About the author: lenix lai is Managing Director of Financial Markets at OKX, a cryptocurrency exchange.
High profile bankruptcies in the crypto industry have exposed a chain of borrowers and lenders that have mismanaged customer funds and undermined counterparty risk. Individual investors, many drawn to the promise of high returns, are now suffering the consequences. As the so-called crypto winter rolls in, it’s an important time to reflect on the lessons learned from those experiences.
The behavior of the major crypto lenders bears strong resemblances to what we saw at Lehman Brothers, Bear Stearns, AIG and the like in the 2008 financial crisis. It is widely reported that Three Arrows Capital and Celsius played with client funds. Just like the financial crisis, opacity, unconventional financial tools and a largely unregulated space allowed these companies to take excessive risks.
The irony is palpable. Bitcoin was created in response to the 2008 crisis. Now, more than a decade later, we are seeing another painful contraction in credit and lender consolidation after risky, over-leveraged moves by institutions at the expense of consumers — this time within the crypto industry itself.
The good news is that this time the industry has the technical capabilities to effectively address the core issues of opacity and excessive risk. The crypto lending sector, and the digital asset market in general, is poised for a strong recovery. The worst-case scenarios are behind us. We just have to apply the lessons we learned from them.
Lesson one: Counterparty risk management is the new yield farming.
The hunt for high returns has been a driver behind every crypto company bankruptcy we’ve seen lately. With yield promises of up to 19%, crypto lenders like Celsius and Voyager began deploying high yields as part of their user growth strategies, eventually becoming over-leveraged when the token Luna crashed and the platforms’ collateral was liquidated. Known as “yield farming,” the pursuit of maximum returns by moving capital via decentralized finance protocols became the norm among crypto institutions prior to the fall of Luna.
With the prospect of outsized returns, many crypto institutions — even those just wanting to do the right thing for their clients — took exposure to at least one of the now-defunct firms. But surely the more established players would at least have seen verified financials from risky counterparties, right?
Not correct. It is now apparent that Three Arrows Capital received billions of dollars in loans without providing verified financial data. To avoid another catastrophic contagion, crypto institutions need to develop resources that better manage risks. There is no better time than a bear market to lay a foundation that can de-risk high-volume institutional activity in the next bull run.
Lesson two: Clarity and transparency are essential.
Worse than the excessive risk institutions took on client money, investors were unaware of the magnitude of that risk. Policymakers are increasingly releasing proposals to protect investors, with MiCA, the proposed EU legislation bringing together crypto assets, issuers and service providers under one regulatory framework, as a good start. Institutions must be held accountable for the promises they sell to consumers – the most obvious being the safety of their funds.
Opacity has long defined traditional capital markets, with the “black box” nature of institutions not only making significant financial opportunities unattainable for the average retail investor, but also leaving them vulnerable to predatory lending schemes. Opacity has no place in the crypto market except when used to protect investors.
The newness of the crypto market means that we don’t have to work towards eradicating ingrained systemic flaws. We can rip them out immediately. Blockchain, the technology underlying the entire digital asset industry, is designed to be auditable. It’s time to set a precedent for institutions that process transactions on-chain to normalize open and transparent finance.
At the very least, we need to set a standard for crypto investors who never again wonder what happens to their funds after depositing them.
Lesson three: Let shakeouts be shakeouts.
Chapter 11 bankruptcy implies that a business is worth saving — that beneath the debt is a business that can be restructured into a potentially profitable entity. We need to draw a line between companies that go bankrupt and companies that are built on fraud and deception.
Celsius, for example, has come to the fore with a fundamentally unstable business model. In the long run, customers will only suffer if companies are organized in this way. Let’s not pretend that a reorganization can fix this when Chapter 7 liquidation is a healthier alternative for investors and the market alike.
In addition, rumors and speculation about “bailouts” in particular make it clear how much the crypto market is still misunderstood.
Crypto was designed without a bailout mechanism. In traditional finance, taxpayers’ money or spending can bail out banks big enough to deserve a bailout. But crypto doesn’t have a centralized party to catch industry-owned firms when they fall. Bitcoin in particular, alongside many other crypto assets, has a fixed supply and cannot be inflated. These bailout-averse properties are in place to keep the crypto market as free as possible.
This is a key way in which crypto and the legacy banking system diverge. Undermining the distinction does a disservice to both industry and the general understanding of it. Crypto isn’t just a digital version of traditional finance — it’s an alternative to it, complete with a different risk-reward dynamic. On the one hand, the decentralization of crypto means there is no institution that can loosen or constrain the money supply, a particularly attractive factor for consumers who have been hurt by inflation. On the downside, this means a lower level of protection, as the Federal Deposit Insurance Corp recently clarified.
The only way to ensure another market-shattering crisis of this nature doesn’t happen again is to set a precedent to move forward without bailouting the institutional actors who are essentially responsible for it.
Major exchanges and institutional players need to come together to rebuild investor confidence and leverage the transparency of blockchain that allows financial technology to iterate. People in the industry also need to work with regulators to foster a working coexistence between decentralized and centralized funding.
Custody is a critical factor to evaluate as we move forward, with recent events likely to draw increased attention. Firms should seek to offer both on-chain and off-chain custody options so investors have full transparency and control over their funds.
The next phase of adoption depends on the ability of industry-owned companies to restore investor confidence in crypto’s future. It has become clear that we will not do this by promising outsized returns, restoring the opacity that exists in legacy banking, or using traditional measures such as Chapter 11 bankruptcy. The most promising path forward is to use what we have learned from crises in both traditional finance and our own industry to drive adoption through risk management and transparency, and outperform failed businesses.
Opinions like this are written by writers outside of the newsrooms at Barron’s and MarketWatch. They reflect the perspective and opinion of the authors. Send suggested comments and other feedback to [email protected]
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