Crypto Crash: Why the FTX Bubble Burst and the Harm to Consumers (U.S. Senate Committee on Banking, Housing, and Urban Affairs)

Hearing	Crypto Crash: Why the FTX Bubble Burst and the Harm to Consumers
Committee	U.S. Senate Committee on Banking, Housing, and Urban Affairs
Date	December 14, 2022

 

Hearing Takeaways:

• The Recent Collapse of FTX and Alameda Research: The hearing largely focused on exploring the recent failures of cryptocurrency exchange FTX and its affiliated trading firm Alameda Research. FTX had allegedly lent customer assets to Alameda Research and had made fraudulent promises to investors and customers about its operations. A key point of debate during the hearing was the extent to which this episode constitutes a one-off instance of fraud or was emblematic of digital assets more generally.
  • Mr. O’Leary’s Theory Regarding FTX’s Failure: Mr. O’Leary (who was in investor in FTX) largely attributed FTX’s recent collapse to its relationship with rival cryptocurrency exchange Binance. He noted how Binance had bought shares in FTX and how FTX had sought to repurchase these shares from Binance so that it could obtain regulatory approvals from various jurisdictions. He indicated that these repurchases had stripped FTX’s balance sheet of assets. He also highlighted how Binance CEO Changpeng Zhao had publicly sought to convert a large sum of FTX’s FTT tokens into fiat currency immediately prior to FTX’s collapse. He asserted that this trade was meant to push down the value of the FTT tokens to drive FTX out of business.
  • Insufficient Due Diligence from Investors: Full Committee Chairman Sherrod Brown (D-OH), Prof. Allen, and Mr. McKenzie Schenkkan criticized venture capital firms and other large investors for their failure to identify FTX’s problems during the due diligence process. 
• Cryptocurrency Oversight and Regulation: Committee Members and the hearing’s witnesses expressed interest in how the U.S. ought to oversee and regulate the cryptocurrency sector moving forward. Committee Republicans, Mr. O’Leary, and Ms. Schulp argued that the U.S. needed to develop a regulatory framework for cryptocurrencies to prevent future FTX-like episodes. They also noted how other countries already had developed robust regulatory frameworks for digital assets and expressed concerns that the absence of a U.S. regulatory framework would undermine the U.S.’s global economic competitiveness. Prof. Allen contended however that the cryptocurrency industry was seeking regulation to provide legitimacy to cryptocurrencies. She called this concerning as such legitimacy would increase the likelihood of problems within the cryptocurrency space migrating to the traditional banking system. She further stated that calls from cryptocurrency firms for regulatory clarity were really calls for bespoke regulations that would be easier to comply with. Sen. Mark Warner (D-VA) expressed concerns that the adoption of cryptocurrency rules could drive certain activity to the unregulated market and stated that policymakers ought to be cognizant of this dynamic.
  • Centralization of Cryptocurrency and Decentralized Finance (DeFi) Platforms: Committee Democrats, Prof. Allen, Ms. Schulp, and Mr. McKenzie Schenkkan expressed concerns that many cryptocurrency and DeFi platforms were not actually economically decentralized. They noted how small numbers of parties often controlled a disproportionate amount of the governance tokens and mining activities on these platforms. Full Committee Chairman Sherrod Brown (D-OH) noted how FTX had performed multiple roles and commented that FTX was not unique among cryptocurrency firms in this respect. He noted how FTX had acted as an exchange, a broker, and a provider of margin. He asserted that the combination of these various roles had undermined the checks and balances that exist to protect consumers and the financial system. There was broad support amongst the hearing’s witnesses for the adoption of strong conflicts of interest rules for cryptocurrency paltforms and related party transactions.
  • Cryptocurrency Advertising: Committee Democrats expressed concerns over how cryptocurrency companies (including FTX) had engaged in expensive advertising campaigns aimed at retail investors. Mr. McKenzie Schenkkan suggested that the U.S. restrict cryptocurrency advertising in the same way that it restricts gambling advertising.
  • Stablecoins: A key area of interest during the hearing was the development of a regulatory framework for stablecoins, which are cryptocurrencies whose value is tied to a reference asset. Full Committee Ranking Member Patrick Toomey (R-PA) mentioned how he had proposed requiring stablecoins to be fully backed by cash and cash equivalents. He also highlighted how this framework would have the U.S. Office of the Comptroller of the Currency (OCC) to oversee stablecoins. Ms. Schulp stated that federal monetary regulators should not be involved in regulating stablecoins. She commented that having the U.S. Federal Reserve regulate stablecoins could lead to conflicts of interest for the central bank. 
  • Veracity of Claims within the Cryptocurrency Space: Committee Democrats and Prof. Allen expressed concern over the veracity of the claims of many cryptocurrency companies. They noted how these claims were mere attestations and were often not reviewed by independent auditors. Of note, Sen. Jack Reed (D-RI) mentioned how he had introduced the Private Markets Transparency and Accountability Act. He explained that this bill would require the U.S.’s largest private companies to disclose basic information about their financial conditions and to comply with basic corporate governance requirements. He noted how this legislation would apply to many of the large cryptocurrency companies.
  • Integration of Cryptocurrencies into the Traditional Banking System: Committee Democrats, Prof. Allen, and Mr. McKenzie Schenkkan expressed concerns that cryptocurrency products could become further integrated into the traditional banking system. They argued that this integration could pose financial contagion risks. Sen. Tina Smith (D-MN) and Prof. Allen expressed specific concerns over Fidelity Investments recent actions to offer cryptocurrencies in their retirement plans. Mr. O’Leary and Ms. Schulp remarked however that this isolation of cryptocurrencies from the traditional banking sector would undermine the U.S.’s global economic competitiveness. They asserted that cryptocurrency risks could be largely addressed through more regulatory clarity.
  • Regulation of Cryptocurrencies as Securities: Prof. Allen and Mr. McKenzie Schenkkan argued that the U.S. should subject all crypto assets to securities regulation from the U.S. Securities and Exchange Commission (SEC). They stated that the proposals for a self-certification regime for crypto assets from the U.S. Commodity Futures Trading Commission (CFTC) would allow for the unlimited supply of crypto assets to continue to proliferate. Full Committee Ranking Member Toomey and Ms. Schulp stated however that many cryptocurrencies (such as Bitcoin) did not meet the requirements of the test established under the U.S. Supreme Court’s SEC v. W. J. Howey Co. decision (commonly known as the Howey test) for defining a security. They stated that the U.S.’s regulatory approach towards digital assets should not treat all of these assets as securities and should instead account for the specific characteristics of each asset.
• Additional Cryptocurrency Concerns: Committee Members and the hearing’s witnesses further used the hearing to discuss additional concerns related to the cryptocurrency space.
  • Use of Cryptocurrencies in Illicit Activity: Committee Democrats, Prof. Allen, and Mr. McKenzie Schenkkan expressed concerns over how rogue estates, cybercriminals, and terrorists made use of cryptocurrencies to facilitate illicit activities. These activities include ransomware attacks, money laundering, sanctions evasion, drug trafficking, and human trafficking. They also raised concerns that cryptocurrency companies were not complying with anti-money laundering (AML) and know your customer (KYC) requirements, which traditional financial institutions complied with to protect against illicit activity. Prof. Allen dismissed the argument that the public nature of blockchains rendered these requirements unnecessary and noted how bad actors could use mixing and tumbler services to conceal their identities on blockchains.
  • Susceptibility of Cryptocurrencies to Fraud and Financial Bubbles: Committee Democrats, Prof. Allen, and Mr. McKenzie Schenkkan argued that cryptocurrencies were uniquely susceptible to fraud because cryptocurrencies could be created out of nothing. Prof. Allen explained that this aspect of cryptocurrencies generated leverage, which made the whole cryptocurrency system more susceptible to booms and busts. She noted how FTX had employed this strategy when it had used its FTT tokens as collateral for the FTX customer assets loaned to Alameda Research. 
  • Concerns Regarding Binance: Sen. Bill Hagerty (R-TN) and Sen. Mark Warner (D-VA) expressed concerns over how Binance (which was now the world’s largest cryptocurrency exchange following FTX’s collapse) had reported involvement with the Chinese Communist Party (CCP). Sen. Hagerty further expressed concerns over how U.S. regulators were limited in their ability to mandate audits and disclosures from Biannce. He warned that the U.S. was currently ill-prepared to respond to any potential problems from Binance.
  • High Energy Consumption of Cryptocurrency Mining Operations: Committee Democrats and Mr. McKenize Schenkkan raised concerns over the energy intensive nature of the cryptocurrency mining and verification process. They stated that this energy intensive nature was leading to more greenhouse gas emissions, noise pollution, air pollution, water pollution, and higher energy costs.
  • Potential Value of Cryptocurrencies and Blockchain Technology: One major area of disagreement during the hearing was the potential value of cryptocurrencies and blockchain technology. Full Committee Ranking Member Patrick Toomey (R-PA), Mr. O’Leary, and Ms. Schulp argued that cryptocurrencies and blockchain technology could provide faster, safer, and more efficient payments and protections against inflation. Ranking Member Toomey also expressed optimism that cryptocurrencies could enable smart contracts, which involve automatic payments based on exogenous and verifiable events. Sen. Warner and Prof. Allen argued however that the purposed benefits of blockchain technology had not yet materialized, despite extensive research and development from industry stakeholders. Prof. Allen also stated that blockchain technology could not fix the underlying political and structural problems that limit access to financial services.

