The year 2022 was an annus horribilis for the crypto ecosystem. The combination of the collapse of the FTX group,[1] the failure of Terra’s UST stablecoin,[2] 3AC’s bankruptcy,[3] and crypto losing $2 trillion in market value became aptly known as the “Crypto Winter” of 2022-23.[4] The irony is that, in the aftermath of the 2008 Global Financial Crisis (‘GFC’), cryptocurrencies and decentralized finance were presented as alternatives to traditional finance that could avoid these kinds of adverse financial events. Through a transparent technological framework, crypto could skirt the downsides of traditional finance: conflicts of interest, information asymmetries, and monopolization of transaction power, all of which introduced massive systemic risk in the financial system.
In a new paper, we highlight how, despite this narrative, it has taken less than 15 years to reveal that crypto is alarmingly vulnerable to the problems that plague traditional finance (“TradFi”). The financialization of crypto saw the duplication of many of the institutions, products, and services common in TradFi. This included the rise of systemically important crypto intermediaries (“SICIs”) that are antithetical to the philosophy of decentralized finance (“DeFi”). The prevalence of crypto intermediaries (we prefer to avoid the term “exchange”) such as FTX have led to a crypto ecosystem that is in some respects more centralized than traditional financial markets but without the same level of regulation or oversight that one would expect in the context of exchanges in traditional finance.
The Crypto Ecosystem
DeFi is characterized by peer-to-peer transactions and an absence of a centralized intermediaries. Smart contracts can execute transactions automatically, and the nodes that support the operation of the protocols and token holders have equal access to data and governance rights. One form of such an arrangement can be referred to as a decentralized autonomous organisation (“DAO”).
Trading platforms governed by a DAO are referred to as decentralized exchanges (“DEX”). However, throughout the crypto industry, centralized intermediaries typically have important functions. For instance, Binance, Coinbase, FTX, and others operate or operated as centralized exchanges (“CEXs). From the perspective of DeFi and the crypto ecosystem, these constitute a type of centralized finance.
CEXs handle most of the trading volume for tokens issued under alleged DeFi protocols and heavily influence the valuation of crypto assets.
FTX: The Lehman Moment for Crypto
FTX was valued at $32 billion in its January 2021 funding round[5] and at the beginning of 2022, was one of the world’s largest so-called cryptocurrency exchanges. FTX’s difficulties first became known through Binance’s publicly aired concerns about exposures of its investment vehicle to Alameda, a part of the FTX crypto conglomerate, and to FTT, FTX’s main crypto token. In many ways, FTX’s failure started as a classic liquidity crisis that turned into a solvency crisis — not dissimilar to what happened to Lehman Brothers in 2008. In traditional finance, the origin of liquidity crises is rarely a regulated entity’s public declaration of mistrust in another — as in the case of Binance and FTX — because market abuse regulations prevent such behavior. When liquidity crises occur, the remedy is provision of liquidity from an external source. FTX’s inability to find a source of liquidity resulted in insolvency.
With crypto, market trust and confidence were meant to flow from the underlying technology instead of regulation and supervision. Cryptocurrencies have their roots in decentralized peer-to-peer money exchanges, a structure designed to avoid liquidity and solvency crises. Questions thus arise as to whether the original design for cryptocurrencies was flawed. In traditional finance, preventative measures, like risk management and market abuse rules, and restructuring and resolution measures aim to prevent or intervene in such crises. These measures were seen as superfluous by crypto enthusiasts due to technological architecture, which in the Crypto Winter failed.
Financialization of Crypto and the Rise of Systematically Important Crypto Intermediaries
SICIs, whether too-big-to-fail or too-interconnected-to-fail in the context of the crypto ecosystem, create their own version of crypto concentration risk. This concentration typically arises because a single crypto intermediary – often the entity controlling the issuance of a fashionable token – assumes a powerful role within its own ecosystem and gains a de facto monopoly on transaction execution. SICIs arose in this ecosystem because all transactions in that crypto asset come to depend upon the intermediaries’ continued existence. This is analogous to systemically significant non-bank financial institutions, or shadow banks, which are complex and opaque.
The concentration in crypto is at odds with DeFi philosophy. Crypto was meant to eliminate the need for traditional financial intermediaries that concentrated the exchange of financial products in a small number of exchanges. It was supposed to leverage its innovative technological infrastructure and the trust it created to maximize democratization, inclusion, transparency, and permanence. However, in so many so-called DeFi business models, crucial elements of the set-up and governance are centralized. The problem is that, despite crypto intermediaries operating as financial institutions, they were not subject to traditional financial regulation and did not have access to protections such as deposit insurance, restructuring frameworks, or central banks as a liquidity provider of last resort. These measures aim to avoid liquidity and confidence crises, which crypto is highly exposed to, yet none apply to crypto. So when Binance publicly aired it’s concerns about the excessive exposure of FTX’s investment vehicle to Alameda and FTT (FTX’s main crypto token), FTX suffered what was functionally a bank run. Customers exited as quickly as they could, which exacerbated a liquidity crisis, and in the absence of measures designed to prevent these runs on crypto, this culminated in FTX’s insolvency. In short, the realization of the DeFi philosophy behind crypto failed utterly.
Regulating Crypto
The question is whether crypto can survive the 2022-23 Crypto Winter. For this to happen, appropriately designed regulation is essential. While some argue the best approach is to isolate crypto from finance and leave it largely unregulated,[6] crypto has already financialized, which creates the need for regulation. Financial regulation is largely about improving market functioning and efficiency. Crypto’s biggest systemic risks are that financialization erodes trust and confidence to such an extent that the market collapses or legislators feel pressed to shut down crypto markets.
