The arrest of FTX founder Sam Bankman-Fried this week amid charges of a billion-dollar fraud corroborates long-standing warnings from critics who have likened the cryptocurrency markets to the Wild West. The question is: Where was the sheriff?
Among the exchanges such as FTX where crypto is traded, enforcement is likewise scant. None of the largest exchanges have registered with the SEC, and the agency has not taken legal action to force them to do so. This gap in enforcement means that thousands of entrepreneurs have been allowed to pitch crypto products without being compelled by financial regulators to disclose key information about the risks or even the identities of the people behind them.
Standing astride the SEC and the unruly markets is agency Chair Gary Gensler, a 65-year-old Washington veteran who, since being sworn in in April 2021, has been among those who compared crypto markets to the Wild West and repeatedly encouraged firms to “come in and register.”
In the wake of the multibillion-dollar collapse of FTX, some U.S. lawmakers are looking to Gensler’s SEC for a fuller accounting: How did the industry grow so fast — the total value of crypto tokens peaked at $3 trillion a year ago — without the SEC imposing more safeguards on digital assets and the platforms that allow investors to trade them?
Gensler met with Democrats on the House Financial Services Committee last week and at least some of those who have previously defended him were unsatisfied with his answers.
“I asked him specifically what the next steps are,” Rep. Jim Himes (D-Conn.) said in an interview. “It’s not clear to me what the answer is there. … We don’t have a clear plan to solve the problem of noncompliance.”
Top Democrats on the Senate Banking Committee, which oversees the SEC, are also signaling that they want to see more action.
Sen. Sherrod Brown (D-Ohio), who chairs the panel, wrote to Treasury Secretary Janet L. Yellen last month that he wants to work with her and other financial regulators to legislate clearer rules for the industry. Sen. Elizabeth Warren (D-Mass.) put it more bluntly in a recent Wall Street Journal editorial, arguing while she agrees the SEC has the authority to bring the industry to heel, “power is worthless if the cop on the beat won’t use it.” The agency, she wrote, “has fallen far behind as the crypto industry has drawn in millions of new investors.”
In an interview with Washington Post reporters on Thursday, Gensler defended the SEC, saying it has filed a number of enforcement cases, focusing on those with broader impact and on the exchanges, where unregistered coins are most often traded. “I couldn’t be prouder of this agency,” he said.
The SEC has filed lawsuits against unregistered coins 44 times between 2013 and 2021, according to Cornerstone Research. Those represent far less than 1 percent of the unregistered coins.
Going after the exchanges takes time, Gensler noted, saying the complex investigations typically take nearly two years to complete. If the SEC can prevail in such cases, more customers would benefit, he said.
“It’s where you could get the maximum investor protection if you could actually get them into compliance,” Gensler said.
Deep-pocketed crypto firms — some of which Gensler described as “deeply resourced, deeply lawyered” — have put up tough, extended court battles to fend off or at least delay SEC enforcement.
The agency has also faced criticism by some in Congress, led by Rep. Tom Emmer (R-Minn.). A bipartisan letter to Gensler in March argued that the agency was inappropriately pestering crypto exchanges with investigative requests for information.
“We have reason to believe these requests might be at odds with the Paperwork Reduction Act,” they wrote, referring to the federal law designed to reduce paperwork.
Yet Emmer also tweeted recently that Gensler “must testify before Congress and answer questions about the cost of his regulatory failures.”
Gensler’s defenders argue the regulator is in a uniquely difficult position. With finite resources, his agency can only do so much against an “entire damn industry that has decided to break the law as a strategy,” said Dennis Kelleher, president of Better Markets, which advocates stricter financial regulation.
The rules
The regulatory powers wielded by the SEC stem from a set of laws passed in the wake of the stock market crash of 1929.
Aimed at curbing irresponsible and fraudulent practices, those laws required that companies issuing or trading securities register with the government, disclose key information and comply with other rules. The SEC was created to enforce the regulations, protect investors and ensure fair markets.
Today, the SEC chiefs from both parties have argued that most crypto tokens are securities like stocks and bonds — and so must comply with the long-standing SEC rules. Like those traditional assets, many crypto tokens are being sold by companies seeking to raise money to investors aiming for a profit.
“From what I’ve seen, initial coin offerings are securities offerings,” SEC Chair Jay Clayton, a Trump appointee, testified to Congress in February 2018. “They are interest in companies, much like stocks and bonds, under a new label.”
