[Senate Hearing 117-757]
[From the U.S. Government Publishing Office]
S. Hrg. 117-757
CRYPTO CRASH: WHY THE FTX BUBBLE BURST AND THE HARM TO CONSUMERS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE FAILURE OF THE NON-U.S. AND U.S. BASED FTX CRYPTO
EXCHANGES AND THE FALLOUT AFFECTING OTHER CRYPTO AND FINANCIAL FIRMS
__________
DECEMBER 14, 2022
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Available at: https: //www.govinfo.gov /
_________
U.S. GOVERNMENT PUBLISHING OFFICE
53-797 PDF WASHINGTON : 2023
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
SHERROD BROWN, Ohio, Chairman
JACK REED, Rhode Island PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey RICHARD C. SHELBY, Alabama
JON TESTER, Montana MIKE CRAPO, Idaho
MARK R. WARNER, Virginia TIM SCOTT, South Carolina
ELIZABETH WARREN, Massachusetts MIKE ROUNDS, South Dakota
CHRIS VAN HOLLEN, Maryland THOM TILLIS, North Carolina
CATHERINE CORTEZ MASTO, Nevada JOHN KENNEDY, Louisiana
TINA SMITH, Minnesota BILL HAGERTY, Tennessee
KYRSTEN SINEMA, Arizona CYNTHIA LUMMIS, Wyoming
JON OSSOFF, Georgia JERRY MORAN, Kansas
RAPHAEL WARNOCK, Georgia KEVIN CRAMER, North Dakota
STEVE DAINES, Montana
Laura Swanson, Staff Director
Brad Grantz, Republican Staff Director
Elisha Tuku, Chief Counsel
Dan Sullivan, Republican Chief Counsel
Cameron Ricker, Chief Clerk
Shelvin Simmons, IT Director
Pat Lally, Hearing Clerk
(ii)
C O N T E N T S
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WEDNESDAY, DECEMBER 14, 2022
Page
Opening statement of Chairman Brown.............................. 1
Prepared statement....................................... 40
Opening statements, comments, or prepared statements of:
Senator Toomey............................................... 4
Prepared statement....................................... 41
WITNESSES
Hilary J. Allen, Professor, American University Washington
College of Law................................................. 6
Prepared statement........................................... 44
Responses to written questions of:
Chairman Brown........................................... 80
Senator Tester........................................... 81
Senator Warnock.......................................... 84
Kevin O'Leary, Investor.......................................... 8
Prepared statement........................................... 64
Responses to written questions of:
Senator Tester........................................... 86
Senator Cortez Masto..................................... 89
Senator Warnock.......................................... 90
Jennifer J. Schulp, Director of Financial Regulation Studies,
Center for Monetary and Financial Alternatives, Cato Institute. 10
Prepared statement........................................... 66
Responses to written questions of:
Senator Tester........................................... 93
Senator Warnock.......................................... 95
Ben McKenzie Schenkkan, Actor and Author......................... 11
Prepared statement........................................... 76
Responses to written questions of:
Chairman Brown........................................... 96
Senator Tester........................................... 96
Senator Warnock.......................................... 98
Additional Material Supplied for the Record
Letter submitted by National Association of Federally-Insured
Credit Unions.................................................. 100
Letter submitted by AFR, et al................................... 101
Letter submitted by North American Securities Administrators
Association.................................................... 105
Letter submitted by Alliance for Innovative Regulation........... 110
(iii)
CRYPTO CRASH: WHY THE FTX BUBBLE BURST AND THE HARM TO CONSUMERS
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WEDNESDAY, DECEMBER 14, 2022
U.S. Senate
Committee on Banking, Housing and Urban Affairs
Washington, DC.
The Committee met at 10 a.m., in room G50, Dirksen Senate
Office Building, Hon. Sherrod Brown, Chairman of the Committee,
presiding.
OPENING STATEMENT OF SENATOR SHERROD BROWN
Chairman Brown. The Senate Banking, Housing, and Urban
Affairs will come to order. Thank you to the witnesses for
joining us today.
Today's hearing, we believe, is in a hybrid format. That
was the intent. We are having some problems, some technical
problems that may be Senate-wide, and Cameron is a genius at
this stuff and doing everything he can to fix it. So we are
letting Committee Members who sometimes want to ask questions
remote, that they probably need to show up in person. So that
is our issue; certainly not the witnesses'.
I want to express my gratitude to the Department of
Justice, the SEC, the CFTC, and the Bahamian authorities for
taking the critical step to hold Sam Bankman-Fried accountable
for his misdeeds. I would also like to thank Ranking Member
Toomey and his staff--thank you--for working with me and my
staff to try to secure Mr. Bankman-Fried's testimony. I trust
that he will soon be brought to justice. It is clear he owes
the American people an explanation.
Meanwhile, our job is to keep learning more about the
collapses of FTX and other crypto firms--and I emphasize ``and
other crypto firms''--and work with regulators to put
consumers, not the crypto industry, first.
This is not just about crypto. This is about protecting the
consumers and the regulated financial sector from bad actors
who think rules simply do not apply to them.
Two-and-a-half years ago, I explained why I thought
Facebook's Libra currency was dangerous. At the time, Facebook
was moving full steam ahead, as most of you know, to create its
own ``currency''--put that in quotation marks--to impose on its
billions of users. Congress, regulators, and policymakers saw
Facebook Libra for what it was: a shiny new tool Facebook could
use to reach into Americans' pockets and profit from, no matter
the risk to consumers or our economy.
Members of this Committee, and others in Congress,
responded. Republicans and Democrats alike made it clear that
Facebook could not be trusted, and our financial system was not
to be played with.
The risk of a company creating its own currency to compete
with the U.S. dollar was obvious. Ultimately, Facebook shut
down its crypto project, but this Committee's work to protect
consumers of course continues. Even though Facebook shelved its
crypto plans, in the last 2\1/2\ years, the stablecoin market
has grown 20 times, to become a tool for rampant speculation.
The number of crypto tokens has exploded, even as the total
value of all crypto assets fell by two-thirds in the last year.
I have noted in the past the similarities that
cryptocurrencies share with risky mortgage bonds and over-the-
counter derivatives during the lead up to the financial crisis.
In all these cases, they told us how great innovation is and
how derivatives make markets efficient. Wall Street made it
easy for everyone to get a mortgage so bankers could create
more mortgage bonds and increase profits. Making money in
crypto seemed easy, too easy. Every crypto token could double
or triple in value in a matter of hours or days.
It did not matter if it was created with vague details or
as a joke. Money still poured in. But no one is laughing now.
The weekend before our stablecoin hearing last February, we
saw crypto companies spending big money on Super Bowl ads to
attract more customers and pump up crypto tokens. I appreciated
the comments of one of you in this panel on public radio today
about that.
Crypto, like Facebook's Libra before it, was the shiny tool
that was supposed to capture our imagination and revolutionize
our lives. Wealthy celebrity spokespeople told Americans, if
you are not buying crypto, you are missing out.
Crypto platforms created dozens of investment products,
products that look and sound like bank deposits, and that used
words like ``lend'' and ``earn,'' or tokens that resemble
securities and have a ``yield'' or governance rights. Yet these
products had none of the safeguards of bank deposits or
securities.
Crypto firms, and their backers, argued that billions of
dollars invested in lending programs, or earning yield, should
be exempt from basic oversight and regulatory protections.
That is not how regulation works. The things that look and
behave like securities, commodities, or banking products need
to be regulated and supervised by the responsible agencies who
protect the public and serve consumers.
Crypto does not get a free pass because it is shiny and
bright, or because venture capitalists think it might change
the world, or its TV ads campaigns were witty and featured
famous people, especially when so many consumers are at risk of
losing their hard-earned money.
And that is before we even consider how crypto has ushered
in a whole new dimension of fraud and threats to national
security--people are talking about that more and more because
it is a central issue in this--that support dangerous Nation
States, embolden criminals, and finance terrorists.
North Korea uses crypto stolen in hacks to finance its
ballistic missile programs. Think of that. Human traffickers
and drug cartels and gunrunners launder their proceeds using
crypto assets--think of that--and some of these laundered funds
end up bankrolling terrorists bent on undermining our Nation
and our society. Think of that.
The ability of rogue States, cyber criminals, and
terrorists to use crypto for their own malign purposes is a
feature of the technology, and that is the point.
Crypto also has made it easier for fraudsters and scammers
to steal consumers' money. Hacks and complex crypto
transactions made it easy to steal billions of dollars of
investors' money. That is what we saw with FTX. That is what
will continue as long as we allow crypto firms to write their
own rules.
The myth of Sam Bankman-Fried and his crypto trading
success was supposed to impress us. We are still learning how
he shuffled money between FTX and his trading firm, Alameda
Research, a name calculated to sound as generic as possible to
avoid raising eyebrows while sending money across the world.
FTX and Alameda Research took advantage of the crypto
industry's appetite for speculation. They were able to borrow
and lend from other platforms and invest in other crypto firms,
inflating the crypto ecosystem and growing their own profits.
Even this summer as crypto values crashed and platforms
began to fail, FTX and Alameda found ways to benefit. In one
case, FTX made a $250 million loan to a platform using its
proprietary token, and Alameda borrowed client deposits worth
more than twice that from the platform.
All the while, venture capitalists and other big
investors--shame on them--fell for it. They were caught up in
the speculative frenzy, missed the red flags at FTX, and
showered Mr. Bankman-Fried with more and more money, and now it
is all most likely gone.
It is no surprise that in 2018, Alameda solicited investors
by guaranteeing 15 percent returns with, quote, ``no
downside.'' That is more than the guaranteed 11 percent that
Bernie Madoff offered. With Madoff and with Sam Bankman-Fried,
investors did not ask questions for fear of missing out. It is
a good reminder that most guaranteed investments are, in fact,
too good to be true.
In this story, Sam Bankman-Fried was also the shiny object.
Now he is the villain, possibly worse. But this story is bigger
than one person or even one firm, and that is the point of this
hearing. This is not just about misconduct at FTX, but about
how to protect consumers and the financial system from
unregulated crypto products.
For many investors, it might be too late. I have heard from
far too many Ohioans who have money stuck at FTX.US, that they
tried to get out before it filed for bankruptcy. But despite
Mr. Bankman-Fried's assertions that the U.S. side of FTX should
be fine, the court proceedings are likely to drag on and on.
If we are going to learn from FTX's meltdown, we must look
closely at the risks from conflicts at crypto platforms that
combine multiple functions. It means thinking about the kinds
of disclosure that consumers and investors really need to
understand how a token or crypto platform works. We can look to
existing banking and securities laws for time-tested approaches
to oversee and examine entities that want Americans to trust
them with their money.
To protect consumers and the financial system we need a
comprehensive framework that looks at crypto products for what
they are, not looking at these products the way crypto
executives want them to be, or want to tell us they should be.
I look forward to working with Treasury Secretary Yellen.
We have been working with her to step and lead this
governmentwide regulatory approach--and the other financial
regulators to ensure there is an all-of-Government approach,
just as we have done in the past. Anything less simply will not
work.
Senator Toomey.
STATEMENT OF SENATOR PATRICK J. TOOMEY
Senator Toomey. Thank you, Mr. Chairman, and I want to
thank our witnesses for joining us this morning.
We are here to discuss the fallout after the collapse of
FTX. Some Americans very likely suffered significant losses
from the bankruptcy of FTX and Sam Bankman-Fried's misconduct.
On Monday, we saw the arrest of Mr. Bankman-Fried. This
came as a surprise to no one, with the possible exception of
Mr. Bankman-Fried. We owe it to each customer to get to the
bottom of the FTX implosion, and any violations of the law
should be aggressively prosecuted. The Department of Justice
and other enforcement agencies should expeditiously investigate
the unseemly relationship between a company that was
effectively a hedge fund, and an exchange entrusted with
customer funds.
While all the facts have not yet come to light, we have
clearly witnessed wrongdoing that is almost certainly illegal.
There was unauthorized lending of customer assets to an
affiliated entity, and there were apparently fraudulent
promises to investors and customers about FTX's operations.
These are outrageous and completely unacceptable. The SEC also
believes FTX committed fraud against equity investors. They are
going to pursue that, as they should.
But I want to underscore a bigger issue here, and that is
the wrongful behavior that occurred here is not specific to the
underlying asset. What appears to have happened here is a
complete breakdown in the handling of those assets. In our
discussion of FTX today, I hope we are able to separate the
likely illegal actions from perfectly lawful and innovative
cryptocurrencies.
Now it is important to define this space. Cryptocurrencies
are analogized to tokens, but they are actually software. The
software protocols that are foundational to the crypto
ecosystem are like operating systems, and then applications are
run on top of these operating systems. Currently there are many
competing operating systems and many apps running on them.
There is nothing intrinsically good or evil about software; it
is about what people do with it.
With this analogy in mind, what we should all understand
here is one simple thing: the code committed no crime. FTX and
cryptocurrencies are not the same thing. FTX was opaque,
centralized, and dishonest. Cryptocurrencies usually are open-
source, decentralized, and transparent.
To those who think that this episode justifies banning
crypto, and I have actually heard that suggested, I would ask
you to think about several other historical parallels.
The 2008 financial crisis involved obvious misuse of
products related to mortgages. Did we decide to ban mortgages?
Of course not. A commodity brokerage firm run by former New
Jersey Senator John Corzine collapsed after customer funds,
including U.S. dollars, were misappropriated to fill a
shortfall from the firm's trading losses. Nobody suggested that
the problem was the U.S. dollar, or that we should ban it. With
FTX, the problem is not the instruments that were used. The
problem was the misuse of customer funds, gross mismanagement,
and likely illegal behavior.
So let us talk about what comes next. Some of my colleagues
have suggested somehow pausing cryptocurrencies before we pass
legislation. This is a profoundly misguided, not to mention
impossible, idea. Short of enacting draconian, authoritarian
policies, cryptocurrency cannot be stopped. If we tried, the
technology would simply migrate offshore; cryptocurrency does
not need brick and mortar facilities to operate. And typing
computer code should clearly be seen as a form of protected
speech.
Are we going to decide to pause the Constitution to stop
crypto? This is exactly the kind of mindset that has driven
this activity to the darker and less regulated parts of the
world.
Now, if Congress had passed legislation to create a well-
defined regulatory regime with sensible guardrails, we would
have multiple U.S. exchanges competing here under the full
force of those laws and regulations. In that scenario, it is
not clear that FTX would have ever existed, at least on the
scale that it did, not if we had American companies that were
an alternative and properly regulated. The complete
indifference to an appropriate regulatory regime by both
Congress and the SEC has probably contributed to the rise of
operations like FTX.
Others have suggested we refrain from addressing
cryptocurrency at all, because we would not want to legitimize
its use. Well, I think that is both misguided and
irresponsible. Congress can and should offer a sensible
approach for the domestic regulation of these activities. I
think we should start with stablecoins. This is an activity
that my colleagues can analogize to existing, traditional
finance products. There is clear bipartisan agreement that
stablecoins need consumer protections. There are virtually none
in place now. I have proposed a framework to do that. Senators
Lummis and Gillibrand have also proposed a framework.
Congress also needs to determine the criteria and the
disclosures by which the issuance of digital assets will be
regulated. And we should acknowledge the possibility that
certain token issuances, like Bitcoin, do not need that kind of
regulation. We should also clearly delineate regulations for
secondary market trading of these assets, including at
exchanges like FTX.US. Some of my colleagues have begun this
important work.
We can provide sensible consumer protections for which
there would be very broad agreement, while still allowing for
the development of applications that are going run on operating
systems that we cannot even imagine today, just as I do not
think any of us ever imagined applications like Uber operating
on iOS today.
Let me conclude with this. It is absolutely essential to
investigate any fraud and violations of existing law, and
prosecute those who are committing those crimes. Congress owes
it to the American people to do so. But this is fundamentally
not about the kind of assets that were held by FTX. It is about
what individuals did with those assets.
Individuals can also be tremendously empowered by the use
and access to cryptocurrencies. Cryptocurrencies can protect
against inflation when Governments irresponsibly manage their
own currencies. They can provide useful services without the
need for a company or a middleman. And they can let individuals
preserve the freedom to transact privately.
Mr. Bankman-Fried may have well committed multiple crimes.
The SEC and DOJ will determine that. But let us remember to
distinguish between human failure and the instrument with which
the failure occurred. In this case the instrument is software,
and the code committed no crime. And while Sam Bankman-Fried
very well may have, it is important we do not convict the code
of anything but preserving and protecting individual autonomy.
Thank you.
Chairman Brown. Thank you, Senator Toomey.
I will introduce today's witnesses. Starting on my left we
will hear from Professor Hilary J. Allen from the American
University Washington College of Law. She has testified
remotely in this Committee last year, I believe.
Mr. Kevin O'Leary, an investor, television personality, and
founder of several companies. Mr. O'Leary, welcome.
Ms. Jennifer Schulp, the Director of Financial Regulation
Studies at Cato Center for Monetary and Financial Alternatives.
Ms. Schulp, welcome.
And Mr. Ben McKenzie Schenkkan, an actor, writer, director
who is cowriting a book on cryptocurrency and fraud. Mr.
Schenkkan, welcome.
And Professor Allen, please begin.
STATEMENT OF HILARY J. ALLEN, PROFESSOR, AMERICAN UNIVERSITY
WASHINGTON COLLEGE OF LAW
Ms. Allen. Chairman Brown, Ranking Member Toomey, and
Members of the Committee, thank you for inviting me to testify
today. My name is Hilary Allen and I am a professor of law at
the American University Washington College of Law, and I am the
author of the book, ``Driverless Finance: Fintech's Impact on
Financial Stability''.
I would like to make three points today. The first is that
FTX's failure was not an isolated incident but is symptomatic
of many broader problems in the crypto industry. FTX is just
the latest in a series of major crypto industry failures,
failures of centralized crypto intermediaries like Celsius, and
failures of DeFi offerings, like Terra Luna. These failures
arose, in large part, because of a feature that is unique to
the crypto industry. Crypto assets can be made up out of thin
air. When assets can be made up out of thin air that generates
leverage that makes the whole system more vulnerable to booms
and busts. When assets can be made up out of thin air, they can
also be used to obscure financial realities, as was done with
FTX's FTT tokens, which were used as collateral for the FTX
customer assets loaned to Alameda.
How can you have any reliable check on the valuation of an
asset with no productive capacity behind it? The attestations
and proof of reserves offered by the crypto industry are poor
substitutes for rigorous and independent audits. Such an
environment is highly conducive to fraud. Sam Bankman-Fried may
have engaged in good old-fashioned embezzlement, as it was put
yesterday, but the embezzlement was able to reach such a scale
and go undetected for so long because it was crypto, shrouded
in opacity, complexity, and mystique.
To be clear, decentralization will not protect us from
future crypto frauds because even if DeFi is technologically
decentralized it is not economically decentralized. If one
person owns 90 percent of the governance tokens that control
the software, which is quite common in DeFi, then they could
cause it to perpetuate shady behavior.
The second point I want to make is that when we talk about
regulating crypto we are often not being specific about the
type of regulation we mean to apply. There are several
different options. A ban on crypto, for example, would be the
most straightforward way of protecting both investors and the
financial system, and because crypto is not really
decentralized it is possible to enforce such a ban. If
policymakers do not wish to proceed with a ban then they will
need to be careful to ensure that any laws that they do adopt
do not inadvertently make crypto too big to fail.
Crypto should not be regulated like banking products
because that would give crypto access to the Government support
that we afford to banking because of its critical role in
providing credit and processing payments for the broader
economy. Banking regulations should, however, continue to keep
actual banks away from crypto. The harm from FTX's collapse has
been limited to those who invested in crypto, but allowing
crypto to integrate with the rest of our financial system could
cause a broader financial crisis that would hurt those who
never even invested.
Investor protection regulation as opposed to banking
regulation does not come with any deposit insurance or lender
of last resort. It does not signal that an investment is a good
investment or that an investment will not lose value. Robust
enforcement of the securities laws could make significant
strides in protecting U.S. investors without conveying the
message that crypto is too big to fail. The SEC has been very
clear in its public statements that most crypto assets are
securities, but Sam Bankman-Fried and the rest of the crypto
industry were not looking for this clarity on the current law.
They were looking for changes in the law that would accommodate
the industry. In particular, they wanted to be regulated by the
CFTC and not the SEC.
I respectfully submit that Congress should not adopt
legislation to that end that was endorsed by Sam Bankman-Fried,
in particular, because the proposed CFTC self-certification
regime for crypto assets would allow the unlimited supply of
crypto assets to continue to proliferate. Energetic enforcement
of the SEC's existing securities registration requirements, on
the other hand, would make it a lot harder to make crypto
assets up out of thin air. If Congress wishes to provide more
clarity and certainty to the crypto industry they could adopt
legislation that categorically provides that all crypto assets
are indeed securities.
The final point I want to make is that we have little to
lose from limiting the growth of the crypto industry. The
underlying blockchain technology can never deliver on the
industry's promises, both because the technology itself is not
very good and because technology is only a tool. After 15 years
without a killer app, it is time for policymakers to listen to
the technologists explain why blockchain technology is
fundamentally not fit for purpose.
Even if it were good technology, though, it would not fix
the underlying political and structural problems that limit
access to financial services. In many ways, relying on the
crypto industry to improve access to financial services is like
adopting a policy to open more casinos in underserved
communities. And to those who say that crypto investment is a
matter of personal choice, crypto creates problems even for
those who choose not to invest in it. It facilitates ransomware
attacks, sanctions evasion, tax evasion, has significant
environmental consequences, and as I have already discussed,
could cause financial crises if allowed to integrate with the
traditional financial system.
I would submit that the United States should not want to be
a world leader in the worst kind of innovation that allows its
suppliers to profit handsomely but offers little benefit to
society and, in fact, inflicts a multitude of harms.
Chairman Brown. Thank you, Professor Allen.
Mr. O'Leary, welcome.
STATEMENT OF KEVIN O'LEARY, INVESTOR
Mr. O'Leary. Thank you very much. Chairman Brown, Ranking
Member Toomey, and Members of the Committee, thank you for
inviting me to testify about crypto and the collapse of FTX.
