Verafin Crypto factsheet

As Crypto’s Winter Thaws, Risk Management Finally Gets its Close-Up

Talk about a bad case of deja vu – in a volatile second quarter of the year marked by the collapse of a major stablecoin, the crypto sector has essentially played out a microcosm of the 2008 global financial crisis. We witnessed significant market players with unsecured creditors who defaulted on their loans, counterparty insolvencies, regulatory investigations around possible financial crime and a huge amount of volatility due to cascading liquidations – and of course, no government bailouts to help stabilize the ecosystem.

While DeFi has taken much of the attention and blame for the meltdown – especially the Ponzinomics behind Terra’s algorithmically backed UST stablecoin – the truth is that the domino cascading liquidations that followed Terra’s demise were mostly a result of bad risk management and systemic overleveraging in the CeFi ecosystem.

Lots of Flash, But No Effective Risk Management

Well-known CeFi firms Celsius and Voyager Digital and industry stalwart hedge fund Three Arrows Capital (3AC) are some of the big names caught up in the insolvency drama. All of these firms carried out lending activities that were, for lack of a better word, opaque. Much of their activity was performed off-chain, and lending deals were done OTC. For retail-focused CeFi firms like Celsius, there was a huge lack of transparency around the use of customer funds.

Much of this risk may not have materialized if these transactions were transparently performed on-chain, especially in light of a lack of regulatory oversight. Or we can say that at least if bad risk management and shady custodianship practices were carried out transparently on-chain, they would be available for the entire public to research and analyze.

Further, it seems that CeFi firms were simply not monitoring risks across both their fiat and crypto flows, especially basic risks around lending standards, creditworthiness, and market volatility. This has very little to do with DeFi. Had CeFi firms pursued better risk management, and if retail had been armed with more transparent data on-chain to make more informed capital allocation choices, the crypto ecosystem may have largely avoided this insolvency crisis or strongly blunted the impact.

DeFi Best Practices = Transparency & Integrity Principles 101

When observing the recent meltdown, the slightly contrarian view is that while CeFi suffers as a result of bad players and bad practice, DeFi has been transparently and orderly chugging along. DeFi has efficiently and transparently dealt with cascading liquidations with minimal fallout on-chain. Every bit of collateral is known, with debt dashboards made publicly available for those who care to look, and every loan liquidation and transaction ‘out in the open’ for the world to see (one caveat to this will be the future adoption of privacy-oriented DeFi protocols which are a large enough topic to be addressed in a subsequent article).

When you take out the nasty side of DeFi - the unsustainable cash grabs and obvious ponzis - much of what is left is a fully functioning financial system that, somewhat ironically, has more efficiency and market integrity in the realm of systemic risk than most regulators could dream of. And this is important given that market efficiency and integrity are the dual mandates of most regulators globally.

What is the lesson here? CeFi clearly needs more regulatory scrutiny, especially if offering products and services to retail. CeFi should be encouraged to use solutions that monitor their risk decisions and help their compliance efforts with all necessary regulations around the custodianship of customer funds – both fiat and crypto. For the latter, should we explore if it makes sense for regulators to encourage CeFi players to move some of their activity on-chain and benefit from DeFi’s transparency?

On this point, clearly, DeFi is still lacking in areas of importance when it comes to risk management as well as stopping financial crime – the pseudo-anonymous nature of on-chain transactions and the lack of KYC are preventing many regulated financial institutions from going all-in on the space. However, while these deficiencies in trust present challenges–and will inevitably be solved in their own way–we shouldn’t hesitate to wait for these solutions to emerge in order to benefit from the transparency that DeFi provides and the inherent systemic risk reduction.

With (Crypto) Crisis Comes (Market Integrity) Opportunity 

Tools today are becoming more sophisticated in identifying and managing risks around pseudo-anonymity in DeFi. Solutions now go beyond simply risk-scoring wallet addresses based on sanctions blacklists or proximity to wallets with fraudulent activity. By monitoring both fiat and crypto transactions, a firm can build a holistic view of their customer’s flow (irrespective of whether that customer is retail or institutional) and manage credit and financial crime risks alike. CeFi firms offering retail products and services and their lenders (who in many cases were their CeFi peers) would have done well to employ these systems to identify and reduce risks much earlier.

From an industry and regulatory point of view, these tools, combined with the realization that DeFi has baked in the ability to manage and iterate to improve systemic risks, should provide confidence to TradFi institutions and regulators alike that 1) we have the tools today for better risk management within crypto, and 2) that DeFi best practices may be a means to enable a safer and more transparent market – even in the face of a major insolvency crisis as have just witnessed.

The fact is, for all intents and purposes, DeFi is a parallel financial system that has shown it can efficiently and effectively clean up its own financial insolvency crisis. This should be recognized rather than criticized. Warts and all, it is an advantageous starting point for a sector-wide vision that embraces management of systemic risk and market integrity through transparency. Add to the mix industry solutions that manage risk and help detect financial crime both on and off-chain. And this is a powerful combination to bolster market integrity.

Thankfully, we already have the tools today to do this; and ultimately, we should utilize these strengths to fight in our collective resolve against overtly risky and integrity-damaging financial practices, and the fight against financial crime, for a better future for our crypto ecosystem and the global financial economy overall.

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