Three years later, Gensler, a Biden appointee, agreed, telling Congress, “Those who use initial coin offerings to raise capital or to engage in securities transactions must comply with the federal securities laws.”
The industry argues that those old rules don’t apply to the new technology and that crypto tokens ought to be considered a commodity, like gold.
The court case of Ripple Labs, widely viewed as critical to the battle of SEC regulation, shows the lengths to which crypto entrepreneurs will go to fend off SEC oversight — and the magnitude of the potential crypto profits.
Ripple Labs created 100 billion of its crypto token, known as XRP, in 2012.
It then raised $1.38 billion by selling XRP, but without providing the type of information typically offered to investors, according to the SEC lawsuit. Between 2015 and 2020, the chairman of the company, Christian A. Larsen, and his wife, sold 1.7 billion XRP and netted at least $450 million from those sales, according to the SEC lawsuit.
Those profits are now paying for a well-equipped defense for the company and its executives. Executives have said they would spend $100 million on lawyers on the case, which is ongoing, and the firm has hired former SEC chair Mary Jo White and former SEC enforcement chief Andrew Ceresney.
As in other cases, advocates for Ripple have argued that XRP is not a security and need not be registered. They argue that in demanding that XRP be registered, the SEC is exceeding its mandate.
“The SEC’s draconian view … would destroy nearly an entire industry,” according to the brief in the Ripple case by the Blockchain Association, an industry group. “Numerous tokens would not be able to function for their intended purpose, or at all.”
Unstable coin
The demise of FTX shows just how much havoc unregistered coins and exchanges can wreak.
The volatility that helped precipitate the FTX collapse began with two unregistered coins, Terra and Luna. Terra was supposed to be a so-called “stablecoin.” Its value would not fluctuate from $1, according to its sponsors, thanks to a computer trading algorithm.
The failure of the Terra coin in May led soon after to the failures of a crypto hedge fund Three Arrows Capital, and then two crypto lenders, Celsius Network and Voyager Digital.
Those failures in turn appear to have precipitated trouble for FTX and its sister company Alameda Research, an investment firm.
The blockchain analytics firm Nansen found that about the same time as the Three Arrows and other bankruptcies, significant amounts were transferred to FTX from Alameda — about $4 billion worth of FTX’s own FTT token. This week, the SEC has charged that company CEO Bankman-Fried was using FTX assets to fund risky investments by Alameda.
Those earlier bankruptcies affected many crypto companies and “we assume that Alameda had some troubles then,” said Niklas Polk, a research analyst at Nansen. The SEC agreed, writing in its complaint against Bankman-Fried that as crypto asset prices sold off in May following Terra’s collapse, the executive’s “house of cards began to crumble.”
FTX filed for bankruptcy last month amid reports that its efforts to bail out Alameda had led to its downfall.
A lawsuit brought by Terra investors argues registration would have forced the company to disclose its signature token was not as “stable” as promoted and that the promised interest rate — of 20 percent — was unsustainable.
“Without SEC registration, it’s really the Wild West for investors,” said John Jasnoch, an attorney representing Terra investors suing the coin’s founders. Crypto firms have a duty to disclose “the risks and material facts that could affect the value of their investments.”
Neel Maitra, a top crypto specialist at the SEC until earlier this year, said if Luna had registered with the SEC as a security, its weaknesses would have surfaced much earlier, potentially avoiding ripple effects in the crypto markets.
To register the token, the company would have had to assemble details about its management, business practices and at least two years of audited financial data, according to Maitra. Teams of external lawyers and auditors would have reviewed that information. Finally, the company would have submitted that package to the SEC, kicking off a back-and-forth that could extend over months as agency officials asked follow-up questions and pressed for more details.
“Satisfying the SEC that their reserves are in line with what they purported would be difficult,” Maitra said. And even if the company could have cleared those hurdles, “with these disclosures out there, every crypto fund would be poring over their financials and seeing whether it was worthy of investment.
“Registration can cost upwards of a million and takes several months,” Maitra added. “If you can distribute your coins for effectively no investment to large groups of people without complying, you’ll do that.”
Regardless of the costs of registration, however, Gensler said his patience for those companies that have ignored his warnings is limited.
“The runway is getting shorter,” he said Thursday, a line he has repeated since FTX imploded last month.