I am the Chairman of O'Shares, an ETF indexing firm, and
also a private equity and venture investor. I support
entrepreneurs at every stage of their journeys. I have dozens
of family run businesses in our investment portfolios. My
extensive social media platform enables me to tell the stories
of their products and services to help reduce their customer
acquisition costs. It is a model that has worked well for over
a decade and helped support so many small American businesses,
which create over 60 percent of the jobs in the American
economy.
In 2017, I was a public critic and skeptic of crypto and
blockchain technology. As the global regulatory environment
began to open up in 2018, I began to invest. Now I am a
shareholder in multiple companies involved in crypto
technology, including WonderFi/BitBuy, the largest and first
regulated broker/dealer crypto exchange in Canada, Immutable
Holdings, a developer of NFT technology, and Circle, the
company that brought USDC stablecoin to market. I have also
invested in multiple crypto tokens, infrastructure and Level 1
and Level 2 blockchains.
I am of the opinion that crypto, blockchain technology, and
digital payment systems will be the 12th sector of the S&P
within a decade.
Many of these technologies are going to disrupt the
existing financial services sector with faster, more efficient,
more productive and more secure ways of investing, paying,
transferring, and tracking assets.
As you are aware, Bitcoin, a store of value, is not a coin.
It is software. Ethereum is software. Blockchain is software.
In the last 30 years, every American enterprise has driven
major efficiencies using various versions of enterprise
software, and crypto is no different. The potential of these
crypto technologies is astronomical in scale.
In August of 2021, nearly 3 years after I started
allocating capital to the crypto sector, I entered into an
agreement with FTX to be a paid spokesperson. I was paid
approximately $15 million for these services, plus
approximately $3 million to cover a portion of the taxes due.
Of the remaining amount, approximately $1 million was invested
in FTX equity and approximately $10 million in tokens held in
FTX wallets. The equity is now most likely worthless and the
accounts have been stripped of their assets and, interestingly,
financial records. I have written them off to zero. Because I
was a paid spokesperson, however, I never invested any capital
from our partners or LPs in FTX. The capital lost was from an
operating company that I had 100 percent ownership in.
I am using my own capital to pursue record recovery of the
FTX accounts so that I can conduct a forensic audit. The truth
of this situation will be discovered by following the
transaction trail after obtaining the records. I have applied
for membership on the FTX creditors' committee, in connection
with the bankruptcy proceedings, because I feel obligated to
pursue the facts on behalf of all stakeholders, and believe my
perspective of this situation will be helpful to the other
creditors' committee members.
The collapse of FTX is nothing new. While this situation is
painful for shareholders, employees, and account holders, in
the long run, it does not change this industry's promise. Enron
came and went and had no impact on the energy markets. Bear
Stearns' and Lehman Brothers' demise had no impact on the long-
term potential of American debt and equity markets.
I am only one of many investors that has experienced this
loss. However, this changes nothing in terms of the potential
of crypto. In fact, the recent collapse of crypto companies has
a silver lining. This nascent industry is culling its herd.
Going or gone are the inexperienced or incompetent managers,
weak business models, and rogue, unregulated operators.
Hopefully, these highly publicized events will put renewed
focus on implementing domestic regulation that has been stalled
for years. Other jurisdictions have already implemented such
policies and are now attracting both investment capital and
highly skilled talent. In the U.S., we are falling behind and
losing our leadership position.
I understand why many leaders in the banking industry are
openly skeptics, calling for the banning of these new crypto
software technologies. Disruption is always uncomfortable at
first, and entrenched businesses abhor new competition. But it
has been proven time and time again that disruption is
absolutely necessary in advancing the economy.
There is the risk of investing in crypto and there is also
the risk of not investing in it and letting others accrue its
benefits first, essentially gifting them a competitive
advantage that could be hard to recapture.
So where to start? We need clear policy and regulation for
the crypto industry, its entrepreneurs, its developers, and its
users. Congress should start by passing bipartisan legislation
that creates a sensible regulatory framework for digital
stablecoins backed by the U.S. dollar. Why? A well-regulated
stablecoin backed by the U.S. dollar and other high-quality,
liquid assets could become the global default payment system
over time. The U.S. dollar already denominates the price of oil
and other commodities. Why not everything else? What could be
more bipartisan than this?
Let me close with this. We need to get to the bottom of
what happened at FTX, but we cannot let its collapse cause us
to abandon the great promise and potential of crypto.
Chairman Brown. Thank you, Mr. O'Leary.
Ms. Schulp, welcome.
STATEMENT OF JENNIFER J. SCHULP, DIRECTOR OF FINANCIAL
REGULATION STUDIES, CENTER FOR MONETARY AND FINANCIAL
ALTERNATAIVES, CATO INSTITUTE
Ms. Schulp. Thank you, Chair Brown, Ranking Member Toomey,
and distinguished Members of the Senate Committee on Banking,
Housing, and Urban Affairs. My name is Jennifer Schulp and I am
the Director of Financial Regulation Studies at the Cato
Institute's Center for Monetary and Financial Alternatives.
Thank you for the opportunity to participate in today's
hearing.
At the outset, I note that because the facts are developing
it is premature to definitively diagnose the causes of FTX's
demise. Claims of fraud and contractual breaches should be
vigorously pursued, and courts should determine what crimes and
violations took place.
Importantly, the issues with FTX do not appear to be
intrinsically tied to cryptocurrencies or other blockchain
technologies. John Ray, the company's bankruptcy CEO, described
the situation as ``a complete failure of corporate controls and
a complete absence of trustworthy financial information.''
These risk management failures, whether the result of
intentionally fraudulent practices or the product of gross
negligence, should reflect on the perpetrators themselves, not
on the crypto ecosystem.
Today I suggest three takeaways for policymakers. First,
there are important distinctions between centralized entities
and decentralized projects. Policies designed to address risks
posed by centralized financial intermediaries should not be
blindly applied to decentralized projects. FTX is, at heart, a
traditional middleman. As a centralized exchange, and like a
traditional bank or broker, FTX took possession of people's
assets and kept the books, however poorly.
Decentralized finance, or DeFi, seeks to mitigate these
intermediary risks through technology. While designs vary,
decentralized exchanges utilize open-source software to provide
exchange services by, among other things, publicly recording
transaction data and allowing users to self-custody assets.
That is not to say that decentralized exchanges solve every
problem or eliminate every risk, or that DeFi is always
preferable to centralized finance. Rather, the point is that
different risks ought to be treated differently.
Second, unclear regulation remains a problem that can drive
innovation offshore. A rational regulatory framework should
distinguish between projects that reproduce the risks of
traditional finance and those that mitigate those risks through
disintermediation. For exchanges to provide rules that are
narrowly targeted to relevant risks, Congress should provide
for centralized marketplaces to register with the CFTC for
crypto commodities and the SEC for crypto securities.
Decentralized exchanges should be permitted to voluntarily
register, which recognizes their capacity to address
intermediary risks through technology.
Addressing marketplace regulation, though, is only part of
the task. It is also important to clearly define when crypto
projects trigger securities regulation to determine which
regulator oversees trading and what customer protections are
appropriate.
Federal securities law is appropriately applied to address
the specific risks of fraud, deception, and manipulation by
developers, sellers, or promoters who are active managers of a
crypto project. But where no individual or entity acts like a
manager, Congress should clarify that securities laws do not
apply. Congress should also provide a disclosure option for
decentralizing projects that covers information relevant to
crypto purchasers.
Finally, following FTX's bankruptcy there have been the
usual calls to protect consumers by banning crypto or,
paradoxically, by declining to regulate crypto, to delegitimize
it. This type of protection, premised on a value judgment about
the worth of the crypto ecosystem, takes the choice to engage
in technological innovation out of the hands of consumers,
investors, and entrepreneurs and wrongly places it in the
Government's hands.
While circumspection around a novel asset class and
technology is more than fair, blocking access to an instrument
that approximately 1 in 5 Americans already have chosen to use
for diverse purposes, from trading to sending remittances, is
entirely different. That crypto has yet to meet all of the
goals that it or other have set is not a reason to limit
access.
Moreover, the risk that some people will lose money does
not justify harsh regulation. Risk is a natural component of
markets, and failure is often necessary for development.
Americans should be able to participate, for better and for
worse, in that process.
Thank you, and I welcome any questions you may have.
Chairman Brown. Thank you, Ms. Schulp.
Mr. Schenkkan, welcome.
STATEMENT OF BEN MCKENZIE SCHENKKAN, ACTOR AND AUTHOR
Mr. Schenkkan. Thank you, Mr. Chairman. Chairman Brown,
Ranking Member Toomey, Members of the Committee, thank you for
inviting me to testify before you today.
This hearing has been called for two reasons. The first is
to examine the spectacular collapse of the crypto exchange FTX
and its sister company, Alameda Research, both owned by Sam
Bankman-Fried. These companies, valued at more than $32 billion
earlier this year, are today worth less than nothing. In fact,
they are $8 billion in the hole.
The demise of FTX and Alameda represent the most
spectacular corporate downfall since Bernie Madoff's Ponzi
scheme imploded in the wake of the Great Financial Crisis. It
has captured the Nation's attention.
Like Madoff, FTX and Alameda owe enormous sums to
supposedly sophisticated investors such as venture capital
firms and hedge funds, and like Madoff, they also owe a lot of
money to regular people.
However, the carnage at FTX is far more widespread. Madoff
defrauded some 37,000 clients. FTX claims 32 times that amount
in the U.S. alone. According to FTX, some 1.2 million retail
traders, aka regular folks, and 5 million worldwide have lose
access to the money they entrusted to FTX. It is unclear when,
if ever, they will get any of that money back.
The harm to those consumers--I would prefer the term
``investors''--is the second reason we are here today, and it
is fitting that I am here, for those people are the focus of my
attention. I believe they, and the estimated 40 million other
Americans who have invested in cryptocurrency, have been sold a
bill of goods. They have been lied to in ways both big and
small, by a once seemingly mighty crypto industry whose entire
existence, in fact, depends on misinformation, hype, and yes,
fraud.
The first lie is the most obvious. Cryptocurrencies are not
currencies by any reasonable economic definition. Anyone with
even an undergraduate degree in economics, such as myself, can
tell you that money services three functions: medium of
exchange, unit of account, and store of value. Cryptocurrencies
cannot do any of the three well, and they have no hope of ever
doing so, for reasons I am happy to discuss at greater length
during our session.
But in the interest of time let us keep it simple for now
and focus on the present. If cryptocurrencies are not
currencies, then what are they? Well, what do they do? How are
they used? Via FTX, Binance, and a host of other exchanges,
usually domiciled overseas, millions of Americans have used
real money to purchase some of the over 20,000 cryptos in
existence today. According to a recent Pew study, they are
doing so as an investment, a way of making money.
So what do we have in the eyes of the law? We have an
investment contract, more precisely, a security, an investment
of money in a common enterprise, with the expectation of profit
to be derived from the efforts of others.
To my mind, the four prongs of the Howey Test are easily
satisfied by every coin, token, or whatever nonsense words the
crypto industry attaches to lines of code, stored on ledgers
called blockchains, in an attempt to convey legitimacy or
technological sophistication to them.
But if these cryptos are securities they are bizarre ones.
They offer no products, no services, no revenue streams. The
projects they represent accomplish almost nothing in the real
world that cannot be done better by other means, and add no
overall value to our economy or any other. They are, at best, a
vehicle for speculation, an exercise in a zero-sum game of
chance, much like online poker. At worst, they are an
instrument of crime.
Surveying the cryptocurrency mania during the summer of
last year, I came to a terrifying conclusion: the supposedly
multitrillion-dollar industry was nothing more than a massive
speculative bubble, bound to pop. Worse than that, I had myriad
reasons to believe that the crypto bubble was built on a
foundation of fraud.
Investment contracts that are effectively valueless are
often described as Ponzi schemes, which are regulated under
American law by the Securities and Exchange Commission. In my
opinion, the cryptocurrency industry represents the largest
Ponzi scheme in history. In fact, by the time the dust settles,
crypto may well represent a fraud at least ten times bigger
than Madoff. The fact that his roped in tens of millions of
Americans from all walks of life, as well as hundreds of
millions of people worldwide should be of concern to us all.
Thank you for your time. I look forward to your questions.
Chairman Brown. Thank you, Mr. Schenkkan.
My first question I would like to ask all four of you, and
please give as close to a yes or no answer as you can.
The world is troubled by the extent of the fraud and
misconduct at FTX. We all agree on that. Too many people have
lost money they thought was safe. Some have suggested that what
we see at FTX was unique, a one-off caused by one immoral
fraudster rather than something more widespread and systemic.
So starting with you, Professor Allen, does this kind of
carelessness, misconduct, or worse exist at other crypto firms?
Ms. Allen. Yes.
Chairman Brown. Mr. O'Leary?
Mr. O'Leary. Yes, the unregulated crypto firms.
Chairman Brown. Ms. Schulp?
Ms. Schulp. Most likely.
Chairman Brown. Mr. Schenkkan?
Mr. Schenkkan. It is endemic.
Chairman Brown. Thank you.
Professor Allen, we know that FTX was overleveraged, but
look beyond, as you did in your testimony, beyond FTX. Given
that a lot of crypto trading recycles one token into another,
often with borrowed money, it seems as if the value of crypto
has detached itself from the actual currency that was
originally invested.
Is it possible to determine how much leverage there is in
the crypto market, and if it is not, why is that a problem?
Ms. Allen. Well, I do not think it is possible to
determine. I think researchers have really struggled to find
data in this space, notwithstanding that people say that the
blockchain is transparent. In fact, a lot of transactions
happen off-chain. There are a lot of sort of back doors in
software. So the data is not available to figure out what
transactions have happened, and the accounting around the
individual crypto assets themselves can be very dodgy as well.
So even before you lose track of them in transactions it is not
clear what they were worth up front.
So for all those reasons, it is very hard to get a bead on
what the leverage is in this space, and that is problematic
because, as we saw in 2008, when you do not understand how much
leverage is in the system, you do not understand how fragile it
is.
Chairman Brown. Thank you. Mr. Schenkkan, your testimony
highlights the similarities between crypto and gambling. Based
on your research, can you describe the parallels between
gambling and stablecoins as casino chips?
Mr. Schenkkan. Sure. Economically speaking, these are zero-
sum games, strictly competitive. For someone to win, someone
else has to lose. That does not mean the distribution is even.
We know, at this point, most people who have invested in
cryptocurrency have lost money. We know that from the
industry's own research. Grayscale December 2021 report said
that 55 percent of people who have ever bought Bitcoin bought
it that year. Given the current price of Bitcoin, those people
have lost money.
That does not include the people who have been locked out
of their accounts. The list is very long and I include it in my
written testimony.
So this is gambling. This is speculation, at best, zero
sum. That is not including the environmental cost that Bitcoin
incurs.
There are also members of the industry who come from online
poker. I would refer you to Stuart Hoegner, general counsel of
a company, Tether, a stablecoin company. He was former
compliance officer of Excapsa, which was the holding company of
Ultimate Bet. Ultimate Bet, from the online poker era, had a
Secret God Mode, where players could see the other players'
cards in order to defraud them, in order to win at poker.
Stuart Hoegner was joined at Excapsa by Daniel Friedberg.
Daniel Friedberg was the former general counsel of FTX. He is
now their chief regulatory officer. Alameda, FTX's sister
company, is Tether's biggest client.
Chairman Brown. Thank you. Last question, again, if you
would answer as close to yes or no as you can. I want to talk
about solutions. FTX, like other crypto firms, perform multiple
roles in crypto trade. It acted as an exchange and as a broker.
It provided margin to investors. FTX was essentially on every
side of every transaction. Combining these functions undermines
the fundamental regulatory checks and balances that exist to
protect consumers and to protect our financial system.
My question, starting again with you, Professor Allen,
should there be strong rules addressing related party
transactions and creating firewalls between related entities?
Ms. Allen. Absolutely, to address conflicts of interest.
Chairman Brown. Mr. O'Leary?
Mr. O'Leary. I find the analogy of crypto to be that of
gambling and speculation interesting. That was exactly what we
described the New York Stock Exchange 150 years ago. And what
happened was because of the nature of the risk we regulated it.
We did it for bonds. We call them securities now. Back then, if
they were speculations, no different than this nascent
industry.
The reason this is happening over and over again, and we
will be back here again soon, when the next one blows up, is
the lack of regulation. That is why we regulate stocks and
bonds. They are speculations too. You speculate the profits of
the companies underlying those securities. We need to regulate
this. I mean, this premise that it is some kind of different
issue, it is not. It is just unregulated, wild west. And it
will go on and on and on. The definition of madness is
expecting different outcomes. I mean, it needs regulation. That
is it.
Chairman Brown. I take that is a yes, that there should be
strong rules addressing related party transactions and creating
firewalls.
Mr. O'Leary. A long yes.
Chairman Brown. A long yes. Ms. Schulp?
Ms. Schulp. I also have a longer answer but I will still
keep it short. I do think that conflicts of interest are
something that need to be examined and addressed. Whether that
results in strong rules banning certain types of transactions
or whether it is simply that disclosures must be made is a
different question. So while I agree that there are potential
issues there, I am not sure I will agree with the outcome that
you are looking for, Mr. Brown.
Chairman Brown. Thank you. Mr. Schenkkan?
Mr. Schenkkan. Yes.
Chairman Brown. Thank you. Senator Toomey.
Senator Toomey. Thanks, Mr. Chairman. Let me start with Ms.
Schulp. Mr. Schenkkan indicated his opinion that, I think he
said every cryptocurrency, or virtually every one, easily meets
the Howey Test for the definition of a security. The Howey Test
includes the investment of money in a common enterprise, with
the expectation of profit, through the efforts of others.
So in Bitcoin, we have no corporation that controls it or
issued it. We have no individual. We have no committee. It
seems to me purely decentralized. Is it not hard to establish
that there is a common enterprise when there is no central
authority that controls and operates it?
Ms. Schulp. I agree. I do not think for Bitcoin you can
meet the elements of the Howey Test, in multiple respects.
Senator Toomey. Right. And would you say, as a general
matter, a truly decentralized protocol, pretty hard to
establish a common enterprise?
Ms. Schulp. I completely agree. The securities laws were
evolved in no small part in order to deal with questions of
information asymmetry coming from managerial bodies that are
doing that.
Senator Toomey. Right. Where is that asymmetry?
Look, I think there is a case to be made that there should
be a regulatory regime on disclosure requirements for an
issuer, that there should be a regulatory regime for secondary
market trading. But I think we ought to make it specific to
this sector because to try to shoehorn it into decades-old
legislation that deals with different instruments, I think is
very problematic.
Mr. O'Leary, it seems to me that tokens are very often the
tool or mechanism to incentivize people to validate and
maintain a distributed ledger. Now you can gamble with them.
You can speculate as to what a given token is going to be
worth. But it seems to me that underlying blockchain technology
is potentially extremely powerful, is actually already being
used in a variety of ways.
Could you address this notion that the only possible use is
a zero-sum gambling enterprise?
Mr. O'Leary. No, I do not agree with that at all. It is
preposterous to say that. The potential of blockchain
technology in authenticating physical assets and contracts and,
and tokens as you suggest, is incredibly powerful. In fact, I
think what is going to happen, as we peel the onion on FTX over
the next year or two, is the shining outcome of the success of
the blockchain to track these assets will become the focus of
everybody. We will realize every security or token that left
FTX, left Alameda, got traded between shareholders, all tracked
irrefutably on the blockchain. The power of this technology is
very harnessable, very powerful, and, of course, we should lead
the world in it because so much of it is developed here.
The hottest hands coming out of MIT right now, where do
they want to work? A third of the class, they want to work on
the blockchain. You cannot take that much potential and not
expect extraordinary outcomes. This is a remarkable technology.
Yes, it requires regulation. But if you just ask where the hot
hands are going, the great engineers, this is where they are
going. We train them here and then we kick them out of the
country so they do their work somewhere else.
Senator Toomey. So let me ask you directly. You were an
investor in FTX, and I know you have spoken frequently with Sam
Bankman-Fried over an extended period of time. Why do you
believe FTX failed?
Mr. O'Leary. I have an opinion. I do not have the records.
Here it is.
After my accounts were stripped of all of their assets, and
all of the accounting and trade information, I could not get
answers from any of the executives in the firm so I simply
called Sam Bankman-Fried and said, ``Where is the money, Sam?''
He said he had been refused access to the servers. He no longer
knew. I said, ``OK. Let us step back.''
This is a simple case in my mind of where did the money go.
And I said, ``Sam, walk me back 24 months. Tell me the use of
proceeds, of the assets of your company. Where did you spend
it?''
And then he told me about a transaction that occurred over
the last 24 months, the repurchase of his shares from Binance,
his competitor. I did not know this at the time, but at some
point CZ or Binance, who runs Binance, purchased 20 percent
ownership in Sam Bankman-Fried's firm, for seed stock, and
then, over time--and I asked him, ``What would compel you to
spend $2 billion,'' which was the number he was giving me at
that time. Later, in a subsequent conversation, about 24 hours
later, he told me it could have been as much as $3 billion, to
buy back the shares from CZ. I asked him, ``What would compel
you to do that? Why would you not keep your assets on your
balance sheet, and why would you offer this to just one
shareholder?'' He said, ``Because every time we went to get
licensed in different jurisdictions--because you must
understand the prize of crypto is to get regulated. For all the
talk we say about Bitcoin and everything else, no institutions
own this.''
I work for the sovereign wealth and pension plans. They do
not touch this stuff because it is unregulated.
Between these two, let us call them ``frenemies,'' because
they obviously were potentially the two largest shareholders in
the firm, they had a disagreement. They had a falling apart.
Apparently, according to Sam Bankman-Fried, CZ would not comply
with the regulators' request in these different geographies, in
these different jurisdictions, to provide the data that would
clear them for a license. He withheld it, according to Sam
Bankman-Fried. The only option the management and Sam Bankman-
Fried had was to buy him out at an extraordinary valuation of
close to $32 billion, less, apparently, a 15 percent discount.
