FTX collapse ‘worse than Theranos, worse than Madoff,’ expert says

John Reed Stark, lecturing fellow at Duke University Law School, and Neel Maitra, partner at Wilson Sonsini Goodrich & Rosati and former SEC senior special counsel, join Yahoo Finance Live to discuss the blowup of crypto exchange FTX, ramifications for the entire industry, and the outlook for SEC enforcement and a regulatory crackdown on digital assets and exchanges.

Video transcript


AKIKO FUJITA: Well, let's continue the discussion with our panel here. John Reed Stark, he's with Duke University's Law School. And Neel Maitra, he's former senior special counsel for digital assets and blockchain technology at the SEC. And, gentlemen, good to have you both on. John, I'm going to start with you because I know you have been very critical about just the Wild West, as you have described it, in the crypto space.

It's worth mentioning the numbers again here. I mean, we're talking about a $32 billion valuation earlier this year. They're now trying to cover a shortfall of $8 billion. How much of what's playing out right now is FTX specific? How much of this is a red flag for the space overall?

JOHN REED STARK: How can you even know? You know, you call it the Wild West. That's really an understatement, Akiko. It's "Walking Dead" like anarchy. There's no regulatory oversight, no consumer protections, no licensure, no insurance, no net capital, no transparency, no sunlight. We have no idea what's going on inside of these entities.

And if SBF is actually using Alameda, which all of the allegations seem to be leading to, as his personal piggy bank for whatever he wants to use it for, this is very serious because you're not just talking about SEC violations. Right now, the Department of Justice is getting together. I was just at the FBI on Friday in a big meeting just relating to some general concerns about cyber and crypto.

And these people are all mobilizing right now. Search warrants, arrests, all of those things are going to happen very quickly. The whistleblowers are mobilizing. The informants are mobilizing because they're seeking immunity. This is worse than Theranos. This is worse than Madoff, if what I'm reading is true, that's my opinion.

AKIKO FUJITA: Worse than Madoff?

JOHN REED STARK: Yes, absolutely, because in this case, you're dealing with all sorts of investors, all sorts of-- look at these financial entities who have had to write down their entire investments. These are supposed to be some of the most sophisticated people around who conducted due diligence on these things. But due diligence in the world of crypto, it's like proving what a poltergeist is wearing. These kinds of things, you can't figure them out. Look at some of these companies. You don't even know where they're headquartered. You don't even know who works there. There's absolutely no transparency.

And the contagion is quickly and rapidly spreading amongst all of the various crypto ecosystems. And that's a serious, serious problem for anybody who's doing anything with crypto. I'm sure the SEC will be sending teams of examiners to all of these regulated entities to find out exactly what their exposure is, if there is any.

And the enforcement [INAUDIBLE] probably standing down while the DOJ is doing their criminal investigation, which might involve informants and search warrants and arrests. And the SEC can't really interfere with that. And they don't want to get situations where you're taking testimony from-- by two different governmental entities.

AKIKO FUJITA: Neel, you know, you're a former insider at the SEC. And I'd be curious to get your take on the impact here to customers. We've got this banner here on the screen. Obviously, the SEC, the CFTC now investigating FTX's handling of customer funds. We know the FTX halted withdrawals of fiat currencies as well as crypto. I mean, what kind of protection is there in place right now for those customers who are saying, how do I get my money out?

NEEL MAITRA: Not a whole lot. And I will echo John here. I think that this is a disaster, especially for retail customers. And, you know, Chair Gensler of the SEC has said on multiple occasions that he thinks that these platforms need to be regulated like national securities exchanges. He's expressed concerns about how they handle custody. He's expressed concerns about, you know, whether they have protections in place.

And if you were setting up a hypothetical to prove him right, you couldn't do better than what has sort of just happened with FTX. So, you know, there are questions here regarding whether FTX and its sister firm, Alameda, as David just discussed, whether there's been-- whether there have been sort of flows of funds between them that perhaps shouldn't have taken place or that are questionable.

You know, there are questions around whether customer funds have been used, whether customer funds have been moved out of custody. And actually, if you look at FTX's terms, they say pretty clearly-- you know, for the standard FTX sort of retail trading product. I think the terms say pretty clearly that customer funds are customer funds. They can't be moved without customer permission.

