The founder was arrested and the FTX collapse is over? Is the SEC's strong regulation coming?

Previously, the crisis caused by the run on FTX, the world's second largest cryptocurrency trading platform, implicated a series of other institutions. After nearly a month of fermentation, the farce seemed to finally come to an end with the arrest of FTX founder and former CEO Sam Bankman-Fried (SBF).

But the problems in the cryptocurrency industry are far from over. The U.S. Securities and Exchange Commission (SEC) is strengthening its supervision of the cryptocurrency industry, but due to the particularity of the industry, how to effectively implement these regulations seems to be fraught with difficulties.

FTX founder arrested in Bahamas

According to foreign media reports, Bankman-Fried was arrested by the Bahamian government on Monday evening. Previously, in order to extradite Bankman-Fried, the U.S. Attorney for the Southern District of New York shared the indictment with the Bahamian government. Before his arrest was announced, he was expected to participate in a hearing of the U.S. House Financial Services Committee via video on Tuesday. Bankman-Fried's arrest is the first time that U.S. regulators have taken concrete action to hold an entity responsible for the FTX bankruptcy.

Damian Williams, the U.S. Attorney for the Southern District of New York, said on social media that the U.S. federal government expects to "announce the indictment on Tuesday morning (local time)." According to foreign media, citing a person familiar with the matter, the charges against Bankman-Fried include online fraud, online fraud conspiracy, securities fraud, securities fraud conspiracy and money laundering.

Bahamas Attorney General Ryan Pinder said the United States "will likely request his extradition." The Royal Bahamas Police Force confirmed Bankman-Fried's arrest and said he will appear in a local court in Nassau, Panama's capital, on Tuesday. "The Bahamas and the United States have a shared interest in holding accountable all individuals associated with Bankman-Fried who may have betrayed the public trust and violated the law," Bahamian Prime Minister Philip Davis said in a statement. "While the United States is bringing separate criminal charges against him, the Bahamas will continue its regulatory and criminal investigations into the collapse of FTX and continue to cooperate with law enforcement and regulatory partners in the United States and elsewhere."

In November, FTX suffered a run due to an article by CoinDesk claiming that FTX used customer funds to support its hedge fund Alameda Research. Subsequently, FTX was unable to honor customer fund redemption requests and had to announce the initiation of bankruptcy proceedings after its competitor Binance refused to acquire it. According to media reports, FTX still has $1 billion to $2 billion of customer funds missing.

After the bankruptcy process was initiated, Bankman-Fried was replaced by John J. Ray III, who oversaw the bankruptcy of Enron. Ray is also scheduled to testify before the U.S. Congress this week. On Monday, Ray said that FTX went on a "spending spree" from the end of 2021 to 2022, when it spent about "$5 billion to purchase a large number of businesses and investments, many of which are currently worth a fraction of the amount purchased at the time," and that FTX also made more than $1 billion through "loans to insiders and other forms of payments to insiders." Ray also confirmed the allegations that FTX customer funds were mixed with Alameda Research's assets. Ray said Alameda did use customer funds for margin trading and faced huge losses as a result.

Legal experts say that if the federal government prosecutes Bankman-Fried for online or bank fraud, he could face life in prison. Such a severe punishment is unusual, but not without precedent. Previously, Ponzi scheme mastermind Bernie Madoff was sentenced to 150 years in prison for his massive scam, equivalent to life in prison. FTX's collapse has already triggered the bankruptcy of cryptocurrency lender BlockFi and thrown the entire crypto asset industry into chaos.

SEC's strong regulatory pressure increases sharply

The FTX bankruptcy farce may be coming to an end, but the strong regulatory needs and difficulties it highlights are far from over. U.S. Treasury Secretary Janet Yellen recently called on the government to strengthen regulation of cryptocurrencies, saying that the recent FTX bankruptcy is an objective lesson that shows that the industry needs to be more regulated. The SEC is facing increasing pressure to strengthen law enforcement at key hubs in the crypto industry.

