FTX’s collapse calls for stronger governance within crypto firms

The dramatic collapse of FTX, one of the world’s largest cryptocurrency exchanges, has shaken the cryptocurrency markets and raised serious questions around governance, corporate controls and the centralisation of power within some of these firms.

The CEO of FTX was arrested in the Bahamas, and is now facing criminal charges in New York. It is reported that billions were transferred out of the company, which filed for bankruptcy in November 2022. Amid reports that some $1bn in customers’ funds are missing, attention is now being drawn to the corporate controls, or lack thereof, at FTX. John Ray III, the insolvency professional appointed to run the FTX bankruptcy, has said that the collapse of FTX is the worst case of corporate failure he has seen in more than 40 years.

It appears that the corporate governance failures at FTX were indeed extraordinary. These alleged failures include not keeping proper books, records, or controls for digital assets, using software to conceal the misuse of customer funds, and even approving payments via the use of personalised emojis.

Corporate control of FTX was concentrated in the hands of a small group of relatively inexperienced and potentially compromised individuals. The collapse of FTX therefore serves as a timely reminder of the importance of corporate controls, and how they act as a system of checks and balances.

Good governance

Key features of good corporate governance in the UK include a separate chairman and CEO, independent audit functions, annual evaluation of a board’s performance and transparency in appointments and pay. Another vital component is shareholders’ rights, and strong shareholder engagement, to drive accountability. All these features help to disperse power and improve decision-making.

The UK’s corporate governance system is based on a network of legislation, codes of practice and regulatory guidance, and is regularly updated in response to new developments. Effective audits underpin transparency and governance. The UK government’s response to recent corporate collapses where poor auditing was implicated, such as Carillion, has been to significantly improve the regulation surrounding corporate audits.

Interestingly, in the US, the response of major audit firms to the FTX collapse has been to designate crypto asset companies as “high-risk”. This means a more lengthy, robust and thorough audit process is required for such businesses.

The broader tech sector, and particularly crypto currency, is widely thought to be a hub of innovation. Such forward thinking can be a real boon and has helped develop creative new ways of living and doing business. On the other side of the coin, it can result in some people believing that the rules do not apply to them. Yet there are often sound reasons why those rules were developed in the first place. That is certainly true when it comes to corporate control and accountability.

The crypto sector is a notoriously volatile sector. A blizzard of new cryptocurrencies emerges regularly on the market, alongside markets in newer crypto assets such as non-fungible tokens. Values rise and fall with stunning speed, and regulators often struggle to keep pace with developments.

However, the global cryptocurrency market was worth $820bn in January according to CoinMarketCap, and governments are taking co-ordinated steps towards regulating crypto asset markets. For example, the 2021 G7’s final communique committed the group to work “to urgently address the escalating shared threat” of ransomware attacks. Many such attacks used cryptocurrencies as the ransom payment method, with many having also been linked to Russia. In the wake of the Ukraine invasion, regulating cryptocurrencies is increasingly seen as a geopolitical imperative.

Cryptocurrencies are also often implicated in money-laundering and fraud. For example, the PlusToken Ponzi scheme caused losses of around $2.9bn. One simple way for governments to tackle the misuse of cryptocurrencies is to increase their corporate regulatory enforcement of crypto asset businesses, including the major cryptocurrency exchanges.

Tarnished reputation

The global crypto sector does not have a stellar reputation. It is still largely unregulated, volatile and has too many unfortunate associations with money-laundering, cybercrime and organised crime. In January 2021, ECB president Christine Lagarde called for the regulation of cryptocurrencies on a co-ordinated global basis. Prior to her appointment as US Secretary of the Treasury, Janet Yellen said cryptocurrencies are now used transactionally “mainly for illicit financing”, saying they must be curtailed.

The Financial Conduct Authority was appointed the UK’s major regulator of the cryptocurrency sector in early 2021. Cryptocurrency firms must now register with the FCA before operating in the UK, although a temporary registration regime was created. The FCA has been active in regulating the cryptocurrency market, even banning Binance from conducting regulated activities in the UK in June 2021. Tighter future regulation of crypto assets now seems inevitable, although such regulation should not be so strict as to choke innovation in the digital finance space.

The FCA’s advises: “Crypto assets are considered very high-risk, speculative purchases. If you buy crypto assets, you should be prepared to lose all your money.” It also banned selling cryptocurrency derivatives to consumers.

Improved corporate control and audit across the cryptocurrency sector, combined with a well-balanced regulatory regime, could help enhance the sector’s reputation, and ultimately help it achieve sustainable long-term growth. If the crypto sector becomes well-regulated, transparent and widely trusted, investment and innovation will only increase.

Published in Global Risk Regulator – 09.01.23 

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