However, in some respects crypto is different from TradFi and thus requires bespoke legislation to regulate it. The most important idiosyncrasy of crypto is its partial decentralization, which requires many entities to work together to deliver compliance, cybersecurity, asset recovery, and investor protection. It also requires additional expertise on the part of intermediaries, regulators, and gatekeepers (lawyers and auditors) because the partially decentralized functions of crypto are technically and financially complex. Finally, the cross-border nature of crypto makes enforcement difficult and costly.
We propose six regulations to address the financialization of crypto and the bespoke issues that are relevant to the partial decentralization of crypto.
- Licensing and supervision of conduct of business and appropriate balanced proportional risk-based prudential regulation of intermediaries
- Disclosure and transparency requirements
- Segregation and custody rules
- Market abuse regulation and enforcement
- Restructuring and resolution legislation
- Cross-border harmonization and coordination
Work has begun internationally and domestically to regulate crypto. The FSB,[7] IMF,[8] and BIS[9] have issued position papers as the G20 considers an internationally coordinated approach. The UK government is planning to implement new regulations and released a consultation paper recently.[10] The new EU Market in Crypto-Assets Regulation (MiCA), due to come into force in 2024, introduced a licensing scheme for crypto intermediaries, prospectus rules, anti-market abuse rules, insider trading rules, and bespoke legislation for stablecoins.[11] Crypto is a major focus of the world’s regulatory agenda.
If forthcoming regulation can effectively respond to the dangers of crypto that emerge from its convergence in structure with TradFi, while being cognizant of the special challenges of crypto, crypto may well have a future as a regulated and supervised industry. However, due to the pace of innovation in the market and the inherent difficulties of regulating decentralized and algorithm-based trading, lending, and investment, ensuring proper governance of crypto will remain a challenge. This makes cross-border coordination even more important because it allows regulators to share knowledge regarding new practices and problems and enhance regulatory learning globally.
ENDNOTES
[1] See, e.g., Peter Fitzgerald & Amalia Neenan, Annus Horribilis 2022: Regulation May Be the Only Way out of Crypto’s ‘Horrible Year’, City Am (Dec. 5, 2022), https://www.cityam.com/annus-horribilis-2022-regulation-may-be-the-only-way-out-of-cryptos-horrible-year.
[2] Antonio Briola et al., Anatomy of a Stablecoin’s failure: The Terra-Luna case, 51 Fin Res. Letters (2023).
[3] See Arjun Khapal, Crypto Hedge Fund Three Arrows Files for Chapter 15 Bankruptcy, CNBC (Jul. 2, 2022), https://www.cnbc.com/2022/07/02/crypto-hedge-fund-three-arrows-files-for-chapter-15-bankruptcy.html.
[4] See Damian Fantato, Crypto and Digital Assets Summit, Financial Times Events (Nov. 28, 2022), https://www.ftadviser.com/events-awards/2022/11/28/crypto-digital-assets-summit.
[5] Bo Li and Nobuyasu Sugimoto, Crypto Contagion Underscores Why Global Regulators Must Act Fast to Stem Risk, IMF (Jan. 18, 2023) https://www.imf.org/en/Blogs/Articles/2023/01/18/crypto-contagion-underscores-why-global-regulators-must-act-fast-to-stem-risk.
[6] Todd H. Baker, Let’s Stop Treating Crypto Trading as If It Were Finance, The CLS Blue Sky Blog (Nov. 29, 2022), https://clsbluesky.law.columbia.edu/2022/11/29/lets-stop-treating-crypto-as-if-it-were-finance/.
[7] See Financial Stability Board, Regulation, Supervision and Oversight of Crypto-Asset Activities and Markets: Consultative Document (Oct. 11, 2022), https://www.fsb.org/wp-content/uploads/P111022-3.pdf.
[8] See International Monetary Fund, IMF Policy Paper Elements of Effective Policies For Crypto Assets (No 2023/004, Feb. 23, 2023), https://www.imf.org/en/Publications/Policy-Papers/Issues/2023/02/23/Elements-of-Effective-Policies-for-Crypto-Assets-530092.
[9] See Matteo Aquilina, Jon Frost & Andreas Schrimpf, Addressing the Risks in Crypto: Laying out the Options, Bank for International Settlements (Jan. 12, 2023) https://www.bis.org/publ/bisbull66.htm.
[10] HM Treasury, Future financial services regulatory regime for cryptoassets: Consultation and call for evidence, (Report PU 3273, Feb. 2023), https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1133404/TR_Privacy_edits_Future_financial_services_regulatory_regime_for_cryptoassets_vP.pdf.
[11] For a good overview of MiCA, see Kai Zhang, Philip J. Morgan, Jeremy M. McLaughlin, MICA – Overview of the New EU Crypto-Asset Regulatory Framework (Part 1), K & L Gates Hub (Nov, 15 2022), https://www.klgates.com/mica-overview-of-the-new-eu-crypto-asset-regulatory-framework-part-1-11-15-2022.
This post comes to us from professors Douglas W. Arner at the University of Hong Kong, Dirk A. Zetzsche at Universite du Luxembourg – Faculty of Law, Economics and Finance, Ross P. Buckley at the University of New South Wales, and Jamieson M. Kirkwood at the University of Hong Kong – Faculty of Law. It is based on their recent paper, “The Financialization of Crypto: Lessons from FTX and the Crypto Winter of 2022-2023,” available here