2022 proved tumultuous for the blockchain and digital assets industry as one destructive event after another rocked the markets. The de-pegging of the Terra/Luna stablecoin, the $612m worth of Ethereum and USDC stolen in the Ronin Bridge attack and finally, the spectacular disintegration of cryptocurrency exchange FTX and its affiliate, Alameda Research, battered the industry and shattered the trust that many had in decentralised financial services (DeFi). By December 2022, cryptocurrency market cap was down 85%, and a new ‘crypto winter’ had set in. And just as the dust began to settle, in 2023 we witnessed the collapse of Silvergate, Silicon Valley Bank and Credit Suisse, further weakening the market and signifying tougher economic times ahead.
Despite these challenges, the view is not entirely bleak. New technologies will continue to be developed, creating new possibilities for financial services. Distributed ledger technology (DLT) is fast changing our concept of how money and payments work. Central Bank Digital Currency (CBDC), bank-backed stablecoins and instant multi-currency settlement are firmly on the horizon. Finally, tokenised financial instruments — equities, bonds and commodities – will reduce our reliance on counterparties and vastly increase trading efficiencies.
As the appalling events of 2022 unfolded, many in the ‘grown up’ side of the industry — former centralised finance (CeFi) bankers, accountants, technologists, regulators and lawyers – were deeply troubled. They knew the situation wasn’t wholly the fault of a few bad actors. They thought long and hard about why the collapse happened and specific preventative measures to avert future crises. In our latest Financial Markets Insights paper 1, “Restoring Trust in Digital Assets.” The Realization Group spoke to industry leaders from layer-1 blockchains, banks, custody providers, crypto exchanges, technology providers and industry associations on how to restore trust with institutions, investors and consumers.
We looked at:
- The reasons for the crisis and the industry’s response
- Myths and misunderstandings perpetuated by the media
- The need for better rules of engagement: the segregation of custody and trade execution, proof of reserves, robust auditing and due diligence
- Improving risk management practices
- New priorities for regulators and legislators
- The role and importance of education
- What we can expect next: new regulations, use cases, and market growth.
Our goal was to unearth pragmatic, actionable insights that we could work towards to help reform and rebuild the digital assets and cryptocurrency ecosystems.
Several themes emerged. Universally, participants felt that re-establishing trust was critical to the ecosystem and their business’s success. Furthermore, it was the industry’s duty to proactively ‘save itself’ and not wait for regulatory action. Companies needed to act responsibly, sustainably and in a more customer-centric manner. Customer assets must be ringfenced, recoverable and kept separate from operating expenses or investments. Sound Know Your Customer (KYC) practices should be required prior to onboarding. Additionally, lessons could be learned from the 2008 financial crisis, particularly around the role of prudential and conduct-level risk frameworks and applied preventatively.
Our participants noted that with the widespread use of cryptocurrencies (in essence, ‘digital money’), the damage from a data loss is even more profound. Interviewees reiterated the importance of robust cybersecurity practices and the role of custodians.
One of the participants, Jack McDonald, CEO of PolySign, put it succinctly: “one of the silver linings after a difficult year is that there will be a real reset in terms of how institutions think about how they enter the business, how they trade, custody and report, which will ultimately be healthy.”
Finally, participants highlighted the need for education and myth-busting. Negative stories about the cryptocurrency market have dominated and skewed recent media coverage. In contrast, actual use cases and content on the benefits of Distributed Ledger Technologies have been less effectively communicated. This environment makes it difficult for time-poor policymakers to properly understand what this emerging technology is and what it means for financial services. This situation often leads to knee-jerk decision-making, jagged regulatory regimes and ‘regulation by enforcement’- which isn’t good for anyone.
In summary, there are many practical approaches to take us forward. Our financial markets have taken hundreds of years to evolve. There are many excellent reasons for Traditional Finance (TradFi)’s risk management and separation of duties and controls. These shouldn’t be entirely abandoned because we now have more efficient technology, new market players and new possibilities with DeFi. We can simultaneously look to the past and to the future as we develop more workable business models, rules of engagement and regulatory regimes to restore trust and help our industry thrive.
1- Interviews took place February 2023
2- Participating firms included: Ava Labs, Bosonic, Circle, Custodiex, GMEX Group, Digital Pound Foundation, Fireblocks, Global Counsel, Greengage, MG Stover, PolySign, Standard Custody and Swarm.