Sir Jon Cunliffe, Lieutenant Governor of the Bank of England, highlighted why the FTX collapse supports the need to legislate cryptocurrency companies. While some consumers might switch from centralized cryptocurrency exchanges to DeFi, Cunliffe also expressed doubts about DeFi. However, he supports the innovative potential of smart contracts and tokenization of real-world assets.

Anyone familiar with FTX’s bankruptcy filings will be aware of the lack of a board of directors, an accounting department, and any financial control.

Speaking about the role of regulation, “The first are fundamental questions about how financial institutions should be organized, by which I mean their corporate structure, governance, internal controls and record keeping,” Cunliffe said. “Regulation in the conventional financial sector imposes strict/substantive requirements. Supervision aims to ensure that they are implemented.”

Financial institutions must be regulated because they represent risks for consumers, other financial companies and the financial system in general.

Former FTX CEO Sam Bankman Fried controlled entities that took on different roles, such as market making for Alameda and FTX exchange and custody. “FTX, along with other centralized cryptocurrency trading platforms, appear to operate like conglomerates, bundling products and functions within one company,” Cunliffe said. “In conventional finance, these functions are separated into different entities or managed with strict controls and fences.”

Cunliffe’s third point concerned guarantees. The trigger for FTX’s run was the price collapse of its FTT token. The Lieutenant Governor noted that for guarantees to play their role in credit risk management, they must have low volatility and high credit quality. Compounding the problem, FTX was willing to accept its own “unbacked crypto asset” as collateral, resulting in extreme “misdirection risk.”

Not convinced by DeFi

He acknowledged that some see the alternative to regulation as embracing decentralized finance (DeFi) with code that manages risk and removes reliance on centralized entities.

Cunliffe noted that driverless cards are only as good as the code used to drive them. It depends on the quality of the code. He questioned whether most DeFi protocols are decentralized with questions about their governance.

Furthermore, in a volatile market, he believes there is a need for liquidity providers to “avoid amplification of force-selling dynamics.”

This led him to believe that it is necessary to regulate crypto companies. The most obvious reason, as FTX points out, is to protect consumers and investors. Particularly, those who want to participate in crypto are not left with the only option of using unregulated entities.

The lieutenant governor chairs the International Financial Stability Board, so it is not surprising that his second motivation is to ensure financial stability. While there is limited interconnection between the cryptocurrency sector and mainstream finance, he does not want to wait until there is greater connectivity before imposing regulation.

The third driver is supporting innovation because Cunliffe sees the benefits of smart contracts and tokenization of real world assets. He used the analogy that people don’t fly unsafe planes.

“Tokenization, encryption, distribution, atomic settlement and smart contracts, not only seem unlikely to disappear as our daily lives become more ‘digital’, but may also have the potential to improve efficiency, functionality and reduce risk in the financial system”. Cunliffe said.

He also touched on UK stablecoin legislation currently before parliament and plans to consult on the details of the regulatory framework. Furthermore, Cunliffe mentioned that the central bank and HM Treasury will shortly share their next steps in their work on a digital pound or retail central bank digital currency (CBDC).