Hearing Witnesses:

1. Prof. Hilary J. Allen, American University Washington College of Law
2. Mr. Kevin O’Leary, Investor
3. Ms. Jennifer J. Schulp, Director of Financial Regulation Studies, Center for Monetary and Financial Alternatives, Cato Institute
4. Mr. Ben McKenzie Schenkkan, Actor and Author

Member Opening Statements:

Full Committee Chairman Sherrod Brown (D-OH):

• He first applauded the U.S. Department of Justice (DoJ), the SEC, the CFTC, and Bahamian authorities for their recent efforts to bring former FTX CEO Sam Bankman-Fried to justice.
  • He stated that the Committee must learn more about the collapses of FTX and other cryptocurrency firms and prioritize the interest of consumers as part of this work.
• He recounted how he had previously raised concerns over Facebook’s efforts to launch a digital currency and asserted that this digital currency would have posed significant risks to Americans and the U.S. economy.
  • He stated that policymaker scrutiny had influenced Facebook’s decision to not pursue a digital currency.
• He noted however that the stablecoin market had grown nearly 20 times in size since Facebook had ended their digital currency project and commented that stablecoins had become a tool for “rampant speculation.”
  • He commented that the number of stablecoin tokens had “exploded,” even as the total value of all crypto assets had fallen by two-thirds over the previous year.
• He compared cryptocurrencies to the risky mortgage bonds and over-the-counter (OTC) derivatives that had caused the 2008 Financial Crisis and commented that all of these products provide consumers with a promise of easy money.
• He also discussed how cryptocurrency companies had engaged in expensive advertising campaigns that sought to capitalize on consumer fears of missing out and had created investment products that sought to resemble bank deposits and securities.
  • He commented that the cryptocurrency companies that created these investment products had argued that they should be exempt from basic regulatory oversight.
• He contended that cryptocurrencies that resembled securities, commodities, and banking products should be regulated and supervised.
• He also accused cryptocurrencies of ushering in a new dimension of fraud and threats to national security.
  • He mentioned how North Korea had used cryptocurrencies stolen through hacks to finance its ballistic missile program.
  • He also mentioned how human traffickers, drug cartels, and gun runners were laundering their illicit proceeds using cryptocurrencies.
• He remarked that the ability of rogue states, cybercriminals, and terrorists to use cryptocurrencies for their own malign purposes was an intentional feature of the technology.
• He also stated that cryptocurrencies had made it easier for bad actors to steal money from consumers and commented that the recent FTX episode had provided an example of this theft.
  • He asserted that these thefts would continue so long as cryptocurrency firms were able to write their own rules.
• He discussed how former FTX CEO Sam Bankman-Fried had shuffled money between his cryptocurrency exchange FTX and his trading firm Alameda Research and asserted that the two entities had taken advantage of the cryptocurrency industry’s appetite for speculation.
  • He elaborated that the two entities were able to borrow and lend using other cryptocurrency platforms and invest in other cryptocurrency firms, which inflated cryptocurrency prices.
• He criticized venture capital firms and other large investors for their failure to identify FTX’s problems.
• He also noted how Alameda Research had solicited investors in 2018 through guaranteeing investors 15 percent returns with no downside.
  • He commented that many investors did not question these promised returns because they were afraid of missing out on the opportunity to invest in the hedge fund.
• He remarked that the hearing’s focus was not limited to FTX’s misconduct and would consider ways to protect consumers from unregulated crypto projects.
• He stated that the U.S. would need to address the risks from cryptocurrency platforms that combine multiple functions and consider new types of disclosures for cryptocurrency platforms to make to consumers and investors.
  • He suggested that the U.S. base its cryptocurrency policies upon existing banking and securities laws.
• He expressed his interest in working with U.S. Secretary of the Treasury Janet Yellen and other financial regulators to develop an “all of government” approach to the issue of cryptocurrency oversight.

Full Committee Ranking Member Patrick Toomey (R-PA):

• He remarked that the Committee must investigate FTX’s collapse and asserted that the U.S. must prosecute any violations of the law.
  • He called on the DoJ and other law enforcement agencies to investigate the “unseemly” relationship between Alameda Research and FTX.
• He noted that while some of the facts surrounding FTX’s collapse remained unknown, he stated that FTX had engaged in the unauthorized lending of customer assets to an affiliated entity and had made fraudulent promises to investors and customers about its operations.
  • He further mentioned how the SEC believed that FTX had committed fraud against equity investors.
• He remarked however that FTX’s wrongful behaviors were not specific to digital assets and expressed his hope that the Committee could separate FTX’s illegal actions from perfectly lawful and innovative cryptocurrencies.
  • He stated that these cryptocurrencies were neither intrinsically good nor evil and commented that cryptocurrencies were merely expressions of their users.
• He asserted that FTX and cryptocurrencies were fundamentally different and noted how FTX was opaque, centralized, and dishonest.
  • He commented that cryptocurrencies by contrast tended to be open source, decentralized, and transparent.
• He stated that FTX’s collapse should not be used as a justification for banning cryptocurrencies and attributed FTX’s collapse to the platform’s misuse of customer funds, gross mismanagement, and illegal behavior.
• He noted how some legislators had proposed that Congress impose a pause on cryptocurrencies until it could enact legislation to govern these assets.
• He called this proposal misguided and impossible and stated that such a pause would merely cause cryptocurrency activity to move offshore.
  • He further noted how the computer code underlying cryptocurrencies constituted a form of speech and commented that any such pause would therefore be unconstitutional.
• He remarked that Congress should have passed legislation to develop a well-defined regulatory regime for digital assets and stated that such a regulatory regime would have likely led to a competitive environment with multiple cryptocurrency exchanges with consumer protections.
  • He contended that this approach would have likely prevented FTX from becoming such a dominant exchange.
• He asserted that the “complete indifference” to an appropriate regulatory regime from both Congress and the SEC had likely contributed to the rise of operations like FTX.
• He also noted how some people had called on the U.S. to refrain from addressing cryptocurrencies so as to not legitimize their use.
  • He called this approach misguided and irresponsible.
• He stated that Congress should propose a framework for the domestic regulation of cryptocurrency activities and suggested that Congress first address stablecoins.
  • He commented that stablecoins were similar to traditional financial products and noted how there existed bipartisan agreement that stablecoins need consumer protections.
• He mentioned how he had proposed a framework for regulating stablecoins.
  • He also mentioned how Sen. Kirsten Gillibrand (D-NY) and Sen. Cynthia Lummis (R-WY) had proposed their own framework for regulating stablecoins.
• He further stated that Congress needed to determine the regulatory criteria and disclosure requirements for digital asset issuances.
  • He commented that Congress should acknowledge that there were certain token issuances (such as Bitcoin) that do not require further regulation.
• He also asserted that Congress should delineate regulations for the secondary market trading of digital assets, including at exchanges like FTX US.
• He remarked that Congress could provide “sensible” consumer protections while still allowing for the development of applications that would be run on currently unimaginable operating systems.
• He called it essential for the U.S. to investigate any fraud and violations of existing law and for the U.S. to prosecute the perpetrators of these crimes.
  • He stated that the hearing should focus on how FTX had misused the assets on their platforms and not on the digital assets themselves.
• He remarked that cryptocurrencies could empower individuals through providing protections against inflation, useful services, and the ability to engage in private transactions.

