Self-Custody Is the Antidote to FTX’s Fraud

Recent bankruptcy filings and Sam Bankman-Fried's criminal indictment make it clear that fraud precipitated FTX's collapse. For many policymakers, the loopholes enabling such criminal acts haven't yet become clear. These loopholes permitted flawed – or in FTX’s case, criminal – intermediaries to stand between consumers and their assets. If the U.S. Congress is serious about preventing future catastrophes like FTX, protecting consumers’ inherent right to self-custody clearly mitigates third-party vulnerabilities.

Warren Davidson is the U.S. representative for Ohio's 8th congressional district.

Just what and who needs legal protection? While Satoshi Nakamoto’s 2008 Bitcoin white paper effectively launched this era of fintech innovation, the legal and regulatory framework today continues to reinforce the structure of our traditional financial system and the legacy flaws that come with it. Fraud is one of these legacy flaws. Fraud committed under the guise of "innovation" is still fraud. FTX exemplified this.

In short, Bankman-Fried found a way to convince customers and investors to allocate dollars to FTX's platform (or, rather, FTX's balance sheet) by promising to be a third-party intermediary to purchase digital assets on their behalf. Customers then maintained "balances" in their FTX accounts while Bankman-Fried put funds under the control of Alameda Research, the trading firm he founded in 2017. He established his own cryptocurrency, FTT, to use as collateral for any loans made from FTX to Alameda. He then leveraged his assets under Alameda's control at unprecedented levels.

While this overview spares many details, this is the same criminal approach that has been seen before in traditional finance. FTX customers who transferred their digital assets off FTX's platform and onto their own self-hosted wallets – devices that allow digital assets to be stored off the internet – protected themselves from FTX's fraud. This approach provides the only sound protection against any third-party intermediary’s failure.

Read more: Marta Belcher - Elizabeth Warren's New Financial Surveillance Bill Is a Disaster for Privacy and Civil Liberties

FTX leveraged the hype around distributed ledger technology but, ironically, FTX promoted the exact opposite framework that Satoshi proposed. Reading the first two sentences of the Bitcoin white paper highlights this irony: "Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model." FTX simply exploited the inherent flaws in the permissioned, third-party financial system Satoshi observed and sought to remedy.

Senator Elizabeth Warren (D-Mass.) recently introduced a bill to build a concrete enclosure around these trust-based models while trapping consumers inside with no way out. Specifically, her bill requires the Treasury Secretary to promulgate a rule prohibiting financial institutions from transacting with self-hosted wallets. She mischaracterizes the FTX situation and claims she's been "ringing the alarm bell in the Senate on the dangers of these digital asset loopholes."

Let's be clear – her open hostility towards financial freedom is a clear and present danger to consumers and will only reinforce the system fraudsters continue to exploit.

That's why I introduced the Keep Your Coins Act last February. It was only a matter of time before someone in Washington, D.C., would try to compel the Treasury Department to interfere with consumers' inherent right to self-custody of their digital assets – to own and possess private property. In the wake of FTX's collapse, it should be evident that protecting self-custody is must-pass legislation.

In his testimony before the House Financial Services Committee, John J. Ray III, the current FTX CEO overseeing the bankruptcy process, discussed how all of FTX customers' digital assets were commingled. This model left customers with only a "claim" over their assets rather than actual possession.

We have a technology that allows consumers to avoid third-party vulnerabilities. It's imperative to embrace this opportunity to protect consumers. FTX was not about crypto; it was about a criminal exploiting a traditional third-party relationship by failing to do what he said he was doing – establishing a property right to digital assets on behalf of customers who deposited funds with his company. Self-custody has proved the only foil to his scheme, and Congress should protect it rather than undermine it with Senator Warren’s disingenuous assault on financial freedom.