That stripped the balance sheet of assets. You asked me why
it went bankrupt. Go to the last week. All of a sudden, in
social media, CZ is asking for another $500 million. He wants
to do a block trade of FTT, or the proprietary token of FTX. He
wants to convert it back to fiat. Why would you put that out
there? You know it is going to push down the value of that coin
dramatically, and that is exactly what happened.
Every trader knows if you have a large block trade you go
negotiate a clearing price with other buyers, and you do the
transaction. In my view, my personal opinion, these two
behemoths that owned the unregulated market together and grew
these incredible businesses in terms of growth, were at war
with each other, and one put the other out of business,
intentionally.
Now maybe there is nothing wrong with that. Maybe there is
nothing wrong with love and war. But finance is a massive,
unregulated global monopoly now. They put FTX out of business.
Now lots of other reasons, I am sure, but that is my personal
opinion. That is what Sam Bankman-Fried told me in terms of
where the assets went. Why should we care? Single reason: I am
a shareholder. You tell me the two largest shareholders do a
transaction together? That is related party transaction. I am
not sure that is OK. Maybe I want a Madoff claw-back on those
proceeds. Maybe I want to pursue----
Chairman Brown. Mr. O'Leary, I am sorry. You are about 3
minutes over. Do you have a follow-up, Senator Toomey?
Senator Toomey. I had another topic, so if we do a second
round I will take it up then. Thank you, Mr. Chairman.
Chairman Brown. Thank you. Senator Reed, of Rhode Island.
Senator Reed. Thank you very much, Mr. Chairman, and thank
you, panel, for your insights.
The restructuring officer John Ray described in detail the
absence of audited or reliable financial statements, absolutely
no internal controls. Professor Allen, I would like to ask you
a few questions about FTX and how they were able to get away
with essentially cooking the books. First, was FTX a publicly
traded company?
Ms. Allen. No.
Senator Reed. As a private company, was FTX required by law
to disclose basic information to the public about its business,
like audited financial statements?
Ms. Allen. No.
Senator Reed. Was FTX required to disclose transactions
with related parties, like Mr. Bankman-Fried's hedge fund
called Alameda Research?
Ms. Allen. No.
Senator Reed. And also Mr. O'Leary's example, that would
not be required to be disclosed. Was FTX required to have a
chief financial officer or disclose whether a financial expert
was on the board of directors?
Ms. Allen. No.
Senator Reed. Was FTX's auditor required to attest to the
effectiveness of the company's internal and corporate controls?
Ms. Allen. No.
Senator Reed. And if FTX had been a publicly traded
company, would it have been required to make disclosures and
attestations that we just discussed?
Ms. Allen. Sorry. I missed the question.
Senator Reed. If FTX had been a publicly traded company,
would it have been required to make the disclosures and
attestations that we have just discussed?
Ms. Allen. Yes.
Senator Reed. OK. Thank you very much. And it is not just
that FTX is a private company. In fact, just about all the
biggest companies in the crypto industry are also privately
held. In September, I introduced S. 4857, the Private Markets
Transparency and Accountability Act, which would require the
Nation's biggest private companies, including FTX, to disclose
basic information about their financial condition and comply
with basic corporate governance requirements. And according to
a letter from the North American Securities Administrators
Administration, this legislation, in their words, ``would have
made it easier for all of us to spot or prevent the alleged
fraud and other misconduct at FTX earlier.''
Mr. Chairman, I am going to ask unanimous consent to
include this letter in the record.
Chairman Brown. Without objection, so ordered.
Senator Reed. The whole point is that we have all talked
about the need for regulation, and I think that is obvious. And
we have many mechanisms pending here in the Senate and the
House to do that. We just have to move quickly. I would suggest
this is a good place to start.
And final question, Professor Allen, do you think that
would have helped illuminate what was going on at FTX?
Ms. Allen. Yes, I think so. I mean, attestations and proof
of reserves and other forms of accounting disclosures common in
the crypto industry, they do not include the rigor or the
independence and the professional skepticism we get from
auditors. But I would note that we should be wary of FASB's
moves to implement fair value accounting for crypto assets
because accepting market valuations from the crypto industry
could potentially undermine the value of the audit function,
and that is something to be wary of.
Senator Reed. Thank you very, very much. When we talk about
crypto tokens, in fact, it is reported that FTX held about $900
million in liquid assets and $9 billion in liabilities when it
failed. And the vast majority of FTX's assets were illiquid
cryptocurrencies created and promoted by FTX and Alameda. The
company held them at wildly optimistic valuations that turned
out to bear little resemblance to reality.
Can you explain how aggressive valuation practices
contributed to the failure of FTX and put customers at risk,
Professor?
Ms. Allen. Sure. As I outlined in my written testimony,
many crypto assets are created out of thin air and there is no
real basis for their valuation. There is simply no way to
perform a sanity check on the valuations that are provided as
those assets trade entirely on sentiment. And so when assets
trade entirely on sentiment, meaning what other people think
they are worth, that creates a space where a significant amount
of leverage can be created and fraud can easily go undetected.
Senator Reed. Thank you very much. Again, I think the one
theme that seems to be consistent is that the need to regulate
not just this industry but private entities that are
controlling a huge amount of funds, that are investing in ways
that are not obvious to the public or even to their own
shareholders or equity owners. And we have to move. I would
suggest as a starting place, the legislation I have proposed.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Reed.
Senator Menendez, of New Jersey, is recognized.
Senator Menendez. Thank you, Mr. Chairman. A lot of
securities regulation essentially comes down to one thing--what
actions are and are not permissible when one person is handling
another person's money? And by and large, we, in Congress, the
securities industry, and the general public have agreed on the
major principles that should guide that activity. For instance,
as you point out in your testimony, Professor Allen, brokers
are not permitted to use customer funds to finance their
business. They are required to fully disclose conflicts of
interest. And when dealing with retail investors they are
required to go further and mitigate certain conflicts. FTX did
not seem to have done any of this, and if they had it seems
like a lot of harm would have been prevented.
So Professor Allen, is there any reason why we should not
apply the same broad regulatory principles that are now in
place with the traditional financial sector to digital assets?
Ms. Allen. I see no reason. The reason we typically hear is
that crypto is different because it is decentralized, but in
fact, it is not decentralized. At every level there are people
controlling things.
So we heard that Bitcoin was decentralized. Well, you know,
Bitcoin is controlled by a few core software developers, fewer
than 10, and they can make changes to the software, and then
that software is implemented by mining pools, and there is just
a few of them.
So in all these spaces there are definitely people, often a
very few people, pulling the strings, but the fact of the
matter is that they are unidentified and unregulated, and that
is not an ideal space to be in.
Senator Menendez. Yeah. Mr. O'Leary, in your testimony you
said you hope that the events at FTX would ``put renewed focus
on implementing domestic regulation.'' Do you agree that FTX
customers, and perhaps your own investments, would have been
better off if FTX had complied with the existing regulation we
have that bars brokers from trading with customer funds?
Mr. O'Leary. Absolutely. But they were not compelled to do
that because they were offshore and unregulated. I think the
model will not work.
There are examples of how regulated exchanges that are
attached to broker-dealers have worked. You only have to look
up to Canada, the OSC order, where Bitbuy wallets are
controlled by the regulator. They limit the number of tokens.
They limit the margin. They limit the lending. They do an
exhaustive test of proof of reserves.
That is just the rules they implemented that they just
copied from their own exchanges. We need to do the same thing
here. It works. It has been proven to work. There are millions
of Canadians that have accounts that are working under a very
strict regulatory environment. We can implement the same.
Senator Menendez. Well, I agree. We already know what
should and should not be allowed when one person is handling
another person's money. Whether we are talking about a new
celebrity-endorsed coin or an index fund, I think we would be
well served to keep in mind the basic principles that have
largely saved and served investors and the markets well for
decades.
As I was listening to some of your testimony back in my
office it all seems like you looked at this as more of a
security than a currency, at the end of the day, and that makes
it pretty clear for me.
In the wake of FTX collapse, many crypto firms have
attempted to reassure the public of their soundness by hiring
outside auditors to provide proofs of reserve. However, the
quality of these audits are inconsistent and often time provide
an incomplete picture of the company's assets and liabilities.
Professor Allen, can you explain some of the flaws in these
reports and why they are not as helpful to investors as the
crypto industry claims?
Ms. Allen. Well, I mean, there is the fundamental issue
that where do you even get the valuation number from these
assets? Do we treat them on a sort of a fair value accounting
basis? If so, we are essentially accepting whatever the market
says about these asset prices, and then they are entirely based
on sentiment.
You know, in addition, even if we put that aside, the
actual attestations, et cetera, that we are getting, they do
not have the skepticism that we expect from professional
auditors who look at the financial statements to find red
flags. They are required to look for red flags. In these
attestations and proof of reserves, it is basically just the
accountants sort of reporting what they have been told by the
industry.
Senator Menendez. Yeah. One of the things I am concerned
about is the extent that cryptocurrency becomes integrated with
the financial system and therefore the risks to financial
system, which up to now has been pretty stable, and that is
something I am concerned about.
Let me close on this. Prior to its collapse, FTX was well-
known for huge spending on celebrity endorsements. Dozens of
sports stars and actors received millions of dollars to
generate hype for FTX and assure the public that crypto was a
safe investment. There have even been reports that FTX was
pursuing a $100 million sponsorship deal with Taylor Swift
earlier this year, even as the firm was hemorrhaging money.
FTX is not the only firm doing this. Endorsements from
public figures are just one of the factors contributing to
misinformation about crypto. Mr. Schenkkan, how can we combat
the spread of crypto disinformation and encourage investor
education?
Mr. Schenkkan. Use words that are accurate. The
cryptocurrencies are not currencies. We need to classify them
as securities properly. I also think that we should consider
treating crypto like gambling and having potential limitations
on advertising and disclosures.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Menendez.
Senator Tester, from Montana, is recognized.
Senator Tester. Yeah, I want to thank the Chairman and
Ranking Member for having this hearing and I want to thank the
folks who testified today for being here to testify. I
appreciate it.
I am concerned that we are signaling to people that this is
a credible and sound investment, but as we have seen lately
there are clearly bad actors. Crypto has been peddled
everywhere, from the internet to the Super Bowl as get-rich
schemes or safe places to put your retirement savings, but
things look pretty uncertain right now, and that is a best-case
scenario.
Ultimately, I want to make sure that taxpayers are not left
holding the bag. These may be interesting technologies but I
have yet to see how it can be useful in a real world without
substantial risks for Americans. I am skeptical, but I am here
to hear from both you, the proponents and opponents, and that
is why I am glad you are all here today.
Professor Allen, when you were in front of this Committee
about a year ago today, as a matter of fact----
Ms. Allen. Exactly.
Senator Tester. ----you discussed similarities with
synthetic products and you highlighted concerns that unlike
2007, these products are targeted to institutions and
individuals. As we have seen larger and larger issues play out
in this industry over the past year, how is your concern that
you expressed a year ago played out?
Ms. Allen. So in some ways I have been heartened by the
fact that the banking regulators have really kept this stuff
out of the banking system, and I think that is why we are
talking about the investors of FTX being harmed rather than
everybody being harmed. But still, I mean, I think the idea
that crypto is trying to disrupt banking is inaccurate. Crypto
and banking would love to merge, and it is the regulators that
are keeping them apart.
And so as we look at the banking industry trying to dip
their toes into this water, I think there are a few causes for
concern. Bank of New York Mellon has custody in crypto.
JPMorgan is doing trades on permission-less blockchains. So I
think we need to firm up the separation between crypto and
banking in order to protect the broader financial system. But
as I said, I think banking regulation has held up pretty well
so far.
Senator Tester. For you again, Professor Allen, the new
bankruptcy-appointed FTX CEO has warned that the U.S. entity is
not solvent. American customer accounts are in doubt. What does
this mean for the consumers who are utilizing FTX?
Ms. Allen. Well, in the short term it means that they are
not going to be able to access their funds because they are
tied up. In the long term it means that they may not have any
funds. So that is, I mean, really devastating, and we have to
think about how much of this we are willing to tolerate in the
name of innovation.
I would point out that the Australian stock exchange spent
years trying to use blockchain technology to restructure it,
and it has just given up entirely because the technology was
not fit for purpose. I think we need to think really hard about
the costs of what is going on.
Senator Tester. So could you tell me what this could have
meant for taxpayers if legislators had gone further with
blessing this industry?
Ms. Allen. Sure. You know, the size of the subprime
mortgage market in 2007 was estimated to--and I do not have my
figures here but I think it was about $1.3 trillion. And, you
know, we have just talked about a crypto industry, and as I
said, the valuations are crazy in crypto, but we have talked
about an industry that has shrunk apparently from $3 trillion
to under $1 trillion.
So if that amount of assets or exposure had been brought
into the existing financial system, intertwined with our
existing financial system, then the banks would have been in a
very serious problem. They would not have been able to lend.
They would not potentially have been able to process payments.
All the things that we count on for our broader economic growth
would be jeopardized.
Senator Tester. Do you think there would have been an
inherent response that would have required Congress to step in
and bail out folks, like happened in 2008?
Ms. Allen. Absolutely. It is simply untenable to let the
economy tank like that. I mean, it is just the fact of the
matter. And so that is why I think it is so critical that
crypto be segregated away from banking. We do not want to make
it too big to fail. Too big to fail is problematic with any
asset class. An asset that has no productive capacity, that
does not serve any capital formation function, that just is
crazy.
Senator Tester. Mr. O'Leary, in one of the answers to one
of the other Senator's questions you said that the prize for
crypto is to get regulated. Is that because it gives it
credibility?
Mr. O'Leary. It can exist for the institutional client. The
potential of crypto is for it to be indexed with sovereign
wealth and pension where about 70 percent of the world's wealth
is actually managed. There is great interest there,
particularly around Bitcoin and Ethereum and a few other
platforms. But they have no infrastructure to apply to their
compliance platforms. When you are managing a $900 billion
fund, every day you have a massive compliance infrastructure
that marks to market all your positions. There is no
infrastructure for crypto.
I want to make a note here, just around this regulatory
issue that you are raising, and it is a good one. Of all the
entities that went to zero, that went to bankruptcy in the FTX
portfolio, the only one that is not bankrupt, out of the 130-
plus--and this is probably the best evidence of why we need
regulation--is LedgerX. Why? It is regulated by the CFTC, 100
percent regulated. It is not bankrupt. Had the other entities
been regulated, wherever they were, they would too not be
bankrupt.
And so just look at this. This is a use case of why we need
regulation. There would not be this tragedy and all of this
drama and all the rest of this stuff and the loss of billions
of dollars. The lack of regulation has caused some problems
here, and will continue to, and the evidence is right here. The
only entity that did not go to zero, in the FTX portfolio, CFTC
forced the scrutiny, forced the transparency, forced the proof
of where the assets were held in the reserves, forced the lack
of comingling with the assets. They forced it. They did it.
Proof positive that you can regulate this asset class.
Senator Tester. I want to thank you all for being here
today. We will have some questions for the record, but I
appreciate the hearing, Mr. Chairman.
Chairman Brown. Thank you, Senator Tester.
Senator Hagerty, of Tennessee, is recognized.
Senator Hagerty. Thank you, Mr. Chairman, Ranking Member
Toomey. Thank you for holding this hearing. To all of our
guests here today I appreciate you being here.
I would like to touch on something that has been troubling
me for some time. We know that FTX's collapse, as the second-
largest exchange, is continuing to have ripple effects
throughout the entire digital asset industry. If you look back
to even early November, FTX did not appear to have the
necessary scale to cause an industry-wide systemic meltdown.
Binance, on the other hand, is the largest global crypto
exchange, nearly 7 times larger than FTX by trading volume--at
least it was in the month leading up to FTX's collapse. And
Binance's market share, now with the absence of FTX, I think
means will only grow.
You think about a similar implosion by Binance. That would
really prove catastrophic. It would prove catastrophic for the
cryptocurrency industry and it would prove catastrophic to all
of the consumers that utilize the industry.
Yet U.S. regulators are limited in the extent to which they
can mandate appropriate audits or appropriate disclosure of
Binance's operations. Unlike the requirements placed on
companies which are publicly traded here in the United States,
Binance operates outside of our system.
Ms. Schulp, I would like to start with you. How can U.S.
regulators work with their global counterparts to bring
transparency to Binance's activities and to understand the
reserves that it holds?
Ms. Schulp. I think you raise a very important point that
when we talk about FTX or we talk about Binance so much of what
we are talking about is happening outside of our shores. And
the influence that U.S. regulation can have on those exchanges
and other crypto projects that are not taking place here is
limited.
I think it is very important to have an ongoing dialogue
with international regulators in order to have influence where
we can. But I think the most important thing for the United
States to do is to create a rational crypto regulatory
framework in the United States to try to bring some of that
home so that we have maximum influence over how those
businesses are operated.
Senator Hagerty. I hear you. Mr. O'Leary, you touched on
this just a moment ago, about the impact of regulation and the
certainty that it could bring. And from your perspective as an
investor, Mr. O'Leary, what needs to change here in Washington
from a regulatory standpoint so that capital actually does
float to U.S.-based entities and empower U.S.-based entities to
win on the global stage?
Mr. O'Leary. Every global platform, the number one prize is
to be regulated in the U.S. market, the number one financial
market on earth, period. Now when you talk about other money
center banks or other financial services industries that want
to do business in the U.S., they must disclose their worldwide
operations. They are scrutinized by the rules we already have
in place.
A coordinated effort between the Canadian regulator, the
U.S. regulator, the ADGM in Abu Dhabi, the regulators in
Singapore, basically laying out the ground rules for any entity
that wishes to do business in the U.S. or any of those
jurisdictions solves this problem. If finance is not willing
to--and you started by talking about them--disclose, and the
reason that Sam Bankman-Fried claims he spent $3 billion was
that he could not get the regulators to approve the fact that
Binance owned 20 percent of their platform. CZ was not
cooperative with any of those regulators. He was shut out of
those markets, and he realized the prize was to get regulated
for institutional capital.
Just having four or five markets coordinate, as we do
already in other securities, solves this problem into
perpetuity. All these regulators talk to each other. I have
been to Abu Dhabi. I have talked to the ADGM. I seek a license
there. And I have done the same in Canada. I am an investor and
licensed there. These are long-term, very sound structural
concepts, but it needs a coordination, and in one phone call we
could solve this problem.
Senator Hagerty. I am going to come back to you, Ms.
Schulp, for a moment, and I want to stay on this concern that I
have, particularly about Binance, about the Chinese Communist
Party's role in support of that. To be clear, Binance is being
proliferated around the world. It is a State-backed network.
They are proliferating in emerging markets in a very predatory
fashion. They are in developed markets. And again, how they
have an even more open platform, as FTX has been taken down.
But think about an example like Binance, with ties to the
CCP, a committed partner to the Belt and Road Initiative, and
particularly as it expands its market dominance with the
collapse of FTX, what does that spell, if lawmakers here in
America follow through with their threats to ban digital
assets, or leave the current regulatory uncertainty in place?
What does it mean for the global crypto market in general? What
does it mean for our Nation's national security and our
economic security? And most important, what does it spell for
the dominance of the U.S. dollar as the world's reserve
currency?
Ms. Schulp. Well, regardless of whether Binance itself is
connected with the Chinese Communist Party, which Binance
denies, but regardless of whether that is the case, by having a
system in the United States that is unclear, that is
regulatorily hostile, that could go so far as banning
cryptocurrency in the United States, we would be losing the
position of having a possibility to maintain American dominance
for these technological innovations.
Senator Hagerty. I am deeply concerned about that.
Ms. Schulp. We would also be losing many of the great minds
that want to work on these types of projects, that can make
strides not just in blockchain and cryptocurrency but in other
technological functions as well. To the extent that the United
States is not a place that people look to for economic
development, that also puts the U.S. dollar at risk.
Senator Hagerty. Thank you. Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Hagerty.
Senator Warner, of Virginia, is recognized.
Senator Warner. Thank you, Mr. Chairman. I appreciate you
holding this hearing. I want to echo some of the concerns my
friend from Tennessee just echoed, about Binance. I do think it
is curious that China has made the decision to basically take
that kind of risk to bank crypto, because of their, at least,
risk reward analysis.
I have got so many questions. I know a lot of this started
around Bitcoin. And I think, Professor Allen, you may have
touched on this in your testimony. The clunkiness of the
technology behind Bitcoin, it could never go to scale, no
matter what. If you can only do five or six transactions per
second, that is not a scalable tool and obviously a technology
at a power and environmental cost that just does not make sense
to me.
But I am going to try to get as quick as I can in my 4
minutes. I am going to start with Professor Allen and Mr.
McKenzie. I sometimes worry that FTX is just a tip of the
iceberg. You know, I am sure many of my colleagues have gone
through all of the bad things Bankman-Fried has done and the
graft and the Ponzi schemes and so forth. And I know Senator
Hagerty already made comments about the Reuters story about
Binance.
I really worry. I mean, I know the original pitch was this
is going to be a seamless ability to transact, without currency
risk, without timing risk. I can send my grandmother in Kenya
resources on Sunday in way that is kind of error-free.
Sitting where I do on the Intelligence Committee, as
Chairman, I have seen virtually no examples of that kind of use
case. I know, Mr. McKenzie, you have gone down to El Salvador,
where they tried to make that as the case. It just does not
seem to be the case. Instead, we are seeing, at least at this
stage--and Senator [unclear] has been a leader on this. I keep
trying to have an open mind on the technology innovation, and I
am all in on technology innovation. But at least so far, you
know, from where I sit on the Intelligence Committee, I see an
awful lot of illegal activity. I see drug deals. I see bad
actors. I see ransomware criminals. And frankly, it is not even
safe for them. Go back to the Colonial Pipeline issue where our
Government, when payment was made in crypto, was able to
recover some of that.
So I guess I would start again with Professor Allen and Mr.
McKenzie. Do you think FTX is a one-off or is this the tip of
the iceberg where we may be seeing a whole series of
activities? And if you want to go ahead--I know it has been
raised but I do not think in any detail--Alameda Research and
some of the potential--I think we are only beginning to see the
conflicts that were taking place there. But I will start with
Professor Allen and Mr. McKenzie.