Witness Opening Statements:

Prof. Hilary J. Allen (American University Washington College of Law):

• She remarked that FTX’s failure was symptomatic of many broader problems within the cryptocurrency industry.
  • She commented that FTX’s failure was part of a broader trend of centralized cryptocurrency intermediary failures (including Celsius) and DeFi offering failures (including Terra Luna).
• She stated that the cryptocurrency industry was uniquely susceptible to failures because crypto assets could be created out of nothing.
  • She commented that this aspect of cryptocurrencies generated leverage, which made the whole cryptocurrency system more susceptible to booms and busts.
• She remarked that the ability to create crypto assets out of nothing could enable bad actors to obscure financial realities and highlighted how FTX had used their FTT tokens as collateral for the FTX customer assets loaned to Alameda Research.
• She asserted that the current attestations and proofs of reserves from the cryptocurrency industry were poor substitutes for rigorous and independent audits.
  • She commented that this type of environment was “highly conducive” to fraud.
• She stated that FTX’s embezzlement of consumer funds was able to achieve a significant scale and evade detection because it involved cryptocurrencies that were “shrouded in opacity, complexity, and mystique.”
• She also contended that decentralization would not protect against future cryptocurrency-related frauds and commented that DeFi was not economically decentralized.
  • She noted how a single party could own a large number of governance tokens within a DeFi system and how this party could cause the DeFi system to perpetuate “shady” behavior.
• She then remarked that there existed multiple approaches for regulating cryptocurrencies and called on policymakers to be more specific when discussing cryptocurrency regulation.
• She stated that a ban on cryptocurrencies would constitute the most straightforward means of protecting investors and the financial system.
  • She commented that the fact that cryptocurrencies were not actually decentralized meant that it was possible for policymakers to enforce such a ban.
• She remarked that policymakers would also need to be careful to ensure that any cryptocurrency-related laws would not inadvertently make cryptocurrencies “too big to fail.”
  • She contended that cryptocurrencies should not be regulated like banking products because such a regulatory approach would provide crypto products with access to government support.
• She stated that U.S. banking regulations should continue to keep actual banks away from cryptocurrencies.
  • She commented that the harms associated with FTX’s collapse had been limited to cryptocurrency investors and asserted that integration between the traditional financial system and the cryptocurrency ecosystem could result in widespread financial contagion.
• She indicated that an investor protection regulatory approach to cryptocurrencies (as compared to banking regulation) would not provide cryptocurrency holders with deposit insurance or access to a lender of last resort.
  • She commented that this approach would signal to investors that cryptocurrencies carried risks and could lose value.
• She contended that robust enforcement of U.S. securities laws could help to protect U.S. cryptocurrency investors without conveying the message that cryptocurrencies were “too big to fail.”
• She noted that while the SEC had been very clear in asserting that most crypto assets were securities, she stated that FTX and the cryptocurrency industry had sought to change the law so that the CFTC would oversee the industry.
• She asserted that the SEC (rather than the CFTC) should oversee the cryptocurrency industry and stated that the proposed CFTC self-certification regime for crypto assets would allow for the unlimited supply of crypto assets to continue to proliferate.
  • She asserted however that “energetic” enforcement of the SEC’s existing securities registration requirements would make it more difficult to create crypto assets out of nothing.
• She suggested that Congress consider adopting legislation that would categorically assert that all crypto assets were securities to provide more clarity and certainty to the cryptocurrency industry.
• She then remarked that the U.S. had “little to lose” from limiting the growth of the cryptocurrency industry and asserted the industry’s underlying blockchain technology could never deliver upon the industry’s promises.
  • She commented that blockchain technology itself was of low quality and merely a tool.
• She also stated that blockchain technology could not fix the underlying political and structural problems that limit access to financial services.
• She further raised concerns that cryptocurrencies created problems for people that choose not to invest in the assets.
  • She noted that these problems included the facilitation of ransomware attacks, sanctions evasion, tax evasion, environmental issues, and financial contagion risk.

Mr. Kevin O’Leary (Investor):

• He mentioned how he had previously been a public critic and skeptic of cryptocurrencies and blockchain technology and discussed how the subsequent onset of regulation for these fields had led him to invest in them.
  • He testified that he was currently a shareholder in multiple crypto technology companies, including WonderFi/BitBuy, Immutable Holdings, and Circle.
• He predicted that cryptocurrencies, blockchain technology, and digital payment systems will be the 12th sector of the S&P 500 within a decade.
  • He asserted that many of these technologies will disrupt the existing financial services sector with faster, more efficient, more productive, and more secure ways of investing, paying, transferring, and tracking assets.
• He discussed how cryptocurrencies and blockchains were fundamentally software and stated that this software would drive significant enterprise efficiencies.
  • He called the potential of cryptocurrency technologies “astronomical in scale.”
• He mentioned how he had entered into an agreement with FTX in August 2021 to be a paid spokesperson and testified that he had been paid approximately $15 million for these services and an additional $3 million to cover tax obligations.
• He also testified that he had invested $1 million invested in FTX equity and approximately $10 million in tokens held in FTX wallets.
  • He commented that this equity was now most likely worthless and noted that the accounts have been stripped of their assets and financial records.
  • He indicated that he had written these holdings off to zero.
• He testified that his investments in FTX did not involve capital from his investment fund’s partners or limited partners (LPs).
  • He indicated that the capital that he lost from his investment in FTX was from an operating company that he owned in full.
• He stated that he was using his own capital to pursue record recovery of the FTX accounts so that he could conduct a forensic audit.
  • He mentioned how he had applied for membership on the FTX creditor’s committee in connection with FTX’s bankruptcy proceedings.
• He stated that while FTX’s collapse was painful for the company’s shareholders, employees, and account holders, he contended that this episode did not impact the broader promise of the cryptocurrency industry.
  • He commented that the recent collapses of cryptocurrency companies were leading weak and incompetent companies to be replaced with better companies.
• He expressed hope that the cryptocurrency industry’s recent issues would put a renewed focus on implementing domestic regulations within this space.
  • He noted how other jurisdictions had already implemented such regulations and were now attracting investment capital and highly skilled talent.
• He contended that the disruptions associated with cryptocurrencies were necessary for supporting economic advancement and raised concerns that U.S. inaction in this space could put the U.S. at an international economic disadvantage.
• He called on Congress to pass bipartisan legislation to establish a “sensible” regulatory framework for digital stablecoins backed by U.S. dollars.
  • He commented that well-regulated U.S. dollar-backed stablecoins could eventually become the dominant form of global payments over time.
• He concluded that the recent collapse of FTX could not lead the U.S. to abandon the promise and potential of cryptocurrencies.

Ms. Jennifer J. Schulp (Cato Institute):

• She first asserted that it remained premature to definitively diagnose the causes of FTX’s collapse and stated that claims of fraud and contractual breaches should be “vigorously” pursued.
  • She commented that courts should determine which crimes and violations had taken place.
• She remarked that FTX’s problems did not appear to be intrinsically tied to cryptocurrencies or other blockchain technologies.
  • She noted how FTX’s current bankruptcy CEO had attributed FTX’s collapse to its lack of corporate controls and lack of trustworthy financial information.
• She stated that policymakers should recognize that there exist important distinctions between centralized entities and decentralized projects.
  • She asserted that policies designed to address risks posed by centralized financial intermediaries should not be blindly applied to decentralized projects.
• She described FTX as a traditional intermediary and highlighted how FTX had taken possession of people’s assets and had provided recordkeeping services to its customers.
  • She acknowledged however that FTX’s recordkeeping services were very poor.
• She discussed how DeFi worked to mitigate intermediary risks through the use of technology and noted how DeFi exchanges employed open-source software to provide exchange services.
  • She indicated that these exchanges will often publicly record transaction data and permit users to self-custody assets.
• She stated that DeFi exchanges did not solve all problems or eliminate all risks and commented that these exchanges sought to provide tailored solutions to specific risks.
• She then remarked that unclear regulation remained a problem within the cryptocurrency space that could drive innovation offshore.
  • She commented that a rational regulatory framework should distinguish between projects that reproduce the risks of traditional finance and those that mitigate those risks through disintermediation.
• She stated that Congress should enable centralized marketplaces to register with the CFTC for crypto commodities and with the SEC for crypto securities.
• She also stated that decentralized exchanges should be allowed to voluntarily register with government entities.
  • She commented that this approach would recognize the capacity of these exchanges to address intermediary risks through technology.
• She further remarked that policymakers must clearly define when crypto projects trigger securities regulations to determine which federal regulator will oversee trading and identify appropriate customer regulations.
• She asserted that federal securities law was 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.
  • She contended however that Congress should clarify that securities laws do not apply when no individual or entity acts as the manager of the crypto project.
  • She further recommended that Congress provide a disclosure option for decentralizing project that would cover information relevant to crypto purchasers.
• She then discussed how there had been recent calls for the U.S. to ban cryptocurrencies or to not regulate cryptocurrencies to delegitimize these assets.
  • She commented that these approaches would prevent consumers, investors, and entrepreneurs from engaging in technological innovation.
• She contended that the U.S. should not limit access to cryptocurrencies simply because the technology had failed to achieve all of its goals.
• She further stated that the fact that cryptocurrencies contained risks was not a sufficient reason for banning cryptocurrencies.
  • She asserted that risk was a natural component of markets and that failure was often necessary for market development.

