Crypto cockroaches flee the contagion: but where?

Apart from inflation, the RBNZ’s 75 basis point OCR hike and the FIFA World Cup in Qatar, the collapse of FTX, a Bahamas-domiciled cryptocurrency exchange, has left the crypto world,...

Apart from inflation, the RBNZ’s 75 basis point OCR hike and the FIFA World Cup in Qatar, the collapse of FTX, a Bahamas-domiciled cryptocurrency exchange, has left the crypto world, and indeed financial markets, reeling for the past few weeks.  This collapse is a massive fall from grace from what was once the darling of the crypto world.  Crypto investors are now nervously looking around wondering who is next and what the contagion will be of these.  Cockroach theory in financial markets:  if you see one cockroach there must be hundreds if not thousands elsewhere…  Some commentators are even calling this the end of crypto claiming that the industry will never be able to regain its standing and the trust that the FTX collapse has lost.

Founded in 2019, FTX had grown exceedingly quickly to become the second largest crypto exchange in the world, transacting over US$2 billion per day in crypto assets.  Its annual revenue leapt to more than US$1 billion in 2021, almost 20 times more than what it had been the previous year.  (That’s warning number one by the way, revenue seemingly appearing from nowhere).  At one stage, the company’s shares were valued at over US$32 billion, and it had recently taken in investment from prominent professional and institutional investors such as Ontario Teachers, Singaporean Sovereign Wealth Fund, Temasek, and leading high-profile US venture capital firms Tiger Global and Sequioia Capital.

Over the past year, the FTX founder and previous CEO Sam Bankman-Fried (SBF as he is referred to on Twitter) had been on a charm offensive all around the world.  He spent time in Washington advocating for increased crypto-regulation and getting friendly with Government figures, lawmakers and lobbyists.  He was the largest donor to Democratic campaigns in the recent US mid-term elections.  Earlier in the year, he was referred to as the modern-day equivalent of J Piermont Morgan, a saviour of the US banking system in the early 1900’s, after he and FTX had bailed out a number of crypto-related firms.

On 11 November 2022, FTX filed for bankruptcy in the US owing creditors a staggering but probably tip of the iceberg US$3.1 billion.  It appears unlikely at this stage that people who had deposited funds in the firm (to trade currency) will be able to get any of their money back, as it looks to have been used for other purposes.  Rather than being the new generation of firm to drive forward the new economy, it appears that FTX was instead a black box with no systems or controls in place.  Client funds were used to fund an affiliated hedge fund, doing heavens knows what, as well as being mis-appropriated to issue loans, sometimes undocumented, worth hundreds of millions of dollars to staff and associates of the firm.  Warning number two by the way.  The administrator John Ray (who also oversaw the administration of Enron) has made his thoughts on the systems and processes very clear “never in my career have I seen such a complete failure of corporate controls and complete absence of trustworthy financial information”.  It is now clear that FTX was simply being used as Sam Bankman-Fried’s own personal fiefdom.

This situation never would have been allowed or been able to occur in a properly regulated environment.  Prohibiting, limiting and/or monitoring related-party transactions, requiring appropriate systems to be in place and ensuring separation of business and client assets are all core tenants of a typical financial regulatory system and if they had been in place, they may have stopped the spectacular fall of FTX.  Here in New Zealand, these rules apply to my private wealth advisory business, Kiwisaver business and the wider financial services sector here in NZ – it’s not rocket science.  Those that argue that FTX was regulated anyway need to recognise that the Bahamas was chosen as the domicile and jurisdiction simply because it was an easy regulatory world with comparatively limited oversight.

Many commentators are talking about this being the end of crypto and that all trust has been broken:  if FTX can fail then anyone can fail.  In my view, the only thing that will re-instate and normalise the crypto industry will be regulation.  As a securities and financial services industry, we need to do a much better job at protecting everyday investors who cannot afford to suffer the losses that we have seen over the past six months.  And the industry needs to remember that with strong and effective regulation comes trust, which is what the industry is sorely lacking at the moment.

Former Prime Minister, Sir John Key, talked about making New Zealand a financial and technology hub – at times referred to as the Switzerland of the South Pacific – and maybe this is our opportunity.  Countries like Singapore and previously Hong Kong have done a great job at attracting financial services and financial technology companies to their geographies and jurisdictions because of their innovative regulatory stances.  Being innovative does not necessarily mean being cavalier, loose or relaxed:  it means recognising new trends and technologies and working with industry to create effective regulation to suit those new technologies that protect investors whilst not stifling innovation.

At present, crypto regulation is not clear cut in New Zealand.  That should change as we need to designate crypto currencies as financial assets and create legislation that ensures investors funds are always kept safe.

The New Zealand approach to financial regulation has traditionally been somewhat reactionary:  we put in place regulation after a crisis has developed and people have lost money and confidence.  And with crypto, the regulators have said clearly that they will continue to watch before determining the best way to regulate.  The FTX collapse is not a crisis that has broadly and directly affected investors in New Zealand, but we can turn this situation into our opportunity.  How can or should crypto businesses and financial services regulators here in New Zealand work together to design a set of rules and policies that provides protections to investors while at the same time protecting clients’ hard earned money?

Regulation does not need to look and feel like existing securities legislation, it can even use innovative and new technologies like the blockchain, but we need to accept that it is necessary and the jurisdiction that can quickly develop a workable set of regulations will be where the jobs, investment, and money flow when the current crypto winter ends.  The Switzerland of the South Pacific, but without the winters…