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In February 2022, I testified before the Senate Agriculture Committee, which oversees the Commodity Futures Trading Commission (CFTC), the US commodities regulator. The obligations for offering and trading commodities are much lower than those for securities, which is the broad category for investment vehicles in the US. Bitcoin, Ether, and tokens with similar characteristics are now understood to be commodities (although the Securities and Exchange Commission has never formalized that finding), so the CFTC has jurisdiction over all the US-based crypto exchanges.

“Regulatory Clarity”

Among the other witnesses was Sam Bankman-Fried (SBF), the now-disgraced CEO of the FTX exchange.

He was there to argue, as he did frequently in Washington, DC over the past year, that the big regulatory problem for the crypto space was “lack of clarity” in the US. Big exchanges like FTX had to locate offshore, and 95% of the trading volume had to follow them, because there was no good framework to register in the US. FTX, he argued, was completely safe and legit; it just couldn’t offer its full gamut of services to eager American customers. The answer was to create a new regulatory regime for digital asset exchanges under the CFTC, which has limited oversight tools under current statutes. That would bring the massive wealth-creation of booming crypto markets back to the US.

I was the only one of the four witnesses who pushed back on this narrative, and urged strong regulatory oversight. As I said at the outset of my testimony:

These are exciting developments, with the potential to revolutionize finance, improve equity in sectors across the economy, increase efficiency in virtually every industry, promote privacy and individual freedoms, and broadly create more competitive, fair, and transparent markets. I emphasize, though, the word “potential.” Trading activity in cryptocurrencies is not the same thing as realization of the dream of Web3, the much-discussed vision that decentralized blockchain-based solutions will replace existing tech platforms, media firms, financial services companies, and other traditional organizations. Holdings of major digital assets such as bitcoin are actually highly concentrated today, with intermediaries occupying important roles in most transactions. Many of the practical benefits of digital assets and blockchain remain uncertain, and there are serious limitations and risks that should not be ignored. Policy-makers and the regulators they oversee, such as the Commodity Futures Trading Commission (CFTC) that falls within the jurisdiction of this committee, must carefully evaluate both benefits and dangers, as well as the range of tools they have at their disposal.

I went through the various risks and concerns in digital asset markets and decentralized finance. The big worry, I argued, was that what we were seeing wasn’t the emergence of a new “trustless” disintermediated financial system, but one that repeated and accentuated the problem with the traditional system:

The growing practice of DeFi yield farming and other mechanisms of leveraging (and then re-leveraging) digital assets is also making these markets more like the fragile interconnected financial markets they seek to replace. One of the major vulnerabilities of the financial system is that intermediaries effectively create money as shadow banks by stacking multiple claims on assets such that holders do not necessarily own what they believe they own. When liquidity dries up, these arrangements can produce the kind of crisis the world witnessed in 2008.

This turned out to be a pretty fair prediction of the chain of events FTX experienced this past week.

While there is surely a need to more expressly define the scope of the securities classification in the US, and legislation to give the SEC, CFTC, and other authorities the tools they need to oversee this market effectively, lack of clarity has never been a big factor holding the market back. To the contrary, players in the digital asset space, including FTX, have used the lack of clarity in the US to set up shop in offshore jurisdictions with very limited regulatory oversight, while still enjoying virtually all of the benefits of being a US company. As I testified:

Even more important, the divide between agencies should not be a reason for unjustified gaps in the regulatory regime. Someone needs clear authority to engage in oversight of spot markets in digital assets that are not considered securities. Someone needs clear authority to exercise oversight of digital asset exchanges that have rapidly become some of the most valuable and prominent firms in financial services, including those exchanges which nominally operate offshore but in practice are heavily active in this country. Someone needs clear authority to oversee stablecoins that claim assets in the tens of billions of dollars and play an oversized role in digital asset markets in the U.S. and worldwide. Loopholes, rented charters, and ill-fitting licenses cannot be the legal foundations for an industry that aims transform all of finance.

The biggest problem in crypto regulation, I pointed out, wasn’t lack of clarity for those in the industry trying to get it right; it was insufficient enforcement against those who weren’t.