The SEC said that many cryptocurrencies can be defined as "securities" and should be traded according to the regulations for stocks and bonds. Based on this, SEC Chairman Gary Gensler said that it is illegal for crypto exchanges to sell "securities" that are not registered and therefore do not need to comply with the trading rules of Nasdaq and New York Stock Exchange.

Some industry lawyers said that despite the SEC's statements, the SEC faces the dilemma of insufficient enforcement because the cryptocurrency market has become a mainstream trading market and investors entrust their savings to cryptocurrency exchanges every day.

In July this year, the SEC accused Coinbase of selling seven illegally issued securities assets, but Coinbase continued to trade six of them. In this case, the SEC could have sued Coinbase, but it did not. A Coinbase spokesperson said at the time that he believed that none of the six cryptocurrencies were securities assets, so the US laws that the SEC referred to and adopted against Coinbase were wrong, and rejected the SEC's warning.

Cryptocurrency industry lawyers say that after years of the SEC forcing securities-like regulations on the cryptocurrency industry, the strategy has become exhausted. Crypto exchanges operate completely differently from stock exchanges and cannot comply with SEC regulations.

“Because the SEC has taken this untenable position that crypto assets are securities, the cryptocurrency industry is now taking the SEC’s allegations less seriously,” said Jake Chervinsky, policy director at the Blockchain Association, which counts many large crypto companies among its members.

John Reed Stark, a former SEC enforcement lawyer, said: “There was a gap in the SEC’s previous regulatory strategy, which was not to go after the entities behind the cryptocurrency industry.”

After the FTX bankruptcy, the SEC has stepped up its warnings. Gensler said in a recent interview that the "runway is getting shorter and shorter" for cryptocurrency exchanges to register with the SEC and adopt the rules that stock exchanges such as Nasdaq must follow, hoping that the platform will separate functions such as storing customer tokens and lending to customers. David Hirsch, head of the SEC's Enforcement Division's Crypto Assets and Network Division, also said at a conference last month: "The Enforcement Division is ready."

Specifically, FTX's bankruptcy has directed the SEC's regulatory focus to crypto exchanges, which are the main core hubs for individual cryptocurrency investors, providing services such as cryptocurrency sales, loans, and asset custody. Previously, although the SEC had investigated parts of the cryptocurrency industry for more than six years, it had only fined or prosecuted dozens of token developers and had not yet prosecuted a major cryptocurrency exchange. At present, according to people familiar with the matter, the SEC is investigating large cryptocurrency exchanges including Coinbase Global Inc., Binance, and FTX's U.S. business.

However, according to foreign media, citing people familiar with the matter, regulators are also aware that it takes time to build an effective enforcement case against crypto exchanges, because cases against exchanges are more likely to require litigation, and large exchanges are unlikely to reach an agreement with the SEC because reaching an agreement may mean that these exchanges have to adopt SEC regulations on a large scale and have to give up some profitable activities.

In addition to investigating cryptocurrency exchanges, the SEC is also trying to negotiate a model with exchanges for the latter to register with the SEC, according to a person familiar with the matter. Coinbase has met with the SEC, but has not yet come close to reaching a framework that it believes is feasible. Before bankruptcy, FTX had also been working to obtain SEC approval to enable it to legally trade digital assets. The plan involves working with stock exchange operator IEX Group, in which FTX took a minority stake in April. IEX has discussed with the SEC how to trade digital assets without violating stock, bond and other securities trading rules. If the plan is realized, it could be a breakthrough for both cryptocurrency exchanges and the SEC.

A Coinbase spokesperson said the company has “no plans to change the operations of the exchange, which were reviewed by the SEC last year as part of our public listing process. Of course, we are always willing and frequently engage in discussions with regulators about potential alternative business models. As we have said, we welcome any regulatory framework that would enable us to offer digital asset securities products in the U.S.”