Ms. Allen. I think we saw the tip of the iceberg a couple
of months ago, and then this is sort of moving further down the
iceberg, you know, with the earlier rounds of Terra Luna and
Celsius.
You know, the concern is that fraud is definitely being
perpetuated, but that the whole industry itself is basically an
asset class built out of nothing. It trades entirely based on
people's belief that it can be worth something. But as you
said, the technology has not worked for a payments mechanism.
It has become a speculative instrument. But ultimately, you
know, as Mr. McKenzie said, it is a zero-sum game, and if
people stop believing in it then it all falls apart.
Mr. O'Leary has talked about that regulation in the United
States is the prize. That is exactly right. Without that
regulation as the prize to legitimize crypto, there is nothing
there, and it could all go to zero. And while that is very bad
news for the people who have already invested, I think it is
very good news for the rest of us because it is being kept out
of the broader financial system, and we will not suffer the
consequences from its broader failure.
Senator Warner. Mr. McKenzie.
Mr. Schenkkan. Thank you, Senator. Yes, I just want to echo
what Professor Allen was saying. One of the many, many
seemingly limitless ironies of cryptocurrency is that the
supposedly decentralized nature of it, it is, in fact, highly
centralized. I know this. I wrote an article with my colleague,
Jacob Silverman, for the Washington Post about Binance this
spring. Binance is incredibly murky, but Binance, as Mr.
O'Leary, as other Senators have pointed out, Binance is in
communication with FTX. They were an early investor in FTX.
There is apparently a private signal chat group entitled
``Exchange Coordination'' that CZ is on. Yes, this is publicly
reported. I believe Mr. Bankman-Fried submitted into the
congressional record, if I am not, yeah. So they are all
talking to each other.
The crypto industry is actually really, really small
amongst the people that count. And a zero-sum, strictly
competitive game, there are winners and losers, and in an
unregulated zero-sum strictly competitive game you are either a
scammer or a mark. If you do not know which one you are, you
have a problem.
Oh, do you want me to answer the remittances question? I am
sorry, sir.
Senator Warner. Well, if you want to just touch on Alameda
as well.
Mr. Schenkkan. Sure. So Alameda is Tether's biggest client.
That is according to reporting from Protos last year.
Supposedly Alameda purchase, I believe, $36.7 billion worth of
Tethers. Given FTX's insolvency, I think one question might be
where did the money come from.
Senator Warner. I know I am running out of time, but Mr.
O'Leary, I have great respect for you as an entrepreneur. I
spent a long time as an entrepreneur. I am trying to sort this
through as well. I get your point, but I guess what I would
raise for the Chairman and the Ranking Member is, you know, I
am still trying to wrestle with this in my mind whether we need
a crypto set of rules or whether we frankly--what are we, 14
years after Dodd-Frank?--ought to take a bigger step backwards
and realize we have got this bright, shiny problem over here
around crypto, but the amount of financial activity--if you
look at the fact that over 50 percent or the mortgage
origination now is outside the regulated banking sector.
I have been a big advocate for fintech for a long time, but
there are a whole series of lending entities out there, again,
that have no regulatory protections around them at all. And
nothing would be worse than doing a relatively good job--and we
maybe overdid it in certain parts on Dodd-Frank--but put a
structure our regulated industry, and suddenly see this huge
escape of financial activity going outside any kind of
regulatory envelope at all.
I am all for innovation, but Lord knows, if crypto was
suddenly followed by a whole series of fintech entities that
were coming back saying, ``Hey, I need my money back as well. I
did not get my lending that was taking place on this
platform,'' we could have a problem. Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Warner.
Senator Lummis, of Wyoming, is recognized.
Senator Lummis. Thank you, Mr. Chairman. I also want to
thank Senator Toomey for his wonderful leadership on this
Committee, just in the event this is our last hearing. Thank
you for your service.
Chairman Brown. We have a hearing tomorrow.
Senator Lummis. We are conflating topics today. Digital
assets are not on trial. Fraud and organizations are on trial.
So let us separate digital assets from corrupt organizations.
FTX, as I have been saying for the last few weeks, is good
old-fashioned fraud, and what they did is separate from digital
assets. Now we have all heard that FTX lent its executives
hundreds of millions of dollars in comingled customer funds for
personal use, and customers who tried to wire money to FTX were
instead given Alameda's routing number. That is fraud. That is
fraud whether it is conducted in U.S. dollars or euros or
digital assets. That is fraud.
Additionally, even though FTX was a multibillion-dollar
enterprise, it had a shocking lack of corporate controls and
enabled affiliates to conceal the movement of money and take on
enormous liabilities, enabling the misuse--well, the misused
customer assets that were supposed to be appropriately
safeguarded. FTX, in its terms of service, said, ``Title to
customer digital assets always remain with the customer.'' Now
that, we know, is a lie, and now millions of FTX customers
around the world will suffer.
So FTX is a failure of people, safeguards, and regulation.
It is not a failure of technology. The people in the digital
asset industry need to get really serious about risk management
and compliance with things like anti-money laundering laws, and
that is why we have seen a failure of a number of firms engaged
in riskier practices, even for the digital markets this year.
So one question people should ask themselves is how FTX
grew so quickly? They were founded in 2019, and grew to be one
of the largest digital asset exchanges in just 2 years. So you
look at other companies like Kraken, Coinbase, and Bitstamp.
They have been around for a decade. They have grown
organically.
This Committee needs to be focused on putting legislative
solutions in place that would have prevented FTX's collapse and
other firms like it. This means things like regulation of
digital asset trading, providing consumers with adequate
bankruptcy protection, disclosures, and stablecoin regulation.
So let us not conflate topics here. Mismanagement, failure
of people, inadequate controls is what is on trial. We need to
regulate this business and lay digital assets on top of our
existing financial regulatory framework.
Questions. Ms. Schulp, why do digital assets and
distributed ledger technology have the power to make our
capital markets safer and more efficient?
Ms. Schulp. There are multiple ways that they can do that,
and one of them is by removing the intermediaries that we have
been talking about, where there are potential for such things
as an FTX to take customer assets and misuse them. When those
intermediaries do not exist in digital asset systems then you
do not have the same risks.
You can also have faster, cheaper payment systems than we
currently have, and a more global payment system, which allow
people to send money cross-border in a way that should be very
important for a country like the United States, which sends a
lot of remittances across the world.
Senator Lummis. I know I am out of time, but I want to make
a plug for the Responsible Financial Innovation Act that
Senator Gillibrand and I have cosponsored, that we have been
talking to our colleagues about. This is a case study in why we
need the Responsible Financial Innovation Act. We will be
reintroducing the bill next year. We are absolutely delighted
and willing to take your comments, suggestions, ideas. And it
is time to move, time to move to regulate the digital asset
industry. Thank you.
Chairman Brown. Thank you, Senator Lummis.
Senator Warren, of Massachusetts, is recognized.
Senator Warren. Thank you, Mr. Chairman.
So Sam Bankman-Fried and other crypto billionaires argue
crypto is special, but a basic principle of our financial
system is same kind of transactions, same kind of risks means
same rules apply. Right now, if a bank takes money from
terrorists and the bank and the banker then have broken the
law, and that is why banks spend so much time and so much
energy identifying who their customers are and reporting
suspicious activity to authorities.
A lot of crypto firms are not doing these kinds of checks,
so crypto has become the preferred tool for terrorists, for
ransomware gangs, for drug dealers, and for rogue States that
want to launder money.
In 2021, at least $14 billion in digital assets went to
criminals. Now that is a lot of drugs and a lot of ransoms and
a lot of bombs and a lot of nuclear materials, but it is likely
only the tip of the iceberg. A new report finds that one crypto
exchange alone helped launder over $10 billion for criminals
and countries like Iran. Even so, the crypto industry continues
to take the position that nothing should change.
Professor Allen, the crypto industry claims that it does
not need to do all of the know-your-customer and other anti-
money laundering checks that banks do and stockbrokers do and
even Western Union does because crypto is uniquely transparent.
Everything is on the blockchain so criminals and rogue States
that try to launder money in crypto will quickly be found out.
Does the fact that the blockchain is public mean that it is
more difficult for criminals to launder money using crypto?
Ms. Allen. In many ways the blockchain is the worst of all
words. For everyday people, the blockchain is a permanent
public record of all their transactions, which is a privacy
nightmare. But for sophisticated players with a vested interest
in hiding their transactions there are all kinds of tools
available--mixers, tumblers, et cetera, that can hide the
provenance of their crypto assets. And far from being difficult
for criminals to use crypto to launder money, the fact that
there are not KYC checks is the point.
Senator Warren. OK. So crypto is actually easier to do
money laundering.
Let us look at another crypto industry argument. Professor
Allen, crypto industry claims that it would be too much trouble
and maybe even technologically impossible for them to check
customers the way that banks and stockbrokers and even Western
Union does. But let me ask, do banks and stockbrokers and
Western Union have to invest money and resources to make sure
that they are set up to conduct those checks?
Ms. Allen. Yea. I mean, KYC requirements are simply part of
operating a financial services business. But avoiding those
requirements, as you say, is critical to many crypto business
models. Blockchain-based transaction processing, as we have
discussed, is very clunky and expensive. Ms. Schulp has just
told us that it can be more efficient. The only way it is more
efficient is if it actually avoids the KYC checks that can slow
things down. So this crypto business model is in many ways a
regulatory arbitrage play.
Senator Warren. Right. So actually it is an interesting
question. If banks and Western Union said they should not have
to follow any money laundering rules, so that they could make
more money, they could improve their profitability, what would
our country say and what does every country around the world in
the financial system say?
Ms. Allen. No.
Senator Warren. Right. OK. So Mr. O'Leary, I know that you
are a big supporter of crypto, even after you lost $10 million
in FTX's collapse, but you are an experienced investor. So let
me ask you, do you believe that the potential benefits of
crypto are so promising that we should accept weaker anti-money
laundering rules and weaker compliance from crypto firms than
we require from banks, from brokers, and from Western Union?
Mr. O'Leary. No. I think we should apply the same
regulatory structure that we apply to existing trading of
stocks and bonds and exchanges tied to broker-dealers. That is
not complicated. It has already been implemented in other
countries.
And I take issue, Senator, with your concept that it makes
it easier to do money laundering. Currencies have been used for
drug trafficking since the '60s, and the American dollar, when
it was thrown out of a Piper aircraft in a duffle bag. The
American dollar is also used by bad actors all the time.
Senator Warren. Mr. O'Leary, I appreciate your point that
everyone tries to engage in money laundering. That is what
terrorists do, that is what drug dealers do, and that is what
States like Iran and North Korea have done.
The only point I am trying to make is should the same rules
against money laundering apply to crypto in the way that they
apply to banks, to stockbrokers, to credit card companies, to
Western Union?
Mr. O'Leary. You know----
Senator Warren. And I think your answer to that was yes. Is
that right?
Mr. O'Leary. No.
Chairman Brown. Mr. O'Leary, you have 30 seconds. Keep your
answer short.
Mr. O'Leary. It is not yes. I am just saying if you know
your client rules on both sides of the transaction and use a
crypto such as USDC, that is regulated, you solve this problem,
Senator, overnight.
Senator Warren. Well, I appreciate that you want the same
kind of rules to apply to everyone, and we can talk about what
is needed to make that happen.
You know, the dark underbelly of crypto is its critical
link to financing terrorism and human trafficking and drug
dealing and helping rogue Nations like North Korea and Iran.
Crypto does not get a pass to help the world's worst criminals,
no matter how many television ads they run or how many
political contributions they make.
It is time for Congress to make the crypto industry follow
the same money laundering rules as everyone else. That is why
Senator Marshall and I introduced a bipartisan bill today that
requires crypto to follow the same money laundering rules that
every bank, every broker, and Western Union all have to follow
today.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Warren.
Senator Van Hollen, of Maryland, is recognized.
Senator Van Hollen. Thank you, Mr. Chairman, and let me add
my words of appreciation to Senator Toomey for his leadership
on all sorts of issues. I have disagreed with Senator Toomey
many, many times, but I have also had the opportunity to work
with him closely on lots of issues. So Pat, thank you.
And thank all of you for being here. You know, over the
last more than 2 years I think this Committee has been trying
to take a crash course on crypto, and understand all its
implications. And I think the fact that we have four very
bright individuals here, with diametrically opposed views, is
an illustration of the challenges we are facing as a Committee.
But I do want to pick up where my colleague, Senator
Tester, did, because the question is where do we go from here.
And on the one hand, the impulse is, of course, to want to
protect consumers. On the other hand, we want to make sure that
in the process of trying to do that we do not give a Government
imprimatur to a system that is so inherently risky and without
necessarily any, at least as two of our witnesses said,
underlying in value.
So Professor Allen, if you were king, queen for the day,
what would you do right now? And let me just say, we have got
the SEC. The SEC clearly has the authority and power to go
after fraud, and we need to make sure they have the resources
to go after fraud in this area because it has grown very fast.
But beyond using the existing tools, what would you do, going
forward?
Ms. Allen. If I were queen for a day I would ban crypto,
but if I were someone who was dealing with multiple
constituencies and realize that that might not be viable, I
think the path I would take would be to strengthen banking law,
what I have been calling Glass-Stegall 2.0, and make it quite
clear that banks simply may not touch crypto in any way, shape
or form. And then I would give the SEC more money. I would pass
legislation that makes it clear, abundantly clear, that all
crypto is a security. And to be clear, the definition section
in the securities legislation does not just list investment
contract. This is not just about the Howey Test. There are all
kinds of securities that do not go through the Howey Test.
Bonds are just listed. If it is a bond, it is a security. So we
could say if this is a crypto asset it is just a security. You
do not have to go through the Howey Test framework. And then we
apply all the securities laws, you know, robustly, and I think
that is the best way forward.
Senator Van Hollen. Thank you. And is it Mr. Schenkkan,
McKenzie Schenkkan?
Mr. Schenkkan. Yes, sir. You can also call me Ryan.
Senator Van Hollen. All right. Well, in that case, listen.
I appreciate your testimony. The bottom line, as I understood,
is you said we should just deal with this and regulate it like
it is gambling. And, you know, I have been listening. I have
been listening to analogies to Enron, and even analogies to the
mortgage meltdown, you know, mortgage-backed security meltdown.
At least in those cases they were backed by real assets, right?
In the case of Enron you have got an energy-producing company.
In the case of mortgage-backed securities it was an outrageous
scandal. At the end it was supposed to be backed.
What is this backed by, if I could ask you? What is this
backed by, at the end of the day?
Mr. Schenkkan. Nothing. It is a story. Robert Shiller, the
Nobel prize-winning economist talks about how economic
narratives form. They are in response to real events. In this
case, with cryptocurrency, I would argue the genesis was the
subprime crisis. The Bitcoin white paper, released in October
of 2008, was perhaps well intentioned. It was intended to be a
peer-to-peer currency that would avoid all intermediaries.
So the story has understandable appeal. I think if crypto
serves any function it is to highlight the myriad failures of
our regulated system and our banking system, and our American
economic system, to provide people with a fair shot at the
American dream, or what is left of it.
That does not make the story true, however, the story of
cryptocurrency. What it does is lend it enormous power, and
these stories spread, as Shiller describes, like viruses,
infecting one person to another, much like a multilevel
marketing scheme. But, you know, for the digital era, instead
of a 5-hour Tupperware party you get a 60-second TikTok video.
And you are encouraged to invest because you see other people
investing. They call it FOMO--fear of missing out. We used to
call it greed.
People get very excited, these bubbles buildup very big,
but then they collapse very swiftly, and I think that is what
we are seeing now today.
Senator Van Hollen. Thank you.
Chairman Brown. Thank you, Senator Van Hollen.
Senator Cortez Masto, of Nevada, is recognized.
Senator Cortez Masto. Thank you. Thank you, Mr. Chairman. I
too, my kudos to our Ranking Chairman. Thank you so much. It
has been a pleasure to work with you. We have not agreed on
everything, but you are a gentleman, and I do always appreciate
the opportunity to have an open line of communication with you,
so thank you.
To everyone here, thank you. This obviously is something we
have been working on for a period of time here, and really
appreciate the insight you all bring.
I do want to follow up on my colleague, Senator Van
Hollen's line of questioning with Professor Allen. I want to
ask the rest of you. Clearly she is supporting banning it. If
we do not ban it, how do we regulate it? She put forth a
proposal which is isolate it from the banking system and then
define it as a security. Does anybody disagree with that or
have any other ideas about how it would be regulated? Mr.
O'Leary.
Mr. O'Leary. The concept of pressing legislation that would
ban banks from integrating cryptocurrencies and crypto
technology, if that were to happen, as an investor, I would
short every American bank stock because it would make it the
most uncompetitive financial services sector in the world.
The innovation that is coming forward, once regulated, is
going to be profound in terms of how it changes the cost, the
efficiency, the auditability, the productivity of the banking
sector. Just look at things as simple as ACH transfers, how
archaic they are. Look at the Fed wire.
Senator Cortez Masto. So let me just stop you there. I only
have so much time. So you do not agree with isolating it from
the banking system.
Mr. O'Leary. That is insanity.
Senator Cortez Masto. OK. Ms. Schulp.
Ms. Schulp. I also do not agree with isolating it from the
banking system. I do think that if I were queen for a day to
regulate I would ask Congress to make some clear lines here
with respect to what is and is not a security, and I think a
lot of crypto tokens do fall under the category of security,
but it is not always clear.
I also would ask Congress to draw clear lines as to which
market regulator handles secondary trading, giving the
commodities segments to the CFTC and the securities segments to
the SEC. That should put good guardrails in place in order to
apply similar risk frameworks to similar risks.
Senator Cortez Masto. Thank you. Mr. Schenkkan?
Mr. Schenkkan. If we allow cryptocurrency to infect our
banking system we will be back here.
Senator Cortez Masto. Thank you.
Mr. Schenkkan. We will be back here, not in a good way.
Senator Cortez Masto. And Professor Allen, anything else to
add. So I am going to ask you, because I also appreciate your
conversation with Senator Tester, and it really focuses on why
we should isolate it from the banking system.
But let me ask you this. Many crypto advocates have taken
this scandal that we are talking about today as an opportunity
to suggest that the failure of FTX was due to its
centralization, and argue for decentralization finance, or
DeFi. Can you talk a little bit--would that have made a
difference, and what impact would the DeFi lead to possible
greater centralization of wealth? I mean, can you talk a little
bit about what that means, if anything?
Ms. Allen. Sure. So DeFi stands for decentralized finance,
but that is a marketing term because it is not actually
decentralized. As I mentioned earlier, technological
decentralization and economic decentralization are not the same
thing. First of all, DeFi is highly integrated with the
centralized crypto ecosystem and it is not sure that it can
survive without it.
And then even within DeFi there are so many intermediaries.
At the underlying blockchain level you are trusting the core
developers of the software that runs the blockchain and the
validators who implement the software changes. On the next
level up, you are trusting the people who program the
application that runs on that blockchain.
Now the people who program that are controlled by the
people who own the DAO governance tokens. So you may have heard
about these DAOs, these decentralized autonomous organizations.
They are basically like creating a partnership on the
blockchain.
The ownership of those tokens, it is meant to be
decentralized and disbursed, but that is not the reality. The
economic reality is that for a lot of these things, like 90
percent of the tokens plus are owned by a single person. So
saying that I could--you know, me, having one governance token
in a DAO, is like me buying a share in Tesla and trying to tell
Elon Musk what to do.
So economically it is very centralized, the whole way up
and down. So much like many of the stories that Mr. Schenkkan
has been talking about, it is a story. You know, I really get
why people want these things. Would it not be nice if we could
create a world where we did not have to trust the
intermediaries who have made so many mistakes, so many times?
But the reality is that economic power concentrates in
these places, and we cannot avoid intermediaries. So what is
the point of DeFi?
Senator Cortez Masto. Thank you. I noticed my time is up.
Thank you, Mr. Chairman.
Chairman Brown. Thank you, Senator Cortez Masto.
Senator Smith, of Minnesota, is recognized.
Senator Smith. Thank you, Chair Brown. I am going to direct
my first question to Professor Allen. The collapse of FTX is
shocking, but it is hard to say that it is surprising, right? I
mean, it is hard not to conclude that this crypto exchange and
its related firm, Alameda Research, completely failed to
safeguard the money of the people they entrusted their money to
there. And we should not lose sight of the fact that millions
of dollars disappeared overnight and that this is money that
belonged to people who could not afford to lose their money.
So Professor Allen, I want to get at this question of
consumer protection, just pretty quickly. People are free to
invest their money pretty much however they want to, but they
deserve to know that the market is fair and that there are
rules that protect them from bad actors, so they are not
getting ripped off. Exchanges and firms that buy and sell
stocks and commodities are required to keep company money
separate from their customers' money. They do not get to gamble
with their customers' money without asking permission first. Is
that correct?
Ms. Allen. Yes.
Senator Smith. And that is not the case with what we saw
with FTX, what we see often in crypto. Is that true?
Ms. Allen. I mean, they often say in their terms of service
that they will not do it, but they do it anyway.
Senator Smith. Yeah. I think that is right. And when a firm
is being paid to give advice to their customers on how to
invest their money, they have to put their customers' interests
first, right? That is basic fiduciary responsibility. Is that
the case in crypto right now?
Ms. Allen. So, I mean, I think there is a big concern here
about crypto being incorporated into things like pension funds
and also into 401(k) plans. So the Department of Labor is being
very clear that they do not think that this is the type of
thing that belongs in any kind of sort of retirement savings.
Unfortunately, Fidelity has made the move to allow people to
invest in Bitcoin through their 401(k) plans, and I think that
is highly problematic.
Senator Smith. Yes, and Senator Warren and Senator Durbin
and I have sent letters to Fidelity and have urged the
Department of Labor to follow up on this, because they have
this highly volatile asset that does not appear to be--it seems
to be exactly the wrong kind of thing to put in a retirement
account, where you are looking for more stability over the long
term. Right?
Ms. Allen. Right.
