The crypto market can learn from traditional risk management

Due to the plunge in the crypto market this summer, highlighted by the collapse of the TerraUSD stablecoin and the insolvency of crypto hedge fund Three Arrows Capital as well as centralized financial platforms Celsius and Voyager, regulators are paying more attention than ever.

These bankruptcies and significant losses reveal a central, even fundamental, economic principle: the risk-return relationship. This relationship implies that investors usually require higher returns to take higher risks. Numerous entities in the crypto community offered annual percentage returns north of 20%, rates unheard of in traditional finance. While high returns are good, investors would do well to make sure they understand that they are taking on higher risks.

One of the advantages of decentralized finance is that the individual has full control over their investments. But at what point does that control start to become risk-return negative? Too much risk can lead to the collapse of the system because the continuous return associated with the undisclosed risk becomes unsustainable over time. This leads to a need for a risk management mindset, combined with risk management methods, in crypto finance.

The realities dictate that regulators around the world are going to have a say. While proportional regulation that does not stifle innovation is important, it need not be the only solution. Even with all the advances over traditional finance, the crypto industry can still learn from traditional finance when it comes to creating and sustaining safe innovation and profit taking.

Traditional finance, while sometimes seen as the antithesis of crypto, uses core principles and tools that the crypto industry can adopt to a greater degree to protect the entire market. Developing these principles will allow the crypto industry to take steps towards maturity.

The crypto market needs a focus on substance. Experts should weigh in before the products go on the market. The form and substance of a new product should be crystal clear and match what a lawyer or auditor would expect. Classifications that look beyond marketing to the underlying characteristics and components of products are important.

The market should also use liquidity analysis and audited finances. If institutional investors involved in crypto conducted thorough pre-investment due diligence and required audited financials, it would force crypto counterparties to adhere to normalized best practices without waiting for regulators to step in.

Continuous performance monitoring should also be carried out. Entities that have made an investment should be responsible for conducting their own ongoing performance monitoring of the crypto product as well as the counterparty. Contracts should provide for regular declarations mirroring those of similar traditional transactions and a statutory right to inspect the books. Reliable assessments of the fair value of krypton held, pledged as collateral or otherwise used must be a central part of this analysis.

There must also be clarity about collateral, custody and segregation of assets. Using traditional financial security and its processes can be transformative for the maturation of the crypto-financial ecosystem. Custody rules should be clear, pledged assets should not be mixed with company assets and security interests should be carefully documented so that lenders are protected.

Finally, increased disclosure should be encouraged. How crypto companies handle customer funds should not be a trade secret. By disclosing risks and basic practices, suppliers will not only protect their customers, but also themselves. Promoting mature and easy-to-understand terms and conditions with full disclosures gives customers a better understanding of the risks they are taking.

Institutional quality solutions to risk issues are essential for businesses engaging in the crypto ecosystem. New computer and software offers, such as Lukka offers, helping businesses manage their risk when interacting with crypto finance.

Traditional finance built up its regulatory framework through hard experiences from crashes and crises. Decentralized finance does not need to learn these firsthand. The crypto market should look at the evolution of traditional finance. By protecting customers, it can reduce risk, reach maturity faster and grow.

Suzanne Morsfield is Global Head of Accounting Solutions and Brian Whitehurst is Head of Regulatory Affairs at Lukka.