FTX, the Bahamas-based cryptocurrency exchange run by Sam Bankman-Fried, was the second-largest crypto exchange in the world before its spectacular collapse at the end of 2022.
Founded in 2019, FTX filed for bankruptcy last November. US prosecutors have subsequently charged Bankman-Fried with several financial crimes and campaign finance violations, including wire fraud and money laundering. Reuters reported that he allegedly orchestrated years of fraud by diverting investor funds to his private hedge fund, using the money to make venture investments, lavish real estate purchases, and large political donations.
At its peak, the company had more than one million users. FTX’s bankruptcy petition reported that it may have had more than 100 000 creditors and estimated its assets and liabilities in the range of $10 billion to $50 billion.
John Ray, who was named chief executive officer of FTX after Bankman-Fried’s arrest, told the US Congress’ House Financial Services Committee the company had “unacceptable management practices”, describing FTX’s use of QuickBooks for accounting and its approval of invoices via Slack messages.
Inexperienced leaders led to FTX’s implosion, he continued.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information,” Ray said. “From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated, and potentially compromised individuals, this situation is unprecedented.”
An article in a Columbia Law School blog argued the lack of audit and supervision at FTX “created a situation where leverage and fraud made FTX’s growth and collapse possible. Its investors did not exercise the minimum oversight.”
“FTX is an example of abject mismanagement, a complete lack of financial discipline, insufficient internal controls and profound conflicts of interest,” according to Rutgers Today, the publication of the State University of New Jersey.
Philip Davis, the prime minister of the Bahamas, said that the cryptocurrency regulations of the Bahamas could not have prevented FTX’s collapse. But the scandal has sparked a regulatory crackdown on crypto assets and intensified scrutiny of the activities of similar exchanges.
Governance and the crypto environment
Appropriate risk controls and processes generally minimise the risk of losses from fraud. However, these cannot entirely eliminate risk. Governance is not the same as regulation, and in its current state, crypto assets exist in an entirely self-governed environment.
As Jemima Kelly wrote in the Financial Times: “In the non-crypto world, there are rules, norms and mores that would aim to prevent this kind of thing from happening. But cryptoland is not a regular place; it is a largely unregulated free-for-all of hype, grift and charlatanism, where value is sustained only by the idea that there will always be a greater fool than you around.”
Good corporate governance is a mechanism for encouraging efficiency and preventing corruption. Standard governance interventions, such as the separation of powers between the CEO, board and shareholders, were sorely lacking in the case of Bankman-Fried and FTX.
An independent board with sufficient oversight is able to detect and prevent irregularities before they become entrenched, and appropriate governance standards and responsibilities of the board include transparency, accountability and risk management.
Making crypto exchanges subject to similar governance standards required of pension funds, with an independent board determining asset allocation and investment strategy, is a potential solution.
The lack of independent board oversight in the crypto arena has resulted in power concentrated in a charismatic individual, where decisions hinge on their whims.
Cryptocurrency exchange FTX failed because it focused power in one person – founder and CEO Sam Bankman-Fried, combined with a lack of expertise in its leadership team.
“The capital-markets system failed to provide the checks and balances that investors count on, leaving the crypto market in the hands of operators hostile to regulation,” Columbia Law faculty member Georges Ugeux wrote, questioning why due diligence, regulation, and governance evaporated in the case of FTX.
Furthermore, he warned that the general lack of governance standards poses a risk to the financial system through the threat of contagion.
“If FTX had more than one million accounts around the world, there is no doubt that, like all crypto products, retail investors had access to those products without any protection or transparency and were subject to profoundly dishonest marketing that made the crypto tokens and crypto exchanges a gambling casino,” Ugeux said.
Regulation as a solution
The Crypto Assets Regulatory Working Group, a joint venture between the Financial Intelligence Centre, National Treasury, South African Reserve Bank and South African Revenue Service, pointed out in a 2021 consultation paper on policy proposals for crypto assets: “The financial system and all participants operate in a highly regulated area, which assists in ensuring a sound and safe financial system. However, crypto assets perform similar financial sector activities without the need for third-party intermediaries and without similar safety mechanisms. This leaves the environment exposed to potential financial and consumer risks.”