Finally, every relevant agency needs the resolve and the capacity to address the clear abuses that are all too common in the digital asset world. Fraud is fraud. Theft is theft. Tax evasion is tax evasion. There are difficult cases and grey areas that deserve careful consideration. There are also far too many examples that are all too clear cut. The question is why so many examples of deception, manipulation, hacks, and other abuses have seemingly gone un-punished. We must examine whether this is a legal gap, a resource gap, an enforcement capabilities gap, or something else. The only way over the long run to promote trust in the legitimate actors within the digital asset world is to distinguish and take down the bad actors.

At the time of the hearing, I didn’t think FTX was the massive fraud it now appears to be. I was skeptical of how it grew so fast, succeeded so consistently, and became a household name in the US while its primary exchange prohibited American customers. I was concerned about the fact that SBF controlled both FTX and the trading firm Alameda Research, an arrangement that would be an illegal conflict of interest for a US-based exchange. However, I didn’t imagine just how fully the entire empire, it now seems, was built on sand and deception.

But in a way, that was my point. The reason for regulation is to prevent exactly what happened in the FTX case: A situation where everyone trusted that someone else had done the due diligence, and no one really had the visibility, authority, and will to pull back the curtain.

Where Do We Go From Here?

Following the spectacular collapse of FTX, I’m hearing many voices in the crypto community saying the real failing was not the bad guys, but the regulators who didn’t stop them. FTX happened, they argue, because of the aforementioned “lack of regulatory clarity,” which forced SBF to a permissive jurisdiction like the Bahamas.

There are two problems with that argument. First, FTX had no trouble establishing a licensed exchange in America FTX.us. It didn’t offer all the speculative opportunities of the offshore FTX.com, but that’s not a problem of clarity. US-based exchanges like Coinbase, Gemini, and Kraken have their failings, but none show any indication of the shady behavior such as manipulating balance sheets and trading with customer funds that FTX seemingly engaged in. And the rules they operate under are still too lax. Digital asset exchanges can register under state regimes designed for money transmitters, which don’t provide the level of oversight extended to securities exchanges.

Second, there is that figure that 95% of the crypto trading volume occurs outside the US. The world’s two most powerful nations, and largest pools of capital, are the US and China. China entirely bans digital asset trading. How can the vast bulk of crypto trading somehow exclude both US and Chinese capital? It doesn’t. A large percentage of the “offshore” volume on FTX must have been coming from the US, either through insufficient Know Your Customer identity checks or through indirect means. That capital isn’t looking for “clarity” to flow to US-based venues; it’s looking for a lowering of standards by US regulators. The US needs new legislation and more explicit guidance from regulators, but the contents of those rules matter a great deal.

Another dimension of the post-FTX discussion is DeFi. The US legislation SBF advocated would, many felt, hamstring DeFi platforms while legitimizing FTX. Legislators and regulators raising concerns about DeFi, some argue, deserve some of the blame for going after the wrong target.

It is true that DeFi protocols can offer transparency and strong commitments backed by smart contracts which prevent some of the behind-the-scenes shenanigans FTX engaged in. But it’s not so simple as “DeFi solves this.” As I alluded to in my testimony, the meteoric rise of DeFi starting in 2020 rode on a tidal wave of capital and wild speculation fueled by none other than FTX and other major centralized exchanges. The origin of the shortfall that ultimately led to the collapse of FTX appears to be fallout from the implosion of the Terra/Luna algorithmic stablecoin protocol. FTX’s apparent manipulation of token prices to goose its balance sheet was heavily related to DeFi activity.

DeFi has many benefits, but it can also facilitate excessive risk-taking, regulatory arbitrage, and money laundering. The question now isn’t whether to regulate DeFi or centralized exchanges; it’s how to ensure the major objectives of financial regulation—investor protection, illicit finance interdiction, and systemic risk moderation—are met in the multi-faceted and fast-changing digital asset world.

How exactly to establish a regulatory framework in the US that provides sufficient protection against abuses while not excessively preventing valuable innovations is a big question that I can’t answer here. There are many pieces to the puzzle. The Biden Administration issued an executive order in March 2022 and a high-level policy framework in September tasking agencies and departments throughout the federal government with engaging different aspects. Congress is actively engaged now in considering serious legislative proposals. We have a ways to go, but the US landscape for digital asset regulation is moving in the right direction. FTX will be a major kick in the pants.

I’ll end with a final quote from my February testimony.

The fact that technology moves quickly, while law evolves slowly, is not a reason to abandon legal protections.

Regulatory clarity is a good thing, but it’s not the only thing.