Streetwise Professor

November 14, 2022

Regulate This! Yeah? How?

Filed under: Cryptocurrency,Economics,Exchanges,Politics,Regulation — cpirrong @ 12:30 pm

As day follows night, the vaporization of FTX has spurred calls for regulation of crypto markets. Well, what kind of regulation, exactly? It matters.

It appears highly likely that SBF and his Merry Gang (of pervy druggies?) broke oodles of laws, in multiple jurisdictions. Class action lawsuits are definitely incoming, and the DOJ’s SDNY attorneys’ office is commencing a criminal investigation. No doubt criminal investigations will follow in other locations. So what would more laws accomplish, and what kind of laws and regulations would help?

It is interesting to note that SBF was going around DC and the media talking up regulating the industry, and winning effusive plaudits (but not from CZ!) for doing so, but his proposals didn’t come within a million miles of his alleged wrongdoing. I’m sure you’re shocked.

On CNBC, Bankman-Fried endorsed three regulatory endeavors: stablecoin auditing, “markets regulation” of spot trading, and token registration (at about the 4:30 mark):

None of which touches on the fundamental issue in the FTX fiasco, and in crypto market structure generally: the role of “exchanges” in supplying broker dealer and banking services, including liquidity, maturity, and credit transformations.

No doubt SBF was adding to his savior glow by pushing regulation that he knew was utterly irrelevant to the core of his business (and the business of all other crypto “exchanges”). And look at how many suckers fell for it.

So what would help? As I noted at the outset, FTX, Bankman-Fried, et al likely violated numerous laws. So what additional laws would reduce the likelihood and severity of such actions?

In thinking about this, remembering the distinction between ex ante and ex post regulation is important. Ex post regulation involves the imposition of sanctions on malfeasors after they have been found to have committed offense: the idea is to deter bad conduct through punishment after the fact. In contrast, ex ante regulation attempts to prevent bad acts by imposing various constraints on potential wrongdoers.

The choice between ex ante and ex post depends on a variety of factors. Two of the most important (and related) are whether the bad actor is judgment proof (i.e., will have the resources to recompense those he has harmed) and the probability of detection. (These are related because a low probability of detection requires a higher penalty to achieve deterrence, but a higher penalty increases the chances that the wrongdoer is judgment proof).

In the case of things like what has apparently happened here, the probability of detection is high (1.00 actually), but the magnitude of the harm is so great and the (negative) correlation between the harm and the wrongdoer’s ability to pay is so high (essentially -1.00) that ex post deterrence is problematic.

(Judgment proof-ness is actually a justification for criminal law and the use of incarceration as punishment. Deterrence through fines doesn’t work with broke bad guys, so non-monetary punishment is necessary–but often not sufficient!)

So there is a case for ex ante regulation here, just as there is a case for ex ante regulation of banks and intermediaries like broker dealers and FCMs. Banking examiners, regulatory audits, customer seg rules, and the like.

But these are obviously not panaceas. Bank fraud still occurs with depressing regularity, and the things that facilitate it, like valuation challenges, accounting shenanigans, and so on, occur in spades in crypto. And, even in highly regulated US markets, violation of seg rules and misuse of customer assets occurs: yeah, I’m looking at you John Corzine/MF Global.

The big problems in crypto markets are essentially agency problems, especially since the crucial agents–crypto “exchanges”–are so concentrated and so vertically integrated into both execution and various forms of financial transformations.

Ex ante regulation focused on such issues could be a boon, and could help stabilize crypto markets generally. The spillovers we are seeing from FTX’s vaporization are essentially a reputational contagion: the mini (so far) runs on other “exchanges” reflect FUD about their probity and solvency. (NB: Binance, as the biggest “exchange,” and as opaque as FTX, is a serious run risk. BlockFi and AAX may already be in the crosshairs here: glitch in the systems upgrade. Riiiiigggghhhht.)

The challenge is that the demise of financial intermediaries is well-described by a famous Hemingway quote:

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.”

