This has been a seminal year for cryptocurrencies, and the events in the FTX, Terra-LUNA and Three Arrows Capital sagas have been discussed at length. As we review the details of what happened, there is a need for us to focus on the questions that emerge repeatedly: What does this mean for the industry? When the dust settles, is this good or bad for the market?
First, let us acknowledge the amount of sheer devastation that these failures have caused for countless people. No one likes to see early adopters and those working in earnest to move this ecosystem forward hurt — they deserve better.
Having said that, and while investor confidence is shaken in the short term, I remain convinced that digital assets are here to stay. Existing use cases such as cryptocurrencies and tokenization are continuing to grow while several other use cases are expected to emerge over the coming years, constituting an integral part of our daily lives.
The events in 2022 have shown that for the industry to thrive in a safe and sustainable manner, there is a need for institutional-grade infrastructure, including but not limited to custody, prime brokerage, robust collateral and counterparty risk management.
Regulatory response and risk management
The first immediate consequence of recent events will be the regulatory response, arguably an imperative for our industry. Centralized intermediaries are deemed opaque and there will be calls for industry players to be more transparent in their practices, be it reserve reporting or showing segregation of client and principal balances. Centralized intermediaries in the digital asset space will likely become subject to stricter oversight, audits and risk controls, particularly those that are consumer-facing. Conversely, this will also require an industry-wide reflection on the risks and dynamics of decentralized protocols and organizations.
The second consequence revolves around risk management. Asset price volatility may have attracted both institutional and retail investors to the asset class. However, this in turn means there is a need for robust risk management tools enabling stress-testing and the management of exposures. Many token-based entities are having to carefully assess the risks and balance sheet impact if they use tokens they have created as collateral. Industry treasury practices and reserve requirements will come under the spotlight.
Further regulation will likely result in a bifurcation in the market between institutions and retail investors where the significant share of activity is driven by institutions (in turn distributing to retail, similar to traditional finance), and where retail will enjoy better protection, also implying restricted access to specific products and services. Additionally, irrespective of regulations, the market ought to evolve to force the segregation of the “one-stop-shop” role that exchanges currently play in custody, execution, market-making and lending.
As with any asset class, the likes of BTC, ETH or XRP will continue to go up or down, trading just like a “normal” asset class, though in this case possibly with sudden bouts of volatility induced by market events. The fact that we have already experienced booms and busts is a sign of increasing maturity, and what emerges from the current period ought to lead to greater resilience.
However, for the asset class adoption to occur at an institutional scale, it will also require institutional grade infrastructure — meaning safe, robust and ultimately “compliant” — combined with more advanced risk management practices, and business conduct than engenders trust from consumers, institutions and society at large.
While the digital asset space is often considered to be disparate from traditional finance, innovation can be built on top of known best practices and the lessons that have been learned during past boom and bust cycles can be applied to avoid repeating the same errors.