The global low-yield environment of the past decade thrust yield-seeking capital towards cryptocurrencies and crypto banking products. However, the recent interest rate hikes by the Federal Reserve and Central banks around the globe have opened the spigots with competitive lower-risk yield products. After over a decade of extremely low-interest rates, the leveraged credit markets in the United States and Europe are awash with products, offering yield-seeking capital and attractive choices away from the higher-risk offerings. These high-yielding products across the relatively lower-risk spectrum are attracting capital that might have gone into crypto lending and Defi products, essentially taking away their punchbowl.
Yield-seeking investors were propelled into assets with opaque risks. Many investors reached out on the risk spectrum, adopting new esoteric finance frontiers seeking attractive yields, i.e., Crypto banking, DeFi, and more. Embracing crypto finance in exchange for yield has resulted in investors incurring dramatic volatility and losses, wiping out capital and multiyear gains. Investors are discovering, they are exposed to much more risk than they had bargained for. Although investment income provides a sense of safety or “downside cushion,” investors with portfolios concentrated in higher-risk areas of the markets are learning that additional risk may far outweigh the expected yield received. The year 2022 is littered with examples and painful experiences for investors, with dire scenarios playing out to the extremes.
Unlike traditional finance and investment banking, crypto finance platforms have no reserve requirements and are not subject to the usual banking regulatory oversights. Similar to conventional banks, crypto finance platforms pool deposits to provide loans to customers. However, in contrast to traditional banks, which had been offering near-zero yield to depositors, centralized crypto platforms were promising superlative payouts, APYs 7-20 %. For centralized crypto platforms to stay solvent, they had to consistently generate high returns to fulfill the promised hefty payouts to depositors, forcing them to make risky bets with the deposited monies. Centralized crypto platforms engage in opaque lending, i.e., loaning to unidentified third parties and institutions for aggressive bets to generate outsized returns. Any cash-flow deficits were likely masked by the incoming streams of new capital continuing to chase high yields.
The big bankrupt platforms in 2022: Terraform Labs, Voyager, Celsius
, and FTX, started as businesses trying to provide above-market returns. However, the promised superlative returns, possibly designed to attract capital, forced companies into taking excessive risks with the depositors’ money by utilizing backdoors (designed by company insiders) to commingle and funnel clients’ money into their trading partners. The usual “fake it till you make it” mantra was forced into failure by the unraveling of financial markets, including crypto, resulting from Federal Reserve’s recent aggressive interest rate hikes. The fierce bear market of 2022 halted the game of musical chairs, unmasking the bleeding balance sheets, torpedoing companies into committing fraud, and marching towards outright Ponzi schemes.
The 2022 crypto meltdown has exposed the industry’s flaws and depleted the wealth of countless crypto companies and individuals, igniting the urgency for financial regulation. With many bankruptcies and defunct platforms, clients cannot access their funds and are now relegated to retrieving pennies on the dollar.
The decade of near-zero/negative global interest rates and easy money increased risk appetites, fueling a speculative investment frenzy into crypto start-ups and bypassing traditional due diligence and oversight mechanisms. Slick fast-talking entrepreneurs were given billions of dollars with carte blanche to make risky bets, enabling them to mask failures. Despite raising $2 billion, Sam Bankman remained the majority owner of FTX, with a board of directors made up of himself, another FTX employee, and a lawyer. To top it off, Sam Bankman-Fried played video games during most meetings! He actively courted U.S. politicians and regulators and seemed to nudge them to scrutinize his rivals. In a matter of days, Sam Bankman-Fried had his billion-dollar fortune collapse, facing the Justice Department, Securities and Exchange Commission, and criminal investigations.
Sam Bankman-Fried was the founding majority owner of FTX and its sister Alameda Research. In a blink, FTX sank from a $32 billion valuation to bankruptcy!
Centralized crypto exchange FTX’s core business was to facilitate buying and selling digital currencies while taking a small cut of transactions. In traditional finance, regulators require brokerages to segregate customer funds from trading capital to remove conflicts of interest from an exchange attached to a trading business. Instead, behind the curtain, FTX tapped into its $16 billion in customer assets and loaned more than half, north of $8 billion, to fund risky trades by Alameda Research. According to CNBC, “he seems to be an investor who over-extended himself, frantically moved to cover his mistakes with questionable and perhaps illegal tactics, and surrounded himself with a tight cabal of advisors who could not or would not curb his worst impulses.”
The root cause of the downfall lay in the intertwining and comingling of funds between FTX and its sister company Alameda Research, a firm known for aggressive trading strategies funded by borrowed money.
Now bankrupt, FTX is facing millions of creditors, and the sheer magnitude of its insolvency has severely damaged crypto credibility. These crypto market failures underscore the dangers of unregulated finance without any backstops. The centralized custodian crypto platforms obscure any proof of reserves or transparency into how the company allocates finances, necessitating regulatory guardrails to safeguard assets. This could delay institutional crypto adoption by years and may initiate draconian measures from regulators.
The Web3 applications across multiple industries attempting to solve ownership issues encompassing privacy, self-sovereignty, and economics continue to evolve. The ongoing Web3 buildout will continue, already funded by billions of venture dollars. These unfortunate meltdowns triggered by rogue actors at the helm and operated without adequate corporate governance are not the norm in the industry but rather aberrations.
High default risks and colossal failures in crypto finance have severely damaged confidence, requiring strong corporate governance and robust stress testing. Centralized crypto finance needs to re-invent itself!