FTX’s unraveling should not have come as any great surprise. When an unregulated market like crypto is opened to financial novices, mistakes are bound to be made and fraudsters are sure to take advantage.
But it’s one thing if a billionaire gets conned, and quite another if a struggling gig worker is gulled into investing their limited assets in a bogus product. That’s why, if crypto was going to be marketed to ordinary people, it should have been regulated first. Policy makers, who are currently letting unwitting consumers engage in unregulated markets even outside of crypto, should take that lesson to heart.
Beyond reconsidering if and how it oversees digital currency markets, Washington needs to rethink its Swiss-cheese approach to the financial regulation more universally.
Regulators are always a step behind
The FTX scandal follows the well-trodden arc of what might be called “regulatory lag.” The Lincoln administration established the Comptroller of the Currency only after “wildcat” bankers invested their customers’ deposits in failed speculative schemes. The Securities and Exchange Commission and the Federal Deposit Insurance Corp. were born only after a financial crisis. The Consumer Financial Protection Bureau was created only after the mortgage bubble popped in 2008.
On occasion, financial crises sometimes emerge because regulators miss a scandal—but more often they’re born from changes in the unregulated corners of the broader financial marketplace. The concern today is that those sorts of risks are growing.
Well beyond FTX, or crypto more generally, “shadow banks” operating without licenses or supervision have quietly begun edging into realms that regulated banks used to serve more exclusively.
Ordinary consumers are getting mortgages, credit cards, and student loans from lenders who operate outside the bounds of traditional examination, deposit insurance, and capital rules. And while that may thrill borrowers who can qualify for loans that banks might deny, or perhaps even pay rates below what banks are willing to offer, the story is likely to change if and when, like FTX, those shadow banks turn out not to be upholding the standards, or boasting the protections, ordinary consumers have come to expect.
Three options for preventing a catastrophe
The question is what to do to head off a shadow-banking catastrophe.
One option is to accept the regulatory lag that already exists—to presume that the “nothing to see here” argument that FTX evangelists once made apply in earnest to well-tread shadow-banking institutions. Given what we know, that represents a grave mistake.
Alternatively, Washington could stand up an entirely new bureaucracy to regulate all these unregulated entities—something Congress intended but failed to do when chartering the CFPB a decade ago. Today, few can reasonably argue that the CFPB has the resources required to meet its mandate, or that creating yet another regulator would correct for that shortcoming.
A third option is to abandon the effort to regulate institutions by charter in favor of regulating activities regardless of who is providing the service.
That is, Congress should direct the nation’s existing regulatory agencies to regulate everything that mimics the activities they already oversee at chartered institutions. The Federal Financial Institutions Examination Council or the Financial Stability Oversight Council, two multiregulatory agency groups, could be charged with dividing up the universe of unregulated financial products among existing regulatory bureaucracies.
As a result, anyone writing mortgages, regulated or unregulated, would be subject to the same standards.
No need to reinvent the wheel
Moreover, chartered banks and shadow banks would have to adhere to the same “community standards,” including the Community Reinvestment Act. After decades working to demand traditional banks do away with the prejudicial practice of redlining, unregulated lenders should not now be able to sidestep those requirements even while competing for the same borrowers.
This “like-for-like” approach, which has been embraced in principle by senior officials including Federal Reserve Chairman Jay Powell, would not require Washington to reinvent the regulatory wheel. Congress would simply need to manage some jurisdictional rejiggering.
And while some shadow-banking executives may take the same position of crypto boosters ahead of FTX—complaining that broader regulation stifles innovation—the response should be clear. Innovators would be free to take risks, but only those that are consistent with maintaining a safe and sound financial system and one that treats consumers fairly and honestly.
Without diminishing that impact of the FTX scandal, we should view its sudden emergence as a wake-up call to what might happen down the line. Shadow banking is creating more endemic risk for ordinary investors and borrowers than many care to acknowledge or address.
If we embrace a like-for-like regulatory approach, we may well avoid much more damage down the line. Rarely does the present provide such a clear view of the future. Washington should act now, before, like with the current crypto damage, it’s too late.
Eugene Ludwig, a former U.S. comptroller of the currency, is a managing partner of Canapi Ventures and CEO of Ludwig Advisors. He is chair of the Ludwig Institute for Shared Economic Prosperity (LISEP).
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