FTX Collapse Has Historical Parallels; Will We Learn From Them?

As details emerge surrounding the collapse of crypto trading firm FTX, investors should believe them.

In much the same way as Shakespeare’s famous adage states that “a rose by any other name is still a rose,” when crypto companies act like banks or casinos, they should be regulated as such — especially when they lose their customers’ money.

So said Xavier Vives, professor of economics and finance at IESE Business School, who sat down with PYMNTS to discuss what regulatory bodies can do in light of cryptocurrency exchange FTX’s recent and widely-reported implosion.

The Enron-style meltdown of one of the higher-valued and better-known cryptocurrency exchanges is spurring greater calls for crypto regulation. The situation surrounding FTX’s demise ”calls into question the promise of the industry,” 

U.S. Sens. Elizabeth Warren, D-Mass., and Dick Durbin, D-Ill., said in a letter.

Read more: Ex-FDIC Head: People ‘Getting Hurt’ by Lack of Crypto Rules

Next Steps Matter

Crypto is likely to survive the FTX scandal, but more scandals will follow if the adults in the room don’t take the necessary action to prevent them. The contagion from FTX’s collapse is already beginning to spread across the rest of the sector.

“This crisis is a game changer,” Vives said. “It has all the elements of a classic bubble, where people get carried away and if you look at it from the outside you say, okay, this is crazy, but when you are in it, you can’t.”

As it is, he said, many people do not understand blockchain technology or its applications, yet they still invested in it because of the hype.  

“These are the classic ingredients for a bubble, no matter what century it is, the Tulip Mania in 17th century Holland or the free banking era in the U.S.,” he said.

The wait-and-see approach to industry regulation is not working, and stifling fraud should be a more important priority for regulators than any fear of being perceived as stifling innovation.

FTX operated a centralized exchange, a role widely understood within traditional finance. Still, a part that, when played within an emergent digital landscape, allowed the company to skate by through a muddled mix of strategic offshore licensing, affiliate umbrellas and tech-speak futurism.

Centralized exchanges make holding and trading cryptocurrencies easy and convenient for users, but just as with any conventional industry operation, they open the door to bad actors and poor managerial decisions.

Read more: Physics of the FTX Bubble: Hot Air Rises Fastest 

Separating Tech from Fraud

Ethereum Co-founder Vitalik Buterin has stated that FTX’s collapse proves that the problem lies in people, not technology. He has, in recent days, called for decentralized cryptocurrency exchanges that leverage “cryptographic proofs that show that the funds they hold on-chain are enough to cover their liabilities to their users.” This approach is opposed to traditional methods like government licenses, auditors and corporate governance controls.

Of course, FTX had neither an on-chain proof protocol showing nor did the company have any semblance of internal controls or record-keeping.

“[FTX] was excessively leveraged and it took excessive risks then moved to hide losses and fraud. With different technology, different participants, different players, this has happened forever throughout history,” Vives told PYMNTS.

It is clearly inconsistent that a company like FTX, which at one point was worth $32 billion, operated without the regulatory oversight and internal controls by which other centralized financial intermediaries are required to abide.

Decentralized exchanges of the type Vitalik is promoting, while academically and theoretically thrilling, are highly inefficient compared to the typical banking and payment transactions consumers have access to in advanced economies.

“Effective regulation is what is needed to restore confidence,” Vives said. “The principle should be if you do an activity, and that activity is the same as another [regulated] activity, you should be regulated just the same as that other actor.”

That there will likely be a market contraction coming out of the FTX debacle is a good thing, as typically, regulators prefer to deal with “more concentrated sectors, because they know the players better,” Vives said.

He believes that without oversight, “crypto as money may be dead. If you are a speculative investment, there are rules that already exist and should be strictly enforced,” he said.

One thing is certain: millions of investors have now lost their savings because the door they walked into wasn’t properly, or accurately, labeled “buyer beware.”