The FTX meltdown has been spectacular. Its sheer scale commands attention. On the other hand, it is wholly familiar in containing all of the telltale signs of financial fraud: sloppy accounting, embezzlement, wishful thinking, “pump and dump,” bribes to media and regulators, and too much hype.
It is remarkable that these types of scams occur so regularly, often with the same breathless “hot takes” about how it’s going to be different this time. Speculative bubbles have had the same trajectory since the 17th century’s tulip mania.
In more recent times, we had Enron, Theranos, Madoff, and now this. Madoff, at least, was the former chairman of the NASDAQ. He had some credibility with investors, and his Ponzi scheme had a long run of consistently good returns—too consistent, in fact. But with crypto in general and FTX in particular, it is surprising that so many sophisticated players gave such large sums to this amateurish and fraud-ridden operation.
Did no one wonder why they were doing business in the Bahamas?
Fraud and the Rule of Law
One thing missing from overseas businesses is the American legal system. For all of its flaws, our legal system is generally predictable and devoid of most forms of corruption, particularly on commercial matters. This is why companies want to do business here, why our capital markets function more efficiently, and it is also why so many lawsuits settle. The end results are highly predictable due to the internal consistency and predictability of American legal rules.
Our legal system is not merely lawsuits by aggrieved parties (i.e., private law), but also regulation (i.e., public law). After the frothy and fraud-ridden early days of the stock market, the Securities and Exchange Commission (SEC) was created during the Great Depression along with the Commodities Futures Trading Commission (CFTC) and similar watchdogs to mandate certain types of internal controls and reporting, which are intended to provide an early warning system of frauds and other actions that damage markets.
Fraud is a straightforward matter. It requires a falsehood, uttered knowingly, on which the counterparty relies to his detriment. When an exchange that is supposed to be holding assets as a custodian instead borrows the funds, fails to inform the account holders, and then “invests” them in speculative crypto investments, this is simple embezzlement. It is illegal everywhere, and requirements such as separate custodianship, which apply to ordinary investments, function to prevent it.
Since it is both international and deliberately flying under the radar of governments, crypto, as well as crypto options and crypto contracts and crypto exchanges, do not typically have the same legal pedigree, regulatory infrastructure, and means of enforcement as ordinary securities and investments.
Does Crypto Add Value?
Even setting aside these particular risks, most crypto-currencies are a solution in search of a problem. With ACH and wire transfers, it is hard to see what value they add. Their volatility makes them nearly useless as an ordinary currency, because they cannot be a predictable store of value. Perhaps this is why crypto’s actual use, other than as a speculative investment, is so intertwined with money laundering, the drug trade, child pornography, and other contraband.
With crypto, there is nearly a weekly meltdown or hacking incident that costs investors hundreds of millions. While there are some established players like Coinbase that appear to follow best practices used among traditional businesses—things like audits and the use of FDIC-insured bank accounts—exchanges are otherwise inherently risk-prone. They house so much money that can be played with secretly and stolen relatively easily. For example, before FTX, there was Mt. Gox, which was hacked to the tune of nearly $500 million.
Since crypto can be held in non-internet-accessible wallets, it’s surprising so many people would leave this vaporous, fugitive, easily transferable resource in the hands of third parties. It is doubly surprising they would do so with a shady character like Sam Bankman-Fried and his crew at FTX. In all of his photos with celebrities, he does not merely look informal, but disheveled and untrustworthy. You don’t need to be Colombo to sniff out something amiss.
When Regulation Makes Sense
Conservatives used to spend a lot of energy thinking about deregulation. In the early 80s, deregulation of interstate shippers and the airline industry led to a massive increase in efficiencies, including the employment of the familiar “hub and spoke” system of major air carriers. This lowered prices and helped everyone who relied on these industries. It was mostly a success story.
Ronald Reagan made deregulation a centerpiece of his presidency, taking aim not merely at price controlling regulations such as those that governed airlines, but the proliferation of rules by OSHA, the EPA, and the SEC. Back then, deregulation was a rallying cry of Republicans, one still visible on the editorial pages of the Wall Street Journal. Today, you rarely hear it discussed among the lower echelons of politics or by voters.
While most of us find opening a business and navigating the myriad rules of the administrative state burdensome and expensive, this annoyance is not connected to a systemic critique or broader position of deregulation. Most of us want smarter regulation and honest regulators—a tall order perhaps—but the absence of regulation is being felt in crypto. More generally, financial regulation has done a worse job with the decline of white collar crime prosecutions.
Now would be a good time to reverse this. Big business has lost a great deal of support from those in the productive half of the economy, not least through businesses’ own frauds and naked rent-seeking from the political establishment. MAGA types have not forgotten TARP, PPP, or any of the other recent giveaways.
Rejecting all regulation results in thieves like Sam Bankman-Fried getting away with their crimes. One reason regulators exist is the same reason we have criminal law: purely after-the-fact civil remedies will be ineffective when people embezzle client funds, gamble them and lose, and thus cannot make their victims whole through a judgment. Preventing the wrongdoing ex ante with reporting requirements or punishing it ex post with prison time adds additional layers of deterrence for what may otherwise be a mathematically justifiable risk.
The FTX fraud should be a cautionary tale for crypto enthusiasts. Regardless of its theoretical benefits, and even if crypto currency were an ordinary asset with measurable cash flows like real estate or equity, the infrastructure surrounding it is not well-suited to detect and prevent fraud, theft, regulatory capture, and other risks. By contrast, real currencies have value roughly proportionally to the sovereignty, integrity, and wealth of the nations in question. There is no such sovereign behind crypto by definition. And, unlike gold or other commodities, the digital code that makes it up has no use value.
A lack of a strong regulatory footprint allows speed, innovation, and reduces cost. This is the environment in which the early internet flourished, and this is the same spirit which crypto enthusiasts embrace.
But, unlike the communication revolution brought on by the internet, there does not appear to be a corresponding social benefit from crypto. Purely as a matter of self-interest, I would caution anyone without money-to-burn to be wary of converting real money into crypto monopoly money, the value of which can evaporate overnight.