Mr. Ben McKenzie Schenkkan (Actor and Author):

• He noted how FTX and Alameda Research had been valued at $32 billion at the start of 2022 and now had a value of -$8 billion.
  • He commented that the demise of these two companies represented the most “spectacular” corporate downfall since Bernie Madoff’s Ponzi scheme had imploded following the 2008 Financial Crisis.
• He stated that FTX and Alameda Research now owe “enormous” sums of money to “supposedly sophisticated” investors, as well as to regular people.
• He noted how FTX had reported that 1.2 million U.S. retail traders and 5 million people worldwide had lost access to funds held on the FTX platform.
  • He commented that it was unclear as to when (if ever) these people would regain access to these funds.
• He remarked that the cryptocurrency industry had lied to investors and asserted that the industry’s existence relied upon misinformation, hype, and fraud.
• He stated that cryptocurrencies did not constitute currencies and noted how money was supposed to serve three functions: medium of exchange, unit of account, and store of value.
  • He commented that cryptocurrencies could not perform any of these functions well and contended that cryptocurrencies would never be able to perform these functions.
• He discussed how millions of Americans had purchased various types of cryptocurrencies from cryptocurrency exchanges and stated that most of these Americans viewed these purchases as investments.
• He contended that the four prongs of the test established under the U.S. Supreme Court’s SEC v. W. J. Howey Co. decision (commonly known as the Howey test) were “easily” satisfied by every cryptocurrency transaction.
  • He stated however that cryptocurrencies constituted “bizarre” securities in that they offered no products, services, revenue streams, or value.
• He asserted that cryptocurrencies were a vehicle for speculation at best and an instrument for crime at worst.
• He remarked that his assessment of the cryptocurrency space had led him to conclude that the cryptocurrency industry was a “massive speculative bubble” that was bound to collapse.
  • He commented that this “bubble” was built upon a foundation of fraud and called the cryptocurrency industry the largest Ponzi scheme in history.

Congressional Question Period:

Full Committee Chairman Sherrod Brown (D-OH):

• Chairman Brown asked the witnesses to indicate whether the carelessness and misconduct that were present at FTX were also present at other cryptocurrency firms.
  • Prof. Allen answered affirmatively.
  • Mr. O’Leary stated that carelessness and misconduct were present at unregulated cryptocurrency firms.
  • Ms. Schulp stated that carelessness and misconduct were “most likely” present at other cryptocurrency firms.
  • Mr. McKenzie Schenkkan stated that carelessness and misconduct were “endemic” within the cryptocurrency space.
• Chairman Brown then discussed how cryptocurrency trading often involved the recycling of one type of token into another type of token. He added that these tokens were often borrowed. He stated that these dynamics led the value of cryptocurrencies to be detached from the value of the originally invested currencies. He asked Prof. Allen to indicate whether it was possible to determine the amount of leverage present within the cryptocurrency market. He also asked Prof. Allen to address why an inability to determine the amount of leverage present within the cryptocurrency market would be problematic.
  • Prof. Allen remarked that it was not possible to determine the amount of leverage present within the cryptocurrency market. She noted that while many cryptocurrency advocates touted the transparent natures of blockchains, she stated many cryptocurrencies often occurred off of blockchains. She commented that blockchain transaction data was therefore missing, which prevented researchers from determining the full extent of the cryptocurrency borrowing that was occurring. She further stated that unclear accounting around the underlying cryptocurrency assets could obscure the value of said assets. She remarked that the inability to determine the amount of leverage within the cryptocurrency market was problematic because it undermined the ability of observers to assess the fragility of the market.
• Chairman Brown then asked Mr. McKenzie Schenkkan to describe the parallels between cryptocurrencies and gambling.
  • Mr. McKenzie Schenkkan remarked that both cryptocurrencies and gambling were zero-sum games. He noted however that the distribution of winners and losers did not necessarily have to be even in both gambling and cryptocurrencies. He indicated that most cryptocurrency investors have lost money according to the cryptocurrency industry’s own research. He also noted that the recent problems within the cryptocurrency space had locked many cryptocurrency investors out of their cryptocurrency accounts. He further stated that cryptocurrencies harmed the environment, which made them worse than gambling. He then discussed how many prominent cryptocurrency industry figures had previously worked in the online poker industry and highlighted how the online poker industry had been rife with fraud.
• Chairman Brown lastly discussed how FTX had performed multiple roles and commented that FTX was not unique among cryptocurrency firms in this respect. He noted how FTX had acted as an exchange, a broker, and a provider of margin. He asserted that the combination of these various roles had undermined the checks and balances that exist to protect consumers and the financial system. He asked the witnesses to indicate whether there should exist strong rules addressing related party transactions and creating “firewalls” between related entities.
  • Prof. Allen expressed support for the adoption of such rules as a means of addressing conflicts of interest.
  • Mr. O’Leary expressed disagreement with the contention that cryptocurrency investing was no different from gambling. He mentioned how the New York Stock Exchange had at one point been compared to gambling. He stated that regulation was key to ensuring the safety of cryptocurrencies and asserted that the U.S.’s failure to regulate these assets would lead to future cryptocurrency problems. He commented that there should exist strong rules for cryptocurrency firms that address related party transactions and create “firewalls” between related entities.
  • Ms. Schulp remarked that policymakers needed to examine and address conflicts of interest present within the cryptocurrency space. She stated however that these conflicts of interest could be addressed through a variety of means, including through strong rules that ban certain types of transactions or through disclosure requirements.
  • Mr. McKenzie Schenkkan stated that there should exist strong rules addressing related party transactions and creating “firewalls” between related entities.

Full Committee Ranking Member Patrick Toomey (R-PA):

• Ranking Member Toomey mentioned how Mr. McKenzie Schenkkan had asserted that every cryptocurrency met the definition of a security under the Howey Test. He explained that the Howey test defined a security as involving an investment of money in a common enterprise with the expectation of profits derived through the efforts of others. He noted however that there was no corporation or party that controls or issues Bitcoin and commented that Bitcoin appeared to be fully decentralized. He asked Ms. Schulp to address whether Bitcoin had a common enterprise given how there was no central authority that controls and operates Bitcoin.
  • Ms. Schulp remarked that Bitcoin did not satisfy the Howey test’s elements for being a security.
• Ranking Member Toomey asked Ms. Schulp to indicate whether it would be difficult to establish the existence of a common enterprise for a truly decentralized protocol.
  • Ms. Schulp remarked that it would be difficult to establish the existence of a common enterprise for a truly decentralized protocol. She stated that U.S. securities laws had been developed to address instances of information asymmetry coming from managerial bodies.
• Ranking Member Toomey stated that there was an argument for creating disclosure requirements for cryptocurrency issuers and a regulatory regime for secondary cryptocurrency market trading. He remarked however that any cryptocurrency regulations ought to account for the specific dynamics of the cryptocurrency sector. He cautioned that the U.S. should not “shoehorn” novel digital assets into laws designed for different types of products. He then discussed how tokens often served as the tool or mechanism for incentivizing people to validate and maintain distributed ledgers. He acknowledged that parties could engage in gambling and speculation with such tokens. He asked Mr. O’Leary to address the assertion that tokens could only be used for the purposes of gambling.
  • Mr. O’Leary expressed his disagreement with the assertion that cryptocurrency tokens could only be used for the purposes of gambling. He remarked that the potential for blockchain technology to authenticate physical assets, contracts, and tokens was “incredibly powerful.” He predicted that blockchain analysis would play a key role in recovering the funds lost during the collapses of FTX and Alameda Research. He asserted that the U.S. should work to become the global leader in blockchain technology and noted that one third of Massachusetts Institute of Technology (MIT) graduates were interested in pursuing blockchain technology jobs.
• Ranking Member Toomey then asked Mr. O’Leary to explain why FTX had failed.
  • Mr. O’Leary testified that all of his FTX accounts had been stripped of all of their assets and accounting and trade information. He recounted how he had called former FTX CEO Sam Bankman-Fried directly to find out about the whereabouts of his assets and account information. He noted how Mr. Bankman-Fried had indicated that he had lost access to FTX’s servers and could therefore not provide information about the whereabouts of the assets and information. He then noted how he had asked Mr. Bankman-Fried to indicate where the money had gone. He testified that Mr. Bankman-Fried had told him that FTX had used its proceeds to repurchase Binance’s shares in FTX. He indicated that Mr. Bankman-Fried’s estimate regarding the amount of this transaction had varied across their conversations. He noted that Mr. Bankman-Fried had justified this repurchase of shares from Binance as a way to improve FTX’s chances of obtaining regulatory approval from various jurisdictions. He explained that Mr. Bankman-Fried had stated that Binance had withheld relevant data that FTX needed to obtain regulatory approvals. He remarked that FTX’s repurchases of shares from Binance had stripped their own balance sheet of assets. He then recounted how Binance CEO Changpeng Zhao had publicly sought to convert a large sum of FTX’s FTT tokens to fiat currency immediately prior to FTX’s collapse. He asserted that this trade was meant to push down the value of the FTT tokens to intentionally drive FTX out of business. He remarked that Binance was now a massive unregulated global monopoly. He suggested that FTX shareholders should be permitted to claw back the proceeds from FTX and Binance’s related party transaction.
• Note: Ranking Member Toomey’s question period time expired here.

