The collapse of FTX: lessons for many

From investors to regulators, FTX Trading Ltd (FTX) filing for bankruptcy was unexpected by all. A catalyst for litigation and regulation over the years to come, this collapse will serve as a warning, particularly to cryptocurrency insurers.

What happened?

Launched in 2019 by Sam Bankman-Fried (SBF), FTX was one of the world's largest cryptocurrency exchanges. Headquartered in the Bahamas, FTX was on track to bring in approximately $1.1 billion in revenue in 2022 until investors withdrew funds following rumours of financial instability, misuse of customer assets / funds and substantial loans made to SBF and other directors. FTX subsequently suffered with liquidity issues, declared bankruptcy through a Chapter 11 filing in the US for over 130 affiliated entities and was placed under provisional liquidation in the Bahamas. SBF was also charged with fraud and money laundering in December 2022.

The bankruptcy proceedings in both the US and the Bahamas are the first of their kind being dealt with by the courts and the extensive backlash is yet to be fully seen. Nonetheless, given digital currency is often cited as the future of finance and the British government aims for the UK to become a global hub for crypto asset technology, it is anticipated that the FTX collapse will pave the way for long awaited deeper regulation of the crypto sector. The government has already begun to scrutinise FTX's downfall and has announced its proposals (subject to a consultation) to bring digital currency in line with the rules governing the issuance, trading and lending of traditional financial assets. It is expected that regulations implemented will benefit  investors, particularly where many are of the view that the collapse was human driven as a result of a lack of controls and trustworthy financial information.

Lessons learned for crypto insurers

A level of caution has always been required given the crypto sector is ever evolving, largely unregulated and in most cases not supported by physical assets. Nevertheless, crypto insurers should take some key lessons away from FTX's downfall:

1. Due diligence is key. A crypto business not being regulated is a telling sign that it may not have adequate anti-money laundering or anti-terrorist financing systems and controls in place. The FCA has previously reported that three quarters of companies carrying out crypto activities in the UK failed to demonstrate that they had sufficient systems and controls in place. Crypto insurers should therefore undertake enhanced due diligence before underwriting any crypto risk. At the minimum, this should involve determining whether the relevant firm is regulated and whether/how investors' monies are secured, i.e. through methods such as encryption, as, if not, this could expose insurers to increased risk.

    

2. Knowledge. Crypto insurers should only underwrite risks which are fully understood. Insurers must therefore stay aware of evolving developments within the crypto space (particularly the enhanced regulatory scrutiny which is required to ensure it is easier to monitor and prevent wrongdoing across the sector).

    

3. Exclusions. Extra caution is required where many of the risks are unprecedented and/or unknown. As insurance typically covers risks that have materialised in the past, crypto insurers have the challenge of anticipating largely uncharted risks (without the benefit of much claims history) and ensuring that the scope of cover reflects their risk appetite. Insurers should look carefully at the scope of their exclusions and ensure these are drafted clearly and concisely so as not to expose them to additional risks beyond their underwriting intent.

Comment

In the wake of FTX's collapse, we can expect an increase in appetite for crypto-related insurance by both investors and crypto businesses, particularly where the sector remains so unregulated and unpredictable. Investors will likely seek to protect their crypto assets and financial investments through insurance to avoid suffering similar losses. Similarly, crypto exchanges will likely seek to reduce their liability and cover their potential losses in similar scenarios, particularly where issues stem from a lack of corporate governance and trustworthy financial information.

The FTX collapse will not only affect those insuring crypto-related risks, however. We are already seeing a number of US claims being issued by investors and other affected third parties against financial institutions and their directors and officers who advised on and facilitated crypto investments without conducting sufficient due diligence. We can also likely expect claims against FTX's management who allegedly failed to implement sufficient controls and procedures. Such claims may give rise to notifications and requests for cover across various policies (professional indemnity, D&O and crime to name a few) in the light of the hundreds of millions of dollars lost by investors, including some of the major venture capital firms.

Insurers should keep abreast of follow-on regulation and litigation and ensure they fully understand the breadth of cover afforded by their policies (including their exclusions) in order that the scope of the policy is as intended. It will also be important that crypto insurers fully understand, and obtain clarity from brokers on, how their policies interact with other policies in their crypto client's insurance portfolio.