remain compliant across multiple jurisdictions.
To learn more about the current KYC landscape, and how Fenergo can help you address your KYC challenges, download our KYC Trends report