According to a September 2022 International Monetary Fund (IMF) paper titled Regulating Crypto: “Crypto assets have been around for more than a decade, but it’s only now that efforts to regulate them have moved to the top of the policy agenda.”
While regulation may seem to be the answer to prevent further asset volatility in a complex system, regulation has limitations, and cannot make a risky asset less so.
“The underlying problem is that when a business model is based on an inherently volatile and novel asset class, our securities regulation and registration do not prevent companies from collapsing. The bankruptcies of the crypto lenders demonstrate the need for a better and different regulatory approach,” according to Rutgers Today.
Crypto assets have moved from being niche products to having a more mainstream presence as speculative investments, hedges against weak currencies, and potential payment instruments, demonstrating spectacular, if volatile, growth.
Applying existing regulatory frameworks to these assets or developing new ones is challenging as the world of crypto is constantly changing, making it difficult for regulators to keep pace.
The IMF has advocated for a global response that is coordinated, consistent and comprehensive, rather than differing, country-based regulations. “A global regulatory framework will bring order to the markets, help instil consumer confidence, lay out the limits of what is permissible, and provide a safe space for useful innovation to continue.”
But is it even real?
There are those who are vehemently opposed to the regulation of the cryptocurrency ecosystem, claiming this would legitimise the asset and give spurious legitimacy to something that has no value and that they claim is a complete scam.
Economist Nouriel Roubini is notoriously critical of crypto assets, and has claimed that FTX and Bankman-Fried’s behaviour is common in the industry.
The NYU professor said in a televised interview at the World Economic Forum earlier this year in Davos, Switzerland: "Literally 99% of crypto is a scam. A criminal activity. A total real-bubble Ponzi scheme that is going bust."
In his book Megathreats, Roubini says, “The rapid rise of Bitcoin, Ethereum, Dogecoin and thousands of fledgling cryptocurrencies exposes our collective wilting faith in the ability of governments to back the money they issue. But elevating crypto to the status of legitimate currencies endorses a dangerous precedent.”
Inadequate oversight
In its 2021 Global Financial Stability Report, the IMF said: “Many of these entities lack strong operational, governance and risk practices. Crypto exchanges, for instance, have faced significant disruptions during periods of market turbulence.”
US lawmakers have expressed concern that the FTX collapse “shows crypto may be more integrated into the banking system than regulators are aware, and that there could be possible implications for people who don’t invest in cryptocurrency.”
Bankman-Fried is due to appear on trial in October, when more details of FTX’s activities will come to light. In the meantime, it is up to the international monetary authorities to act in order to prevent another collapse, one that could perhaps cause more widespread damage to the broader financial system.
The failure of FTX will serve as an example of bad governance and is a stark reminder of why individuals should avoid investing their wealth in opaque exchanges and wealth vehicles that are subject to deeply dishonest marketing.
KEY TAKEAWAYS
- US prosecutors have charged FTX founder and former CEO Bankman-Fried with several financial crimes since the collapse of the crypto exchange.
- Appropriate risk controls and processes generally minimise the risk of losses from fraud. However, these cannot entirely eliminate risk.
- The financial system and all participants operate in a highly regulated area. However, crypto assets perform similar financial sector activities without the need for third-party intermediaries.
- While regulation may seem to be the answer to prevent further asset volatility in a complex system, it has limitations, and cannot make a risky asset less so.
- There are those who are vehemently opposed to the regulation of the cryptocurrency ecosystem, claiming this would legitimise the asset and give spurious legitimacy.
Environmental, social and governance goals
While this article has explored the governance of crypto assets, there are also environmental concerns attached to the technology. The underlying technology used to create crypto assets known as “mining” requires enormous underlying energy intensity.
“Creating cryptocurrency consumes so much energy and there is a high environmental cost of the data mining that bitcoin demands. Crypto assets are energy hogs, using as much energy as the Netherlands or Argentina. If crypto mining accelerates, they will blunt urgent climate initiatives to slow down global warming.” – Nouriel Roubini, Megathreats
Thomas Kgokolo CA (SA) was previously the interim chief executive officer of South African Airways from April 2021 and was responsible for transitioning the airline out of business rescue. He lectures in finance and strategy at GIBS.
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