FTX’s collapse highlights the need to regulate crypto

Never let a good crisis go to waste. A near-existential catastrophe appears to have struck the cryptosphere: FTX, a major exchange that had a valuation of $32 billion in January, has collapsed with an $8 billion hole. FTX founder Sam Bankman-Fried – hitherto the friendly face of crypto – is mired in allegations that his firm misplaced or misused customer funds. Confidence in the broader crypto market – its trading holdings – was hit hard as Bitcoin fell in value. The time is now for politicians, policymakers and regulators to take protective measures.

There's an attractive simplicity to crypto's largely unregulated status: Don't invest unless you're willing to lose your shirt. It is a message that is easy for punters to understand. Whether they follow the advice is another question, given the siren call of easy wins promised by supermodels and sports stars in primetime advertising. The current approach has arguably helped to isolate the crypto crisis from the rest of the financial system.

To improve the status quo, there can be no half measures. A spate of retail investment scandals has shown that regulating only parts of a company's business gives the gloss of respectability without the benefits. It's confusing for regular customers who see that a company can have certain permissions and mistakenly assume that their investments are safe if something goes wrong. Crypto investors should not be bailed out when bets on an asset with no intrinsic value go wrong. Existing criminal laws can be applied to cases of fraud and theft. But there are simple improvements that could and should be made to protect consumers and the entire financial system from the risk of crypto.

The parts of the crypto ecosystem that touch the real world should have the most effective guardrails. This means that both stablecoins, which are supposedly backed by real-world assets as a way for traders to safely park their money between bets, and exchanges like FTX should be brought under the purview of regulators. Stablecoins should at least be required to publish verified reserves to show that their claims are true.

Similar transparency should be imposed on stock exchanges. The boss of Binance, FTX's arch-rival and once-controversial savior, has said that exchanges should now publish their proof of reserves. But that's of little use without also revealing the other side of the ledger. Binance has so far refused to publish its liabilities.

Beyond its exchange services, FTX has been engaged in lending, issuing tokens, and brokerage. Regulation of crypto exchanges should stop interconnected functions that can lead to conflicts of interest and “hyper-correlated” risks, as Bankman-Fried described it. Regulation should also require the segregation of customer assets to prevent the type of lending with other people's money that FTX gave to its sister hedge fund.

The US, UK and EU have draft legislation to try to close some of the loopholes. But political gridlock and turf wars have stalled progress, certainly in the United States. The weight of US markets and the long arm of its economic laws make it imperative that momentum is not lost.

It will be difficult to impose rules on an industry that has deliberately positioned itself outside of them, as a matter of principle and sometimes for more nefarious reasons. Smaller jurisdictions with looser regimes have provided a safe haven, as they have in other financial areas. This is undoubtedly problematic. But without action from the largest and most powerful jurisdictions, arbitrage, charlatans and outright fraudsters will continue to proliferate. Waiting for the next, more consequential crisis before acting may be too late.