The Post-Terra Era: Incentivising Innovation and Longevity Through Regulation
Vincent Chok is the CEO of First Digital Trust, a Hong Kong-based technology-driven financial institution powering the digital asset industry and servicing financial technology innovators including blockchain clients, payments companies, and virtual banks.
The world is reeling from the events of the last two years. The COVID-19 pandemic and the Ukraine Crisis have had a catastrophic effect on the global economy, its effects reverberating across regions at huge economic, financial, and humanitarian costs. The US Federal Reserve is now tapering off its pandemic-era economic stimulus, resulting in the shrinkage of the US economy during the first two quarters of 2022.
Amid fears of a looming recession, the US Federal Reserve also managed the complicated task of combatting sky-high inflation by increasing the interest rate by 75 base points in July 2022, the largest hike since 1994.
Crypto was born out of the ashes of the 2008 Financial Crisis as an alternative monetary solution — it did so on the core premise of decentralisation, one that isn’t susceptible to the influences of centralised institutions. Thirteen years later, crypto has garnered mainstream interest and cemented itself as a disruptor to the traditional financial system, but this proposition has been questioned and is constantly tested.
The current bear market is the latest example of this. Whilst grappling with the aftermath of the Terra/Luna crash and the domino effect that led to the collapse of Celsius, Three Arrows Capital (3AC), and Voyager, crypto also faces an existential question:
Is crypto suffering from the same problem that it was once created to solve and how can we address the issues of systemic risks and unsustainable financial models that led us to a crisis of epic proportions?
We are witnessing the growth of crypto, culturally and otherwise, via mainstream adoption across various sectors including art, film, and business. The onboarding of institutional investors into the industry has accelerated this adoption. BlockData reported that of the top 100 listed public companies, 40 have invested in blockchain & crypto companies between September 2021 and June 2022, including financial empires such as BlackRock, Samsung, and Goldman Sachs. Each major investment bridges the gap between traditional financial markets and the emerging crypto market, but widespread adoption will only be meaningful if the industry is willing to confront some of its fundamental issues.
CeFi lending platforms at the heart of DeFi
While the impact of the Fed’s recent policies cannot be understated, with some arguing that the interest rate hikes created a dollar liquidity crisis, which catalysed the Terra/Luna collapse, it was the unsustainable business models of CeFi [centralised finance] lending platforms that set the foundation for, and incentivised arguably unscrupulous behaviours that sparked the crypto contagion.
When centralised lending platforms entered the industry during the previous bull run, they saw the lack of regulatory structures in place as an opportunity to make easy money in the absence of robust credit conditions.
This was done in two distinct ways.
First, lenders began leveraging high-yield returns to investors. In the case of Celsius, the crypto lending platform promised high yield returns of up to 18% APY [annual percentage yield], placing part of their investors’ deposits in yield aggregators and other DeFi [decentralised finance] protocols.
Second, they imposed a far-reaching and unstructured lending system, sanctioning loans with assets that they themselves borrowed from various decentralised exchanges. Essentially, paying off the debt of a credit card with another credit card.
These types of investment models worked when the industry was riding the wave of the bull run. However, easy money is rarely ever sustainable. We all know how the saying goes: if it’s too good to be true, it usually is. When Terra collapsed back in May, the crypto market experienced seismic shockwaves which exposed the overleveraged positions of many crypto lending firms. During the Terra collapse, it was reported that Celsius withdrew an estimated ETH 225,000 out of Anchor Protocol — a borrowing and lending platform developed by Terra.
The fallout of this exposed the flawed business models of CeFi lending platforms and in the process caused life savings and investments to plummet on the part of ordinary investors.
The issue of regulation also resurfaced, as regulatory bodies needed to posit a strong stance on regulations and crack down on those who caused the catastrophe. In 2008, governments and central banks were able to bail out major players behind the subprime mortgage crisis, subsequently coining the term “too big to fail” in the process by economic and political elites. In the crypto world, where the sector takes pride in the lack of an intermediary whose mandate is to intervene when market forces fail, who can they turn to?
Stabilising the market: The need for regulation
There is no doubt that the crypto lending crisis will accelerate the regulatory crackdown, whether that's for optics purposes or a genuine readiness to implement change. Already, we are beginning to see the discourse shift, focusing on the classification of digital assets into either securities or commodities. Legislative bodies are issuing guidance for banks considering digital asset investment. And on a grander scale, regulators are imposing their authority on major crypto players.
During the aftermath of the 2008 Financial Crisis, steps were taken to silo the global financial sector. Governments looked to reset the status quo by issuing a series of measures aimed at regulating economic activities and protecting investors. Crypto is now faced with the same situation, a possibility to upend the status quo and streamline the market.
Crypto is a decentralised and borderless product, and regulation, by default, requires the presence of a centralised player and to intervene when market forces fail.
Evangelists in the crypto community will staunchly oppose any notion of regulation. But if we want to create an environment that encourages institutional onboarding and protects retail investors, we need to welcome an open dialogue on regulation and a bottom-up approach. This means not only a willingness to engage with regulators, but also incentivising creators and builders of crypto projects to implement rules by design.
There are also risk management practices that can be considered. A starting point to bolster crypto’s lending and borrowing systems is to introduce credit conditions that will prevent both CeFi and DeFi exchanges from lending uncollateralised assets to just anybody.
A reliable risk analysis framework that is fundamental to any robust credit system are the 5Cs of Credit:
- Character — a borrower’s creditworthiness;
- Capacity — debt-to-income ratio;
- Capital — amount of money;
- Collateral — securitisation of the loan;
- Conditions — specifics of the loan.
This system is widely used by lenders across traditional markets in order to effectively vet borrowers and ensure their overall credibility.
Another solution, one that is regularly used in financial services, and is emerging in crypto, is Know Your Customer (KYC) audits. In the case of compliant exchanges, KYC outlines a set of standards that determine whether participants can borrow and lend. While this solution endorses a bottom-up approach to regulation, the issue is that this process is currently self-regulatory. This allows players like Celsius, 3AC, and Voyager to refrain from complying.
Regulation of crypto is highly complex due to the innate contradiction between one and the other. There are more questions than answers at this point, but it’s important we ask the right questions in order to find a path forward.
Does regulation completely undermine the premise on which crypto exists, and to what extent? Is there a balance or tradeoff we are willing to accept?
Incentivising a regulatory strategy that starts from the bottom-up is crucial to ensuring any regulatory actions are introduced with the crypto community’s buy-in — that it is seen as beneficial rather than purely antagonistic. At the same time, state-level regulators need to gain a comprehensive understanding of the industry.
Crypto is a unique alternative solution to the traditional markets, and a powerful one at that. However, if it wants to continue challenging the status quo and co-exist with its traditional counterparts, it needs to be realistic about some of its fundamental flaws and adopt an open-door policy to address them. No one paradigm can be the answer to everything, but maturing the DeFi sector is integral because it is without a doubt the future of finance.
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