Senator Smith. And let me just ask, just following up on
what Senator Warren was focusing on, banks and other financial
services firms have as their responsibility the duty to know
who their customers are. That is how we protect against money
laundering. Is that the case in crypto?
Ms. Allen. No. I mean, I think generally speaking there is
sort of a failure of gatekeepers all over the crypto industry.
We have talked about we do not have the auditors being able to
exercise oversight. We do not have KYC functions there.
Another failure of oversight is the venture capital firms.
We sort of expect them to exercise a restraint and exercise
diligence before lending their reputation to these businesses.
But venture capital firms were throwing money at FTX and
similar firms without doing their diligence.
So as I explored in my written testimony, one of the things
we can achieve by enforcing the securities laws is actually
holding venture capitalists to account a little more because of
potential liability as statutory sellers of unregistered
securities.
Senator Smith. Yep. So I agree with that. I think that the
crypto world at FTX shows us what can happen when we do not
have basic consumer protections in place. And, you know, crypto
is a relatively new thing, but we know what to do to make sure
that our markets are fair and that financial institutions know
their customers. So it seems to me that our job here is to
enforce the laws that we have, make sure that we are plugging
holes where they exist, and making sure that our enforcement
agencies have the authorities and the resources they need, or
we are going to see more disasters like this.
Mr. Schenkkan, I would like to follow up and ask you a
question. I want to talk about the external impacts of crypto.
So crypto mining and verification is a highly energy-intensive
process that requires more electricity annually than many
individual countries. The worst offender is Bitcoin, but this
is a widespread problem. In the U.S. alone, crypto operations
require as much electricity as all home computers or
residential lighting, and this is, of course, contributing to
our challenges around carbon emissions. And then there is the
issue about crypto mining exacerbating local noise and air and
water pollution as well. So lots of externalities, as we say.
As I understand it, crypto mining is built on a process
that becomes more and more energy-intensive over time. Is that
correct?
Mr. Schenkkan. Yes.
Senator Smith. So it is inherently inefficient. Is that
correct?
Mr. Schenkkan. Yes. The technology is bad.
Senator Smith. And so where is the benefit of this kind of
innovation and how should we think about the impacts of this
when it comes to the climate and energy use impacts? Because in
fact, when crypto mines are located in communities, those
communities often see their energy prices go up, their energy
rates go up. Is that correct?
Mr. Schenkkan. That is right. I visited the largest crypto
mine in the country, Whinstone, which is in Rockdale, Texas,
just outside of my hometown of Austin, Texas. Local citizens
are upset. It raises the cost of electricity for all citizens,
and it also uses an enormous amount of energy. It took over a
former Alcoa aluminum smelting plant that had been abandoned,
and now we are using it to mine ephemeral digital assets of no
productive value. I think that says a lot.
Senator Smith. Thank you. Thank you, Mr. Chair.
Chairman Brown. Thank you, Senator Smith.
My understanding is Senator Sinema is joining us remotely.
Senator Sinema, from Arizona.
Senator Sinema. Thank you, Mr. Chairman, and thank you to
our witnesses for being here today.
You know, Arizonans are always interested in investment
opportunities that allow them to build better lives for
themselves and their families, especially in the last few
years. In conversations at the grocery store, the gym, the
coffee shop, or the kitchen table, Arizonans have been talking
about cryptocurrency--the hype, the skepticisms, the questions
of how it works and how it will work going forward.
Like most Arizonans, I am a skeptical optimist. I believe
in the future and the potential of this technology, that it can
be a force for good, and that it can ultimately make people's
lives better, but also clear-eyed about what is happening right
now, how technology and anonymity can be misused and abused and
how people are being deceived and defrauded.
The collapse of FTX is just one of many recent market
events that are shaking investors' faith in the ecosystem. Some
will say this is about the ecosystem as a whole. Others will
say this merely applies to centralized entities and that this
criticism should not apply to more decentralized projects.
But even in the context of decentralized projects, we need
to understand how dispersed ownership truly is. This is a
complex issue but I want to put the focus where it should be,
on everyday Arizonans, many of whom put their faith in a
technology that appeals to our independent leanings and our
natural skepticism of Government and centralized control.
So I believe we have some obligations to everyday
Arizonans. First, to make sure they have the information they
need to understand risks and opportunities, and ultimately to
make investment decisions that work for themselves and for
their families. Second, to grow the U.S. economy and protect
the integrity of our capital markets. Third, to provide a
regulatory framework that responsibly promotes innovation here
in the U.S. while increasing funding through enforcement to
ensure that any bad actor is pursued quickly and harshly. So
protect investors, protect the economy, promote innovation, go
after the bad guys--it is pretty fundamental.
So I would like to turn to Professor Allen and thank him
[sic] for being here. Your testimony cites a Financial Times
article entitled ``Let It Burn'', that calls for crypto to do
just that, to burn down as a fully unregulated business. So let
us be specific. In the cases of FTX, Terra Luna, Celsius, and
others, who exactly got burned?
Ms. Allen. It was the investors.
Senator Sinema. That is right. I also want to apologize,
Professor Allen. I misnamed you there for a moment. I
apologize.
Ms. Allen. That is fine.
Senator Sinema. In other words, it was investors, right,
everyday Arizonans, people who work hard for the money they
make and are just trying to provide for their families, save
for their kids' college, or take that vacation they have always
dreamed of.
The founders did not get burned, even if ultimately they
got arrested. It is regular people who got burned. And that is
why it frustrates me when people say, flippantly, ``Let it
burn'' because that is the hard-earned savings that everyday
people invested in good faith, with promises of big returns.
And for FTX customers, all of that is now gone.
Most people had no idea they find themselves as unsecured
creditors, unlikely to get back the investments they entrusted
to Mr. Bankman-Fried, and others, and they are last in line
behind banks, lawyers, other lenders, and venture funds.
For months, I have had people in Washington tell me and my
staff that new legislation is not necessary here. They say that
there is sufficient regulatory authority and that the
regulators should just handle it unimpeded. But my question is,
where were the regulators? I was encouraged to see fraud
charges pressed against Mr. Bankman-Fried and his subsequent
extradition and arrest, but let us be serious--that was
reactive, not proactive, and frankly, it is the least that
Government could do. And perhaps most importantly, for all
those regular Americans, it is not going to get them their
money back.
And others will say that this is a classic case of buyer
beware. It is clear that due to murky jurisdictional issues,
unanswered legal questions, and a lack of regulatory clarity,
investors are having a difficult time accurately pricing risk.
In finance, we learn that the return on your investment should
be related to the risk that you bear, but if you cannot price
the risk it is hard to understand what return you should
expect, and that cuts at the core of how a healthy market
should function.
Professor Allen, your testimony highlights a number of ways
that greater regulation enforcement can be valuable for
investors, and I am interested in identifying specific ways
that we can assist investors in quantifying the risks they may
be taking on. Are there specific disclosure or registration
requirements that you believe may assist investors in more
accurate price discovery?
Ms. Allen. Thank you, Senator. So first of all I want to
point out that the ``let it burn'' argument may seem harsh, and
it is not one that I advocate for this reason. But it may seem
harsh to the individual investors. But it is advocated in a
sense of trying to protect people who have not invested in
crypto from broader financial failure. So it is not as harsh as
it might seem. We are trying to find a regulatory regime that
can protect noninvestors as well as investors, and that is what
I have tried to advocate for in my testimony.
In terms of protecting investors, as I have said, I do not
know how you can really protect them from crypto assets with
more disclosures because what are you actually disclosing about
an asset that nothing behind it? I think that the securities
laws are effective in requiring registration, which means
people who have assets with nothing behind them will not be
able to offer them in the first place, and that, I think, is
the value, the ex ante value, as you said, instead of an ex
post enforcement action. I think that is the value of applying
the securities laws here.
And yes, I wish they had been enforced more aggressively in
the lead-up to this. I think the SEC has not had enough
resources. I also think that the SEC has faced a lot of
significant political pressure to back off from the crypto
industry. It received letters from Congresspeople last year,
saying, ``Don't look at FTX.''
So I think that full-throated support from Congress for the
SEC's investor protection mission could be very effective in
increasing enforcement in this space.
Chairman Brown. Thank you, Professor Allen. Thank you,
Senator Sinema.
Senator Toomey has one last question, as I do, and then we
will wrap. Thank you.
Senator Toomey. Thanks, Mr. Chairman. I think during the
course of this hearing we have not talked as much as we ought
to about some of the, I think, really exciting and terrific
applications that the crypto ecosystem makes possible. One of
the categories that comes to mind is the ability to use
stablecoins in conjunction with smart contracts. Basically it
turns into what I think of as programmable money, where you can
write into the code a payment that will occur, based on some
exogenous and verifiable event, and the payment requires no
human intervention. It just happens when the exogenous event
occurs.
So, Ms. Schulp, I wonder, first of all, could you comment
on whether you think there is a lot of future in this idea of
programmable money, and then second, I think you are familiar
with the legislative framework that I have laid out for
stablecoins. I think the heart of that is the requirement that
we have 100 percent cash and cash equivalence as a backing for
a stablecoin and oversight by the OCC, but not the Fed. And I
wonder if you would comment also on whether you think that is
the right approach to regulating stablecoins?
Ms. Schulp. Of course. I do believe that stablecoins have a
lot of promise, not only I terms of the programmable money
concept that you state but also in terms of just being a faster
and more stable way to work within a digital ecosystem rather
than relying on kind of creaky payment rails. Stablecoins can
offer a lot of alternatives in that space, where we have truly
digital money.
I am familiar with your legislation, and I think that it
addresses what is one of the, I think the most obvious risks in
the stablecoin space, which is the concern that stablecoin
issuers do not have stable coins, because the reserves that
they have behind them might not be what they say they are.
I think that there are a number of ways that you can go
about creating a regulatory regime to take account of that
risk. I myself have proposed kind of a disclosure-based
framework that could be put into place by something like the
SEC. In fact, it is very similar to the disclosure framework
that you have proposed with the OCC.
I do think it is important to separate that type of
regulatory function from the Federal monetary regulator so that
the Federal Reserve is not the one charged with handling
regulation of kind of a money substitute here. There are a lot
of conflicts of interest that can exist in that space, and I
think it is wise to keep stablecoin regulation, which is
something that I think is kind of low-hanging fruit at this
point. There are obvious risks, and I think there are pretty
obvious ways to deal with those risks in a pretty simple
fashion. But we should keep that type of regulation separate
and apart from monetary regulation.
Senator Toomey. Thank you.
Chairman Brown. Thank you. And my question--in fact, thank
you for that answer--Professor Allen, my question is, in part,
a follow-up with your answer to Senator Sinema about the
difficulty of regulating crypto. Crypto firms have called for
regulatory clarity, is a term that some of them use. Do you
think crypto platforms could mostly comply with actual
regulations?
Ms. Allen. No, I do not, and I think when they are calling
for regulatory clarity what they are asking for is actually
bespoke regulation that they can comply with.
Chairman Brown. OK. Good answer. Thank you.
Thanks to the witnesses for your testimony. The events of
this week should be a warning to others about accountability,
not just in crypto. How we discuss crypto from this point
forward will define crypto markets for the future.
For Senators who wish to submit questions for the record,
those questions are due Wednesday, December 21st. Witnesses, we
ask you within 45 days to respond to any questions.
Thank you again. The Committee is adjourned.
[Whereupon, at 12:54 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN SHERROD BROWN
Today's hearing is in a hybrid format. Our witnesses are in-person
and virtual, and Members have the option to appear either in-person or
virtually.
First, I want to express my gratitude to the Department of Justice,
the SEC, the CFTC, and the Bahamian authorities for taking this
critical step to hold Sam Bankman-Fried accountable for his misdeeds.
I'd also like to thank Ranking Member Toomey and his staff for working
with me and my staff to try to secure Mr. Bankman-Fried's testimony.
I trust that Mr. Bankman-Fried will soon be brought to justice. It
is clear he owes the American people an explanation.
Meanwhile, our job is to keep learning more about the collapses of
FTX and other crypto firms, and work with regulators to put consumers--
not the crypto industry--first.
This isn't just about crypto. This is about protecting the
consumers and the regulated financial sector from bad actors who think
rules don't apply to them.
Two-and-half years ago, I explained why I thought Facebook's Libra
currency was dangerous.
At the time, Facebook was moving full steam ahead to create its own
``currency'' to impose on its billions of users.
Congress, regulators, and policymakers saw Facebook Libra for what
it was: a shiny new tool Facebook could use to reach into Americans'
pockets and profit from--no matter the risk to consumers or our
economy.
Members of this Committee, and others in Congress, responded.
Republicans and Democrats alike made it clear that Facebook couldn't be
trusted, and our financial system was not to be played with.
The risk of a company creating its own currency to compete with the
U.S. dollar was obvious.
Ultimately, Facebook shut down its crypto project, but this
Committee's work to protect consumers continues. Even though Facebook
shelved its crypto plans, in the last two-and-a-half years, the
stablecoin market has grown five-fold to become a tool for rampant
speculation.
The number of crypto tokens has exploded, even as the total value
of all crypto assets fell by two-thirds in the last year.
In the past, I've noted the similarities that cryptocurrencies
share with risky mortgage bonds and over-the-counter derivatives during
the lead up to the financial crisis. In all these cases, they told us
how great innovation is and how derivatives make markets efficient.
Wall Street made it easy for everyone to get a mortgage so bankers
could create more mortgage bonds and increase profits. Making money in
crypto seemed easy, too easy--every crypto token could double or triple
in value in a matter of hours or days.
It didn't matter if it was created with vague details or as a
joke--money poured in. But no one is laughing now.
The weekend before our stablecoin hearing last February, we saw
crypto companies spending big money on Super Bowl ads to attract more
customers and pump up crypto tokens.
Crypto, like Facebook's Libra before it, was the shiny tool that
was supposed to capture our imagination and revolutionize our lives.
Wealthy celebrity spokespeople told Americans, if you're not buying
crypto, you're missing out.
Crypto platforms created dozens of investment products. Products
that look and sound like bank deposits, and that used words like
``lend'' and ``earn.'' Or tokens that resemble securities and have a
``yield'' or governance rights. Yet these products had none of the
safeguards of bank deposits or securities.
Crypto firms, and their backers, argued that billions of dollars
invested in lending programs, or earning yield, should be exempt from
basic oversight and regulatory protections.
That's not how regulation works. The things that look and behave
like securities, commodities, or banking products need to be regulated
and supervised by the responsible agencies who serve consumers.
Crypto doesn't get a free pass because it's bright and shiny. Or
because venture capitalists think it might change the world. Or its TV
ads campaigns were witty and featured celebrities.
Especially when so many consumers are at risk of losing their hard-
earned money.
And that's before we even consider how crypto has ushered in a
whole new dimension of fraud and threats to national security that
support dangerous Nation States, embolden criminals, and finance
terrorists.
North Korea uses crypto stolen in hacks to finance its ballistic
missile programs. Human traffickers and drug cartels and gunrunners
launder their proceeds using crypto assets, and some of these laundered
funds end up bankrolling terrorists bent on undermining the United
States.
The ability of rogue States, cyber criminals, and terrorists to use
crypto for their own malign purposes is a feature of the technology.
That's the point.
Crypto also has made it easier for fraudsters and scammers to steal
consumers' money. Hacks and complex crypto transactions made it easy to
steal billions of dollars of investors' money.
That's what we saw with FTX. That's what will continue as long as
we allow crypto firms to write their own rules.
The myth of Sam Bankman-Fried and his crypto trading success was
supposed to impress us.
We are still learning how he shuffled money between FTX and his
trading firm, Alameda Research. A name calculated to sound as generic
as possible to avoid raising eyebrows while sending money across the
world.
FTX and Alameda Research took advantage of the crypto industry's
appetite for speculation.
They were able to borrow and lend from other platforms and invest
in other crypto firms--inflating the crypto ecosystem and growing their
own profits.
Even this summer as crypto values crashed and platforms began to
fail, FTX and Alameda found ways to benefit. In one case, FTX made a
$250 million loan to a platform using its proprietary token, and
Alameda borrowed client deposits worth more than twice that from the
platform.
All the while, venture capitalists and other big investors fell for
it. They were caught up in the speculative frenzy, missed the red flags
at FTX, and showered Mr. Bankman-Fried with money.
And now it is all most likely gone.
It's no surprise that in 2018, Alameda solicited investors by
guaranteeing 15 percent returns with quote ``no downside.'' That's more
than the guaranteed 11 percent that Bernie Madoff offered.
With Madoff and with Sam Bankman-Fried, investors didn't ask
questions for fear of missing out. It's a good reminder that most
guaranteed investments are too good to be true.
In this story, Sam Bankman-Fried was also the shiny object. Now
he's the villain, possibly worse. But this story is bigger than one
person or even one firm.
This is not just about misconduct at FTX, but about how to protect
consumers and the financial system from unregulated crypto products.
For many investors, it might be too late. I've heard from Ohioans
who have money stuck at FTX.US--that they tried to get out before it
filed for bankruptcy. But despite Mr. Bankman-
Fried's assertions that the U.S. side of FTX should be fine, the
court proceedings are likely to drag on.
If we are going to learn from FTX's meltdown, we must look closely
at the risks from conflicts at crypto platforms that combine multiple
functions.
It means thinking about the kinds of disclosure that consumers and
investors really need to understand how a token or crypto platform
works. We can look to existing banking and securities laws for time-
tested approaches to oversee and examine entities that want Americans
to trust them with their money.
To protect consumers and the financial system we need a
comprehensive framework that looks at crypto products for what they
are, not what crypto executives want them to be.
I look forward to working with Treasury Secretary Yellen and all
the financial regulators to ensure there is an all of Government
approach--just as we've done in the past. Anything less just won't
work.
______
PREPARED STATEMENT OF SENATOR PATRICK J. TOOMEY
We're here today to discuss the fallout after the collapse of FTX.
Some Americans likely suffered significant losses from the bankruptcy
of FTX and Sam Bankman-Fried's misconduct.
On Monday, we saw the arrest of Mr. Bankman-Fried. This came as a
surprise to no one, save for maybe Mr. Bankman-Fried. We owe it to each
customer to get to the bottom of the FTX implosion, and any violations
of the law should be aggressively prosecuted. The Department of Justice
and other enforcement agencies should expeditiously investigate the
unseemly relationship between a company that was effectively a hedge
fund, and an exchange entrusted with customer funds.
While all the facts have not yet come to light, we've clearly
witnessed wrongdoing that is almost certainly illegal. There was
unauthorized lending of customer assets to an affiliated entity, and
there were fraudulent promises to investors and customers about FTX's
operations. These are outrageous and completely unacceptable. The SEC
also believes FTX committed fraud against equity investors. They're
going to pursue this, as they should.
But I want to underscore a bigger issue here: The wrongful behavior
that occurred here is not specific to the underlying asset. What
appears to have happened here is a complete breakdown in the handling
of those assets.
In our discussion of FTX today, I hope we are able to separate
potentially illegal actions from perfectly lawful and innovative
cryptocurrencies.
Now it's important to define this space. Cryptocurrencies are
analogized to tokens, but they are actually software. The software
foundational to the crypto ecosystem are like operating systems.
Applications then run on top of these operating systems. Currently
there are many competing operating systems, and apps running on them.
There is nothing intrinsically good or evil about software; it's about
what people do with it.
With this analogy in mind, what we should all understand here is
one simple thing: The code committed no crime. FTX and cryptocurrencies
are not the same thing. FTX was opaque, centralized, and dishonest.
Cryptocurrencies are open-source, decentralized, and transparent.
To those who think that this episode justifies banning crypto, I'd
ask you to think about several examples. The 2008 financial crisis
involved misuse of products related to mortgages. Did we decide to ban
mortgages? Of course not. A commodity brokerage firm run by former New
Jersey Senator John Corzine collapsed after customer funds--including
U.S. dollars--were misappropriated to fill a shortfall from the firm's
trading losses. Nobody suggested that the problem was the U.S. dollar,
and that we should ban it. With FTX, the problem is not the instruments
that were used. The problem was the misuse of customer funds, gross
mismanagement, and likely illegal behavior.
Let's talk about what comes next. Some of my colleagues have
suggested pausing cryptocurrencies before we can address it. This is
profoundly misguided, not to mention impossible. Short of enacting
draconian, authoritarian policies, cryptocurrency cannot be stopped. If
we tried, the technology would simply migrate offshore; cryptocurrency
does not need brick and mortar facilities to operate. And typing
computer code should clearly be seen as a form of protected speech.
Are we going to decide to pause our Constitution to stop crypto?
This is exactly the kind of mindset that has driven this activity to
the dark and less regulated parts of the world.
Now, if Congress had passed legislation to create a well-defined
regulatory regime with sensible guardrails, we'd have multiple U.S.
exchanges competing here under the full force of those laws. It's not
clear that FTX would have existed, at least at its scale, if we had
domestic guidelines for American companies. The complete indifference
to an appropriate regulatory regime by both Congress and the SEC has
probably contributed to the rise of operations like FTX.
Others have suggested we refrain from addressing cryptocurrency at
all, so as to not legitimize its use. This is not only misguided, it's
irresponsible. Congress can and should offer a sensible approach for
the domestic regulation of these activities.
We could start with stablecoins. This is an activity that my
colleagues can analogize to existing, traditional finance products.
There's clear bipartisan agreement that stablecoins need additional
consumer protections. There are virtually none now. I've proposed a
framework to do that. As have Senators Lummis and Gillibrand.
Congress also needs to determine the criteria by which the issuance
of digital assets will be regulated. And we should acknowledge the
possibility that certain token issuances, like Bitcoin, don't need any
further regulation. We should also clearly delineate regulations for
secondary market trading of these assets, including at exchanges like
FTX.US. Some of my colleagues have begun this important work.
We can provide sensible consumer protections for which there would
be very broad agreement, while still allowing for the development of
applications that are going run on operating systems that we can't even
imagine today. Just as we never imagined applications like Uber
operating on iOS today.
