Reporting and Governance

According to the Bank of England’s Financial Policy Committee, the market capitalisation of digital assets tumbled to about $900bn at the start of July 2022 from a peak of almost $3tn in late 2021. This near $2tn drop in the value of crypto assets has delivered the industry one mighty shock to the system. The crypto winter is well and truly here. By Charley Cooper, managing director at R3.

Players in this space previously heralded as being at the forefront of monetary innovation – or even the future of finance – are now dragging their feet through the swamp of price drops, job cuts and bankruptcies that have come to dominate the headlines. The precipitous drop in crypto’s fortunes has highlighted several worrisome issues, in particular the lack of transparency and safeguards in place to protect investors, especially those who are less experienced traders. 

For the industry to emerge from this crisis and regain confidence among investors, it cannot simply sit tight and wait for legislative reform, which is likely to take years to come into force. Instead, it must act now to formulate the framework needed to restore investor confidence through greater transparency, education and protection. 

A 2008-style crash?

In the lead-up to the 2008 financial crisis, the US economy was in a period of growth and stability, until it became clear that the supposedly rock-solid housing market was in fact backed by subprime mortgages that were anything but solid, causing one of the greatest financial crises in history.

It is ironic that cryptocurrencies – the creation of which was partly motivated by dissatisfaction with the financial system in reaction to the 2008 crisis – appear to have had their very own ‘2008 moment’. In the first week of May 2022, the stablecoin TerraUST proved to be far less “stable” than promised by its creators, losing its peg to the US dollar and triggering one of the most serious downturns in the history of cryptocurrencies. The Federal Reserve itself has compared the risks of stablecoins to those of the money market funds that played such an important role in the 2008 crash.

Overnight, the crypto bubble burst. Bitcoin is down almost 70% from its record-high value in November 2021, while the collapse of the Terra ecosystem made $40bn of tokens virtually worthless. 

The numbers are shocking, but our perception of this crash should not be based purely on statistics. At the heart of this ‘winter’ are real victims who have lost huge amounts of money and are now facing hardship when times are already tough. Coinbase alone has laid off nearly a fifth of its workforce, while lenders such as Celsius have gone bankrupt and frozen withdrawals entirely, effectively blocking investors from accessing their own assets. Real people are losing their jobs and money, causing very real pain as a result. 

As the crypto industry comes to terms with what has happened, what emerges is a worrisome picture of an ecosystem lacking sufficient risk management controls and consumer protections. The problem with a system of near limitless leverage has been laid bare. 

Huge uncollateralised loans have allowed companies and people to invest well beyond their means. These loans, which are not protected by a guarantor, are essentially ticking time bombs that leave investors with nothing in the event of a default. In the case of crypto hedge fund Three Arrows Capital – which plunged into bankruptcy following its default on a $350m loan from broker Voyager Digital – its subsequent liquidation has left thousands with no certainty that they will be ever be able to access their funds. 

No such construct would be permitted in mainstream banking, and nor should it be allowed in the crypto space. If the crypto community is to fulfil its aim of genuinely moving today’s financial infrastructure forward, then it must adapt itself to the rules of that very system. 

Balancing act

Government-driven regulation – such as the Lummis/Gillibrand proposed crypto bill in the US Senate and the EU’s more recent provisional plan to regulate crypto – is gaining momentum, yet these proposals are still in their early stages and will most likely take years to approve and implement. 

In the meantime, the onus falls on crypto platform providers and other players to establish best practices when it comes to investor protection, both because it is the right thing to do and because their failure to act will inevitably result in even heavier-handed regulatory action down the road. In this scenario, regulation could hamper innovation and reduce many of crypto’s positive attributes, such as greater financial inclusion and heightened efficiency. 

It is up to the industry itself to work out what these standards might look like. By looking at principles in other well-established markets – take the FX Global Code, for example – these firms can redirect crypto onto a safer path. 

Such safeguards should not seek to shutdown innovation nor remove risk entirely. After all, there is no such thing as a risk-free investment. Innovation and safety can coexist, and striking that balance will help the industry thrive. Standardised measures should inform consumers of the risks they are taking on and ensure that the technology which underpins cryptocurrency is compliant with the markets in which it operates. Doing so will allow crypto to earn the trust and demonstrate the integrity needed to change finance for the better.

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