Sen. Jack Reed (D-RI):

• Sen. Reed noted how current FTX CEO John Ray had stated that FTX had lacked auditing, reliable financial statements, and internal controls. He asked Prof. Allen to indicate whether FTX was a publicly traded company.
  • Prof. Allen answered no.
• Sen. Reed asked Prof. Allen to indicate whether FTX was legally required to disclose basic information to the public regarding its business (such as audited financial statements).
  • Prof. Allen answered no.
• Sen. Reed asked Prof. Allen to indicate whether FTX had been required to disclose transactions with related parties (such as transactions involving Alameda Research).
  • Prof. Allen answered no.
• Sen. Reed asked Prof. Allen to indicate whether FTX had been required to have a chief financial officer (CFO) or disclose whether a financial expert was on the company’s board of directors.
  • Prof. Allen answered no.
• Sen. Reed asked Prof. Allen to indicate whether FTX had been required to provide attestations regarding the effectiveness of the company’s internal and corporate controls.
  • Prof. Allen answered no.
• Sen. Reed asked Prof. Allen to indicate whether FTX would have been required to make the aforementioned types of disclosures and attestations if it had been a public company.
  • Prof. Allen answered affirmatively.
• Sen. Reed noted how almost all of the cryptocurrency industry’s biggest companies were privately held. He mentioned how he had introduced the Private Markets Transparency and Accountability Act. He explained that this legislation would require the U.S.’s largest private companies to disclose basic information about their financial conditions and to comply with basic corporate governance requirements. He noted how the North American Securities Administrators Association (NASAA) had stated that this legislation would have made it easier for observers to identify and prevent FTX’s alleged fraud and misconduct. He commented that this legislation would provide some level of regulation to the cryptocurrency space. He asked Prof. Allen to address whether the Private Markets Transparency and Accountability Act would have made it easier for observers to identify FTX’s suspicious activity.
  • Prof. Allen answered affirmatively. She stated that attestations, proofs of reserves, and other forms of accounting disclosures common within the cryptocurrency industry did not include the rigor, independence, and professional skepticism that were common amongst auditors. She remarked however that the U.S. should be wary of the recent actions from the Financial Accounting Standards Board (FASB) to implement fair value accounting for crypto assets. She commented that the acceptance of market valuations from the cryptocurrency industry could undermine the value of the audit function.
• Sen. Reed then noted how FTX had reportedly held about $900 million in liquid assets and $9 billion in liabilities at the time of its failure. He highlighted how most of FTX’s assets had been illiquid cryptocurrencies that had been created and promoted by FTX and Alameda Research. He commented that FTX had held these illiquid cryptocurrencies at “wildly optimistic” valuations. He asked Prof. Allen to explain how aggressive valuation practices had contributed to FTX’s failure and had imperiled FTX’s customers.
  • Prof. Allen stated that many crypto assets were created out of nothing and had no basis for their valuations. She asserted that it was impossible to assess the sanity of the valuations of such crypto assets and commented that these assets traded entirely on sentiment. She stated that this dynamic enabled the creation of leverage, which in turn could enable fraud to go undetected.
• Sen. Reed remarked that the U.S. must regulate both the cryptocurrency industry and private entities that controlled large numbers of funds. He reiterated his call for the Committee to take up the Private Markets Transparency and Accountability Act.

Sen. Robert Menendez (D-NJ):

• Sen. Menendez remarked that many securities regulations tended to focus on what actions are permissible when one party is handling another party’s money. He noted how current securities regulations prevent brokers from using customer funds to finance their businesses, require brokers to fully disclose conflicts of interest, and require brokers to actively mitigate certain conflicts of interest when dealing with retail investors. He remarked that FTX did not appear to have followed any of these rules and commented that FTX’s adherence to these rules would have resulted in the prevention of harm. He asked Prof. Allen to indicate whether there existed any reason for not applying traditional regulatory principles to the digital assets space.
  • Prof. Allen remarked that traditional regulatory principles should be applied to the cryptocurrency space. She disputed the assertion that the cryptocurrency space was decentralized and noted how a small number of core software developers controlled Bitcoin. She further noted how the Bitcoin mining pool market was also very concentrated. She remarked that unidentified and unregulated nature of the major players within the cryptocurrency space was not ideal.
• Sen. Menendez then noted how Mr. O’Leary had expressed hope that FTX’s collapse would put renewed focus on implementing a domestic regulatory regime for cryptocurrencies. He asked Mr. O’Leary to indicate whether FTX’s customers and his own investment in the company would have been better served had FTX complied with existing rules that barred brokers from using customer funds to trade.
  • Mr. O’Leary answered affirmatively. He remarked however that FTX was not subject to these regulations because FTX was an offshore and unregulated company. He stated that a regulated exchange connected to a broker-dealer could protect customers. He mentioned how Canada imposed stringent regulations on cryptocurrency wallets that involved limits on the number of tokens, the amount of margin, and the amount of lending. He added that Canada conducted “exhaustive” tests of the reserves for these wallets. He asserted that the U.S. needed to adopt similar rules.
• Sen. Menendez remarked that the U.S. should apply traditional regulatory principles to the digital assets space. He then discussed how many cryptocurrency companies had worked to reassure the public of their soundness through hiring outside auditing firms to provide proof of reserves. He stated however that the quality of these audits was inconsistent and that these audits often provided incomplete pictures of the assets and liabilities for these companies. He asked Prof. Allen to identify some of the flaws in these audits of cryptocurrency companies. He also asked Prof. Allen to explain why these audits were often not as helpful as claimed by the cryptocurrency industry.
  • Prof. Allen remarked that the fundamental issue underlying the audits of cryptocurrency companies involved how digital assets should be valued. She noted how a fair value accounting basis would effectively have market sentiment dictate digital asset prices. She also stated that the attestations from cryptocurrency companies were not receiving sufficient skepticism from outside auditors. She asserted that auditors were merely accepting the reported totals from cryptocurrency companies.
• Sen. Menendez then raised concerns about the extent to which cryptocurrencies would become integrated into the traditional financial system. He commented that such integration could create financial contagion risks. He then discussed how FTX had been known for its large expenditures on celebrity endorsements prior to its collapse. He noted that FTX was not unique among cryptocurrency companies in its use of celebrity endorsements. He asked Mr. McKenzie Schenkkan to address how the U.S. could combat the spread of cryptocurrency disinformation and encourage investor education.
  • Mr. McKenzie Schenkkan remarked that the U.S. should work to classify cryptocurrencies as securities. He also suggested that the U.S. consider treating cryptocurrencies the way it treated gambling. He commented that this treatment would entail limitations on advertisements and the imposition of disclosure requirements.

Sen. Jon Tester (D-MT):

