Written by: Chris Zuehlke, Global Head of Cumberland and Partner at DRW
Markets are Darwinian. They steadily march towards efficiency. Occasionally, they must sprint away from faulty constructs. As we look back on 2022, it is easy to get lost in a deluge of market changing headlines: Terra and Luna intertwined in mutual implosion, lenders relearning the lesson of duration and liquidity risk, and FTX’s fraud demonstrating the necessity of separation of responsibilities in all markets. It would be misguided to believe that this series of events hasn’t increased skepticism about the value and future of DeFi projects and blockchain infrastructure. We understand that, but it’s not a sentiment we share. With DRW’s heritage firmly planted in the TradFi markets, our experience tells us that complex market events often lead to the next tranche of progress as these new challenges spur the creation of innovative solutions.
Through the volatility of the past year – in both traditional and crypto markets, I frequently asked myself the same question: “Can blockchain technology improve the market’s ability to navigate this uncertainty?” My conclusion was usually yes. There is significant potential to leverage the transparency, determinism, and velocity of on-chain value movement. From extreme transparency of deposits to 24/7/365 near-real time movement of collateral, the potential to use blockchain technology to reduce system risk is too powerful to ignore. Case in point, we include the monitoring of liquidation levels for on-chain borrows in our risk management process. In a perfect world, centralized lenders would adopt similar transparency, but there is a more obvious upstream step: establishing a regulatory framework for fiat-backed stablecoins.
I don’t anticipate this shift being quick, but the adoption of fiat-backed stablecoins beyond DeFi is bordering on inevitable at this point. The stablecoin bill making its way through the US Congress shares many characteristics with a recent Consultation Paper from the Singaporean MAS on the same topic. Separate jurisdictions converging on similar principles (e.g., oversight by banking regulators, regular audits, backing limited to fiat/short-dated bills/repo, SLAs for minting and burning) is a good sign in our experience that we’re narrowing in on a path forward. While there will be more to be done to enable wider adoption of stablecoins by regulated institutions, establishing this framework is a critical next step.
I also anticipate that the events of 2022 will herald in a new wave of specialists, created to break the conflicts of interest that were put under a microscope in the aftermath of FTX’s implosion. This breaking apart of responsibilities was something DRW called for in our comment letter to the CFTC responding to the FTX US Derivatives amended DCO filing. While we think there is room to innovate new market structures that support a degree of vertical integration, there are certain structures that should not be permitted. Common control of a trading firm and an exchange that custodies customer assets is an obvious practice that needs to be expunged from the industry. There are sure to be more identified in due course. This will lead to an emergence of more single-responsibility service providers in the industry, ultimately improving overall resiliency.
Skeptics will be quick to argue that no amount of additional oversight or limitations on conduct will be sufficient for the industry to increase its credibility. We respectfully, but staunchly, disagree. The events of the past two months were not an indictment on Bitcoin, Ethereum, or blockchain technology. Rather, they were the result of the misappropriation of customer funds at a massive scale and perpetrated by bad actors. This, unfortunately, is not a cryptoasset specific issue (see MF Global). The irony is that DeFi primitives could have been used to help mitigate the potential for bad actors to perpetrate such a fraud.
The proper take-away, in our humble opinion, is for the industry to learn from the events of the past year, take a critical look at what evolution is needed, and then work together to establish the proper regulatory frameworks (changing the order of those operations is ill-advised). With that in place, institutional service providers will have a roadmap to follow as they expand their utilization of cryptoassets and blockchain infrastructure. We also expect to see a market that puts a premium on risk-mitigating offerings. Previously, market participants prioritized maximizing yield and capturing the convexity to the upside. In the future, they will prioritize tri-party qualified custodians, spot trading with no prefunding, ISDAs & CSAs, and transparency into reserves and liabilities. This shift in priorities, coupled with the continued efforts of good actors leading from the front, is sure to usher in the next wave of survival of the fittest in crypto markets. Evolution will take place right before our eyes. Let’s make Darwin proud.
Read Part 2 of our Year in Review series, "Lessons Learned on Risk Management."
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