And, you know, so there are going to be questions raised around whether the terms were sort of complied with in this case. So a lot of the protections that people have were contractual. They had terms of service with sort of-- that they signed up to with FTX. What happens if those are violated? You have a breach of contract against an institution that's basically could be looking at bankruptcy. So you just don't know how strong those contractual protections are.

In terms of federal protections, I mean, until you have-- until you're a registered national securities agency, you don't have a lot of protection. You might have protections in terms of fraud, where the DOJ can come in, but you're not really under the SEC umbrella.

AKIKO FUJITA: Neel, we had a guest on yesterday, Peter Tchir from Academy Securities, who said that he thinks this is going to trigger a bit of a land grab from regulators as to what should be defined as securities. And I wonder, if you take that thesis, how much of this could be avoided, could have been avoided if, you know, crypto-- you look at some of these exchanges-- they had all fallen under the same kinds of regulations that are applied to securities.

JOHN REED STARK: Well, let's take that. Let's break that down. You know, I think that-- when you look at exchanges and broker dealers, they've been writing since like 2017 that they should have to register with the SEC like everyone else. And as Neel said, these people are now-- they're not customers. They're going to become unsecured creditors.

And I worked in the division of enforcement for almost 20 years, 11 years as chief of the office of internet enforcement. And I can tell you, the SEC has brought over 100 cases, and they haven't lost a single one in the area of crypto.

And they've been very, very aggressive in enforcement. They've experienced incredible criticism for doing so. Hester Peirce, one of the commissioners, they call her the Crypto Mom. The SEC brings a case against BlockFi. Hester Peirce announces her dissent. The SEC forms a crypto unit. Hester Peirce says this is regulation by enforcement.

The SEC has been regulating the marketplace, has been shouting from the rooftops what the law is. And just yesterday, the case came down in New Hampshire where a federal judge said to one of the crypto defendants who claimed that they hadn't received fair notice of the SEC rules and regulations that that defense was useless, weak, pathetic, absurd, and wholly dismissed. So I think the SEC has been very active here, and they're going to get more active. My view is they're going to sue more of these exchanges, probably, again, in my opinion, starting with Coinbase.

AKIKO FUJITA: Neel, you agree?

NEEL MAITRA: Yeah, I think I largely agree. The SEC has been aggressive in enforcement. It's sort of said outside of the enforcement context. It's talked about how it needs to go after these exchanges and make sure that they're sort of registered.

But you know, enforcement is a Whac-A-Mole problem because, you know, it takes years to build a case against a sizable entity like an exchange. And you shut one down. There's still 100 more operating. A lot of the money just gravitates over to the next exchange. So enforcement is a powerful tool, but enforcement has its limitations. And so, you know, really, there's going to have to be a question here, whether Congress or one of the regulators or someone steps in to essentially just make sure that there's umbrella regulation of all of these platforms that are trading crypto.

AKIKO FUJITA: Finally, John, you know, as we're watching what's playing out with FTX, there is a question of confidence in the system that exists right now, confidence in the other tokens. I mean, what's the next shoe to fall here? How big is the contagion effect?

JOHN REED STARK: I think it's larger than the one we experienced in July, Akiko, I really do, because again, it's amazing the cycle of news. Within 24 hours, SBF goes from rescuer to rescued to potential global fugitive. You know, so it's happening very quickly. It's a matter of trust. There's never been a lot of trust.

Most of-- most of what keeps-- props up cryptocurrency is just the greater fool theory. There's no intrinsic value there. There's nothing-- there's no fundamentals. There's no balance sheets. There's no account statements. There's nothing. It's just a mathematical computational bladder. It's just computer code.

And this glorified append-only limited-writer spreadsheet is not some kind of global panacea. So it's really no use. Crypto doesn't really function well as an investment, because it's just the greater fool theory. You're not basing it on any actual information.

And it doesn't function well as a currency. It's far too volatile. There's many-- too many tax consequences. There's going to be extraordinary reporting consequences associated with it. The only thing crypto does really well is provide a way for criminals to commit horrific crimes like ransomware, murder for hire, drug dealing, terrorism.

A report just came out yesterday about how Russia is using crypto for its various nefarious activities. North Korea is using it to build its nuclear weapons arsenal. So I don't see anything except the killer app for criminals.

AKIKO FUJITA: Yeah, John and Neel, I get the sense that we could be talking about this for another hour. We will have to have both of you back on the show. But I do appreciate your insight today. John Reed Stark as well as Neel Maitra.