In this photo illustration FTX logo is displayed on a smartphone screen and in the background.
Omar Marques-SOPA Images/LightRocket
Ideas
November 22, 2022 10:35 AM EST
Klein is the Miriam K. Carliner Chair and Senior Fellow in Economic Studies at the Brookings Institution. He served as Deputy Assistant Secretary of the Treasury 2009-2012 and Chief Economist of the U.S. Senate Banking Committee before that.

The collapse of FTX, the world’s second largest crypto-exchange, raises major questions about the viability of cryptocurrency and the state of America’s financial regulatory system. While the debate on whether FTX’s collapse means crypto should be more regulated or kept further out of the regulatory safety net rages, we must ensure that those who might have broken the law at FTX be aggressively prosecuted. Failure to prosecute individuals who broke the law is a key lesson from the last financial crisis that we must not forget as we enter the crypto crisis.

It’s clear that the 2008 global financial crisis continues to shape reaction to what some are calling crypto’s ‘Lehman Brothers’ moment. However, the more accurate analogies for FTX are the massive corporate frauds such as Enron, Tyco, and MCI WorldCom. These firms cooked their books as it seems likely that FTX did. FTX’s misdeeds appear more akin to Bernie Maddoff’s ponzi scheme and MF Global’s illegal use of customer money to fund their own speculative investments.

For those who argue that more regulation of crypto would have prevented FTX’s implosion, recall that MF Global, Lehman Brothers, and Bear Sterns were all regulated by the Securities and Exchange Commission (SEC). Similarly, Bernie Madoff who ran the largest ponzi scheme at the time in American history was well known to regulators, having served as Chairman of the NASDAQ stock exchange. FTX was not exactly out of America’s financial regulatory system either, it was licensed and registered with the Commodities Future Trading Commission (CFTC). There is no guarantee that had FTX been more closely regulated it would not have stolen customer funds like MF Global or potentially run a ponzi scheme like Madoff. Ultimately, regulation alone cannot stop people from acting illegally and unethically. Laws define what is illegal but law enforcement is required to catch and prosecute criminals.

Congress’s decision to hold hearings to uncover facts, expose wrongdoing, and amass evidence for prosecution is the right first step. These hearings will likely uncover more misfeasance in the crypto space. Potential domino contagion within crypto is quite possible, witness another crypto exchange BlockFi halting redemptions in the wake of FTX’s collapse. When consumer confidence is shaken, investors will run. The lack of regulatory safeguards and transparency into other crypto exchanges and currencies could mean that FTX is not the last or even the largest player to fail. Recall after Enron went MCIWorldComm, after Lehman went AIG.

How should the government respond? Enron executives went to jail. So did Bernie Madoff. However, almost no bank executives were personally prosecuted after the financial crisis, despite widespread misconduct. This was a major mistake in ensuring greater public confidence and accountability in how our financial system operates.

FTX is a critical opportunity for the government to get it right. Even if prosecution is more challenging because crypto’s status under the law is unclear and FTX was operating through multiple offshore enterprises, it is critical that the government use every mechanism possible to ensure personal accountability when illegal activity takes place and investors have their money stolen. One reason given during the financial crisis for the lack of prosecution was that prosecutors were afraid of losing cases. It is far better for the public to see the government attempt and fail prosecution than to not try at all. If the laws are insufficient to convict, then failed prosecutions will help build political support to change the law.

Will Congress act to regulate crypto? There had been growing bipartisan support for draft legislation on stablecoins and for crypto exchanges. Those proposals need to be fundamentally rethought in the wake of FTX’s implosion. Many on the left and right want to keep cryptocurrencies out of the regulatory system. FTX’s implosion can justify keeping crypto out of the regulated system just as it can be argued that its implosion means regulation is more urgently needed.

Crypto remains in the netherworld of financial regulation, caught between traditional definitions of securities, commodities, assets, money, and payments. As former CFTC Chairman Tim Massad pointed out the problems of our regulatory system’s fragmentation back in 2019, writing that while both the Securities and Exchange Commission and the CFTC have: “some authority over crypto-assets, neither has sufficient jurisdiction, nor do they together.” Although crypto exploded in popularity between Massad’s paper and FTX’s implosion, new regulatory authority was not given to either agency. Federal bank regulators generally tried to keep crypto out of the regulatory system, which so far seems to have limited the contagion from FTX’s implosion to the broader financial system. New York’s financial regulator never gave FTX the license necessary to operate in the Empire State, a decision that saved New Yorkers a lot of money. Sometimes the right answer by a regulator is no.

Congress should not rush to regulate crypto, nor treat the industry with a broad brush assuming all crypto is as corrupt as FTX appears to have been. As legislators take the time necessary to figure out what the right regulatory system is, prosecutors need to step up. Americans lost a lot of money in FTX, just as they did in many other large corporations that broke the law. People need to be held accountable to restore faith in the system. Let’s do a better job this time than in 2008.

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