An intermediary can go along swimmingly, meeting all seg requirements and the like, and a big market move or bad bet or an operational SNAFU can put it on the brink very suddenly–and encourage gambling for resurrection by using customer funds to extend and pretend. So don’t expect such regulation to be a panacea, and prevent the recurrence of FTXs. Regulation or no, this happens with intermediaries that engage in liquidity, maturity, and credit transformations that are inherently fragile. (And may be fragile by design, as Doug Diamond has pointed out.)

On the regulation issue, one fascinating sidebar is my old bête noire, Gary Gensler. You don’t need to play 6 Degrees From SBF to ensnare most of the Democratic establishment: one or two degrees will do, and Gensler definitely qualifies.

In addition to the MIT connection, Gensler apparently had other interactions with Bankman-Fried. And of course Gensler is a player in the Democratic Party (he was Hillary’s campaign’s finance chair, after all), and Bankman-Fried was a major Dem donor (second largest after Soros in the most recent cycle, and he had talked about spending up to a billion in the 2024 campaign).

Questions have been raised.

When initially questioned about FTX, Gensler was very defensive:  “Building the evidence, building the facts often takes time.”

I am reserving judgment, but I hope someone takes the time to examine the links and interactions between SBF/FTX and Gensler (and other DC creatures)–and build the evidence and facts, if it comes to that.

My guess is that Gensler will try to pull a judo move and use this fiasco as a justification for expanding the power of the SEC. Indeed, I expect him to be in high dudgeon precisely to deflect attention from his (and his party’s) links to SBF. Don’t let him get away with it.

And don’t think that these links can be exposed through a FOIA. Gensler has long been known for using his private email to conduct official business. (Which is precisely why I didn’t bother FOAI-ing him years ago regarding my suspicions of his interactions with David Kocieniewski.) So deeper digging is required, and it should commence, post haste.

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  1. I don’t understand. The connection is MIT? John Corzine has University of Chicago in his resume, just like yourself. Just saying.

    Comment by aaa — November 14, 2022 @ 3:32 pm

  2. C’mon Man !

    Big money moves from the US to the Ukraine (military aid)

    Ukraine sends part back to FTX (less the handling fee to facilitate property purchase in Yurope & US for Zelensky)

    FTX bankrolls Democrats (No 2 donor in the run up to recent MidTerms)

    How is this not money laundering & a criminal conspiracy to evade political campaign finance laws ?

    Comment by djm — November 14, 2022 @ 4:43 pm

  3. Mr Bagman-Fraud must be in danger of being Epsteined (as I saw someone else phrase it). Perhaps his squeeze too. Then the whole affair will seem less entertaining.

    I don’t suppose the Bahamians are too happy about it unless they think all publicity is good publicity.

    Comment by dearieme — November 14, 2022 @ 4:52 pm

  4. I would point out that the E-gold system, back in 2007 or so, *voluntarily* undertook a 3rd-party audit from Deloitte & Touche to demonstrate that they were fully reserved. Far from requiring it, encouraging it, or merely leaving Douglas Jackson alone, the Feds actually undermined sound business practice here, and pressured D & T from releasing the results. Clearly, the deepstaters don’t want sound banking practice: insufficient opportunities for graft.

    Compared to traditional finance, crypto exchanges can prove reserves with much less trust in a “Big N, oops, now it’s Big N-1” accounting firm. Since blockchain assets are programmable, POR can be done with cryptographic proofs. Not always: you can’t prove the bank account balances behind a stablecoin with a merkle tree. The technology has been out there for years, see for example

    Comment by M. Rad. — November 15, 2022 @ 2:58 am

  5. Is that squeaking sound I hear coming from a thousand democrat arses or from a swinging stable door?

    I’ll make a prediction. There will be calls for regulation of crypto markets and exchanges, not least from crypto mugs who have lost their “investment”.

    At which point, crypto loses its appeal, which was independence from government oversight and politicians’ manipulation.

    CBDC here we come.