Let me conclude with this. It's absolutely essential to investigate
any fraud and violations of existing law, and prosecute those who are
committing those crimes. Congress owes it to the American people to do
so here. But this is fundamentally not about the kind of assets that
were held by FTX. It's about what individuals did with those assets.
Individuals can also be tremendously empowered when they use
cryptocurrencies. They can protect against inflation when Governments
irresponsibly manage their own currencies. They can provide useful
services without the need for a company or middleman. And they can let
individuals preserve the freedom to transact privately.
Mr. Bankman-Fried may have well committed multiple crimes. The SEC
and DOJ will determine that. But let's remember to distinguish between
human failure and the instrument with which the failure occurred. In
this case the instrument is software. And the code committed no crime.
And while Sam Bankman-Fried very well may have, it is very important we
do not convict the code of anything but preserving and protecting
individual autonomy.
PREPARED STATEMENT OF HILARY J. ALLEN
Professor, American University Washington College of Law
December 14, 2022
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF KEVIN O'LEARY
Investor
December 14, 2022
Chairman Brown, Ranking Member Toomey, and Members of the
Committee, thank you for inviting me to testify about crypto and the
collapse of FTX.
I am the Chairman of O'Shares, an ETF indexing firm and also a
private equity and venture investor. I support entrepreneurs at every
stage of their journeys. I have dozens of family-run businesses in our
investment portfolios. My extensive social media platform enables me to
tell the stories of their products and services to help reduce their
customer acquisition costs. It is a model that has worked well for over
a decade and helped support so many small American businesses, which
create over 60 percent of jobs in the American economy.
In 2017, I was a public critic and skeptic of crypto and blockchain
technology. After observing the extraordinary advances in these
technologies and watching the amount of intellectual capital that was
being invested in them and the innovation they were producing, I
completely reversed my position. I am now of the opinion that crypto,
blockchain technology, and digital payment systems will be the twelfth
sector of the S&P within a decade. Today, I am a shareholder in
multiple companies involved in crypto technology, including WonderFi/
BitBuy, the largest and first regulated broker/dealer crypto exchange
in Canada, Immutable Holdings, a developer of NFT technology, and
Circle, the company that brought USDC stablecoin to market. I have also
invested in multiple crypto tokens, infrastructure and Level 1 and
Level 2 blockchains.
Many of these technologies are going to disrupt the existing
financial services sector with faster, more efficient, more productive
and more secure ways of investing, paying, transferring and tracking
assets. If properly regulated and implemented, they will undoubtedly
make the entire American economy more competitive and productive.
As you are aware, Bitcoin--a store of value--is not a coin, it is
software. Ethereum is software. Blockchain is software. In the last 30
years every American enterprise has driven major efficiencies using
various versions of enterprise software and crypto is no different. The
potential of these crypto technologies is astronomical in scale.
In August of 2021, nearly 3 years after I started allocating
capital to the crypto sector, I entered into an agreement with FTX to
be a paid spokesperson. I was paid approximately $15 million for these
services; plus approximately $3 million to cover a portion of the taxes
due. Of the remaining amount approximately $1 million was invested in
FTX equity and approximately $10 million in tokens held in FTX wallets.
The equity is now most likely worthless and the accounts have been
stripped of their assets and financial records. I have written them off
to zero. Because I was a paid spokesperson, I never invested any
capital from our partners or LPs. The capital lost was from an
operating company that I had 100 percent ownership in.
I am using my own capital to pursue record recovery of the FTX
accounts so that I can conduct a forensic audit. The truth of this
situation will be discovered by following the transaction trail after
obtaining the records. I have applied for membership on the FTX
creditors' committee, in connection with the bankruptcy proceedings,
because I feel obligated to pursue the facts on behalf of all
stakeholders and believe my perspective of this situation will be
helpful to the other creditors' committee members.
The collapse of FTX is nothing new. While this situation is painful
for shareholders, employees and account holders, in the long run, it
does not change this industry's promise. Enron came and went and had no
impact on the energy markets. Bear Stearns and Lehman Brothers demise
had no impact on the long term potential of American debt and equity
markets.
I am only one of many investors that has experienced this loss.
However, this changes nothing in terms of the potential of crypto. In
fact, the recent collapse of crypto companies has a silver lining. This
nascent industry is culling its herd. Going or gone are the
inexperienced or incompetent managers, weak business models and rogue
unregulated operators. Hopefully, these highly publicized events will
put renewed focus on implementing domestic regulation that has been
stalled for years. Other jurisdictions have already implemented such
policies and are now attracting both investment capital and highly
skilled talent. In the U.S., we are falling behind and losing our
leadership position.
I guest lecture graduating cohorts of engineers all across the
country because approximately a third of each class will start their
own company. Where do they want to work? On blockchain technology and
the new emerging digital economy. These are the best and brightest
hands over keyboards. I ask you to consider this: how is it possible to
invest this much intellectual capital into a sector, and not expect
extraordinary outcomes in the future? Now is the time to embrace the
potential of crypto, regulate it, and allow its potential to be fully
realized for the benefit of the entire economy.
I understand why many leaders in the banking industry are open
skeptics, calling for the banning of these new crypto software
technologies. Disruption is always uncomfortable at first, and
entrenched businesses abhor new competition, but it has been proven
time and time again that disruption is absolutely necessary in
advancing the economy.
There is the risk of investing in crypto and there is also the risk
of not investing in it and letting others accrue its benefits first,
essentially gifting them a competitive advantage that could be hard to
recapture.
So where to start? We need clear policy and regulation for the
crypto industry, its entrepreneurs, its developers and its users.
Congress should start by passing bipartisan legislation that creates a
sensible regulatory framework for digital stablecoins backed by the
U.S. dollar. Why? A well-regulated stablecoin backed by the U.S. dollar
and other high quality, liquid assets could become the global default
payment system over time.
The U.S. dollar already denominates the price of oil and other
commodities, why not everything else? What could be more bipartisan?
Let me close with this: we need to get to the bottom of what
happened at FTX, but we can't let its collapse cause us to abandon the
great promise and potential of crypto.
PREPARED STATEMENT OF JENNIFER J. SCHULP
Director of Financial Regulation Studies, Center for Monetary and
Financial Alternatives, Cato Institute
December 14, 2022
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF BEN MCKENZIE SCHENKKAN
Actor and Author
December 14, 2022
Chairman Brown, Ranking Member Toomey, and Members of the
Committee:
Thank you for your invitation to testify before the Committee on
matters relating to the growth of crypto trading and lending, as well
as the recent collapse of FTX/Alameda and the broader implosion of the
cryptocurrency markets.
A little over a year ago I embarked on a journey to explore the
inner workings of the cryptocurrency industry. My initial reaction was
one of confusion. I am an actor, and therefore words are the tools of
my trade. I also hold a degree in economics. When I began to look at
the cryptocurrency industry, many of the words used did not correlate
to their functional reality, economically or otherwise.
``Cryptocurrencies'' are not currencies by any reasonable economic
definition, as they are unable to fulfill any of the three functions of
money. They are a poor medium of exchange, unit of account, and store
of value. Bitcoin cannot work as a medium of exchange because it cannot
scale. The Bitcoin network can only process 5 to 7 transactions a
second. By comparison, Visa can handle tens of thousands. To facilitate
that relatively trivial amount of transactions, Bitcoin uses an
enormous amount of energy. In 2021, Bitcoin consumed 134 TWh in total,
comparable to the electrical energy consumed by the country of
Argentina. Bitcoin simply cannot ever work at scale as a medium of
exchange.
Other blockchains are more efficient, but suffer from other
problems, such as hacks and periodic outages. Even amongst
cryptographers, blockchain technology is considered to be of limited
use, only potentially applicable in small systems requiring low
throughput. Some view it even more dimly. Bruce Schneier is one of the
leading cryptographers in the field, a lecturer at the Harvard Kennedy
School and a board member of the Electronic Frontier Foundation:
What blockchain does is shift some of the trust in people and
institutions to trust in technology. You need to trust the
cryptography, the protocols, the software, the computers and
the network. And you need to trust them absolutely, because
they're often single points of failure.
I've never seen a legitimate use case for blockchain. I've
never seen any system where blockchain provides security in a
way that is impossible to provide in any other way.
Blockchain technology is at least 30 years old, not some new
invention with a still-promising future.
I interviewed cryptographer David Chaum recently. Chaum's work in
the early 1980s laid the intellectual foundation for blockchain, and he
is widely credited with being a pioneer of cryptographic methods of
payment. Even he referred to blockchain as ``primitive''.
Cryptocurrencies are similarly unable to serve as an adequate unit
of account or store of value, primarily because of their volatility.
For a currency to be consistently useful, it must remain relatively
consistent over time. Bitcoin and all other cryptocurrencies have never
been able to do so. Despite the industry's insistence to the contrary,
their volatility has not lessened over time. The precipitous collapse
of the entire cryptocurrency market over the last year provides a good
example. Imagine a scenario in which the U.S. dollar lost 70 percent of
its value in less than a year. Pandemonium--and a global recession--
would ensue.
Unfortunately, the problems with crypto as money run even deeper
than that. What cryptocurrency wants to be is private money,
unencumbered by interference from a Nation-State issuer. We have tried
private money before, during the Free-Banking Era (1837-1864) when
banks were allowed to issue their own notes. It did not work very well.
In many States, banks failed at alarming rates, often due to fraud.
The need for a trusted third party to backstop the banks was the
impetus behind the creation of the Federal Reserve in 1913, as well as
the Federal Deposit Insurance Corporation. Since the FDIC's creation in
1933, not a single penny of insured deposits has been lost. People
trust that when they put their money in a licensed U.S. bank, it will
be there when they need it, and the Federal Government provides that
assurance in times of crisis. In exchange for that FDIC license, banks
must comply with a litany of regulations.
Crypto's stated goal of creating a ``trustless'' form of money by
removing all intermediaries between individuals wishing to transact
directly holds understandable appeal. Everyone is aware of the myriad
flaws in our current financial system, and banks are rarely looked upon
favorably by the general public. There are many reasons for this, not
the least of which is their complicity in the debacle that was the
subprime crisis.
However, that does not mean that cryptocurrency is any better. In
fact, it cannot function as a currency, and for a very simple reason.
You cannot create ``trustless'' money because money is trust. We made
it up; it's a social construct. Like all social constructs, money
relies on trust forged through social consensus. You can no more create
a ``trustless'' money than you can a governmentless Government or a
religionless religion. The applicable words are anarchy and cult.
What ``trustless'' means in practice in crypto is placing your
trust in the people who run the exchanges, or issue the coins, or
anyone else who takes your real money in exchange for lines of computer
code stored on ledgers called blockchains. Code does not fall from the
sky; people write it. I believe few of the people in the cryptocurrency
industry have earned the trust of the public.
Cryptocurrencies are not currencies, and they are not used like
them. Alongside my colleague, journalist Jacob Silverman, I visited the
only country in the world trying to use cryptocurrency as money: El
Salvador. It is not working. The Chivo wallet system set up by the
Government is largely ignored. According to the Government's own
figures, less than 2 percent of remittances use Chivo. Instead, El
Salvador's president, Nayib Bukele, has reportedly gambled some of his
Government's money--meaning his people's money--on Bitcoin. If this is
true, then much like the overwhelming majority of cryptocurrency
investors, Bukele has lost money on his wager.
How are cryptocurrencies used by the wider public? Tens of millions
of Americans, and supposedly hundreds of millions of people worldwide,
have bought and sold crypto primarily through centralized exchanges
such as Binance and until recently, FTX. To state the obvious,
transacting through a centralized exchange run through shell
corporations in the Caribbean and elsewhere is the antithesis of the
stated goal of cryptocurrency to create a peer-to-peer currency that
would avoid all intermediaries.
The cryptocurrency industry is in fact heavily centralized, and a
few key players wield enormous power. For example, according to recent
reporting from the New York Times and The Wall Street Journal, a small
group of elite crypto executives communicate via the encrypted app
Signal. It would be wise to remember the words of Adam Smith:
People of the same trade seldom meet together, even for
merriment and diversion, but the conversation ends in a
conspiracy against the public, or in some contrivance to raise
prices.
Because cryptocurrencies don't really do anything in the real world
they are at best an exercise in a zero-sum game of chance, much like
online poker. Fittingly enough, several key players in the
cryptocurrency industry cut their teeth in the online poker craze of
the late 2000s. Chairman Gensler of the SEC has referred to stablecoins
as ``the poker chips in the casino'' and I believe his metaphor is apt.
The largest stablecoin in crypto by a country mile is Tether. Stuart
Hoegner, Tether's general counsel, was once the compliance officer for
Excapsa, which was the holding company of Ultimate Bet, an online poker
website from the era. Ultimate Bet was ultimately revealed to have a
secret ``god mode'' where insiders could see the other players cards so
as to cheat them.
Working alongside Mr. Hoegner at Excapsa/Ultimate Bet was Daniel
Friedberg, former general counsel of FTX and now its chief regulatory
officer. Stuart Hoegner's company Tether counts as its biggest client
Alameda Research, the sister company of FTX. According to reporting
from crypto media company Protos, Alameda purchased some $36.7 billion
worth of Tether coins. Given Alameda's current insolvency, it would be
wise to ask where this money came from and what arrangement existed
between the two companies.
So if cryptocurrencies are not currencies, then what are they?
Well, what do they do? How do they function in the real world? People
put money into them and expect to make money off of them, through no
work of their own. As Members of this Committee well know, that is an
investment contract under American law. More precisely, it is a
security: (1) an investment of money (2) in a common enterprise (3)
with the expectation of profit (4) to be derived from the efforts of
others. To my mind, every coin or token easily satisfies the four
prongs of the Howey Test.
The rapid rise of cryptocurrency both in purported value and number
of tokens issued should give us all pause. There are now over 20,000
cryptocurrencies, more than all the securities offered for sale through
the major U.S. stock exchanges. An estimated 40 million Americans have
bought or sold cryptocurrency at some point. According to the
industry's own polling, the majority of investors who have ever
purchased Bitcoin did so in 2021. Given the recent collapse in the
price of Bitcoin, it is reasonable to assume most of them have lost
money.
When added to the millions already locked out of their accounts at
places like FTX and Celsius those numbers soar even higher. A
nonexhaustive list of crypto players who have stopped or paused
withdrawals just this year includes BlockFi, Voyager Digital, Genesis,
CoinFlex, Gemini, Three Arrows Capital, Hodlnaut, Poolin, Digital
Surge, Orthogonal Trading, AAX, Hoo, SALT, Babylon Finance, Nuri,
Bithumb, Upbit, Coinone, Babel Finance, WazirX/CoinDCX, Bexplus, AEX,
Vauld, 2gether, Finblox, and well, you get the point.
There are many reasons that so many customers cannot get their
money back, but the simplest one is that much of it was never there to
begin with. The prices of these speculative so-called `digital assets'
were bid up/manipulated far beyond the actual real money backing them.
You don't have to take my word for it. In March of this year, I
asked Alex Mashinsky, CEO of the now failed crypto lending firm
Celsius, how much real money was in crypto and he estimated: ``10 to 15
percent. The rest is speculation.'' Given crypto's market cap at the
time (about $1.8 trillion), that would imply only a few hundred billion
dollars of actual money was backing these assets. When I asked Sam
Bankman-Fried the same question in July of this year, he broadly
concurred with Mashinsky, estimating around $200 billion was left in
crypto. Personally, I suspect the true number to be far, far lower, but
even taking these assessments at face value there is no denying that
the amount of nominal value of crypto far exceeds the actual dollars in
the crypto ``ecosystem.''
Leverage accounts for some of this disparity, and is not unique to
crypto. It exists in our regulated markets as well. But as Professor
Hilary Allen points out, with crypto the potential leverage in crypto
is far higher:
The amount of leverage in the system can also be increased by
simply multiplying the number of assets available to borrow
against. That is a significant concern with DeFi, where
financial assets in the form of tokens can be created out of
thin air by anyone with computer programming knowledge, then
used as collateral for loans that can then be used to acquire
yet more assets.
Of course leverage is not the sole culprit behind the collapse of
crypto. One of the other contributing factors is fraud. Cryptocurrency
has attempted to assemble a parallel financial universe that in some
ways mirrors our regulated one, only absent meaningful regulations. Be
careful what you wish for. The simple truth is that in an unregulated
market, at every juncture where value is transferred from one party to
another, not only is there nothing preventing one or more parties from
committing fraud, there is often very little even disincentivizing them
from doing so. If you can rip people off and get away with it, why not
do it?
If you lose money in cryptocurrency, advocates proudly state the
only person you have to blame is yourself. DYOR (Do Your Own Research)
is their motto. The system cannot fail; you can only fail the system.
The language of crypto is eerily reminiscent of multilevel marketing
schemes. Words such as ``community'' obscure the financial nature of
these endeavors, cloaking them in a false sense of shared purpose. The
illegal version of multilevel marketing schemes are called pyramid
schemes.
Now that tens of millions of Americans have lost money in crypto,
and millions more have been prevented from withdrawing their money as
crypto companies shut down, seemingly on a daily basis, we are left
with an obvious question: is any of this worth it?
Our securities laws have been on the books since the 1930s. They
were written broadly on purpose; ever since there has been money,
people have been interested in gathering quantities of it and putting
it to productive use so as to make more of it. Most of these endeavors
are well-intentioned, if not always successful. But some are nothing
more than lies designed to separate people from their money.
Securities that have no underlying value are often described as
Ponzi schemes. As such, under American law Ponzi schemes are regulated
by the Securities and Exchange Commission.
I submit to you today that the entire cryptocurrency industry
resembles nothing more than a massive speculative bubble built on a
foundation of fraud. In my opinion, it is the largest Ponzi scheme in
history by an order of magnitude.
Cryptocurrency is in fact only a story, or rather a constellation
of stories that form an economic narrative. As Nobel prize-winning
economist Robert Shiller has observed, an economic narrative can be
defined as:
a contagious story that has the potential to change how people
make economic decisions, such as the decision to . . . invest
in a volatile speculative asset.
Shiller's first example? Bitcoin.
If cryptocurrency is only a story then it is fitting that I am
here, for I am a storyteller at heart. I know a few things about money
and lying. I learned about money from my economics degree, as well as
by making a bit of it during my two decades spent in showbusiness. I
know about lying because as an actor I do it for a living.
Unfortunately for the tens of millions of Americans who have lost
money in cryptocurrency, the reality behind the story has become
apparent to all who care to see it. The economic narrative surrounding
cryptocurrency is untrue. In fact, it is a story meant to deceive.
We should give the SEC, DOJ, OFAC, and other relevant agencies the
resources and support they need to enforce laws already in existence
today. They should act swiftly before more Americans are hurt.
Let the chips fall where they may.
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
FROM HILARY J. ALLEN
Q.1. Professor Allen, some have claimed that FTX, and other
failed crypto platforms, collapsed because they were
centralized. Your written testimony addressed that issue,
explaining that decentralized platforms share the same problems
as centralized ones. Can you elaborate on why the problems in
crypto are so fundamental that they impact both decentralized
and centralized platforms?
A.1. The issue here is that most so-called ``DeFi'' or
``decentralized'' offerings are not, in fact, decentralized
from an economic perspective (research from the BIS has
therefore labelled DeFi's claims of decentralization as an
``illusion''). \1\ If the offering is technologically
decentralized, it will rely on software to operate: if power
over that software is concentrated in the heads of one or a few
individuals, there is no reason to expect those individuals to
behave any better than the individuals operating more openly
centralized crypto platforms. The people who control DeFi
platforms have the same incentives and opportunities as the
operators of centralized platforms to take advantage of
investors--in fact, they may have more opportunities as the
technological complexity of decentralized offerings may confuse
investors and obfuscate who is in charge. This complexity and
obfuscation may also make it more challenging (although by no
means impossible) for regulators to enforce existing law
against the operators of DeFi platforms. DeFi's increased
technological complexity also offers many opportunities for
hacks and other operational problems. \2\ Finally, as I explore
at length in my law review article ``DeFi: Shadow Banking
2.0?'', there are plenty of opportunities for leverage and
automation in DeFi that make DeFi inherently fragile and
susceptible to runs--just as more openly centralized crypto is.
\3\
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\1\ https://www.bis.org/publ/qtrpdf/r-qt2112b.pdf
\2\ See https://web3isgoinggreat.com for examples.
\3\ https://papers.ssrn.com/sol3/papers.cfm?abstract-id=4038788
Q.2. Many crypto advocates have talked about the potential of
blockchain technology to revolutionize financial services. You
testified that the Australian Stock Exchange tried to use this
technology, but found it unworkable. Are there other examples
where blockchain technology has been deemed not fit for
purpose? Please discuss if there potential applications for the
blockchain in financial services that you believe are
---------------------------------------------------------------------------
improvements over current processes.
A.2. With regard to your question ``are there potential
applications for the blockchain in financial services that you
believe are improvements over current processes,''
respectfully, I think a better question to ask is ``are there
potential applications for the blockchain in financial services
that you believe are improvements over other existing
technological alternatives?'' There are certainly places where
our current financial infrastructure needs updating--sometimes,
the need is so acute that almost any change might be an
improvement. When choosing a solution, though, we can choose
between the blockchain and many other available technological
solutions (in other words, the blockchain isn't the only
alternative to our status quo). Given the menu of technologies
currently available, it would be rare (if ever) that a
blockchain is the best technological solution. As I have
written previously, ``it does not seem possible that a
technology that has been intentionally made more complex (in
order to nominally decentralize) could ever be more efficient
than a simpler, centralized alternative.'' \4\
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\4\ DeFi: Shadow Banking 2.0?
---------------------------------------------------------------------------
To elaborate some more on the technological limitations of
blockchains, no matter which consensus mechanism is chosen for
a decentralized ledger (proof-of-work, proof-of-stake, or
something else), it must always be slower and more cumbersome
than validation by a centralized intermediary. Otherwise it
will be too easy for a bad actor to take over: costly
computations are the sinequanone of decentralized consensus
mechanisms. This expense and inefficiency mean that it is very
challenging for decentralized services to scale up--one
illustration of this is the significant increases in gas fees
users of the Ethereum ledger experience when it's busy.
