Due to the fall in the crypto market this summer, highlighted by the collapse of stablecoin TerraUSD and the insolvency of crypto hedge fund Three Arrows Capital as well as centralized funding platforms Celsius and Voyager, regulators are giving it more more careful than ever.
These major bankruptcies and losses lay bare a key, even fundamental, financial principle: the risk-return relationship. This relationship implies that to take a higher risk, investors generally demand a higher return. Many entities in the crypto environment were offering annual percentage returns north of 20%, rates unheard of in traditional finance. While high yields are attractive, investors would be wise to make sure they understand they are taking on higher risks.
One of the virtues of decentralized finance is that the individual has complete control over their investments. But when does this control start to become negative risk-return? Too much risk can lead to system collapse as the continued returns associated with undisclosed risk become unsustainable over time. This leads to the need for a risk management mindset, coupled with risk management methods, in crypto finance.
Realities dictate that regulators around the world will have a say. While proportional regulation that does not stifle innovation is important, it need not be the only solution. Even with all of its advancements over traditional finance, the crypto industry can still learn from traditional finance when it comes to creating and sustaining safe innovation and profit-taking.
Traditional finance, while sometimes seen as the antithesis of crypto, uses basic principles and tools that the crypto industry can adopt to a greater degree to protect the broader market. The development of these principles will allow the crypto industry to move towards maturity.
The crypto market needs to focus on substance. Experts should weigh in before products hit the market. The form and content of a new product must be clear and correspond to the expectations of a lawyer or an auditor. Classifications that go beyond marketing to the underlying features and components of products are important.
The market should also use liquidity analysis and audited financial statements. If institutional investors involved in crypto performed extensive pre-investment analysis and required audited financial statements, it would force crypto counterparties to comply with standardized best practices without waiting for regulators to intervene.
Ongoing performance monitoring should also be performed. Entities that have made an investment should be responsible for undertaking their own ongoing monitoring of the performance 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 assessments of the fair value of crypto held, pledged or otherwise used should be a key part of this analysis.
There is also a need to clarify safeguards, custody and segregation of assets. The application of traditional financial guarantees and their processes could be transformative for the maturation of the crypto-finance ecosystem. Custody rules should be clear, pledged assets should not be confused with business assets, and collateral should be carefully documented so that lenders are protected.
Finally, increased disclosure should be encouraged. How crypto firms handle client assets shouldn’t be a trade secret. By disclosing risks and standard practices, providers will protect not only their customers, but themselves as well. Promoting mature, easy-to-understand terms and conditions with detailed information helps clients better understand the risk they are taking.
Institutional-grade solutions to risk issues are essential for businesses engaged in the crypto ecosystem. New data and software offerings, such as those provided by Lukka, help businesses manage their risk when interacting with crypto finance.
Traditional finance has built its regulatory framework on the hard lessons learned from crashes and crises. Decentralized finance doesn’t have to learn them firsthand. The crypto market is expected to look to the development of traditional finance. By protecting customers, it can reduce risk, mature faster, and grow.
Suzanne Morsfield is Global Head of Accounting Solutions and Brian Whitehurst is Head of Regulatory Affairs at Lukka.