• Sen. Tester expressed concerns that the U.S. was currently signaling to people that cryptocurrencies constitute credible and sound investments. He stated that the U.S. should work to protect its taxpayers from having to bail out a downturn in the cryptocurrency market. He expressed concerns that cryptocurrencies could not be useful without imposing substantial risks for Americans. He then noted how Prof. Allen had previously raised concerns that cryptocurrency products were being targeted toward individuals and institutions during a December 2021 hearing. He asked Prof. Allen to address how these concerns had played out over the previous year.
  • Prof. Allen expressed her encouragement with how banking regulators have kept cryptocurrency products out of the traditional banking system. She commented that this approach had resulted in FTX’s collapse only harming FTX’s investors (rather than the broader economy). She remarked however that the assertion that cryptocurrencies were trying to disrupt banking was inaccurate. She contended that the cryptocurrency and banking industries would love to merge and commented that banking regulators were currently keeping the industries separate. She expressed concerns over how several banks were attempting to enter the cryptocurrency space and called on U.S. regulators to maintain the separation between cryptocurrency activity and banking activity.
• Sen. Tester then noted how FTX’s current CEO John Ray had warned that FTX’s U.S. entity was not solvent and that U.S. customer accounts were in doubt. He asked Prof. Allen to address how this situation would impact FTX users.
  • Prof. Allen noted that FTX users would be unable to access their funds held on the FTX platform in the short-term and stated that FTX users might ultimately lose these funds. She called this situation “devastating.” She remarked that the U.S. needed to consider how much risk it would tolerate in the name of cryptocurrency innovation. She mentioned how the Australian Securities Exchange (ASX) had spent several years trying to use blockchain technology to restructure its operations. She noted that the ASX eventually gave up on this effort because of the technology’s issues.
• Sen. Tester asked Prof. Allen to project how U.S. taxpayers would have been impacted had Congress provided additional validation to the cryptocurrency industry.
  • Prof. Allen noted how the value of the U.S. subprime mortgage market in 2007 had been around $1.3 trillion. She highlighted how the cryptocurrency’s market capitalization had recently shrunk from around $3 trillion to under $1 trillion. She stated that the intertwining of the cryptocurrency industry with the traditional financial system would have created significant problems for banks. She elaborated that such intertwining would have jeopardized the ability of banks to lend money and process payments.
• Sen. Tester asked Prof. Allen to indicate whether Congress would have needed to authorize a bailout of the cryptocurrency sector had there existed more linkages between the cryptocurrency space and the traditional financial system.
  • Prof. Allen answered affirmatively and called it critical for the cryptocurrency space to be segregated away from the traditional banking sector. She asserted that policymakers should work to guard against a cryptocurrency space that was too big to fail. She further stated that cryptocurrencies lacked productive capacity and did not support capital formation.
• Sen. Tester then asked Mr. O’Leary to address whether he desired regulation for cryptocurrencies so that these assets could obtain credibility.
  • Mr. O’Leary remarked that the regulation of cryptocurrencies would be necessary for institutional clients to become involved with the asset class. He noted how sovereign wealth funds and pensions currently manage about 70 percent of the world’s wealth. He stated that institutional investors were interested in Bitcoin, Ethereum, and several other platforms and were currently unable to apply their compliance infrastructures to cryptocurrencies. He then highlighted how the only FTX-affiliated entity that had not gone bankrupt was LedgerX and indicated that LedgerX was a CFTC-regulated entity. He asserted that regulation of the cryptocurrency sector would have prevented FTX’s other affiliated entities from going bankrupt. He commented that CFTC’s successful regulation of LedgerX had demonstrated that cryptocurrencies could be effectively regulated.

Sen. Bill Hagerty (R-TN):

• Sen. Hagerty discussed how FTX’s recent collapse was continuing to have “ripple effects” throughout the entire digital assets industry. He noted that Binance was the world’s largest cryptocurrency exchange and was nearly seven times larger than FTX in terms of trading volume. He predicted that Binance’s market share would grow following the collapse of FTX and stated that a collapse of Binance would prove “catastrophic” to the cryptocurrency industry and consumers. He noted however that U.S. regulators were limited in their ability to mandate audits and disclosures for Binance’s operations and highlighted how Binance operated offshore. He asked Ms. Schulp to address how U.S. regulators could work with their global counterparts and to bring transparency to Binance’s activities and to understand Binance’s reserve holdings.
  • Ms. Schulp noted how a large amount of FTX and Binance’s activities occurred outside of the U.S.’s jurisdiction and stated that the U.S. had a limited ability to influence cryptocurrency exchanges and projects that occurred offshore. She remarked that the U.S. should maintain an ongoing dialogue with international regulators so that it could exert some degree of influence over the cryptocurrency space. She called on the U.S. to establish a “rational” domestic regulatory framework for cryptocurrencies. She commented that a domestic regulatory framework for these assets would bring cryptocurrency activity onshore so that the U.S. would have maximum influence over the operations of cryptocurrency businesses.
• Sen. Hagerty asked Mr. O’Leary to provide recommendations for reforming U.S. cryptocurrency regulations so that the U.S.-based cryptocurrency entities could attract capital.
  • Mr. O’Leary remarked that every global financial platform’s ultimate goal was to be regulated in the U.S. market given the U.S. financial market’s global dominance. He noted how foreign financial services companies that wanted to engage in business within the U.S. were required to disclose their worldwide operations. He remarked that a coordinated effort amongst international regulators would ensure that any cryptocurrency company operating within the U.S. would meet certain minimum regulatory standards. He noted how former CEO Sam Bankman-Fried had spent a large sum of money repurchasing FTX’s shares from Binance so that FTX could obtain regulatory approvals for its platforms. He noted how Binance by contrast had decided to pursue an approach where it would not seek to cooperate with regulators.
• Sen. Hagerty expressed concerns over the CCP’s involvement with Binance. He stated that Binace was being proliferated throughout the world in both emerging and developed markets. He asked Ms. Schulp to address how a U.S. ban on digital assets and continued regulatory uncertainty for these assets would impact the global cryptocurrency market, U.S. national security, and U.S. economic security. He further asked Ms. Schulp to address how a ban on digital assets and continued regulatory uncertainty for these assets would impact the U.S. dollar’s status as the world’s reserve currency.
  • Ms. Schulp first noted how Binance denied that it was connected to the CCP. She then remarked that an outright U.S. ban of cryptocurrencies would remove all possibility of the U.S. becoming the global leader in blockchain technology innovation and would cause technology talent to move abroad. She further stated that this ban’s impact on the U.S.’s economic development would jeopardize the U.S. dollar’s dominance.

Sen. Mark Warner (D-VA):

• Sen. Warner first expressed agreement with Sen. Bill Hagerty’s (R-TN) concerns over Binance’s involvement with the CCP. He then remarked that the “clunkiness” of the technology underlying Bitcoin would ultimately prevent it from achieving scale. He noted how the Bitcoin network only permitted around five transactions per second and stated that Bitcoin also carried significant environmental costs. He then expressed concerns that FTX’s problems constitute “the tip of the iceberg.” He stated that there did not appear to exist any use cases of cryptocurrencies currently enabling cross border remittances of funds at a mass scale. He remarked however that cryptocurrencies were currently facilitating significant amounts of illicit activity, including drug trafficking and ransomware attacks. He asked Prof. Allen and Mr. McKenzie Schenkkan to address whether FTX’s collapse was a one-off event or if it was a harbinger of future problems within the cryptocurrency space. He also commented that the U.S. was only beginning to identify the conflicts of interest that had occurred at Alameda Research.
  • Prof. Allen remarked that the cryptocurrency industry’s initial problems had involved Terra Luna and Celsius earlier this year. She asserted that FTX’s recent collapse constituted a continuation of these problems. She stated that her fundamental concern about the cryptocurrency industry was that it was built upon an asset class that was based on sentiment. She noted that while investors traded cryptocurrencies out of a belief that these assets will eventually have value, she commented that the technology underlying cryptocurrencies was not sufficiently supporting payments. She stated that cryptocurrencies have become speculative instruments and asserted that cryptocurrency speculation was ultimately a zero-sum game. She warned that the cryptocurrency market would crash if consumers stopped believing that the assets contain value. She remarked that the cryptocurrency industry saw U.S. regulation as critical for legitimization and commented that the absence of this regulation could cause the cryptocurrency sector to crash. She stated that the current separation of cryptocurrencies from the traditional banking system would protect against a broader financial crisis in the event of a cryptocurrency market crash.
  • Mr. McKenzie Schenkkan expressed agreement with Prof. Allen’s response. He remarked that the cryptocurrency space was actually highly centralized. He noted how Binance was an early investor in FTX and highlighted how former FTX CEO Sam Bankman-Fried was in a private Signal chat group with Binance CEO Changpeng Zhao. He indicated that this chat group’s name was “Exchange Coordination.” He described the cryptocurrency market as an unregulated zero-sum game and asserted that the dominant cryptocurrency exchanges were scammers in this game. He then discussed how Alameda Research was Tether’s largest client and noted how Alameda Research had reportedly purchased $36.7 billion worth of Tether stablecoins. He questioned where this money had come from considering FTX’s insolvency.
• Sen. Warner lastly expressed concerns that the adoption of cryptocurrency rules could drive certain activity to the unregulated market. He mentioned how over 50 percent of mortgage origination now occurred outside of the regulated banking sector. He stated that policymakers must be cognizant of this dynamic.

