Due to the plunge of 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 centralised finance platforms Celsius and Voyager, regulators are paying more attention to it than ever.
These bankruptcies and significant losses expose a key, even basic, financial principle: the risk-return relationship. This relationship implies that to take on higher risk, investors typically require a higher return. Numerous entities in the crypto environment offered annual percentage yields north of 20%, rates unheard of in traditional finance. While high yields are nice, investors would be wise to ensure they understand that they are taking on higher risk.
One of the virtues of decentralised finance is that the individual has complete control over their investments. But at what point does that control start to become risk-return negative? Too much risk can lead to a collapse of the system because the continuous returns associated with the undisclosed risk become untenable over time. This leads to a need for a risk management mindset, coupled with risk management methods, in crypto finance.
Realities dictate that regulators worldwide are going to have a say. While proportional regulation that doesn’t stifle innovation is important, it doesn’t need to be the only solution. Even with all its advances over traditional finance, the crypto industry can still learn from traditional finance when it comes to creating and maintaining safe innovation and profit-taking.
Traditional finance, while sometimes viewed as the antithesis of crypto, uses core principles and tools which the crypto industry can enact to a higher 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 products go to market. The form and substance of a new product should be crystal clear and match what a lawyer or auditor expects. Classifications that look beyond marketing to the underlying characteristics and components of the products are important.
The market should also use liquidity analysis and audited financials. If institutional investors involved with crypto conducted thorough pre-investment analysis and required audited financials, that would oblige crypto counterparties to comply with normalised best practices without waiting for regulators to step in.
Ongoing performance monitoring should also be conducted. Entities who made an investment should be responsible for undertaking their own ongoing performance monitoring of the crypto product as well as the counterparty. Contracts should provide for regular statements that mirror those of similar traditional transactions and a legally enshrined right to inspect the books. Reliable fair value assessments of the crypto held, pledged as collateral or otherwise used, need to be a key part of this analysis.
There also needs to be clarity on collateral, custody and the segregation of assets. Applying traditional financial collateral and its processes could be transformative for the maturation of the crypto finance ecosystem. Custody rules should be clear, pledged assets should not be commingled with corporate assets and security interest should be carefully documented so that lenders are protected.
Finally, enhanced disclosure should be encouraged. How crypto businesses handle customer assets should not be a trade secret. By disclosing risks and basic practices, providers will not only protect their customers, but also themselves. Promoting mature and easy to understand terms and conditions with fulsome disclosures provides with customers a better understanding of the risk they are taking on.
Institutional quality solutions to issues of risk are critical for businesses engaging in the crypto ecosystem. New data and software offerings, such as that provided by Lukka, aid businesses in managing their risk when they interact with crypto finance.
Traditional finance built up its regulatory framework through hard lessons learned from crashes and crises. Decentralised finance does not have to learn these first hand. The crypto market should look to the development 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.