The Financialization of Crypto: Lessons from FTX and the Crypto Winter of 202-2023

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The year 2022 was an annus horribilis for the crypto ecosystem even before the collapse of the FTX group. In just one year, the crypto has lost around $2 trillion in market value. Following the failure of FTX, one of the biggest corporate or financial failures since the 2008 global financial crisis, the urgent need for a comprehensive and coordinated approach to crypto regulation has become apparent.

The inherent irony of what has been called the Crypto Winter of 2022-2023 is the fundamental premise of our new article, The Financialization of Crypto: Lessons from FTX and the Crypto Winter of 2022-2023 by Douglas W Arner, Dirk A Zetzsche, Ross P Buckley, Jamieson M Kirkwood :: SSRN. Bitcoin, cryptocurrencies, and decentralized finance (which we collectively refer to for these purposes in crypto shorthand) have been touted as an alternative to the failures of traditional finance, as demonstrated by centuries of financial crises and culminating in the global financial crisis of 2008. Thanks to a transparent technological framework, crypto was precisely designed to avoid the drawbacks of traditional finance: conflicts of interest of many powerful intermediaries, information asymmetries, centralization of functions and crucial markets , control by a few large, often interconnected intermediaries, abundance of ill-informed and over-enthusiastic market-playing intermediaries (irrational behavior), as well as agency, operational and financial risks, and of course fraud, manipulation and misconduct . Financial regulation and supervision have evolved over centuries to seek to enhance financial stability, provide adequate protection for investors, depositors and consumers, enhance market fairness, efficiency and integrity, and guide the financial system towards economic growth, financial inclusion and sustainable development.

We argue that crypto, despite its intent and underlying technological design, as decentralized finance has evolved in less than 15 years to display all of the classic market failures and externalities that characterize traditional finance. With the widespread duplication of traditional financial products and services in the crypto ecosystem, we call this evolutionary process the financialization of crypto. Where the underlying market failures and externalities and economic motivations and goals of participants mirror traditional finance, so does our proposed solution: the crypto ecosystem, to function properly in the future, requires regulatory and supervisory systems designed to address its market failures and externalities. Similar risks and activities require similar regulatory approaches to support orderly market functioning and reduce regulatory arbitrage.

The question going forward is whether crypto can survive the 2022-23 crypto winter. We argue that to survive and thrive, well-designed regulation is essential, and that such financial regulation must address the range of market failures, externalities, and inefficiencies that have arisen in the crypto ecosystem.

The same question, the future of crypto is currently at the center of the regulatory agenda. The Financial Stability Board (FSB), International Monetary Fund (IMF) and Bank for International Settlements (BIS) have issued position papers as the Group of 20 considers an internationally coordinated approach. Major jurisdictions are implementing or designing new measures.

We consider FTX and other crypto meltdowns that are collectively referred to today as the Crypto Winter of 2022-23, and put them in context with previous crises, including Mt Gox in 2014 and the ICO bubble of 2017-2019.

We argue that these crises are characterized by what we call the financialization of crypto. This process of financialization has included the rise of systemically important crypto intermediaries (SICI) which, contrary to the philosophy of decentralized finance (DeFi), dominate the ecosystem. Due to the lack of regulation and transparency, we classify them as forms of shadow finance, which in the formal banking sector was a precipitant of the 2008 global financial crisis. In the context of financialization and the evolution of SICIs, we present a macro perspective on the crypto industry and argue that crypto, despite its promising and potentially transformative underlying technology, is neither immune nor special when it comes to conflicting interests. interests, information asymmetries, centralization of critical functions, interconnections of key players, irrational behavior, criminal conduct, and a wider range of agency, operational, and financial risks. It is ironic that any rating of major crypto exchanges, a term we strongly support, should only be used for companies that are duly licensed and operate under well-recognized and appropriate principles and requirements for designation suggests that the industry of crypto, rather than being decentralized, is perhaps even more centralized in some ways than traditional financial markets. At the heart of these new centralized financial systems are a number of non-transparent crypto intermediaries and crypto conglomerates, similar to those that have often proven problematic in the history of traditional finance.

We distinguish between risks where crypto exhibits characteristics of traditional finance, and those where idiosyncrasies warrant tailored regulation. We then propose a set of regulatory solutions to address the financialization of crypto: (1) licensing and supervision of related business conduct and appropriate and balanced risk-based prudential regulation of intermediaries, (2) disclosure and transparency, (3) segregation and custody rules, (4) regulation and enforcement of market abuse, (5) restructuring and resolution legislation, and (6) harmonization and cross-border coordination.

Douglas Arner is Kerry Holdings Professor of Law at the University of Hong Kong.

Ross Buckley is a Scientia Professor at UNSW Sydney.

Jamieson M Kirkwood is a postdoctoral researcher at the University of Hong Kong.

Dirk Zetzsche is a law professor at the University of Luxembourg.

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