We are in a new financial era, let's avoid old mistakes

Author: Lennix, OKX

Original Title: “It's Time to Leave Failed Crypto Companies Behind”

This is a crucial moment as we build a brighter future, striving to get through the so-called cryptocurrency winter while reflecting on and learning from the lessons of the industry. Several high-profile bankruptcy events have exposed a chain of borrowers and lenders where customer funds were mismanaged, trading pair risks were weakened, and many individual investors attracted by high yield returns are now facing the consequences.

Overall, the actions of companies like Three Arrows Capital, Celsius, and Babel Finance are no different from those of Lehman Brothers, Bear Stearns, and AIG in 2008. In both cases, large companies attempted to exploit customer funds through opaque, novel financial instruments and a largely unregulated manner.

It is ironic, to say the least. Bitcoin was created in response to the 2008 crisis. More than a decade later, we are witnessing painful credit contractions and bank consolidations again, driven by institutions taking high-risk, over-leveraged actions at the expense of consumers—this time within the crypto industry itself.

The good news is that this time, we have the technological capability to effectively address core issues like opacity and excessive risk. The crypto lending space and the entire digital asset market are poised for a strong recovery; the worst is behind us… all we need to do is learn the lessons from these events.

“Counterparty Risk Management” is the New “Yield Farming”

Chasing high yields is one of the key factors leading to the bankruptcies we have seen among crypto companies. With promises of returns as high as 19%, some lending platforms and exchanges began using high yields as part of their user growth strategies, ultimately becoming over-leveraged during the LUNA collapse and collateral liquidations. Pursuing maximum returns by transferring funds within decentralized finance (DeFi) protocols, known as “staking mining,” became the norm for crypto institutions before the LUNA era.

In the face of massive returns, many crypto institutions—even those that only wanted to do right by their customers—at least engaged with a now-bankrupt company. But surely, more mature participants would at least see audited financial statements of high-risk counterparties, right?

Wrong. In fact, the most renowned accounting firms (read: the Big Four) often refuse to engage with crypto businesses in jurisdictions where auditor liability is not limited. There is a clear mismatch between auditors and crypto companies; auditors are inherently cautious and conservative, while crypto companies are not only high-risk but also operate in a constantly changing industry.

It is now evident that Three Arrows Capital obtained billions in loans without submitting audited financial reports. To prevent another catastrophic event, we need to develop better resources for managing risk. There is no better time than a bear market to lay the groundwork for mitigating the risks of institutional operations in the next bull market.

Clarity and Transparency

Worse than the excessive risks taken with customer funds by institutions is the fact that investors are completely unaware that this is happening. Policymakers are increasingly proposing measures to protect investors, with the EU's MiCA being a good starting point. Institutions need to be accountable for the promises they make to consumers—most notably regarding the safety of their funds.

For a long time, opacity has characterized traditional capital markets, and the “black box” nature of institutions not only prevents ordinary retail investors from accessing a wealth of financial opportunities but also exposes them to predatory lending schemes. Apart from being used to protect investors, there is no place for opacity in the cryptocurrency market.

The novelty of the crypto market means we do not need to work hard to clear out entrenched systemic flaws; we can eliminate them now. Blockchains designed to be auditable are the technology that underpins our entire industry. It is time to set a precedent for institutions to handle transactions on-chain, normalizing open and transparent finance.

At the very least, we need to establish a standard that ensures cryptocurrency investors never have to worry about what happens to their funds after they are deposited.

Shuffle is Shuffle

Chapter 11 of the Bankruptcy Code means that an entity with potential profitability can be saved after restructuring under debt. We need to draw a line between bankrupt companies and those built on fraud and deception.

For instance, Celsius rose with a fundamentally unsustainable business model that ultimately harmed customers in the long run. When bankruptcy liquidation is a healthier option for investors and the market, let’s not pretend that restructuring can solve the problem.

Moreover, rumors and speculation about “bailouts” highlight more than anything else that the cryptocurrency market is still misunderstood.

Cryptocurrency deliberately lacks a bailout mechanism. In traditional finance, sufficiently large banks may receive bailouts through taxpayer money or currency issuance. But if needed, there is no centralized institution in cryptocurrency to catch them when native industry companies fall. Particularly with Bitcoin, among many other crypto assets, there is a fixed supply that cannot be inflated. These emergency bailouts have the poetic characteristic of keeping the cryptocurrency market as free as possible. This is a significant way in which cryptocurrency diverges from the traditional banking system. Undermining this distinction is harmful to both the industry and mainstream understanding.

Looking Ahead

To ensure that another crisis of this nature does not disrupt the market again, the only way forward is to set a precedent of not rescuing fundamentally flawed institutions as we move ahead.

Major exchanges and institutional builders must come together to rebuild investor confidence and adopt transparent blockchains to iterate financial technology. We also need to collaborate with regulators to foster the coexistence of DeFi and centralized finance (CeFi) in functionality.

Custodianship will be a key factor in our future assessments, and recent events may draw increasing attention. Companies should seek to provide both on-chain and off-chain custody options, giving investors full visibility and control over their funds.

Ultimately, cryptocurrency will continue to exist, learning and maturing as the industry evolves. Meanwhile, the regulatory environment is also evolving, aimed at protecting investors and building confidence in assets, the entire industry, and users.