2022 was a turbulent year for the cryptocurrency sector, with one of the worst bear markets ever recorded and the collapse of several major cryptocurrency platforms. The breakout of Terra's UST stablecoin peg caused a ripple effect on the crypto market as a whole. It led to the bankruptcy of other crypto asset companies, such as Celsius, Three Arrows Capital, and the largest of all to date, FTX.
As the OECD found in its analysis, Lessons from the crypto winter, published last December, the failures of crypto companies during the current crisis are mainly related to CeFi (centralized finance) platforms and DeFi (decentralized finance) platforms whose decentralization feature is in name only. These platforms were given the derogatory nickname "Dino" (decentralized in name only).
CeFi platforms have clear centralized control over the operation of the platform, over the management of user funds and over decision-making, but without adequate internal or external supervision and control mechanisms. The concentration of large platforms, over-leveraging and lack of risk management, as well as the interconnectivity between them, caused a domino effect that resulted in the collapse of many of the main players in the industry. On the other hand, the โrealโ DeFi platforms that offer a significant decentralization feature continued to perform as expected, despite the massive decline in the value of the collateral promised on them.
Ripple effect of the great collapse
Last May, the peg of the algorithmic stablecoin UST to the USD was broken. This resulted in significant losses for its holders and rendered the stablecoin worthless in less than a week. The developers of the project initially tried to re-peg the UST to the dollar, but sales of the currency continued because it had lost market confidence. As a result, incumbents made massive withdrawals from the protocol, the cryptographic version of a โrun on the bankโ scenario.
Celsius, a crypto asset lending platform, was the first major company affected by the UST collapse. The company allowed its clients to lend and borrow against digital assets and offered deposit services that bear interest at a rate of around 15% to 20%. The collapse of UST and other assets hurt the value of the company's collateral, prompting a number of withdrawals by Celsius users. The company announced the suspension of withdrawals and eventually had to declare bankruptcy. The revelations in the Celsius case highlight the risks of the lack of clear standards in user terms of use, the lack of transparency regarding the business model and investment standard, and the disparities in regulatory oversight between traditional companies and innovative companies offering similar services.
The instability in the crypto market had an immediate impact on other major players, including Three Arrows Capital (3AC), Voyager Digital, BlockFi, and more. The 3AC collapse had a direct impact on the Voyager and BlockFi collapses. Both companies had made loans to 3AC totaling hundreds of millions of dollars, so 3AC's inability to repay its loans led to its collapse.
FTX collapse
FTX collapsed last November, one of the largest crypto asset trading exchanges in the world. The FTX founder has been accused of committing a number of fraudulent acts over the years. These include the illegal use of client assets for the benefit of another company they own (Alameda Research), inflating the value of the balance sheet through means of manipulation, false representations, and a long list of other crimes. This event further undermined confidence in the crypto industry and demonstrated the need for regulations, certainly in relation to Ce-Fi players.
Regulation
The series of crashes severely hurt cryptocurrency users, who relied on platforms that engaged in aggressive marketing efforts without any oversight. It seems that the member states of the European Union are in the most advanced position to promote the regulation of this industry. The European Union approved its proposed framework, the Markets in Crypto Assets (MiCA) regulation, in October 2022, which will come into force in 2024. This framework strives for comprehensive regulation. The MiCA regulation specifies, in hundreds of pages, the rules that will apply to crypto asset service providers:
- Meet the minimum capital requirements (depending on the type of services provided).
- Separate and protect customer assets and prevent them from using them on their own.
- Impose adequate anti-money laundering policies and procedures.
- Maintain effective policies for the prevention of conflicts of interest.
- Publication of a white paper.
- Imposing regulations on stablecoins and a long list of other issues.
If most of the collapsed rigs had chosen to operate in EU member states, they would have been subject to clear rules, which would likely have prevented or minimized the damage.
Regulations in Israel
The enactment of regulations in Israel lags behind that of Europe, and the current discourse is entirely at the recommendation stage. He Digital Asset Regulation Report, prepared by the Ministry of Finance and the department of the chief economist and published in November 2022, contains important policy recommendations regarding the creation of a new regulatory infrastructure for asset-backed digital tokens. However, it lacks the legal framework that could actually rectify the existing flaws in Israeli law.
De-Fi and Compliance
At the beginning of 2022, it was possible to believe that you could use DeFi without having to comply with the requirements of the regulatory authority. As time went by, an increasing number of incidents proved otherwise. Last August, the US Treasury Department imposed sanctions on Tornado Cash due to allegations that it was laundering virtual currencies. Aave and DAO Maker, who are members of decentralized autonomous bodies, did not remain indifferent and decided to act in accordance with the sanctions. Last December, decentralized cryptocurrency exchange Uniswap published an update to its privacy policy regarding the collection and storage of user data as part of its commitment to transparency.
While FTX liquidators are trying to pick up the pieces, DeFi platforms continue to operate, attracting users, offering non-custodial trading services, and rapidly liquidating risky positions. The FTX crash led users to seek non-custodial cryptocurrency trading alternatives. Therefore, as the largest and most liquid DeFi exchange on the market, it captured higher trading volume. Last month, one of the non-custodial hardware wallet providers reported a series of record sales.
Regulatory Twilight Zone
On the one hand, it seems that the cryptocurrency industry is still hesitant, even after one of the biggest scandals in all of financial history. On the other hand, transparent and decentralized alternatives to the CeFi sector demonstrate why they are so important, as well as their ability to function effectively even in times of crisis.
Despite the differences in business models and their labeling, both CeFi and DeFi platforms currently operate in a way that is not compliant with regulations. Alternatively, some are operating in a twilight zone that regulation has not yet reached. Consequently, due to the absence of consumer and investor protection, such platforms expose their users to material risks. The recent crashes of major crypto players highlight the importance and urgency of enacting proper regulations.
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