In a few months, when calm returns to the cryptocurrency market, the lessons of the current liquidity crunch will come yet clearer and the crypto industry will overcome this crucial test of its young history.
The promise the crypto industry has made is a valid one -- to democratize finance and provide access to money and financial services to those who are often excluded from the traditional financial system: underserved and underprivileged communities and minorities.
How many times have we heard stories from people of color about a legacy bank refusing to open an account for them? How many times have we heard that a traditional bank has refused a loan to a person of color, even as they meet the required creditworthiness criteria?
The crypto space is supposed to be borderless, colorless and permissionless. But it so far has been something of a minefield for investors. That's got to stop.
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The Key Lesson: Lack of Transparency
This current crisis of confidence has been fueled mainly by a credit crunch that affects crypto lenders, such as Voyager Digital, BlockFi, Celsius Network, Vauld, Babel Finance, CoinLoan and CoinFlex.
The first, and key, lesson to be taken here is: Transparency must be the basic principle in the crypto industry.
Two months after this disaster started, investors are still in the dark about many critical matters. Like: Which other companies are in financial trouble or have effectively collapsed and haven't so indicated? How much exposure to the main crypto firms have to the failed hedge fund Three Arrows Capital (also known as 3AC)?
Transparency would put an end to the guessing game that investors are currently engaged in and could prevent panic.
On June 17, 3AC Co-Founder Kyle Davies told The Wall Street Journal that the firm was considering asset sales and a bailout after it suffered huge losses. On July 8 Coindesk disclosed that cryptocurrency exchange Blockchain.com was preparing to take a $270 million loss related to 3AC. Why did it take three weeks to inform investors?
"Many of the major lenders released little information about their lending activity, leaving the market grasping in the dark as participants try to 'price in' the risk of further contagion," Shane Molidor, chief executive of cryptocurrency financial platform AscendEX (formerly BitMax), told me.
A big group of crypto lenders, which operate as banks while touting themselves as democratized interest-income and lending platforms, do not have enough cash on hand to provide to clients who want to withdraw their funds.
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Focus on High Yields
They got themselves into this mess because they loaned their clients' deposits to 3AC, which used the same collateral with all these firms, according to experts.
3AC invested these large sums in cryptocurrencies, and in particular in Luna, a digital currency that collapsed in May, along with its sister token, UST. At least $55 billion was lost in this debacle. As a result, 3AC could no longer repay its creditors, causing significant holes in its reserves.
Many of today's troubled lenders are what are known as centralized finance players. They offer crypto financial services and thus act as intermediaries for all the activities of their customers.
Initially, they lent money to traders and managed risk by requiring heavy collateral from borrowers. But for the past two years at least, these lenders have been lending to actors that "can transact and generate income for themselves through arbitrage, market making, or shorting certain stocks or digital assets," as Celsius Chief Executive Alex Mashinsky said in a video in 2020.
Basically, these firms have started to take big risks by lending their customers' money to players who rely mainly on the evolution of the prices of the cryptocurrency market in return for high yields.
We are now witnessing the backlash from this change.
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"Many of these lenders were lending customer deposits out to 3AC in return for high yields, but in doing so, the lenders were apparently comfortable accepting zero visibility into how 3AC deployed the borrowed capital," Molidor says.
"[Centralized finance-decentralized finance] lenders are generally considered black boxes, making it difficult for investors, analysts, and market participants to judge their risk levels and exposure to other segments of crypto markets," he adds.
In the future, crypto lenders must explain to the general public, and to retail and professional investors alike, how they expect to generate yields of 10% to 17%. And investors must demand that information and review it carefully.
If the firms are transparent, everyone will know what to expect. The crypto space will then distinguish itself from traditional finance, which it hopes to compete with and disrupt.
What is the point of creating a financial system that claims to be democratic if it repeats the same opaque practices for which we blame the current system?
