Kate Gee and Tom Crawford discuss the impact of the FTX collapse on the crypto industry in Investment Monitor

By Kate Gee & Tom Crawford

Counsel Kate Gee and Associate Tom Crawford discuss the impact of the FTX collapse on the crypto industry and consider whether improved regulation and a suite of disputes will follow.

Kate and Tom’s article was originally published in Investment Monitor, 2 December 2022, and can be found here

The implosion of FTX has seen the Bahamas-based crypto asset platform go from enjoying a $32 billion valuation to filing for bankruptcy in less than eight months. As a run on deposits left the world’s second largest cryptocurrency exchange owing $9 billion, investigations were launched by the US Securities and Exchange Commission (SEC) and the US Department of Justice (DoJ) over the potential misappropriation of funds.

We have been here before, of course. When Lehman Brothers filed for bankruptcy in September 2008, it was the fourth-largest investment bank in the US with $639 billion in assets. Yet despite being ultimately brought down by the collapse of the subprime mortgage market, Lehman was nevertheless operating in an environment where its activities were largely regulated.

By contrast, in many jurisdictions from which it succeeded in attracting more than a million investors, the FTX exchange was largely unregulated. For example, approximately 8% of FTX’s users were UK-based, meaning that around 80,000 Britons are affected without protection from UK regulators (and despite warnings against FTX from the FCA). The immediate impact of the FTX collapse on the crypto industry has led a cohort of crypto firms to emphasise the urgent need for much tougher regulation of digital assets to be implemented.

So, if FTX is crypto’s Lehman moment, what happens next?

In the US and in Europe, a swath of regulation followed the Lehman collapse – but much of it took years to put in place. When it comes to crypto, things will have to move faster and at a global level.

This puts immediate pressure on the Financial Conduct Authority (FCA) to act decisively and swiftly.

Unlike conventional retail banking and financial services activity, where deposit protection schemes are well-established, no crypto safety net exists. The absence of consumer protection for crypto investors is arguably made worse by the lack of information that the FCA holds on UK consumers’ investment in crypto overseas. In order to restore confidence in the crypto market, and to prevent fraudulent activity, additional collapses / insolvencies and, critically, potential losses for investors, the FCA must co-operate with other regulators and take prompt, decisive steps towards putting in place extended regulatory oversight of centralised exchanges and the wider crypto industry.

FTX is not the only prominent collapse of the maturing digital asset industry, but it is the biggest so far. The chain reaction from FTX’s collapse has already begun with U.S. cryptocurrency lender BlockFi filing for Chapter 11 bankruptcy protection on Monday; in doing so, it listed FTX as its second-largest creditor, with $275 million owed on an unsecured loan.  Further crypto casualties are likely, not least because of the absence of strong, reliable business practices and effective regulation for these types of volatile assets.

A degree of regulatory impetus was already apparent in the UK before FTX collapsed, as evident from the recent amendment to the Financial Services and Markets Bill 2022. In October, the City minister Andrew Griffith, proposed an amendment to the bill, broadening its remit to include regulations that concern both stablecoins and crypto assets, together with a broad definition of the same. When passed into law, the bill will ultimately boost regulators’ powers over crypto firms, impose rules on digital assets and help restore investors’ confidence in the UK crypto market.

We anticipate that this will serve as the prompt for regulators to act more quickly to draft effective rulebooks that help to protect investors going forward and in anticipation of further collapses.

What about legal action to recover losses?

As with Lehman, which left a long tail of disputes lasting more than a decade, the collapse  of FTX and BlockFi will invariably see litigation arising on both sides of the Atlantic. A range of claims, including potential group actions, are likely, dependent on what net asset position emerges from the insolvency proceedings currently being heard by the US Courts.

Resolution of these disputes may well take years, as the collapse of one company puts others in difficulty.

Absent regulatory protection, investors will need to continue to rely on the courts – including the courts of England and Wales – to adopt a pro-active, robust and innovative approach to assisting investors and creditors who have been the victim of a fraud involving cryptocurrency or digital assets.  In particular as regards FTX, investors should act quickly to appoint legal advisors.  As a starting point, FTX’s terms of service on its website indicate that any dispute involving FTX Trading Ltd will be governed by English law.  How investors can use those terms to their advantage is something that will need to be assessed on a case-by-case basis, and those who move quickly will put themselves in the best position to take all possible steps towards recovery.

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