Decentralized ledgers also face limitations because it is not
possible for software to cater for all possible eventualities:
intermediaries are often needed to resolve unanticipated
situations (for example, reversing erroneous or problematic
transactions). As I mentioned in response to Senator Warren's
question at the hearing, blockchain technology's main
contribution to efficiency is avoiding the anti-money
laundering checks that slow down the processing of traditional
financial transactions.
The inefficiencies of blockchain technology ultimately led
to the Australian Stock Exchange abandoning its blockchain
project. \5\ It was also recently announced that IBM and Maersk
are abandoning their logistics blockchain. \6\ In 2020, one
report from Deloitte indicated that the vast majority (85
percent) of corporate blockchain projects had failed, while 93
percent of user led blockchain projects had failed. \7\ While
most useful technologies have bumps in the road, blockchain
technology is not just experiencing teething pains: hundreds of
technologists have warned that blockchain technology is not fit
for the use cases its proponents espouse. \8\
---------------------------------------------------------------------------
\5\ https://cointelegraph.com/news/aussie-stock-exchange-abandons-
blockchain-plans-leaving-170m-hole
\6\ https://www.coindesk.com/business/2022/11/30/ibm-and-maersk-
abandon-ship-on-tradelens-logistics-blockchain/
\7\ https://www2.deloitte.com/us/en/insights/industry/financial-
services/evolution-of-blockchain-github-platform.html
\8\ https://concerned.tech
---------------------------------------------------------------------------
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TESTER
FROM HILARY J. ALLEN
Q.1. Taxpayer Protection--Is it clear enough to investors that
making bets in the cryptocurrency space is at their own risk?
And that the U.S. taxpayers won't be stepping in to bailout
this industry?
A.1. It appears that, for many investors, crypto assets seem
like reasonable alternative investments that are on par--in
terms of risk--with many other types of investments. For
example, letters submitted to the judge in the Celsius
bankruptcy paint a picture of customers who genuinely believed
their money was safe with Celsius. \1\ Even after the crypto
failures of the last year, one recent survey suggests that many
investors still believe crypto investments to be safe and well-
regulated. \2\ According to this 2022 survey, Black investors
are more likely than White investors to believe that this is
the case: ``Black investors are also more likely than White
investors to believe investments in cryptocurrency are both
safe (33 percent vs. 18 percent) and regulated by the
Government (30 percent vs. 14 percent).'' \3\ In short, even
after what has happened in 2022, it appears that there are
still some investors who underestimate the risks of making bets
in the cryptocurrency space. Some members of the public even
believe that the FDIC protects crypto investments. This
confusion has sometimes been encouraged by members of the
crypto industry--in August of 2022, the FDIC issued Cease and
Desist Letters to five crypto businesses (including FTX.US) for
making false or misleading representations about deposit
insurance. \4\
---------------------------------------------------------------------------
\1\ https://blog.mollywhite.net/celsius-letters/
\2\ https://cepr.net/crypto-and-building-black-wealth/
\3\ https://www.schwabmoneywise.com/tools-resources/ariel-schwab-
survey-2022
\4\ https://www.fdic.gov/news/press-releases/2022/pr22060.html
---------------------------------------------------------------------------
As for U.S. taxpayers bailing out the crypto industry, I
would note that since I testified before the Committee in
December, it has been reported that Silvergate Bank (which
provides payment and other services to the crypto industry)
significantly increased its reliance on loans from the Federal
Home Loan Bank of San Francisco in the last quarter of 2022. To
quote one report, ``FHLB borrowings funded only 5 percent of
$13.9 billion in total funding (deposits plus borrowings) as of
Sept. 30 . . . the current industry norm is for FHLB borrowings
to provide about 5 percent to 6 percent of funding. But that
ballooned to 41 percent of total funding as of Dec. 31.'' \5\
This increased borrowing occurred at the same time as FTX's
failure--if banks were to more fully integrate with the crypto
industry, we could reasonably expect to see more Government
funding being used to indirectly support the crypto industry.
---------------------------------------------------------------------------
\5\ https://www.marketwatch.com/story/cryptocurrency-bank-
silvergate-has-lost-68-of-its-digital-deposits-heres-what-we-know-
about-its-predicament-11672946903
Q.2. Contagion--It is clear that there was poor corporate
governance, and it appears flat-out fraud, at FTX. But over
this last year we've seen a series of failures and challenges
in the industry. There may be benefits to some of the related
technologies, but there have been numerous problems--even just
in recent months--for cryptocurrency companies and, more
importantly, investors.
How could this or other failures in the cryptocurrency
industry have spread to our other financial institutions and
systems in the U.S.? What has protected them so far?
How would this crash have been different if Federal
financial regulators had allowed our banking institutions in
this country to do more in the cryptocurrency space?
A.2. As we learned from 2008, problems in traditional financial
markets can be transmitted both through contractual
counterparty relationships and through metastasizing loss of
confidence in similarly situated firms. The events of 2022
indicate that those same channels of contagion exist in the
crypto industry. Fortunately, there were few contractual
interconnections between the crypto industry and the
traditional financial system, and the general public had little
reason to think that the traditional financial industry had
significant exposure to the crypto industry. As a result, the
spillover effects from crypto failures have largely remained
contained within the crypto industry.
There are many possible explanations for why the banking
industry was not significantly exposed to crypto. Many people
believe the narrative that crypto is trying to disrupt banks,
and that banks therefore see the crypto industry as a kind of
adversary--and so banks did not invest in crypto for that
reason. Others believe that banks thought crypto was too risky,
and avoided investing out of a sense of self-preservation. In
my view, both narratives are overstated. I believe that many
traditional financial firms would have integrated more fully
with the crypto industry had regulators allowed them to do so.
Even with financial regulators' strong admonitions to be wary
of crypto, we have seen some integration. For example, the
Department of Labor provided guidance that strongly cautioned
against administrators of 401k plans including crypto assets to
their investment menus: \6\ Fidelity created a Bitcoin option
regardless. \7\ Banking regulators have been reasonably strict
about separating banking from crypto, \8\ but have allowed Bank
of New York Mellon to custody crypto assets for its clients.
\9\ They also appear to have acquiesced in banks like
Silvergate and Signature Banks providing services to the crypto
industry, at least for a time.
---------------------------------------------------------------------------
\6\ https://www.dol.gov/newsroom/releases/ebsa/ebsa20220310
\7\ https://www.cnbc.com/2022/11/04/fidelity-forusall-offering-
401k-investors-access-to-cryptocurrency.html
\8\ https://www.fdic.gov/news/press-releases/2023/pr23002a.pdf
\9\ https://www.wsj.com/articles/americas-oldest-bank-bny-mellon-
will-hold-that-crypto-now-11665460354
---------------------------------------------------------------------------
These kinds of banking activities did not create direct
crypto exposure for banks. Had banks accepted crypto as
collateral for loans or invested directly in crypto assets
(particularly if they had used leverage to do so), then the
events of 2022 would no doubt have had repercussions for the
banking industry. Still, even indirect exposure to crypto could
conceivably cause problems in the future because of how
important confidence is to the banking industry. For example,
if a bank's revenue were dependent on providing services to the
crypto industry or crypto custody services to its clients, then
implosions in the crypto industry might raise concerns about
the viability of the bank's business model. Or if a bank were
to make loans secured with traditional assets to large
institutional customers, and then those customers were to incur
significant crypto exposure and default on their loans, that
might raise concerns about the bank's solvency. Or if a bank
were holding the reserves of a stablecoin on deposit and there
were a run on that stablecoin, the bank would see those
reserves withdrawn. Could that be enough to raise liquidity
concerns about the bank, exposing the bank to the risk of a run
itself? This is not an exhaustive list of possible contagion
channels; instead it is a list of examples provided here to
bolster the case for a complete separation of banking and
crypto.
Q.3. Regulation--What are the benefits and drawbacks from
creating additional regulation, and with it perhaps perceived
or real Government endorsement, for a product with no inherent
value?
A.3. There is a risk that applying any regulatory framework to
crypto, other than a ban, could legitimize it. However, as I
outlined in my testimony, I believe concerns about perceptions
of Government endorsement must be balanced against the need for
investor protection, and that if lawmakers do not wish to enact
a ban, then these perceptions can be managed in an investor
protection regime like the one administered by the SEC. It is
critical, though, that banking regulation not be applied to
crypto. While securities regulation does not suggest that any
investment is a good investment--and it is well understood that
a share in a corporation, for example, could lose all of its
value--banking regulation puts Government backing behind
certain assets (like deposits) in order to ensure that people
retain confidence in those assets. This kind of regulation and
Government backing would be extremely dangerous if applied to a
product with nothing concrete behind it, that serves no real
capital formation function.
It is also critical that no bespoke regulatory regime is
devised for crypto. The creation of a bespoke regulatory regime
would communicate to the public that there is something special
about crypto that is worth accommodating. During the hearing,
witness Kevin O'Leary mentioned several times that the crypto
industry wants this kind of regulation so that it can attract
money from institutional investors. This would allow the crypto
industry to grow--but in my view, if crypto cannot comply with
existing securities regulation (and much of it probably cannot)
then it should not exist.
Q.4. National Security--Are there benefits that outweigh the
facilitation of crime that we've seen from these products and
this industry?
A.4. Proponents of blockchain technology rarely claim it can do
something new--instead, they claim it can do existing things in
decentralized ways. However, as I described in my testimony,
even if the technology is decentralized, it does not operate in
a decentralized way because economic control of the technology
is so concentrated. There therefore seem to be few social
benefits of the technology, except that some people seem to
enjoy tinkering with blockchain technology on an intellectual
level. If this tinkering had no social cost to it, I would see
no reason for regulation to intervene, notwithstanding that I
see little real decentralization or utility in blockchain
technology. Unfortunately, this technology creates significant
negative externalities--from a national security perspective,
as well as from the perspective of harm to consumers, the
environment, and the stability of our financial system. In
other situations, it might be difficult to decide how to
respond to an innovation that has real promise and real peril:
this is an easy case, though, given the lack of significant
benefit and the obvious harm associated with the blockchain.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR WARNOCK
FROM HILARY J. ALLEN
Q.1. According to press reports, FTX Trading Ltd. (FTX)
collateralized billions of United States dollars in loans using
the FTX Token (FTT), which functioned similarly to a form of
stock in FTX. If FTX were a traditional bank, this practice
would seem to be prohibited under the National Banking Act of
1864. \1\
---------------------------------------------------------------------------
\1\ 12 U.S.C. 83(a) (``No national bank shall make any loan or
discount on the security of the shares of its own capital stock.'').
---------------------------------------------------------------------------
In your view, is there a conflict of interest for a
cryptocurrency exchange to issue its own token, given the lack
of public markets and other methods of ensuring transparency
and price discovery?
A.1. In general, crypto exchanges are vertically integrated,
offering multiple services that are typically disaggregated in
traditional finance. For example, while stock exchanges do not
do not take proprietary trading positions opposite their
customers, this kind of practice is common in crypto exchanges.
Housing brokerage, exchange, clearing, and proprietary trading
services in one business inevitably creates conflicts of
interest.
With that said, there is not an inevitable conflict of
interest in an exchange issuing its own token. As an analogy,
the owner of the New York Stock Exchange is International
Clearing, a publicly traded company (meaning anyone can buy
shares in the parent company of the New York Stock Exchange).
Conflicts of interest can arise, however, if the exchange is
trading in its own token against its customers, or manipulating
the supply of tokens that its customers have invested in
(conflicts of interest may also arise if the exchange misleads
its customers about the relationship between acquiring the
tokens and accessing exchange functionality).
In the absence of mandated disclosures and market
transparency, these kinds of activities can easily go
undetected. As I stated in my written testimony, ``when assets
have no fundamentals and trade entirely on sentiment,
traditional checks on fraud (like valuation methodologies and
financial accounting) will inevitably break down.'' Using wash
trading to manipulate the value of a token is a particular
concern when it comes to exchanges issuing their own tokens.
Wash trading involves ``simultaneously selling and buying the
same financial assets to create artificial activity in the
marketplace, which is known to distort price, volume, and
volatility, and reduce investors' confidence and participation
in financial markets,'' and this practice has been found to be
rife in unregulated crypto exchanges. \2\
---------------------------------------------------------------------------
\2\ https://www.nber.org/papers/w30783
Q.2. How does allowing cryptocurrency exchanges to issue their
---------------------------------------------------------------------------
own tokens affect fair competition?
A.2. I am not an expert in competition law, and do not feel
qualified to speak to this issue.
Q.3. How does allowing cryptocurrency exchanges to issue their
own tokens affect systemic risk in financial markets?
A.3. We know from past experience with the traditional
financial system that excessive leverage makes the system more
fragile and susceptible to booms and busts, increasing systemic
risk. One way of increasing the amount of leverage in a system
is to multiply the number of assets available to borrow
against. That is a significant concern with crypto, where
assets in the form of tokens can be created out of thin air by
anyone with computer programming knowledge. This concern
applies to all tokens, including those issued by exchanges.
In addition, when cryptocurrency exchanges accept their own
tokens as collateral for margin loans to others, that creates
wrong-way risk. Bloomberg journalist Matt Levine analogized FTX
accepting FTT as collateral to a bank accepting its own stock
as collateral for a loan:
If you go to an investment bank and say ``lend me $1
billion, and I will post $2 billion of your stock as
collateral,'' you are messing with very dark magic and
they will say no. The problem with this is that it is
wrong-way risk . . . If people start to worry about the
investment bank's financial health, its stock will go
down, which means that its collateral will be less
valuable, which means that its financial health will
get worse, which means that its stock will go down,
etc. It is a death spiral. In general it should not be
possible to bankrupt an investment bank by shorting its
stock. If one of the bank's main assets is its own
stock--is a leveraged bet on its own stock--then it is
easy to bankrupt it by shorting its stock. \3\
---------------------------------------------------------------------------
\3\ https://news.bloomberglaw.com/banking-law/matt-levines-money-
stuff-ftx-had-a-death-spiral
A practice that makes it easy to bankrupt an exchange is
likely to have systemic ripples in crypto, where the events of
2022 have demonstrated that crypto exchanges and other
intermediaries often lend to and borrow from one another and
thus are tightly interconnected.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TESTER
FROM KEVIN O'LEARY
Q.1. Taxpayer Protection--Is it clear enough to investors that
making bets in the cryptocurrency space is at their own risk?
And that the U.S. taxpayers won't be stepping in to bailout
this industry?
A.1. It is generally understood that investing in the
cryptocurrency space carries a high degree of risk and that
there is no guarantee of returns. Additionally, most
participants now realize that it is unlikely that the U.S.
Government will step in to bailout the cryptocurrency industry,
as it is not considered a traditional financial sector.
However, it is always important for investors to conduct their
own research and understand the risks involved before making
any investment decisions.
Q.2. What steps need to be taken to protect everyday investors
from schemes like this?
A.2. An Individual considering investing in crypto should
follow some pragmatic common sense rules, such as:
1. Educating yourself about the basics of cryptocurrency and
how it works, as well as the risks involved.
2. Investing only what you can afford to lose and
diversifying your portfolio. When asked, I suggest
starting by investing $100 in a centralized wallet like
Coinbase and $100 in a decentralized one like Metamask.
Working with them both is educational and not alot of
capital is at risk if mistakes are made.
3. Being cautious of projects or companies that lack
transparency or have a history of fraud or misconduct.
4. Checking the credentials and regulatory compliance of any
cryptocurrency exchange or platform you plan to use.
5. Staying informed about current events and regulatory
developments in the cryptocurrency space.
6. Consider consulting with a financial advisor or
professional for guidance.
Q.3. What additional resources do institutional investors or
more experienced investors like yourself need to have adequate
information about investing in companies like FTX?
A.3. Institutional investors or more experienced investors
looking to invest in crypto companies like FTX may benefit from
a variety of additional resources. These can include:
1. Company financial statements and regulatory filings,
which can provide insight into the company's financial
performance, management team, and overall business
strategy.
2. Research reports from reputable financial institutions
and industry experts, which can provide in-depth
analysis of the company and its market position.
3. Market data and analytics, such as trading volume, price
movements, and trading metrics, to gain insight into
market trends and the overall performance of the
company.
4. Industry news and events, to stay informed about
developments in the crypto space, regulatory changes,
and other important news.
5. Networking and connecting with other experienced
investors in the crypto space, to share knowledge,
insights, and ideas.
6. Understanding the legal and regulatory aspects of the
crypto industry in the country and worldwide.
7. Having a solid knowledge of the technology behind the
coin or token that is being considered for investment.
It's important to note that even with these resources,
investing in the crypto space still carries a high degree of
risk, and investors should always conduct their own research
and seek professional advice before making any investment
decisions.
Q.4. Regulation--What are the benefits and drawbacks from
creating additional regulation, and with it perhaps perceived
or real Government endorsement, for a product with no inherent
value?
A.4. Benefits of regulation:
Increased investor protection: Regulation can help
to protect investors from fraud and other types of
financial misconduct by requiring companies to disclose
information and adhere to certain standards.
Improved market integrity: Regulation can help to
promote fair and orderly markets by preventing
manipulation and other types of market abuse.
Greater legitimacy: By being regulated, a product
can be perceived as more legitimate, which can increase
the overall trust and confidence in the market.
Institutional investors would have greater interest in
crypto assets if they were regulated. They have a fiduciary
duty to their clients, which means they are legally obligated
to act in their clients' best interests. As a result, they may
be more likely to invest in crypto assets if they feel that the
market is more secure and less prone to fraud or other types of
financial misconduct.
Regulation can provide investors with the transparency and
oversight needed to assess the risks and potential returns of
crypto assets. It can also help to create a more stable and
predictable environment, which is often more appealing to
institutional investors who are looking for long-term
investments.
Additionally, institutional investors are subject to strict
regulations and compliance requirements, so they are more
comfortable investing in an asset class that is also regulated.
It's important to note that the crypto market is rapidly
evolving and the regulatory landscape is still developing, so
it's hard to predict how it will affect institutional
investors' interest. However, as crypto assets continue to
mature, it is likely that we will see increased institutional
interest and investment in the crypto space if regulations are
put in place to protect the investors.
I don't think there will be material appreciation in the
value of crypto assets until they are regulated and sovereign
wealth and pension funds begin to allocate to this new asset
class.
Drawbacks of regulation:
Increased compliance costs: Companies may face
higher costs in order to comply with regulatory
requirements.
Reduced innovation: Regulation can create barriers
to entry, making it harder for new companies to enter
the market, which could stifle innovation.
Slower adoption: Heavy regulation can discourage
some investors from entering the market, slowing
adoption and limiting its growth.
Possibility of Government intervention: Advocates
of decentralized finance view Government regulation as
the Government's attempt to intervene or control the
crypto market. They do not agree that regulation would
attract institutional capital.
It's important to note that there is no one-size-fits-all
solution when it comes to regulating a product like
cryptocurrency, as the appropriate level of regulation will
depend on a variety of factors, such as the specific risks
associated with the product, the overall maturity of the
market, and the objectives of regulators.
While many advocates of decentralized finance abhor the
concept of Governments regulating crypto assets, I believe the
majority of participants are now fatigued by the almost weekly
bankruptcy of poorly managed unregulated crypto companies and
exchanges and are becoming open to a more structured and
regulated version of the crypto market
------
RESPONSES TO WRITTEN QUESTIONS OF
SENATOR CORTEZ MASTO FROM KEVIN O'LEARY
Q.1. Please list the cryptocurrencies you have invested in over
the past decade. Please note any you currently hold.
A.1. ETH, BTC, HNT, MATIC, AVAX, FTM, ALGO, SX, MER, SBR,
ATLAS, AUDIO, USDC, DOGE, LHC, USDC, HBAR.
I currently hold: ETH, BTC, MANIC, USDC, HBAR, DOGE, LHC.
Q.2. Please list any cryptocurrencies, crypto companies or
projects that have provided compensation to you.
A.2. FTX.
Q.3. As a frequent contributor on financial topics, how do you
draw the line between opinion and financial advice? When you
provide financial advice, do you include a disclaimer in your
videos and media appearance that you received compensation by
crypto firms or own the crypto assets you are discussing?
A.3. If I'm a paid spokesperson for a company's product or
service I disclose it. When asked about any potential
investment I talk about how I manage my own money and encourage
diversification across sectors. Network, cable broadcasters
usually include standard disclaimers at the head or end of
programming for almost all contributors, I am no exception.
Q.4. Have you ever shorted your position in a digital asset
with a digital asset you have promoted? If so, when and which
one?
A.4. No
Q.5. Prior to becoming a sponsor of FTX, had you invested in
FTX? If so, how much did you invest--please include all
compensation including any product you may have received, taxes
paid on the compensation, etc.?
A.5. No, I was not an investor in FTX prior to entering into a
partnership and endorsement services agreement. FTX had already
closed their most recent round of financing and I insisted they
open it up and allow me to purchase equity. In most paid
spokesperson deals I enter into with companies I ask for equity
participation so that my interests are transparently aligned
with shareholders. FTX accommodated my purchase of equity in
FTX International and FTX.US Prior to becoming a paid
spokesperson to FTX I had been investing in various crypto
positions on multiple centralized and decentralized wallets.
I disclosed the details of the FTX contract in previous
testimony. I also invested in FTX equity. Details of this
investment were also disclosed in my prior testimony.
Q.6. What did you see as your role as a sponsor of FTX?
A.6. I saw my role as an endorser and a spokesperson for FTX.
Because of my business background, my investments in multiple
companies involved in crypto technology, and my extensive work
supporting entrepreneurs at every stage of their journeys, I
had some calls with FTX regarding the features that
institutional investors would require in any crypto platform.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR WARNOCK
FROM KEVIN O'LEARY
Q.1. According to press reports, FTX Trading Ltd. (FTX)
collateralized billions of United States dollars in loans using
the FTX Token (FTT), which functioned similarly to a form of
stock in FTX. If FTX were a traditional bank, this practice
would seem to be prohibited under the National Banking Act of
1864. \1\
---------------------------------------------------------------------------
\1\ 12 U.S.C. 83(a) (``No national bank shall make any loan or
discount on the security of the shares of its own capital stock.'').
