Crypto Industry Is Going Through Growing Pains – Maturing Into A Robust Ecosystem

The global crypto market, at $895 billion, has lost over $2 trillion in value since the market peaked in November 2022. It includes centralized finance (CeFi), decentralized finance (DeFi), nonfungible tokens (NFT), and stablecoins. The bear market of 2022 has culminated in numerous market failures and bankruptcies in custodian CeFi platforms. On the other hand, DeFi platforms are functioning, although not unscathed. Just as traditional finance (TradFi) went through its growing pains, Crypto finance is also maturing similarly. Modern financial institutions and surrounding regulatory/oversight policies took decades to achieve their present-day trustworthiness, whereas the nascent Crypto finance institutions are barely a few years old. The 2008-2009 financial crises helped clean TradFi; similarly, the ongoing market forces through failures and bankruptcies are removing excesses and fragile actors, paving the way for a robust Crypto ecosystem.

Billions in venture dollars chasing crypto projects fueled innovations and, unfortunately, attracted bad actors for exploits. The actions of a few rogue individuals should not relegate the entire industry towards being bankrupt or finished. Several macro and micro economic factors fueled the 2020-2021 crypto market frenzy. For example, “free money” policies by global banks encouraging excessive risk-taking; hockey-stick growth prospects; billions in herd-mentality venture investments; fear-of-missing-out (FOMO); aggressive promotions by media and influential people, and more. The crypto gold rush lured venture investors, entrepreneurs, depositors, and speculators into the craze, shortchanging the needed checks and balances. Due diligence and fiduciary duties on Crypto projects were thin. Governance, compliance, risk management, and third-party audits were nonexistent or afterthoughts. Ironically, many who fervently cheered the speculative frenzy are now the loudest voices portending the death knell for Crypto.

Blockchain and Crypto innovations that turbocharged the industry growth and adoption still remain. Its distinctive features, i.e., self-sovereignty, transparency, and decentralization, will continue to find new emerging market opportunities, enabling Crypto to surmount the present setbacks and hurdles. Novel innovations, such as Tokenomics, peer-to-peer transactions, and asset tokenization, can only be implemented within the Crypto ecosystem. Sam Huber, CEO of LandVault, states, “Technological innovations go through cycles of hype. Just as the dot com crash in 2000 didn’t kill the emerging internet, the crypto crash of 2022 will not stop Web3 in its tracks. It is weeding out the bad actors, but the ones who strategically remain will have time to build for the next bull market. The metaverse fundamentals driven by the convergence of gaming and the blockchain are now inevitable trends.”

Crypto Finance: Banks and brokerages provision yield products, trading, and other financial services to fiat depositors and holders; DeFi, and CeFi platforms provide similar products and services to crypto depositors and holders.

Non-Custodial Decentralized Finance, or DeFi, is a decentralized, open source, transparent, verifiable, blockchain-based financial ecosystem. Immutable smart contracts and programmable codes are the intermediaries responsible for underwriting and executing Crypto financial transactions risk management. Crypto lending protocols utilize traditional credit check and underwriting mechanisms, allowing borrowers to use their existing real-world assets as collateral for DeFi loans or staking. DeFi typically offers higher yields relative to the traditional banks; however, loans are generally overcollateralized, i.e., borrowers have to deposit assets worth much more than their loans. Deposited assets remain custodied with the user, even as they leave the user’s wallet and enter into a smart contract. They are always instantly accessible by the user with no lockup periods, and funds cannot be rehypothecated.

Through the market chaos, fully automated, transparent, and decentralized DeFi protocols, such as Aave, MakerMKR
, Rocket Pool, CompoundCOMP
, and more, have been functioning as designed without catastrophic failures. Unlike CeFi, which has seen numerous market failures, frauds, and bankruptcies, Defi loans have not defaulted because they are the senior debt in the overcollateralized capital stack and the first to get paid when the market tanks. If falling asset prices trigger a margin call, the smart contracts liquidate the positions and automatically pay back the outstanding debts. There is no ability to restructure/renege on the smart contracts within DeFi. Darren Langley, General Manager at Rocket Pool, states, “What makes DeFi special is its focus on transparency and controls. A good DeFi protocol has open source code and is audited by respected security professionals; their balances can be verified on-chain and have public, decentralized governance.”

