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The Crypto Winter: A Risk Management Reckoning That Needed to Happen

July 8, 2022

Charlie Beach

The Crypto Winter: A Risk Management Reckoning That Needed to Happen

While shocking headlines catch the eye, risk experts believe the recent crypto market events could be catalyst for much-needed change in the industry

A cursory glance at the markets right now may cause many crypto investors to feel uncertain. Bitcoin is now down close to 70% off its previous all-time high, and many altcoin projects appear to be circling the drain. The Bitcoin fear and greed index currently hovers over extreme fear as the number-one cryptocurrency wrestles to defend the $20,000 mark.

If crypto was once an isolated ecosystem independent from established global markets, rising institutional adoption and strengthening fundamentals have distinctly changed the game.

Bitcoin and cryptocurrencies are now very much affected by global macro factors like any other market. The S&P500 tumbled 4% recently to mark a new low for the year, and the painful sell-off in the Nasdaq continues, with crypto following suit.

The global cost of living crisis marked by four-decade high inflation, post-pandemic supply shocks, the war between Russia and Ukraine, and the expansion of the money supply in response to COVID-19 has spurred the Federal Reserve and other global central banks into action, rising interest rates at a pace that those born after the early 1980s have never seen before.

Contrary to the one-time belief that Bitcoin would position itself as a flight-to-safety asset and an inflation hedge, it has emerged as a risk asset and the deteriorating macro picture has sparked a major sell-off.

This has also been exacerbated by a number of crypto-specific risk events. The much-publicised crash of Terra’s stablecoin TerraUSD (UST) and sister token LUNA wiped tens of billions of dollars off the market, accelerating crypto’s plummet.

More recently, the uncertainty surrounding the crypto lending platforms that have paused customer withdrawals and swaps under “extreme market conditions” is adding fuel to the fire.

As many firms across the industry freeze hiring or make drastic cutbacks, the crypto naysayers are smugly predicting that this could be the death of crypto as we currently know it.

But there is also a more optimistic way to look at things.

The recent series of events have brought to light the inadequate risk management practices and regulatory gaps that have been a barrier to more widespread adoption. If sunlight is the best disinfectant, this period, while intensely uncomfortable, could compel responsive action and transformative change that will result in a far more resilient and safer crypto marketplace for investors in the future.

The Inevitable Crypto Shakeout

As Terra and countless other over-leveraged lending projects have proven, crypto assets are intrinsically risky and require careful risk management. High-yielding stablecoins with near-20% returns may be attractive but come with equally high risk.

Many crypto operators, including exchanges, have not always acted responsibly, nor in the best interests of investors by listing a myriad of tokens and overhyped projects, only to leave investors reeling from their losses.

Likewise, the practices of certain crypto lending operations have also revealed that high rewards typically come with high risk. This style of crypto lender gathers crypto deposits from retail customers and re-invests them in various, sometimes aggressive trading strategies to fund the high yields offered to attract those deposits.

In good times, they were able to proclaim double-digit returns and attract tens of billions of dollars in assets. Now, as their fortunes reverse, they have been unable to redeem their clients' assets and face a very grave future. Their clients share the pain.

A Leaf out of the traditional finance risk playbook

The Global Financial Crisis of 2008 revealed the shockingly cavalier practices of systemically important financial institutions in a risk event that almost took out the entire global economy. But the aftermath resulted in greater regulatory scrutiny, more robust capital and liquidity requirements and the adoption of risk management practices that built a far stronger financial system.

If we look at the current state of play as a period of both reflection and action, the industry can create a new roadmap for the future. Risk leaders need to stand up and play a defining role. And as an industry, we need to take a look at ourselves in the mirror, even if the reflection looking back is a little scary.

Crypto is still in its infancy and, as often seen in nascent industries, the pace of innovation has been too fast for critical aspects of the infrastructure, such as good risk management. Symptoms of this include poor counterparty due diligence, excessive leverage, and systematic offering of inadequately collateralized loans.

Firms across the industry need to adopt and develop more sophisticated risk management techniques. They need to be more prudent and prioritize long term safety over short-term, unsustainable returns.

At a time when the industry is laying off employees, crypto firms need to be investing in risk, compliance and regulatory departments, and staffing them with expert practitioners.

In these savage market conditions, this crypto winter will likely result in a shakeout that will see companies and projects that lack solid foundations and sound risk management falling to the wayside.

It is also important to recognize that not all crypto companies should be tarred with the same broad brush. There are many credible businesses that operate with expert management teams, integrity, transparency and sound risk management.

After winter comes spring. At which time, the most innovative, experienced, and responsible will be needed to drive the industry forward and build the next generation of finance.



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