Maria T. Vullo (Photo courtesy of the author)
The much-anticipated jury verdict,[1] convicting former FTX CEO Sam Bankman-Fried (SBF) of seven felonies, after less than five hours of deliberations, demonstrates the strength of the prosecution’s case and that juries have no patience for financial fraud. While many reports correctly note that fraud is at the core of the FTX/SBF case, the verdict also sends a clear message that regulatory arbitrage should not be tolerated.
Regulatory arbitrage is a practice where firms exploit regulatory differences in order to circumvent unfavorable regulation and thereby seek to reap higher profits.[2] In the U.S. dual banking system, banks have the choice of a federal or a state charter, which at times has created the risk of arbitrage. Following the 2007-08 financial crisis, Congress acted to eliminate regulatory arbitrage on the federal level, by closing the former Office of Thrift Supervision (OTS), which had the reputation of courting financial firms to its charter on the promise of lax regulation. As a result, all national bank and thrift charters are now consolidated within the Office of the Comptroller of the Currency (OCC), eliminating the charter choice and opportunity for arbitrage.[3] Regulatory arbitrage also has been employed by companies that have crafted banking products in clever ways to evade regulation, including supervision by the Federal Reserve Board of Governors.[4]
The FTX saga is a paradigmatic case of regulatory arbitrage. Through FTX and its affiliate hedge fund, Alameda Research, SBF and his (former) friends[5] siphoned close to $10 billion of customer funds, which they freely moved through affiliated entities[6] and used to make risky investments, large political donations, and to support their lavish lifestyles. While the jury did not believe SBF’s claim that he simply made mistakes while acting in good faith, these activities would not have been possible had FTX been a regulated financial institution subject to regular examination. As FTX’s new CEO, John Ray, told the U.S. Bankruptcy Court, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”[7] This complete absence of controls in a company once valued in excess of $30 billion and led by a 30-year-old fraudster is an example of individuals seeking higher profits by structuring a company’s operations precisely to evade governmental regulation.[8]
The FTX case has been likened to Bernie Madoff’s massive fraud, and while the cases might share some characteristics, it would be a mistake to move on from the SBF verdict by assuming that FTX is simply a case of crimes committed by a lone fraudster in a unique enterprise. Rather, the FTX saga must be considered in the context of numerous other cryptocurrency collapses brought about by individuals who chose to conduct their operations without complying with well-established regulatory rules for financial services firms so they could reap higher profits from such arbitrage. In fact, each of Voyager, Celsius, BlockFi and Three Arrows Capital collapsed after undertaking highly risky financial transactions through structures that abused the lack of a comprehensive regulatory structure for the achievement of outsized profits. Like FTX and Alameda, some of these firms domiciled their principal operations outside of the U.S. to evade regulation and conducted interconnected and highly risky crypto lending transactions. While many crypto firms tout that they are alternatives to banks, these noted firms clearly did not implement internal controls that would satisfy banking “safety and soundness” standards.
Indeed, the FTX-Alameda relationship, and others structured like it, could not exist under U.S. laws applicable to regulated financial institutions. For example, under the Federal Reserve Act, U.S. banks are restricted in their transactions with their affiliates, yet Alameda had a virtually limitless unsecured credit line from FTX, permitting the companies to siphon (and steal) customer funds without any restrictions or controls.[9] Moreover, under the Volcker Rule, most banks and securities firms are prohibited from engaging in proprietary trading or owning a hedge fund or private-equity fund, yet the Alameda hedge fund was affiliated with FTX. [10] And, in no legitimate regulated financial institution could the 30-year-old SBF have become the CEO of a $30 billion empire that had no risk management, accounting department, internal controls, or corporate governance.[11]
To be clear, SBF and his cohorts are fully responsible, and must be held accountable, for their serious criminal misconduct. But the full accounting of the lessons learned from the FTX debacle must include the realization that these criminals could not have risen to power without the help of people who financed and structured FTX precisely to avoid regulation in the search for outsized profit. Indeed, regulatory arbitrage created the foundation on which SBF and his cohorts could run wild with billions of dollars of customer funds, without rules or regulatory oversight. While the criminals are responsible for their misconduct, large investors had the power to withhold their funds from a business based first in Hong Kong and then in the Bahamas that flourished for some, but then collapsed of its own making causing billions in customer losses, due to the absence of regulatory controls. Can you imagine a bank CEO tweeting, “f&@k regulators”?[12]
The FTX situation will repeat itself if it is cabined as sui generis.[13] Time is of the essence for Congress to act to impose a comprehensive regulatory structure for all cryptocurrency firms that includes strong supervisory oversight and uniform rules that prevent conflicts of interest, misuse of customer funds, and unchecked affiliate and high-risk financial transactions. In the meantime, state regulators, the SEC and the CFTC will continue in their efforts to address this industry within their existing powers, even while the nuances of cryptocurrency create opportunities for regulatory arbitrage. Only a comprehensive regulatory regime for all cryptocurrency firms and products will mitigate the risk of repeating the FTX saga.
Footnotes
[1] https://www.cnn.com/2023/11/02/business/ftx-sbf-fraud-trial-verdict/index.html
[2] E.g., AML/CFT Library, https://aml-cft.net/library/regulatory-arbitrage/.
[3] Cyran, Robert, “The Downfall of a Regulator,” The New York Times, April 9, 2009, https://www.nytimes.com/2009/04/09/business/09views.html
[4] In Federal Reserve System v. Dimension Financial Corp., 474 U.S. 361 (1986), a financial institution created customer accounts that were not “demand” deposits as defined under the Bank Holding Company Act (BHCA), in order to evade Federal Reserve supervision. Following the Supreme Court’s decision strictly interpreting the BHCA in favor of the financial institution, Congress amended the BHCA to prevent this result.
[5] SBF’s former girlfriend, Caroline Ellison, was the CEO of Alameda Research, and she and two other senior members of management, Gary Wang and Nishad Singh, pleaded guilty to felonies and testified against SBF.
[6] One of the seven charges on which SBF was convicted is money laundering.
[7] Brasseur, Kyle, “No Time Managing Risk? No Wonder FTX Collapsed,” Compliance Week, December 6, 2022, https://www.complianceweek.com/opinion/no-ti”me-managing-risk-no-wonder-ftx-collapsed/32414.article.
[8] Wasserman, Noah, “FTX and the Problem of Unchecked Founder Power,” Harvard Business Review, December 1, 2022, https://hbr.org/2022/12/ftx-and-the-problem-of-unchecked-founder-power.
[9] See 12 U.S.C. 371c and Federal Reserve Board of Governors Regulation W.
[10] Section 619 of the Dodd-Frank Act; see Board of Governors of the Federal Reserve System, “The Volcker Rule,” https://www.federalreserve.gov/supervisionreg/volcker-rule.htm.
[11] See footnotes 8 and 9, supra.
[12] Crooks, Nathan, “Sam Bankman-Fried says ‘f*&k regulators’ in wide-ranging interview with Vox, The Block, November 16, 2022, https://www.theblock.co/post/187767/sam-bankman-fried-says-fck-regulators-in-wide-ranging-interview-with-vox.
[13] Sui generis is a Latin phrase that means “of its own kind”, see https://www.dictionary.com/browse/sui-generis.
Maria T. Vullo is the former Superintendent of Financial Services for the State of New York and presently serves as a Senior Fellow for PCCE. In addition, Ms. Vullo is the CEO of Vullo Advisory Services, PLLC, Regulator-in-Residence at the Fintech Lab NYC, and an Adjunct Professor of Law at Fordham Law School.
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