Sen. Cynthia Lummis (R-WY):

• Sen. Lummis remarked that the hearing was conflating digital assets with corrupt organizations. She stated that FTX had engaged in fraud through lending its executives hundreds of millions of dollars in co-mingled customer funds for personal use. She also noted how customers that had tried to wire personal money to FTX had been provided Alameda Research’s routing number. She further discussed how FTX had maintained a “shocking” lack of corporate controls and had enabled affiliates to conceal the movement of money. She stated that FTX’s terms of service had lied when it said that title to customer digital assets would always remain with the customer. She remarked that FTX’s collapse was the result of a failure of people, safeguards, and regulation. She contended that FTX’s collapse could not be attributed to digital assets technology. She stated that the digital assets industry needed to address their risk management practices and ensure their compliance with AML laws. She then questioned how FTX had been able to grow so quickly and noted how FTX had been founded in 2019. She highlighted how other cryptocurrency companies (including Kraken, Coinbase, and Bitstamp) had been in existence for a decade and had grown organically. She remarked that the Committee needed to adopt legislative solutions that would have prevented FTX’s collapse. She specifically called for the regulation of digital asset trading, the provision of bankruptcy protections for consumers, disclosure requirements for cryptocurrencies, and the regulation of stablecons. She then asked Ms. Schulp to address why digital assets and distributed ledger technology (DLT) had the power to make U.S. capital markets safer and more efficient.
  • Ms. Schulp remarked that digital assets and DLT could make capital markets safer and more efficient through removing intermediaries. She commented that the absence of intermediaries would prevent bad actors (such as FTX) from misusing customer assets. She also stated that digital assets and DLT could support faster, cheaper, and more global payment systems. She commented that the facilitation of global payments would be especially important for the U.S. considering that it tended to send a lot of international remittances.
• Sen. Lummis acknowledged that her question period time had expired. She mentioned how she had introduced the bipartisan Lummis-Gillibrand Responsible Financial Innovation Act with Sen. Kirsten Gillibrand (D-NY). She stated that this legislation would have prevented FTX’s collapse and expressed her intention to reintroduce the legislation during the upcoming 118th Congress.

Sen. Elizabeth Warren (D-MA):

• Sen. Warren remarked that a basic principle of the U.S. financial system was the equitable application of rules to similar transactions with similar risks. She noted how it was illegal for banks to take money from terrorists and mentioned how banks spend large amounts of time and energy identifying their customers and reporting suspicious activity to law enforcement authorities. She stated however that many cryptocurrency firms were not performing similar customer due diligence. She remarked that cryptocurrencies had become the preferred tool for terrorists, ransomware perpetrators, drug dealers, and rogue states engaged in money laundering. She noted how at least $14 billion in digital assets had gone to criminals in 2021. She highlighted how a single cryptocurrency exchange had reportedly helped to launder at least $10 billion for criminals and hostile countries (such as Iran). She remarked however that the cryptocurrency industry remained resistant to changes, even considering this use of cryptocurrencies in illicit activities. She stated that the cryptocurrency industry had argued that it should not be subject to KYC and AML requirements because cryptocurrencies were uniquely transparent. She asked Prof. Allen to address whether the public nature of blockchains meant that criminals could not as easily launder money using cryptocurrencies.
  • Prof. Allen remarked that blockchains are “the worst of all worlds.” She stated that blockchains raise privacy concerns for normal people as blockchains create a public record for all transactions. She stated however that sophisticated people can use tools to hide their transactions on blockchains. She indicated that these tools include mixers and tumblers. She asserted that cryptocurrencies make it easier for bad actors to hide their ill-gotten funds because cryptocurrencies are not subject to KYC requirements.
• Sen. Warren also stated that the cryptocurrency industry had claimed that it would be burdensome and technologically infeasible for cryptocurrency businesses to vet their customers. She asked Prof. Allen to indicate whether traditional financial institutions (including banks, stockbrokers, and traditional money transmitters) have to spend money and resources to vet their customers.
  • Prof. Allen answered affirmatively and stated that KYC requirement adherence was a fundamental aspect of operating a financial services business. She remarked however that many cryptocurrency business models were premised upon avoiding KYC requirements. She described blockchain-based transaction processing as “clunky and expensive.” She asserted that this processing could only be more efficient than traditional processing if it avoids KYC requirements. She commented that cryptocurrency businesses were engaging in regulatory arbitrage when they avoided KYC requirements.
• Sen. Warren emphasized that traditional financial institutions were required to adhere to AML rules, even if these rules would reduce their profitability. She asked Mr. O’Leary to indicate whether the potential benefits of cryptocurrency were so promising that the U.S. should accept weaker AML rules and compliance from cryptocurrency businesses relative to the rules and compliance from banks, stockbrokers, and traditional money transmitters.
  • Mr. O’Leary answered no. He remarked that the U.S. should apply the same regulatory structure to cryptocurrencies that it applied to the trading of stocks and bonds on exchanges tied to broker-dealers. He commented that this application would not be difficult to implement and noted that it was already occurring in other countries. He then disputed Sen. Warren’s assertion that cryptocurrencies were making money laundering easier to perpetrate. He noted how bad actors had transacted in currencies (including the U.S. dollar) for decades.
• Sen. Warren interjected to assert that AML rules should apply to cryptocurrency firms in the same fashion that they already applied to banks, stockbrokers, credit cards, and traditional money transmitters.
  • Mr. O’Leary stated that the combination of KYC requirements for both sides of a transaction and the use of a regulated cryptocurrency would immediately address money laundering concerns.
• Sen. Warren remarked that the “dark underbelly” of cryptocurrencies was its link to the financing of terrorism, human trafficking, and drug dealing, as well as its use by rogue nations. She asserted that cryptocurrencies should not be provided with a laxer set of rules. She called on Congress to apply traditional AML rules to the cryptocurrency industry. She mentioned how she had introduced bipartisan legislation with Sen. Roger Marshall (R-KS) that would apply these rules to the cryptocurrency industry.

Sen. Chris Van Hollen (D-MD):

• Sen. Van Hollen remarked that the Committee must work to protect consumers while not providing the imprimatur of the U.S. government to an inherently risky system that lacked any inherent value. He asked Prof. Allen to describe her ideal policy approach for the cryptocurrency system.
  • Prof. Allen remarked that her ideal policy would be to ban cryptocurrencies. She acknowledged however that such a course of action might not be politically viable. She recommended that the U.S. strengthen its banking laws and fully prohibit banks from becoming involved with cryptocurrencies. She also recommended that Congress increase funding for the SEC and explicitly define cryptocurrencies as securities. She noted how the definition of a security under U.S. securities laws was broader than investment contracts and stated that many securities did not undergo the Howey Test. She called on the U.S. to “robustly” apply U.S. securities laws and regulations to cryptocurrencies.
• Sen. Van Hollen then noted how Mr. McKenzie Schenkkan had called for the U.S. to regulate cryptocurrencies in a manner similar to gambling. He noted how previous financial frauds and crises (such as Enron and the 2008 Financial Crisis) involved financial instruments that were backed by real assets. He asked Mr. McKenzie Schenkkan to indicate what was backing cryptocurrencies.
  • Mr. McKenzie Schenkkan remarked that cryptocurrencies were backed by nothing. He stated that cryptocurrencies fundamentally relied upon economic narratives and mentioned how Bitcoin was originally intended to be a peer-to-peer currency that would avoid all intermediaries. He remarked that the promises of cryptocurrencies did highlight the shortcomings of the current U.S. financial system in terms of providing ordinary Americans with economic opportunities. He asserted however that the economic narratives underlying cryptocurrencies were false and that these narratives made it easier for people to accept the promises of cryptocurrencies. He warned that this dynamic would lead to economic booms and busts.

Sen. Catherine Cortez Masto (D-NV):

• Sen. Cortez Masto mentioned how Prof. Allen had called on the U.S. to isolate cryptocurrencies from the traditional banking system and to define cryptocurrencies as securities. She asked the other witnesses to indicate whether they disagreed with Prof. Allen’s proposed approach to cryptocurrencies.
  • Mr. O’Leary remarked that legislation that banned banks from integrating cryptocurrencies into their systems would make the U.S. financial services sector globally uncompetitive. He stated that cryptocurrency innovation would profoundly change the cost, efficiency, auditability, and productivity of the banking system. He described proposals to isolate cryptocurrencies from the traditional banking system as “insanity.”
  • Ms. Schulp also expressed her opposition to proposals that would isolate cryptocurrencies from the traditional banking system. She recommended that Congress provide more clarity around which assets constitute securities. She commented that while many cryptocurrency tokens did fall under the definition of securities, she asserted that it was not always clear as to whether an asset constitutes a security. She also called on Congress to provide clear indications as to which market regulator would handle secondary trading. She stated that the CFTC should have jurisdiction over the secondary trading of commodities and the SEC should have jurisdiction over the secondary trading of securities. She commented that this approach would ensure that similar risk frameworks would be applied to similar risks.
  • Mr. McKenzie Schenkkan remarked that allowing cryptocurrencies to interact with the traditional banking system would lead to future problems.
• Sen. Cortez Masto then mentioned how many cryptocurrency advocates had asserted that FTX’s failure was attributable to its centralization. She noted how these cryptocurrency advocates had called for the promotion of DeFi. She asked Prof. Allen to address whether the use of DeFi could have prevented FTX’s collapse and to discuss DeFi’s potential impact on the centralization of wealth.
  • Prof. Allen asserted that the term DeFi was a misnomer because DeFi was not actually decentralized. She commented that technological decentralization and economic decentralization were distinct items. She stated that DeFi was “highly integrated” with the centralized cryptocurrency ecosystem and expressed doubts over DeFi’s ability to survive without this ecosystem. She also discussed how there existed numerous intermediaries within the DeFi system. She noted how the blockchain level of DeFi relied upon the core developers of the software that ran the blockchain and validators that implemented the software changes. She noted how the next level of DeFi relied upon blockchain application developers. She indicated that decentralized autonomous organization (DAO) token holders control these blockchain application developers. She commented that while the ownership of these DAO tokens was meant to be decentralized and dispersed, she stated the ownership of these tokens was often concentrated in a single person. She expressed agreement with Mr. McKenzie Schenkkan’s assertion that the popularity of cryptocurrencies and DeFi was based on false economic narratives. She stated that the tendency for economic power to concentrate in DeFi systems meant that intermediaries would be unavoidable.