    Comment by philip — November 15, 2022 @ 2:57 pm

  6. I passed on so many crypto exchanges…and invested in one They do things right. Physical delivery of crypto and went through the CFTC process to become a DCM. One business we invested in did things right. They were the only ones to make it through the SEC regulatory thicket and get a license to trade security tokens. Too bad the SEC didn’t let security tokens trade.

    there is potential for crypto, but you have to be an adult in the room and get rid of all the shiesters.

    Comment by Jeff Carter (@pointsnfigures1) — November 15, 2022 @ 11:51 pm

  7. @aaa, don’t you think there might be relationships that were exploited there? Connect the dots….

    Comment by Jeff Carter (@pointsnfigures1) — November 15, 2022 @ 11:53 pm

  8. @Jeff Carter: ‘Physical delivery of crypto’…well, somebody told me, so I remember now, that a certain Chuck Norris counted up to infinity twice in his lifetime…he must have done things right also…apart from this: not sure where I’m getting the impression from, but this crypto scene seems to involve a lot of people one wouldn’t like to get physical with…

    Comment by Mikey — November 16, 2022 @ 2:12 am

  9. Someone on Twitter posted that one the criminals at FTX was a large Republican donor. Another naive idiot who doesn’t understand political money is just a protection racket made legal.

    Comment by The Pilot — November 16, 2022 @ 9:28 am

  10. @The Pilot
    according to this,
    $36,000,000 to progressives, $105,000 to conservatives. There’s your twit.
    Crypto has attracted a swarm of crooks. But so did the internet in early days, online porn. And the boom in graphics cards and memory was in response to demand from gamers. Real actual usefulness comes along later. As it might in the case of crypto, but I’m not holding my breath.

    Comment by philip — November 16, 2022 @ 6:19 pm

  11. Here’s a good summary, I think, of the FTX fraud, where the speaker goes into regulatory capture – an ancient practice which SBF/FTX practiced with a vengeance, as noted in the blog post.

    a plan to capture crypto

    Crypto-currency is thin air – so who were the lenders that loaned against the crypto so as to enable FTX/SBF to give $40 million to the Dems? He also gave to the Repubs, but nowhere near as much.

    One more thing – for some reason, many of the reports on the evildoings of FTX/SBF bring in —– Ukraine. Seems like Ukraine is a pawn caught in the middle of a justifiable attack on this Madoff-type fraud by the Repubs against the Dems.

    Comment by elmer — November 17, 2022 @ 9:14 am

  12. money being funneled back to Dems through Ukraine – ain’t that a beauty of a hoax

    no question that big money was funneled to Dems by FTX/SBF – and certainly connections to Gensler and company, mentioned in the post, were “helpful.”

    but – where is the EVIDENCE as to Ukraine being a funnel?

    Comment by elmer — November 17, 2022 @ 9:18 am

  13. SBF interview:

    Comment by Mikey — November 17, 2022 @ 10:56 am

  14. Not suggesting anything necessarily illegal but … the intimate involvement in a gigantic clusterfkkk with starring roles for the spawn of such esteemed academics at MIT and Stanford as Profs Ellison, Bankman and Fried does beg for the use of a pejorative adjective: incestuous.

    Whole thing stinks to High Heaven, methinks.

    Comment by Simple Simon — November 20, 2022 @ 12:06 pm

  15. The core issue has been missed here. Bankman-Fried was throwing around money in Washington in order to get himself regulated – by the CFTC, and NOT by the SEC. Whereas all of crypto with the exception of Bitcoin are securities, according to the defintition everyone else follows. SBF was shouting ‘Don’t throw me in the briar patch!’ and people actually thought he wanted to be regulated. If the SEC regulated non-Bitcoin as securities, all of the exchanges would go out of business. The entire crypto industry only exists because the sharps saw the lack of regulation and moved in. Cory Klipstten has called multiple crypto frauds, including FTX, and you can listen to him on Youtube lay it out in plain English.

    Comment by jonfrum — March 29, 2023 @ 4:43 pm

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