The most significant vulnerability of a DeFi platform lies with potentially faulty protocol design, unintentional or deliberate, which can trigger market instability and failures. Hidden bugs in the open-source smart contract code can set in motion unintended consequences. DeFi projects offered inflated yields, fueling the speculative frenzy and creating a web of the interconnected undercollateralized house of cards, which now has collapsed and threatens the entire Crypto ecosystem. In May 2022, the undercollateralized algorithmic TerraLUNA3
stablecoin (USTUST
) lost its US dollar peg, crashing the whole Terra DeFi ecosystem and sparking contagious failures of interconnected CeFi platforms. This malfunction was triggered by the design flaw in the UST algorithm, causing its de-pegging under extreme market volatility and downward draft in asset prices.

Custodial Centralized Finance or CeFi: Digital asset intermediaries hold custody of user funds and trust, providing crypto products and financial services. CeFi platforms include centralized crypto exchanges (CEXs), crypto lending companies, and digital currency payment providers; Binance, Coinbase, Kraken, and now bankrupt FTX, CelsiusCEL
, Voyager, BlockFi, Three Arrows Capital (3AC), and more.

CeFi platform insiders control the deposited Crypto assets in custodied wallets. Although these funds are purportedly housed on these platforms, they are maintained outside of the user control and oversight. In the aftermath of the CeFi implosion, depositors are painfully learning that the Crypto assets held in their accounts were not “theirs,” i.e., not your keys, not your coins. Rogue and fraudulent individuals at the helm of now bankrupt CeFi platforms, such as Celsius, Voyager, BlockFi, Gemini, FTX, and more, co-mingled user deposits into omnibus wallets and treated their customers as “unsecured creditors.” They rehypothecated the customer deposits and lent them out to speculative investors and hedge funds, creating a mass of undercollateralized IOUs, which ultimately defaulted. The steep decline in the re-invested loan values triggered the unwinding of the leverage, resulting in a domino effect of defaults in CeFi. Millions of investors and depositors are now horrifyingly looking at wiped-out losses with suspended accounts.

CeFi executives allegedly misused their access to user wallets and plundered billions of deposited assets. They committed fraudulent acts because they could. Acting unilaterally and recklessly, company insiders breached their fiduciary duty of safeguarding user funds and created a confidence failure in the entire Crypto ecosystem. Egregiously, many individuals at the helm of these bankrupt platforms being accused of fraud are now “profusely sorry” and want to help.

The rise of CeFi: Participation in the DeFi banking system has a steep learning curve. The user must interact with the protocol directly, have higher technological knowledge, and be much more hands-on. These technical barriers enticed venture investors and entrepreneurs to create centralized user-friendly middleware CeFi platforms, i.e., BlockFi, Celsius, Voyager, and more. These CeFi platforms require users to simply deposit their assets with the central entity and collect the promised yield in exchange, providing a straightforward and familiar entry point. CeFi companies attracted millions of depositors and experienced explosive growth in custodied assets by providing a seamless, user-friendly interface and a promise for high yields.

Jessica Walker from Fluid Finance states, “The centralized cryptocurrency platforms have acted as wolves in sheep’s clothing. Users were storing their funds in a black box and had no oversight into how they were being stored.” The recent CeFi fiascos underscore the need for education and training. Ryan Horst, the CEO of Blockchain Insight Group states, “There’s a great opportunity to make sound investments and passive income in the Crypto pace; however, without proper training, you might as well be entering into a casino.”

The Crypto industry is at a crucible moment. It is facing serious trust and confidence issues due to personal wallet exploits, exchange hacks, smart contract failures, stablecoins de-pegging, rug pulls, and more. In the aftermath of the cataclysmic market failures, industry oversight of CeFi platforms incorporating consumer protection is paramount. The Crypto industry collectively could create robust autonomous oversight middleware protocols that conduct stress tests, verify proof of reserves, audit protocols to confirm functionality, transactional security, and more.

DeFi has significantly outperformed CeFi during the Crypto market turmoil, offering a framework to move forward in building a solid foundation for the industry. Impressively, in a few years, Crypto finance has achieved what took decades to build in the traditional financial services industry. Going forward, these maturing companies, creating innovative crypto products and services, will understand and implement robust risk mitigation controls in their platforms. Risk management and compliance cannot be “oops” or afterthoughts. If the Crypto industry wants to fulfill its aspirations of serving billions of users, it needs to learn from these mistakes. Yes, the Crypto industry needs to and is growing up!