FTX Collapse A Warning Bell; Will India Speed Up Crypto Regulation To Protect Investors?

The recent collapse of the world’s third-largest crypto exchange FTX came as a shocker to the digital assets industry. But the bigger question is: How badly has it impacted Indian investors?

Many would put the damage to a minimum, given the limited exposure of Indian crypto investors. However, more than 2 Mn people have already lost over INR 1,50,000 Cr due to the volatile crypto assets market and the worrying developments around them.

Big-time crypto scams like GainBitcoin, BitConnect and Morris Coin rackets, the vastly mismanaged Luna and Terra crash and the latest FTX fall have left homegrown crypto investors pretty jittery. So much so that cryptocurrency exchanges like CoinDCX and CoinSwitch Kuber have to reassure investors and traders about reserves and exposure status. These exchanges claim to hold sufficient reserves (in crypto and INR) to match their customers’ funds and investments.

Whether investors can solely rely on these statements after the FTX fiasco is a matter of individual choice. After all, FTX founder and CEO Samuel Bankman-Fried continued to tweet till November 7 (these are now deleted) that everything was fine at FTX and it was just a competitor trying to malign the company.

According to Reuters, FTX had earlier called itself the ‘most regulated’ exchange on the planet. This attracted people, and the money followed.

Similar was the case with Do Kwon, founder of Terra USD stablecoin and Luna crypto tokens. Amid murmurs of Terra USD going down, Kwon tweeted on May 7, 2022, “Men will literally attack a stablecoin unsuccessfully instead of going to therapy.” The tweet was deleted later.

As is expected, FTX filing for bankruptcy along with 130 affiliate companies has a global impact, much like the cascading effect on the global economy post the fall of Lehman Brothers in 2008.

Earlier, too, we saw how the Luna incident triggered the shutdown of numerous entities, including Vauld, Celsius, Three Arrow Capital, Voyager and more, in India and abroad.

The impact could be bigger this time as FTX seems to have parked a lot of assets from outside. Multicoin Capital, a leading crypto venture capital company, has reportedly exposed $863 Mn of assets on FTX and chose to write down FTX to zero after the latter filed for bankruptcy. With the FTX promoting some major projects on Solana, Solana DeFi also suffered a $700 Mn wipeout in value. Media reports further stated that Muticoin had a hefty position in the Solana token, and the hit could be harder than the initial estimates.

Probes into the FTX debacle have started in a bid to return as much of investors’ money as possible. While the US Securities and Exchange Commission (SEC) is looking for potential violations of securities rules, the Bahamas, where the company is located, has frozen some of its assets and will initiate a criminal inquiry. Even Turkey, often considered an emerging crypto market, has announced an investigation into the collapse. In contrast, Indian probe agencies have yet to airdrop a single statement.

The Reserve Bank of India (RBI) has issued a series of notifications since 2017, making people aware that cryptocurrencies are not legal tender and warning them about the risky nature of crypto investments.

Incidentally, the crypto industry formed an advocacy body called Blockchain and Crypto Assets Council (BACC) under the Internet and Mobile Association of India (IAMAI). The idea was to move towards self-regulation for better transparency and consumer awareness. But in July 2022, the internet lobby disbanded BACC, citing an uncertain regulatory environment. The decision was reportedly taken without consulting BACC officials.

But given the catastrophic incidents across cryptocurrency markets, most stakeholders think that the digital assets ecosystem in India clearly needs a regulatory framework to ensure consumer protection and transparency. They also believe that building investor awareness is a critical criterion that must be addressed at the earliest.

“Regulations could have helped to tackle situations like this For eg- proof of reserves & proof of liabilities by the exchange is a must so that there’s clear transparency between CEX & users. For stablecoins definitely, a better backup reserve in case there is a depeg to extreme buy/ sell pressure and 1:1 backing with Native currency,” said Punit Agarwal, founder of crypto tax platform KoinX.

Inc42 spoke to many industry experts and stakeholders to understand these regulatory requirements and how they should be addressed.

Consumer Protection Must Be At The Core 

“If history is any guide, we could be on the cusp of a mainstream crypto revolution. But we’ll need robust consumer protections to get there,” – Vinod Khosla, founder, Khosla Ventures, Sun Microsystems

For a long time, Indian crypto investors have demanded a comprehensive regulatory framework for consumer protection. And the FTX developments have once again underlined its necessity.

Asked what the FTX crash would mean for Indian investors, Raj Karkara, COO of ZebPay crypto exchange, said, “The collapse of FTX and its native token, FTT, has been a shock for the entire crypto community. I am deeply sorry for those impacted by the subsequent fallout. We have seen significant industry players falter recently, and incidents like these reinforce the need for government regulation. It will ensure that all industry players follow a mandated code of conduct that safeguards investor interests. I will also urge investors to do due diligence to select the right investment partners.”

Vikram Subburaj, founder and CEO of Giottus crypto exchange, further explained why U.S. citizens were least affected by the FTX meltdown.

“If you are an exchange there, you will have to get registered and get a licence. You will have to follow certain procedures. SBF [Sam Bankman-Fried] is also saying this. For instance, they have been asked to submit audit reports [for the authorities to look into].”

Even finfluencers have to abide by certain norms. It is worth noting that the SEC fined model/reality TV star Kim Kardashian $1.26 Mn in October 2022 for illegally promoting a crypto asset on social media.

India should set similar examples, said Ravindra Sharma, who invested in Vauld after a paid finfluencer said so on YouTube. “Had we taken similar steps, people would have been more careful about promoting anything and everything,” he added.