Sen. Tina Smith (D-MN):

• Sen. Smith called FTX’s collapse shocking but not surprising. She stated that FTX and Alameda Research had failed to safeguard customer funds and that these losses of customer funds had harmed many vulnerable investors. She noted how traditional financial exchanges and trading firms were required to keep customer funds separate from their own funds. She asked Prof. Allen to indicate whether a similar requirement existed for cryptocurrency exchanges and trading firms.
  • Prof. Allen noted that while the terms of services for these cryptocurrency exchanges and trading firms often claimed that the businesses would not commingle customer and institutional funds, she stated that these businesses will sometimes still commingle customer and institutional funds.
• Sen. Smith also noted how financial firms were required to prioritize the best interests of their customers when giving financial advice to paying customers. She asked Prof. Allen to indicate whether a similar fiduciary requirement existed for cryptocurrency firms.
  • Prof. Allen noted how there were concerns surrounding the incorporation of cryptocurrencies into pension funds and traditional retirement accounts. She mentioned how the U.S. Department of Labor (DoL) had stated that cryptocurrencies should not be included in retirement savings plans. She expressed concerns over how Fidelity Investments had moved to permit people to invest in Bitcoin through their 401(k) plans.
• Sen. Smith mentioned how she had joined Sen. Elizabeth Warren (D-MA) and Sen. Dick Durbin (D-IL) in urging Fidelity Investments and the DoL to not include cryptocurrencies in retirement savings plans. She stated that cryptocurrencies were “highly volatile,” which made them ill-suited for retirement savings plans. She then noted how banks and traditional financial services firms had a duty to know the identities of their customers. She asked Prof. Allen to indicate whether a similar duty existed for cryptocurrency firms.
  • Prof. Allen answered no. She remarked that there was a “failure of gatekeepers” throughout the cryptocurrency industry. She noted how the cryptocurrency industry lacked auditors and KYC requirements. She also criticized venture capital firms for failing to perform sufficient due diligence on cryptocurrency businesses. She stated that the U.S.’s application of securities laws to the cryptocurrency space could increase the accountability of venture capitalists.
• Sen. Smith remarked that FTX’s recent collapse demonstrates the problems associated with an absence of consumer protections. She noted that while cryptocurrencies were relatively nascent, she stated that the U.S. knew how to oversee financial markets. She called on Congress to apply the U.S.’s existing laws to the cryptocurrency space. She then discussed how cryptocurrency mining and verification were energy intensive processes. She noted how cryptocurrency mining operations in the U.S. required as much electricity as all home computers or residential lighting. She commented that this high energy consumption resulted in more greenhouse gas emissions. She further stated that cryptocurrency mining was exacerbating noise, air, and water pollution for many communities. She noted how cryptocurrency mining involved a process that would become increasingly energy intensive over time and commented that this mining was inherently inefficient. She asked Mr. McKenzie Schenkkan to indicate whether there were any benefits associated with cryptocurrency innovation. She also asked Mr. McKenzie Schenkkan to address how policymakers should approach the environmental and energy impacts associated with cryptocurrency mining. She stated that cryptocurrency mining operations often drove up energy prices for nearby communities.
  • Mr. McKenzie Schenkkan mentioned how he had visited the Whinstone cryptocurrency mining facility, which is the largest cryptocurrency mining facility in the U.S. He stated that this mining facility was driving up electricity costs for nearby residents and was consuming a large amount of energy. He noted that this facility had taken over a former aluminum smelting plant and commented that the facility was being used to mine “ephemeral digital assets of no productive value.”

Sen. Kyrsten Sinema (D-AZ):

• Sen. Sinema discussed how her constituents were very interested in cryptocurrencies and stated that there were both benefits and drawbacks associated with these assets. She remarked that FTX’s collapse was one of many recent market events that had undermined consumer confidence in cryptocurrencies. She expressed interest in learning about how dispersed the ownership dynamics were in decentralized cryptocurrency projects. She remarked that the U.S. must ensure that consumers possessed sufficient information to assess risks and opportunities. She also stated that the U.S. must work to protect the U.S. economy, grow the integrity of its capital markets, develop a regulatory framework that fostered responsible innovation domestically, and increase funding for enforcement efforts. She then noted how Prof. Allen’s testimony had cited an article that called for cryptocurrency projects to fail. She asked Prof. Allen to identify the parties that were harmed by the failures of FTX, Terra Luna, and Celsius.
  • Prof. Allen stated that the failures of FTX, Terra Luna, and Celsius had harmed investors.
• Sen. Sinema stated that these failures had harmed regular investors more than they had harmed the founders of said projects. She expressed frustration with calls for cryptocurrency projects to fail because such failures would most harm regular investors. She noted how most cryptocurrency investors did not realize that they would be considered unsecured creditors when an exchange fails. She indicated that these investors were considered junior in the bankruptcy process to banks, lawyers, other lenders, and venture funds. She mentioned how lobbyists had told her that the U.S. did not require new cryptocurrency legislation and that regulators should use their existing regulatory authority to address problems within the cryptocurrency space. She expressed uncertainty however as to how regulators were overseeing the cryptocurrency space when FTX had been engaging in its questionable activities. She expressed her encouragement with the recent fraud charges filed against former FTX CEO Sam Bankman-Fried. She commented however that these charges were reactive in nature and would likely not address the funds lost due to FTX’s collapse. She then remarked that many cryptocurrency investors could not accurately price risks due to “murky” jurisdictional issues, unanswered legal questions, and a lack of regulatory clarity. She asked Prof. Allen to indicate whether there existed specific disclosure or registration requirements that could assist investors in making more accurate price discoveries.
  • Prof. Allen acknowledged that while calls for cryptocurrency projects to fail might seem harsh to individual investors, she stated that these calls were meant to protect people that have not invested in cryptocurrencies from broader financial failure. She expressed interest in having the U.S. develop a regulatory regime that would protect non-cryptocurrency investors. She then questioned the effectiveness of having more disclosures for crypto assets because the assets have no backing. She stated that U.S. securities laws were effective in requiring registration, which would ensure that new assets with no backing could not be offered in the first place. She also called for more aggressive enforcement of U.S. securities laws within the cryptocurrency context. She stated that the SEC’s lack of resources had likely prevented the Agency from identifying problems with FTX before the exchange had collapsed. She further stated that the SEC had received significant political pressure to back off from its oversight of the cryptocurrency industry. She called on Congress to provide more support for the SEC as it worked to pursue investor protections within the cryptocurrency space.

Full Committee Ranking Member Patrick Toomey (R-PA):

• Ranking Member Toomey discussed how stablecoins could be used in conjunction with smart contracts and explained that smart contracts would allow for automatic payments based on exogenous and verifiable events. He asked Ms. Schulp to comment on the prospects for smart contracts. He also mentioned how he had proposed a framework for regulating stablecoins and noted how this framework would require stablecoins to be fully backed by cash and cash equivalents. He also highlighted how this framework would have the OCC oversee stablecoins He asked Ms. Schulp to indicate whether this constitutes the right approach for regulating stablecoins.
  • Ms. Schulp remarked that stablecoins contain significant promise in terms of their ability to enable smart contracts and provide for faster payments within the digital payments ecosystem. She then stated that Ranking Member Toomey’s stablecoin proposal would address concerns over the reserves that backed stablecoins. She expressed her support for establishing a discourse-based framework for ensuring that stablecoins maintained their promised reserves and commented that the SEC could administer this disclosure framework. She stated that federal monetary regulators should not be involved in regulating stablecoins. She commented that having the U.S. Federal Reserve regulate stablecoins could lead to conflicts of interest. 

Full Committee Chairman Sherrod Brown (D-OH):

• Chairman Brown noted how many cryptocurrency firms had called for regulatory clarity. He asked Prof. Allen to indicate whether cryptocurrency platforms would be able to mostly comply with any such regulations.
  • Prof. Allen answered no. She stated that calls from cryptocurrency firms for regulatory clarity were really calls for bespoke regulations that would be easier to comply with.