In a continuous effort to improve the security of user funds in crypto exchanges, New York’s Chief Financial Regulator drafted guidance on Monday, January 23rd. The Guidance on Custodial Structures for Customer Protection in the Event of Insolvency (Guidance) stipulates that companies involved with crypto funds must separate users’ assets (crypto assets) from company funds - an issue underscored by FTX’s failures to do so which resulted in significant losses to clients.
On November 11th, 2022, FTX and its 130 subsidiary companies declared bankruptcy under Chapter 11 in the U.S. Bankruptcy Court. While the money involved in the fall of FTX is significant, the fallout has underscored the need to correct weak governance practices and poor financial reporting to ensure history doesn’t repeat itself. Due to these shortcomings, FTX and CEO Sam Bankman-Fried (SBF) have been accused of fraud, mismanagement, and other wrongdoings. Regulatory attention has also been drawn to FTX as a failure of this magnitude hasn't been seen since Enron in the early 2000s.
The ripple effects of FTX’s crash are already manifesting. Genesis, which filed for Chapter 11 bankruptcy on 19th January 2023, has an estimated liability of around $5.1 billion. It owes Gemini, its single largest creditor, nearly $769 million through its Gemini Earn program. BlockFi, a prominent crypto exchange, also filed for bankruptcy on November 28th, 2022. Its liabilities are estimated to be around $1 to $10 billion.
Regulators are intervening to ensure the proper functioning of the crypto companies in light of FTX’s contagion effect. The recent advisory is the latest crypto-related guidance released by the New York State Department of Financial Services (NYDFS), which saw the cryptocurrency market contract by around $1.3 trillion by the end of 2022.
The launch of a new set of guidelines comes at a time when regulators are once again calling out the lack of consumer protection in the cryptocurrency market and provides regulators additional powers to ensure consumer protection in case any company files for solvency moving forward.
Post the FTX fallout, crypto asset standards are under scrutiny by central banks, regulators, and international organizations. The U.S. Senators and members of the European Parliament are pressuring their respective organizations to regulate crypto under existing guidelines. This Guidance will further increase consumer protection as it addresses key fund management issues by crypto organizations. Due to the inherent cross-border nature, governance, management, and policy enforcement around crypto assets can be particularly difficult. Several virtual asset service providers – wallets, exchanges, and issuers – conduct their business from offshore jurisdictions, although they offer their services around the world. Without a unified global strategy, companies prefer tax or regulation-friendly jurisdictions and continue to serve customers in other locations.
