The crypto industry is going through growing pains to become a robust ecosystem

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The $895 billion global crypto market has lost over $2 trillion in value since the market peaked in November 2022. It includes centralized finance (CeFi), decentralized finance (DeFi), non-fungible tokens (NFTs) and stablecoins. The 2022 bear market has resulted in numerous market failures and bankruptcies on CeFi depository platforms. In contrast, DeFi platforms are working, but not unscathed. Just as traditional finance (TradFi) has gone through its growing pains, Crypto finance is also maturing in the same way. Modern financial institutions and surrounding regulatory/supervisory policies have taken decades to reach their current reliability, while nascent Crypto financial institutions are barely a few years old. The financial crises of 2008-2009 helped clean up TradFi; likewise, ongoing market forces through failures and bankruptcies weed out excesses and weak players, paving the way for a robust Crypto ecosystem.

Billions of dollars in venture capital chasing crypto projects have fueled innovations and, unfortunately, attracted bad actors for exploits. The actions of a few rogue individuals should not relegate the entire industry to bankruptcy or the end. Several macro and microeconomic factors fueled the crypto market frenzy in 2020-2021. For example, the “free money” policies of global banks encouraging excessive risk taking; hockey stick growth prospects; billions of herd mentality venture capital investments; fear of missing out (FOMO); aggressive promotions by media and influencers, and more. The crypto gold rush has drawn venture capitalists, entrepreneurs, depositors and speculators into the craze, bypassing necessary checks and balances. Due diligence and fiduciary duties on Crypto projects were thin. Governance, compliance, risk management and third-party audits were non-existent or an afterthought. Ironically, many of those who fervently cheered on the speculative frenzy are now the loudest voices heralding Crypto’s death knell.

The Blockchain and Crypto innovations that drove industry growth and adoption remain. Its distinctive characteristics of self-sovereignty, transparency and decentralization will continue to find new opportunities in emerging markets, allowing Crypto to overcome current setbacks and obstacles. New innovations, such as Tokenomics, peer-to-peer transactions, and asset tokenization, can only be implemented within the Crypto ecosystem. Sam Huber, CEO of LandVault, says, “Technological innovations go through cycles of hype. Just as the dot com crash of 2000 didn’t kill the emerging internet, the crypto crash of 2022 won’t stop Web3 in its tracks. Weed out the bad players, but those who stay strategically will have time to build for the next bull market. Metaverse fundamentals driven by the convergence of gaming and blockchain are now inevitable trends.

Crypto Finance: Banks and brokerage houses provide yield products, transactions and other financial services to fiat depositors and holders; DeFi and CeFi platforms provide similar products and services to crypto depositors and holders.

DeFi – Decentralized finance. Blockchain concept, decentralized financial system

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Non-custodial decentralized finance, or DeFi, is a decentralized, open-source, transparent, verifiable, and blockchain-based financial ecosystem. Immutable smart contracts and programmable codes are the intermediaries responsible for underwriting and executing the risk management of Crypto financial transactions. Crypto lending protocols use traditional credit checking and underwriting mechanisms, allowing borrowers to use their existing real assets as collateral for loans or DeFi staking. DeFi generally offers higher returns compared to traditional banks; however, the loans are usually over-collateralized, meaning that borrowers must deposit assets worth far more than their loans. The deposited assets remain in the custody of the user, even if they leave the user’s wallet and enter into a smart contract. They are always instantly accessible by the user with no lock-up period, and the funds cannot be re-mortgaged.

Through the market chaos, fully automated, transparent, and decentralized DeFi protocols, such as Aave, Maker, Rocket Pool, Compound, etc., performed as intended without catastrophic failures. Unlike CeFi, which has experienced numerous market failures, frauds and bankruptcies, Defi loans have not defaulted as they are the senior debt in the over-collateralized capital pile and the first to be paid when the market crashes. . If falling asset prices trigger a margin call, smart contracts liquidate positions and automatically repay outstanding debts. There is no possibility to restructure/disclaim smart contracts within DeFi. Darren Langley, CEO of Rocket Pool, says: “What makes DeFi special is the emphasis on transparency and controls. A good DeFi protocol is open source and audited by security professionals. respected; their balances can be verified on-chain and have public and decentralized governance.

The most significant vulnerability in a DeFi platform is potentially flawed, unintended or deliberate protocol design, which can trigger instability and market failures. Hidden bugs in open source smart contract code can trigger unintended consequences. DeFi projects offered inflated returns, fueling speculative frenzy and creating a network of interconnected and under-collateralized house of cards, which has now collapsed and threatens the entire Crypto ecosystem. In May 2022, the under-collateralized Terra (UST) algorithmic stablecoin lost its peg to the US dollar, crushing the entire Terra DeFi ecosystem and causing contagious failures of interconnected CeFi platforms. This malfunction was triggered by the design flaw of the UST algorithm, causing it to become unanchored in extreme market volatility and falling 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 (CEX), crypto lending companies, and digital currency payment providers; Binance, Coinbase, Kraken, and now bankrupt FTX, Celsius, Voyager, BlockFi, Three Arrows Capital (3AC), and more.

Insiders of the CeFi platform control Crypto assets deposited in custodial wallets. Although these funds are allegedly hosted on these platforms, they are kept out of user control and monitoring. 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 head of now bankrupt CeFi platforms, such as Celsius, Voyager, BlockFi, Gemini, FTX, etc., mixed user deposits into omnibus wallets and treated their customers like ” unsecured creditors”. They re-mortgaged customer deposits and lent them to speculative investors and hedge funds, creating a mass of under-secured IOUs, which eventually defaulted. The sharp decline in reinvested loan values ​​triggered the unwinding of leverage, resulting in a domino effect of defaults on CeFi. Millions of investors and depositors now watch horribly as losses are erased with suspended accounts.

CeFi executives allegedly abused their access to users’ wallets and looted billions in deposited assets. They committed fraudulent acts because they could. Acting unilaterally and recklessly, company insiders violated their fiduciary duty to protect user funds and created a lack of trust in the entire Crypto ecosystem. Blatantly, many of the people running these failed platforms accused of fraud are now “deeply sorry” and want to help.

The rise of CeFi: Participation in the DeFi banking system has a steep learning curve. The user should directly interact with the protocol, have higher technological knowledge and be much more practical. These technical obstacles have prompted venture capitalists and entrepreneurs to create centralized and user-friendly CeFi middleware platforms, namely BlockFi, Celsius, Voyager, etc. These CeFi platforms require users to simply deposit their assets with the central entity and collect the promised return in exchange, providing a simple and familiar entry point. CeFi companies have attracted millions of depositors and experienced explosive growth in deposit assets by offering a seamless, user-friendly interface and a promise of high returns.

Jessica Walker of Fluid Finance says, “Centralized cryptocurrency platforms acted like wolves in sheep’s clothing. Users stored their funds in a black box and had no control over how they were stored.” Recent CeFi fiascos highlight the need for education and training. Ryan Horst, CEO of Blockchain Insight Group, says: There is a great opportunity to make smart investments and passive income at the pace of crypto; However, without proper training, you might as well walk into a casino.

The crypto industry is at a crucial time. He faces severe trust issues due to personal wallet exploits, exchange hacks, smart contract failures, stablecoin unpecking, rug pulls, and more. In the aftermath of cataclysmic market failures, industry oversight of CeFi platforms incorporating consumer protection is paramount. The crypto industry could collectively create robust autonomous monitoring middleware protocols that perform stress testing, verify proof of reserves, audit protocols to confirm functionality, transactional security, and more.

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

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