Crypto Winter: It’s Time to Abandon Failed Companies
About the author: Lennix Lai is the CEO of Financial Markets at OKX, a cryptocurrency exchange.
High-profile insolvencies in the crypto industry have exposed a series of borrowers and lenders where customer funds were mismanaged and counterparty risk undermined. Private investors, many of whom were attracted by promises of high returns, are now suffering the consequences. As the so-called crypto winter sets in, it is an important time to reflect on the lessons from these experiences.
The behavior of major cryptolenders bears strong similarities to what we saw from Lehman Brothers, Bear Stearns, AIG and the like in the financial crisis of 2008. Three Arrows Capital and Celsius are widely reported to have gambled away client funds. Just like the financial crisis, opacity, unconventional financial instruments and a largely unregulated space enabled these firms to take excessive risks.
The irony is palpable. Bitcoin was created in response to the crisis of 2008. Now, more than a decade later, we are again seeing a painful credit crunch and consolidation by lenders following high-risk moves and survival 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 deal with the core problems of opacity and excessive risk. The crypto-credit sector, and the digital asset market in general, is well equipped for a strong recovery. The worst-case scenarios are behind us. All we have to do is apply the lessons we have learned from them.
Lesson one: “Counterparty risk management” is the new “return farming”.
Chasing high yields was a driving force in all the crypto company insolvencies we’ve seen recently. With promises of returns as high as 19%, cryptolenders like Celsius and Voyager started using high returns as part of their user growth strategies, and were eventually handed over when the Luna token crashed and their platforms’ collateral was liquidated. Known as “yield farming,” the pursuit of maximum returns by moving capital across decentralized finance protocols became the norm among crypto institutions before Luna’s fall.
With the prospect of outsized returns, many crypto institutions – even those that only want to do right by their clients – gained exposure to at least one of the now insolvent firms. But the more established players would have at least seen audited financials from high-risk counterparties, right?
Error. It is now clear that Three Arrows Capital was given multi-billion dollar loans without presenting audited financials. To avoid another catastrophic contagion, crypto institutions must develop resources that better manage risk. There is no better time than a bear market to build a foundation that can reduce the risk of high-volume institutional activity in the next run.
Lesson two: Clarity and openness are essential.
Worse than the excessive risk institutions took with client funds was that investors did not know the extent of this risk. Politicians are increasingly releasing proposals to protect investors, with MiCA, the EU’s proposed legislation to bring cryptoassets, issuers and service providers under one regulatory framework, a good start. Institutions must be held accountable for the promises they sell to consumers – the most obvious being the safety of their money.
Opacity has long defined traditional capital markets, with the institutions’ “black box” nature not only putting significant financial opportunities 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 newness of the crypto market means we don’t have to work to weed out deep-rooted systemic flaws. We can tear them out right now. Blockchain, the technology that underpins the entire digital asset industry, is designed to be auditable. It is time to set a precedent for institutions to handle transactions on the chain to normalize open and transparent finance.
At the very least, we need to set a standard for crypto investors to never again wonder what happens to their money after deposit.
Lesson Three: Let shakeouts be shakeouts.
Chapter 11 bankruptcy implies that a business is worth saving – that underneath the debt is a company that can be restructured into a potentially profitable entity. We must 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 in this way. Let’s not pretend that a restructuring can fix this when a Chapter 7 liquidation is a healthier option for both investors and the market.
Beyond this, rumors and speculation surrounding “bailouts” highlight, more than anything else, the extent to which the crypto market remains misunderstood.
Crypto was designed without a mechanism for bailout. In traditional finance, taxpayer dollars or money issuance can bail out banks that are big enough to merit a bailout. 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 cannot 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 old banking system diverge. Undermining the distinction is a disservice to both the industry and the mainstream 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 fact that crypto is decentralized means that there is no institution that can ease or tighten the money supply, a particularly attractive factor for consumers who have been hurt by inflation. On the other hand, this means that a lesser degree of protection is available, as the Federal Deposit Insurance Corp recently clarified.
The only way to ensure that another crisis in the market of this nature does not happen again is to create a precedent for moving forward without bailing out the institutional actors who are fundamentally at fault.
Large exchanges and institutional players need to come together to rebuild investor confidence and use the transparency blockchain enables to iterate on financial technology. People in the industry must also 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 bring increased attention to it. Companies should look to offer custody options both on-chain and off-chain, so that investors can 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 has become clear that the way we are going to do this is not by promising outsized returns, replicating the opacity found in legacy banking, or using traditional measures like Chapter 11 bankruptcy. The most promising path forward is to leverage what we have 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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