Periodic Audit Reports Can Bring Transparency, Win Trust

Keeping tabs on exchange activities may result in early red flags and timely action. But investors across the globe are not too worried about periodic and mandatory audits of crypto assets for a simple reason. As crypto is built on blockchain technology, every transaction leaves a non-fungible trail in public that can be easily accessed and assessed. But the reality is somewhat different.

According to Subburaj of Giottus, decentralised exchanges can be easily monitored using their codes, but the centralised ones operated in India or elsewhere rarely function as transparently.

A look at the FTX’s leaked balance sheets and some curious business interlinking will throw further light on this.

For context, the FTX founder and CEO also set up a quantitative trading firm called Almeda Research, which is a major DeFi investor. Commenting on a leaked balance sheet its CEO Caroline Ellison recently said in a tweet:

“A few notes on the balance sheet info that has been circulating recently:- that specific balance sheet is for a subset of our corporate entities, we have > $10b of assets that aren’t reflected there.

“…the balance sheet breaks out a few of our biggest long positions; we obviously have hedges that aren’t listed — given the tightening in the crypto credit space this year we’ve returned most of our loans by now.”

This was also retweeted by SBF.

However, Reuters and The Wall Street Journal later reported that the $10 Bn assets SBF transferred from his crypto exchange FTX to his trading firm, Alameda Research, has disappeared since, resulting in a gaping shortfall.

It is not the only concern. The other worst part of the FTX saga is the way its balance sheet has been produced. It is an excel sheet with no concrete details and contains vague terms like “Hidden, poorly internally labeled ‘fiat@’ account.” with a balance of negative $8 Bn entry.

This presented a classic case of how mismanagement at the top level. Subburaj had an idea of how things could be improved.

“Exchanges should have an auditing and reporting structure just like our banks. At the end of every day, a bank submits its daily report. Maybe now it could be even more in real-time. This brings transparency to the institution. From an organisation’s point of view, there might be a bit of hesitation when you have to present the audit report to the public. But you can definitely do it to a regulator.”

Regulation Alone Won’t Help; Investor Awareness Is Needed

Mohammed Roshan, cofounder and CEO of the Bitcoin reward platform GoSats, said no specific regulation could help in such scenarios because it was all about the “crypto token illusion” sold by many crypto platforms and finfluencers in India.

“It is essential to realise that bitcoin is not at the same level as the entire crypto industry. The industry is experimental, like a casino. It is highly leveraged, and unregistered securities are very much in use, which means a lot of risks.

“Many crypto investors also thought that the FTX CEO was a godlike figure in this space. This completely defeats the ethos of bitcoin, or any other crypto, which should be ‘never trust and always verify’. For safe investments, crypto players in India need to educate people along these lines. After all, FTX is not the last. There will be many more disasters,” said Roshan.

Pratik Gauri, founder and CEO of L1 blockchain platform 5ire concurred, saying awareness is critical. “We have planned to start a digital university to educate people on crypto because many investors are now entering the market. These newcomers usually go to Twitter or other social media platforms to get [popular] opinions and end up investing in tokens based on those.”

This creates a cascading effect. If one goes down, the whole ecosystem falls. Investors, especially new investors.

“If we want to prevent those losses, two things need to come into play. First, there should be an awareness/knowledge portal to educate people about the crypto industry. This should be considered the ultimate resource, the crypto Bible. Second, you need to study it thoroughly, as no one can rely on social media to gain knowledge,” said Gauri

How To Start The Uphill Journey

They say well begun is half done. But in a country like India, where crypto’s legal status is not recognised and digital assets are always under the government’s scanner, a regulatory framework for private digital currencies may not happen anytime soon. Still, it may help to look around and see what works for the rest of the world in a bid to stay prepared for India’s [private] crypto odyssey.

According to Ajeet Khurana, former CEO of ZebPay and currently the founder and CEO of Reflexical, a Web3 startup enabler, there are primarily three to four scenarios.

The first is a complete absence of regulation where governments look the other way and pretend that crypto does not exist. Then there is the most common scenario followed by all major territories – the US, the UK, Canada, Australia, Singapore and many more. They look at their existing laws and change or tweak them to include crypto.

For example, if you look at Coinbase, a US-based, US stock exchange-listed and the world’s most valued cryptocurrency exchange, you will see it does not have any crypto exchange licence. It has things like money transfer licences. Similarly, in the EU, it would have an eMoney licence and the like. Larger economies are taking this approach – they tweak their existing systems.

Interestingly, India has started its journey by tweaking its Income Tax Act. Theoretically, it can also tweak its Foreign Exchange Management Act (FEMA), the RBI Act, the SEBI Act and more without passing any new law to regulate crypto. This has been done in other countries.

The third type includes financial havens like Malta, Estonia and Cayman Islands, which have implemented crypto-specific acts.

The fourth, literally one of its kind, features Dubai (the UAE). It has created the Virtual Assets Regulatory Authority, or VARA, a dedicated regulator for the crypto industry.

The most suitable model for India is what the US or Singapore does, which means tweaking existing laws to incorporate crypto, said Khurana.

Asked who should regulate it, he added, “Crypto has dual features – it can be treated as money or commodity. That makes it very clear that the money part of crypto has to be governed by the RBI, and SEBI should regulate the commodity part.”

But to develop an effective regulatory framework, India should understand the issues plaguing the industry. Undoubtedly, there are many loopholes, but they differ from what the purists think. The crypto ecosystem is unlikely to pose any threat to any country’s economic sovereignty. After all, decentralisation does not pose much of a problem; centralisation does.

As for trust issues, Subburaj of Giottus hit the nail on the head. “Crypto has not failed. The people i.e. the portions of trust have failed.”

The framework needs to address the existing issues and should not become an issue in itself as and when it comes, hopes the industry.