---------------------------------------------------------------------------
In your view, is there a conflict of interest for a
cryptocurrency exchange to issue its own token, given the lack
of public markets and other methods of ensuring transparency
and price discovery?
A.1. It is possible for a cryptocurrency exchange to have a
conflict of interest if it issues its own token. One concern is
that the exchange may have an incentive to promote its own
token over other tokens listed on the platform, which could be
perceived as unfair to other projects and potentially lead to a
lack of trust in the exchange. Additionally, if the exchange
has significant control over the supply and demand of its own
token, it could potentially manipulate the price to its own
benefit.
To ensure transparency and price discovery, it would be
beneficial for there to be multiple, diverse sources of demand
for the token, such as from external investors or through use
cases within the exchange's ecosystem. It would also be
important for there to be clear and transparent information
about the token's distribution and economic model, as well as
any potential conflicts of interest that may exist.
Why do unregulated exchanges issue tokens? Because they
can. Operating in multiple jurisdictions with no one regulator
having control over their activity, creating tokens out of thin
air is easy to do. An equally important question is why would
anyone buy them? Traditionally, unregulated exchanges use them
as incentives to give account holders reduced trading fees. If
you open an account and buy and hold the exchange's token in
it, you pay less trading fees. Sometimes the more you hold the
less fees you pay. So there is a rational economic reason for
account holders to convert currencies into the exchange's token
and leave it sitting there while the exchange holds the real
cash.
These tokens are a form of ``faux'' equity because they
hold no relevant rights other than trading discounts. They
should be thought of as discount coupons.
For example the Binance exchange (symbol BNB) token has a
fully diluted market capitalization of approximately $61
Billion however it is tightly held. The top two wallet holders
own 97 percent of the float. Who are these owners? Unknown. If
there is a run on BNB and one of these wallets wants to
immediately convert back to $USD are there sufficient reserves?
Unknown. Meanwhile this token could be ascribed a $60 Billion
plus value to the Binance balance sheet. Who audits this and
where is it held? Unknown.
Q.2. How does allowing cryptocurrency exchanges to issue their
own tokens affect fair competition?
A.2. Allowing cryptocurrency exchanges to issue their own
tokens can potentially affect fair competition in a number of
ways.
First, an exchange's own token may have an advantage over
other tokens listed on the platform due to the exchange's
ability to promote it more heavily. This could lead to a
distortion of the market and an unfair advantage for the
exchange's own token.
Second, if an exchange has significant control over the
supply and demand of its own token, it could potentially
manipulate the price to its own benefit. This could lead to
unfair competition with other projects and potentially harm
investor confidence in the market.
Overall, it is important for exchanges to be transparent
about their operations and any potential conflicts of interest
that may exist, in order to promote fair competition and
maintain trust in the market.
Q.3. How does allowing cryptocurrency exchanges to issue their
own tokens affect systemic risk in financial markets?
A.3. Allowing cryptocurrency exchanges to issue their own
tokens can potentially affect systemic risk in financial
markets in a number of ways.
First, if an exchange's own token becomes widely used and
is tightly integrated into the exchange's operations, a failure
or problem with the exchange could have a cascading effect on
the value of the token and potentially create losses for token
holders. This could increase the systemic risk of the overall
market, as the failure of a single entity could have wider
implications.
The FTX exchange token (Symbol FTT) had a material role in
the collapse of FTX itself. Prior to November 2022 FTX had
repurchased approximately $2.1 billion of its equity from
Binance a global competitor also unregulated. A material amount
of this transaction may have been done using FTT tokens as
currency. In addition to alleged inappropriate transfers of
cash between FTX and Alomedia that could have weakened FTX
balance sheet, Binance attempted to ``dump'' approximately $550
million of FTT tokens onto the market the week of Nov. 7, 2022.
It was the proverbial ``straw that broke the camel's back'' as
FTX did not have the reserves to back that transaction and
subsequently filed for bankruptcy November 11, 2022.
Why would FTX deplete its balance sheet of $2.1 billion of
assets, including FTT tokens, to buy back its own stock from
Binance? According to FTX management it was to clear regulatory
hurdles in new geographies where FTX was seeking licenses to
operate. Apparently, according to FTX management, Binances 20
percent ownership in FTX made it a material participant in the
licensing process. However, according to FTX management Binance
was becoming less and less cooperative in proving the level of
transparency that regulators required and FTX license
applications were getting rejected because of is 20 percent
held by ``opaque ownership''. Who owns Binance? Unknown. This
became an insurmountable problem for FTX and, according to FTX
management, they had no choice but to repurchase their stock.
What valuation was this transaction done at? Records have not
been released yet but it is alleged by FTX management and also
detailed in Business cable interviews of Binance management to
have been done at a 15 percent discount to a $23 billion FTX
valuation. It seems that at least $550 million of the clearing
price was done in FTT tokens, which is the block that Binance
attempted to put to the market the week of Nov. 7th 2022 that
forced FTX into bankruptcy.
From my perspective this was a battle royal between two
giant global unregulated exchanges that together owned over 90
percent of global crypto market liquidity. One put the other
out of business. The highly effective weapon of choice? The FTT
exchange token.
If an exchange has significant control over the supply and
demand of its own token, it could potentially manipulate the
price to its own benefit. This could lead to market instability
and increase systemic risk, as investors may not have a clear
understanding of the true value of the token.
It is not clear what the long term value of an exchange
token is. If an exchange wants to raise capital why does it not
just sell its equity into the highly regulated equity markets.
If it wants to provide discounts on trading fees why not just
provide discounts? There is no need for a token for this
purpose. On the regulated on-line stock trading platforms
competition has driven trading fees to $0. Undoubtedly as
regulated broker/dealer crypto exchanges emerge fee structures
will also be determined by the market.
It is important for exchanges to be transparent about their
operations and any potential conflicts of interest that may
exist, in order to minimize the potential impact on systemic
risk in financial markets. To date this has not been the case
in the global crypto exchange market. The lack of definitive
regulation allows these exchanges to continue to operate in the
``wild west'' and they will continue to fail when stress tested
by accelerated liquidations.
Solving this problem may not be as complex as some have
suggested. Crypto has one unique attribute as an asset class.
It does not trade by geography or by schedule. Unlike a stock
or bond Bitcoin is not listed on the London or NYSE stock
exchange. It trades freely everywhere 24/7. However, what is
valuable to exchanges that seek licenses are the on and off
ramps into and out of the regulated banking system in each
region.
One good example of this solution is the highly regulated
crypto broker/dealer/exchange Canadian market. The OSC order
that allows exchanges to obtain licenses and operate there
restricts which tokens can be traded and held in accounts. To
date approximately 33 are permitted but no exchange tokens.
Exchanges in good standing can transfer funds in and out of
regulated bank accounts after appropriate KYC (know your
client) protocols have been satisfied. The regulatory controls
come from restricting which tokens can be traded, which can be
staked or lent and how regulated currency comes on and off the
exchanges. There is also proof of reserves, audit and ownership
transparency requirements that must be met and maintained in
order for the broker/dealer/exchange to continue to operate.
Regulators in all markets already cooperate together
developing and maintaining policy in the equity and debt
markets. Crypto trades everywhere with no regard to political
or economic borders so the best way to regulate it is to
control how it's converted into local currencies on and off
regulated broker/dealer/exchange platforms with a ``passport''
issued by the local regulator. Under a Passport Program
regulated banks in the region could only transfer capital to
broker/dealer/exchanges that have and maintain a Passport.
The Golden Passport would quickly become the one issued by
U.S. regulators that would allow its owner to operate within
the U.S. banking system. To accommodate the global liquidity of
Crypto regulators that standardized on the cooperative Passport
system could fast track the issuance of licenses if the
operator already had a Passport issued in a cooperating
jurisdiction. There are a handful of markets that make up the
majority of global liquidity. To reconstruct a regulated global
exchange under the Passport system, you would need to obtain
North American, British, Euro, UAE, and Asian Passports. To
maintain operations operators would need to remain compliant in
all regions simultaneously. Getting a passport revoked in any
one region would cause operations to be suspended in all
licenced markets until the breach was remedied in the market
the infraction occurred. Passported operators would gain an
advantage over ``rogue'' exchanges that continued to operate
free of regulation because the majority institutional capital
would flow through the regulated exchanges to remain compliant.
Cutting off unregulated exchanges from dealing with
regulated banking entities for fiat to crypto fund transfer is
no different than cancer therapies that cut off blood flow to
tumors and starve them to death.
This is not a new policy. Many international trading
agreements, in multiple asset classes, operate under mandates
similar to these.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TESTER
FROM JENNIFER J. SCHULP
Q.1. Taxpayer Protection--Is it clear enough to investors that
making bets in the cryptocurrency space is at their own risk?
And that the U.S. taxpayers won't be stepping in to bailout
this industry?
A.1. Investors should understand the risks associated with
investing in the cryptocurrency space. There is certainly an
opportunity for better investor education about cryptocurrency
investment and usage, and private market solutions have been
growing to address this need. \1\ Where individuals or entities
have misrepresented those risks or misrepresented the
availability or applicability of Federal Government backstops,
like deposit insurance, such misstatements should be subject to
appropriate liability either through private causes of action
or through Government enforcement action.
---------------------------------------------------------------------------
\1\ See, for example, the work being done by the Blockchain
Foundation (https://theblockfound.com/) and educational resources that
are provided by popular crypto marketplaces (https://www.coinbase.com/
learn and https://www.gemini.com/cryptopedia).
---------------------------------------------------------------------------
It is unfortunate that some investors have the expectation
that the Government, and by extension taxpayers, will act to
bail out any industry. Market forces should be permitted to
drive the success--or failure--of the industry.
Q.2. Contagion--It is clear that there was poor corporate
governance, and it appears flat-out fraud, at FTX. But over
this last year we've seen a series of failures and challenges
in the industry. There may be benefits to some of the related
technologies, but there have been numerous problems--even just
in recent months--for cryptocurrency companies and, more
importantly, investors.
How could this or other failures in the cryptocurrency
industry have spread to our other financial institutions and
systems in the U.S.? What has protected them so far?
A.2. It is difficult to predict the impact of any particular
event on other actors within the financial system. Not
surprisingly, the effects of FTX's bankruptcy have first been
felt by entities that engaged directly with now-bankrupt FTX-
related entities. This includes customers of the crypto trading
operation and those who invested in FTX, as well as companies
that lent to or borrowed from FTX. Second order effects were
felt by entities that engaged with those who had direct contact
with FTX. And so forth. The magnitude of FTX's failure means
that effects were significant. But not all effects were
catastrophic, and protection from such effects could come in
many forms, including a variety of good risk management
practices on the part of the entities that interacted with FTX
and its connections. The goal should not be to legislate to
prevent failure.
Q.3. How would this crash have been different if Federal
financial regulators had allowed our banking institutions in
this country to do more in the cryptocurrency space?
A.3. This counterfactual is difficult to answer because it
requires a host of assumptions about what regulation would look
like and what effect such regulation would have on both banking
institutions and cryptocurrency projects. On the one hand,
allowing additional touchpoints between banking institutions
and crypto may have limited the extent to which FTX and other
crypto entities were engaging in poor risk management practices
(or outright fraud), including by allowing for customer crypto
assets to be custodied by regulated banking institutions. In
this way, more integration between the banking and crypto
spaces may have limited the impact of the crash. On the other
hand, allowing additional touchpoints may have also imported
some risks from FTX's crash to the traditional financial
sector. But risks by themselves do not mean catastrophic
failure, and the purported benefits of isolating the banking
industry from cryptocurrencies must be examined in connection
with the costs of doing so.
Q.4. Regulation--What are the benefits and drawbacks from
creating additional regulation, and with it perhaps perceived
or real Government endorsement, for a product with no inherent
value?
A.4. This question, at least as stated, begs the question that
crypto--writ large--has no inherent value. This assumption is
not warranted. In addition, it treats ``crypto'' as a monolith
and does not take into account the wide variety of projects
that can be generally grouped under the ``crypto'' banner.
Moreover, the Government's role is not to determine whether
crypto has value; rather, regulation should do no more than
support the free market's ability to determine whether a
project succeeds or fails. Thus, regulation should not be
understood as a Government endorsement of any kind. The
benefits and drawbacks of additional regulation are highly
dependent on the type of regulation that is created; such
regulation should seek to neither advantage nor disadvantage
crypto projects vis-a-vis more traditional financial products.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR WARNOCK
FROM JENNIFER J. SCHULP
Q.1. According to press reports, FTX Trading Ltd. (FTX)
collateralized billions of United States dollars in loans using
the FTX Token (FTT), which functioned similarly to a form of
stock in FTX. If FTX were a traditional bank, this practice
would seem to be prohibited under the National Banking Act of
1864. \1\
---------------------------------------------------------------------------
\1\ 12 U.S.C. 83(a) (``No national bank shall make any loan or
discount on the security of the shares of its own capital stock.'').
A.1. Before addressing the specific questions below, I note
that it's not clear that FTX Trading is easily analogized to a
``national bank'' to which the National Banking Act is
applicable. FTX engaged in a number of lines of business, the
primary of which was serving as a cryptocurrency exchange
specializing in leveraged and derivative products. Other
services offered, including yield-bearing accounts, look more
akin to traditional banking, but it is difficult to generally
---------------------------------------------------------------------------
characterize FTX Trading's business as bank-like.
Q.2. In your view, is there a conflict of interest for a
cryptocurrency exchange to issue its own token, given the lack
of public markets and other methods of ensuring transparency
and price discovery?
A.2. Regardless of whether a token issued functions like a form
of stock in the exchange, the mere issuance of a token does not
signal a conflict of interest. Using such a token as collateral
for an exchange's borrowing or lending activities, or for other
purposes, may raise conflict of interest questions,
particularly where there is a lack of methods for ensuring
reliable rice discovery or assignment of value to such a token.
Such activity also raises questions about the exchange's risk
management practices.
Q.3. How does allowing cryptocurrency exchanges to issue their
own tokens affect fair competition?
A.3. There is nothing inherently anticompetitive in allowing
token issuance by cryptocurrency exchanges. To the extent such
tokens function as stock in the exchange itself, allowing such
issuance is akin to allowing the public ownership of stock
exchanges, which is currently how most major stock exchanges
are owned in the United States.
Q.4. How does allowing cryptocurrency exchanges to issue their
own tokens affect systemic risk in financial markets?
A.4. The issuance of tokens by cryptocurrency exchanges does
not itself necessarily have a systemic effect on financial
markets. As noted above, where such a token is used
inappropriately as collateral by the exchange or by others,
there may be broader implications relating to risk management.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN BROWN
FROM BEN MCKENZIE SCHENKKAN
Q.1. Many crypto advocates have talked about the potential of
blockchain technology to revolutionize financial services and
other industries. Based on your research, do you agree?
Are there any uses that you believe are on the horizon?
A.1. I do not agree. Blockchain technology is old, dating back
at least 30 years. It has not gained widespread adoption
because it suffers from several fundamental weaknesses.
Distributed ledger technology has thus far been unable to scale
without significant costs attached. Similarly, the
irreversibility of the blockchain, which advocates promote as a
selling point, makes it unsuited to human interaction. People
make mistakes, and tying the fate of our financial system to an
append-only ledger is unwise in the extreme.
The only use for blockchain technology on the horizon that
I have found in my research is potentially for small systems
with low throughput such as the wholesale side of the banking
system. But even there, it is unclear if the benefits outweigh
the drawbacks. More than 30 years after its invention,
blockchain is a still searching for a use case that does not
involve speculation and criminal activity.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TESTER
FROM BEN MCKENZIE SCHENKKAN
Q.1. Risks of Crypto Products--As I've discussed in this
Committee previously, I have long had concerns that aspects of
the crypto market reminded me of synthetic financial products
ahead of the Global Financial Crisis. I'm glad that our Federal
financial regulators have focused on safety, soundness, and
fairness in approaching these new products--I think taxpayers
could be in a much different position right now if regulators
had handled it differently in recent years.
On this and other occasions in the Banking Committee I have
discussed my concerns around these similarities with synthetic
products, which Professor Allen and I have discussed: What
concerns do you have about the risk posed to institutions and
individuals who invest in these products?
A.1. I have myriad concerns, but first and foremost it troubles
me that the cryptocurrency market is opaque to the point of
incomprehensibility to those not within the small circle of
meaningful players in the industry. Institutions and
individuals are at a severe disadvantage when investing in
these products. Prior to the last bull market in 2017, the
cryptocurrency industry was incredibly small. Since then it has
ballooned in size, in part because I believe regulators did not
properly classify cryptocurrencies as securities and regulate
them and the exchanges that sell them robustly. Investors have
little understanding of what transpires behind the scenes to
inflate the purported value of these cryptocurrencies, and even
less recourse to get their actual money back should they lose
it.
Q.2. Taxpayer Protection--Is it clear enough to investors that
making bets in the cryptocurrency space is at their own risk?
And that the U.S. taxpayers won't be stepping in to bailout
this industry?
A.2. It is not. Investing in cryptocurrency is extremely risky,
but it is not marketed as such. In fact, many claims by
cryptocurrency companies appear to be deliberately misleading.
Multiple players in cryptocurrency, including the now defunct
FTX, implied their accounts were FDIC-insured when they were
not. Cryptocurrency has been sold as a bet on technology and
innovation. It has been described as ``the future of money'', a
way of building generational wealth, and a method of banking
the unbanked. Unfortunately, none of those stories are true.
Investing in cryptocurrency is at best a zero-sum game of
chance, much like its predecessor, online poker. And much like
the early days of online poker, fraud is rampant.
Similarly, investors in cryptocurrency should be aware that
it is highly unlikely that the majority of taxpayers who have
not invested will be willing to bail out those who have been
defrauded. The blame lies with those who have committed fraud,
and no one else.
Q.3. Contagion--It is clear that there was poor corporate
governance, and it appears flat-out fraud, at FTX. But over
this last year we've seen a series of failures and challenges
in the industry. There may be benefits to some of the related
technologies, but there have been numerous problems--even just
in recent months--for cryptocurrency companies and, more
importantly, investors.
How could this or other failures in the cryptocurrency
industry have spread to our other financial institutions and
systems in the U.S.? What has protected them so far?
A.3. The bright red line between our regulated banking sector
and the wild west of cryptocurrency has thus far spared the
majority of the public from suffering a fate similar to the
majority of those who have invested in cryptocurrency. That
said, if cryptocurrency were to ever become embedded in our
regulated financial systems despite not following the same laws
as other financial products, the damage to our economy could be
immense.
Q.4. How would this crash have been different if Federal
financial regulators had allowed our banking institutions in
this country to do more in the cryptocurrency space?
A.4. It is not hyperbole to imagine that a subprime crisis 2.0
could emerge from a cryptocurrency crash in the future were it
infect our banking institutions. At a minimum, cryptocurrency
must not be allowed to avoid laws that have served the public
well for nearly a century.
Q.5. What steps need to be taken to protect everyday investors
from schemes like this?
A.5. We need to properly classify the nearly 20,000
cryptocurrencies as securities and enforce laws applicable to
them. Additionally, anti-money laundering laws and know your
customer laws should be enforced. Lastly, American customers
should not have access to cryptocurrency exchanges registered
overseas that do not comply with U.S. laws.
Q.6. What additional resources do institutional investors or
more experienced investors like yourself need to have adequate
information about investing in companies like FTX?
A.6. All investors need the same protections afforded by robust
enforcement of our securities laws. We should also consider a
marketing ban on risky investment products sold to the general
public.
Q.7. Regulation--What are the benefits and drawbacks from
creating additional regulation, and with it perhaps perceived
or real Government endorsement, for a product with no inherent
value?
A.7. Despite industry claims to the contrary, cryptocurrency is
not unique as an investment product. In fact, it is a
repetition of several failed ideas of the past. The United
States tried what cryptocurrency purports to be--private
money--in the 19th century during what has become known as the
free-banking era. It did not work very well. Similarly, the
drawbacks of selling unregulated securities to the general
public became clear during the stock market crash of 1929 to
1932 and the ensuing Great Depression, which led to the passage
of Federal securities laws in 1933 and 1934.
Rather than creating unnecessary additional regulation, we
should rigorously enforce the laws on the books so as to
protect the public.
Q.8. National Security--Are there benefits that outweigh the
facilitation of crime that we've seen from these products and
this industry?
A.8. No.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR WARNOCK
FROM BEN MCKENZIE SCHENKKAN
Q.1. According to press reports, FTX Trading Ltd. (FTX)
collateralized billions of United States dollars in loans using
the FTX Token (FTT), which functioned similarly to a form of
stock in FTX. If FTX were a traditional bank, this practice
would seem to be prohibited under the National Banking Act of
1864. \1\
---------------------------------------------------------------------------
\1\ 12 U.S.C. 83(a) (``No national bank shall make any loan or
discount on the security of the shares of its own capital stock.'').
---------------------------------------------------------------------------
In your view, is there a conflict of interest for a
cryptocurrency exchange to issue its own token, given the lack
of public markets and other methods of ensuring transparency
and price discovery?
A.1. Yes. Conflicts of interest abound in cryptocurrency, but
overseas exchanges with little transparency issuing their own
tokens is problematic to say the least. The public is largely
unaware of how the price of those tokens may be manipulated by
the exchanges issuing them.
Q.2. How does allowing cryptocurrency exchanges to issue their
own tokens affect fair competition?
A.2. Because the cryptocurrency exchanges issuing their own
tokens are largely domiciled overseas, it's virtually
impossible to know whether they are complying with applicable
U.S. laws. The fair competition American investors have become
accustomed to in domestic regulated markets is largely absent
in cryptocurrency, where the majority of the volume flows
through those overseas exchanges.
Q.3. How does allowing cryptocurrency exchanges to issue their
own tokens affect systemic risk in financial markets?
A.3. Thankfully, the exchanges that issue these tokens are
domiciled overseas. Thus far, they are largely isolated from
our regulated markets. That said, the more cryptocurrency
becomes intertwined with our regulated financial markets, the
more the systemic risk to them grows.
Additional Material Supplied for the Record
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]