About the author: Lennix Lai is the managing director of financial markets at OKX, a cryptocurrency exchange.
High-profile insolvencies in the crypto industry have exposed a daisy chain of borrowers and lenders through which customer funds were mismanaged and counterparty risk was undermined. Retail investors, many of whom were drawn to promises of high-yield returns, are now suffering the consequences. As the so-called crypto winter settles in, it’s an important time to reflect on the lessons of these experiences.
The behavior of major crypto lenders has broad similarities to what we saw from Lehman Brothers, Bear Stearns, AIG, and the like in the 2008 financial crisis. Three Arrows Capital and Celsius are widely reported to have gambled with customer funds. Just like the financial crisis, opacity, unconventional financial instruments, and a largely unregulated space made it possible for those firms to take excessive risks.
The irony is palpable. Bitcoin was created in response to the 2008 crisis. Now, more than a decade later, we’re again seeing a painful credit contraction and consolidation of lenders following high-risk, overleveraged 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 credit sector, and the digital asset market at large, are well-poised for a strong recovery. The worst case scenarios are behind us. All we need to do is apply the lessons we’ve learned from them.
Lesson one: “Counterparty risk management” is the new “yield farming.”
Chasing high yields was an impetus in all the crypto company insolvencies we’ve seen recently. With promises of returns as high as 19%, crypto lenders like Celsius and Voyager began to employ high yield as part of their user growth strategies, ultimately becoming overleveraged when the token Luna crashed and the platforms’ collateral was liquidated. Known as “yield farming,” the pursuit of maximum returns by shifting capital across 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 wanting to only do right by their customers—gained exposure to at least one of the now-insolvent firms. But surely the more established players would have at least seen audited financials from high-risk counterparties, right?
Wrong. It’s now evident that Three Arrows Capital was given multi-billion-dollar loans without presenting audited financials. To avoid another catastrophic contagion, crypto institutions need to develop resources that better manage risk. There’s no better time than a bear market to build 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 that institutions took with customer funds was that investors didn’t know the extent of this risk. Policymakers are increasingly releasing proposals to safeguard investors, with MiCA, the EU’s proposed legislation for bringing crypto assets, issuers, and service providers under one regulatory framework, being a great start. Institutions need to be held accountable for the promises they sell to consumers—the most obvious being the security of their funds.
Opacity has long defined traditional capital markets, with the “black box” nature of institutions not only putting substantial financial opportunity out of reach for the average retail investor, but making them vulnerable to predatory lending schemes. Opacity has no place in the crypto market, except when used for investor protection.
The novelty of the crypto market means we don’t need to work toward weeding out deeply-rooted systemic flaws. We can rip them out right now. Blockchain, the technology that underpins the entire digital asset industry, is designed to be auditable. It’s time to set a precedent for institutions to handle transactions on-chain to normalize open and transparent finance.
At the very least, we need to set a standard of crypto investors never again wondering what happens to their funds post-deposit.
Lesson three: Let shakeouts be shakeouts.
Chapter 11 bankruptcy implies that a business is worth being salvaged—that beneath the debt is a company 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, rose to prominence with a fundamentally unstable business model. In the long run, customers will only suffer when companies are organized this way. Let’s not pretend that a restructuring can fix this when a Chapter 7 liquidation is a healthier alternative for investors and the market alike.
Beyond this, rumors and speculation around “bailouts,” more than anything else, highlight the extent to which the crypto market is still misunderstood.
Crypto was designed without a mechanism for bailouts. In traditional finance, taxpayer dollars or monetary issuance can save banks that are large enough to merit a rescue. But crypto doesn’t have a centralized party to catch industry-native firms when they fall. Bitcoin in particular, among many other crypto assets, has a fixed supply and can’t be inflated. These bailout-averse characteristics are in place to keep crypto as free a market as possible.
This is an important way in which crypto and the legacy banking system diverge. Undermining the distinction is a disservice to both the industry and mainstream understanding of it. Crypto is not just a digital version of traditional finance—it’s an alternative to it, complete with a different risk-reward dynamic. On one hand, crypto being decentralized means there isn’t an institution that can ease or tighten monetary supply, a particularly appealing factor for consumers who’ve been hurt by inflation. On the other hand, this means a lesser degree of protection is available, as the Federal Deposit Insurance Corp recently clarified.
The only way to make sure another market-upending crisis of this nature doesn’t happen again is to set a precedent of moving forward without saving the institutional actors fundamentally at fault.
Major exchanges and institutional players must come together to rebuild investor confidence and employ the transparency blockchain enables to iterate on financial technology. People in the industry also need to work with regulators to cultivate a functional coexistence between decentralized and centralized finance.
Custody is a critical factor to evaluate as we move forward, with recent events likely to spark increased attention around it. Firms should look to offer both on-chain and off-chain custody options, allowing investors to have full visibility and control over their funds.
The next phase of adoption depends on the ability of industry-native firms to rebuild confidence among investors in the future of crypto. It’s become clear that the way we’re going to do this isn’t by promising outsized yield, recreating the opacity that exists in legacy banking, or employing traditional measures like Chapter 11 bankruptcy. The most promising way forward is to leverage what we’ve learned from crises in both traditional finance and our own industry to drive adoption through risk management and transparency, leaving failed companies behind.
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