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 breaking of Terra’s UST stablecoin peg caused a domino effect in the crypto market as a whole. It led to the bankruptcies of other crypto-asset companies, such as Celsius, Three Arrows Capital, and the largest of them all to date, FTX.
As the OECD found in its analysis, Lessons from the Crypto Winter, published this past December, crypto companies’ failures during the current crisis mainly relate to CeFi (centralized finance) platforms and to 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 platform’s operation, over the management of users’ funds, and over decision-making, but without adequate internal or external oversight and control mechanisms. The concentration of the large platforms, over-leveraging, and the lack of risk management, as well as the interconnectivity between them, caused a domino effect that resulted in the collapse of many major players in the industry. On the other hand, “real” DeFi platforms offering a major decentralization feature continued functioning as expected, despite the massive decline in the value of the collateral pledged in them.
Last May, the pegging of the UST algorithmic stablecoin to the USD was broken. This resulted in significant losses to its holders and rendered the stablecoin worthless in less than a week. The developers of the project initially tried to re-peg UST to dollar, but sales of the coin continued because it had lost market confidence. As a result, holders made massive withdrawals from the protocol, the crypto version of a “run on the bank” scenario.
Celsius, a crypto-asset lending platform, was the first major company affected by UST’s collapse. The company enabled its customers to lend and borrow against digital assets and offered interest-bearing deposit services at a rate of about 15%-20%. The collapse of UST and other assets impaired the value of the company’s collateral, triggering a series of withdrawals by Celsius users. The company announced the suspension of withdrawals and eventually had to file for bankruptcy. The disclosures in the Celsius case highlight the risks of the absence of clear standards in users’ terms of use, a lack of transparency regarding the business model and the investment standard, and disparities in regulatory supervision 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 provided loans to 3AC totaling hundreds of millions of dollars, such that 3AC’s inability to repay its loans led to their collapse.
FTX collapsed this past November, one of the world’s largest crypto-asset trading exchanges. The founder of FTX has been accused of committing a series of fraudulent acts over the years. These include illegal use of customers’ assets for the benefit of another company he owns (Alameda Research), inflating balance sheet value through manipulative means, false representations, and long list of other crimes. This event further undermined confidence in the crypto industry and demonstrated the necessity of regulations, certainly in relation to Ce-Fi players.
The series of collapses severely harmed cryptocurrency users, who trusted platforms that engaged in aggressive marketing efforts without any supervision. It appears European Union member states are in the most advanced position to promote regulation of this industry. The European Union’s approved its proposed framework, Markets in Crypto Assets (MiCA) regulation, in October 2022, set to take effect in 2024. This framework strives to achieve comprehensive regulation. The MiCA regulation specifies, in hundreds of pages, the rules that will apply to crypto asset service providers:
Had most of the collapsed platforms opted to operate in EU member states, they would have been subject to clear rules, which would likely have prevented or minimized the damage.
The enactment of regulations in Israel is lagging behind Europe, and the current discourse is entirely at the recommendations stage. The Digital Assets Regulation Report, prepared by the Ministry of Finance and the chief economist’s department and published in November 2022, does indeed contain important policy recommendations regarding the creation of new regulatory infrastructure for asset-backed digital tokens. However, it lacks the legal framework that could actually rectify the existing flaws in Israeli legislation.
At the beginning of 2022, it was possible to believe you could use DeFi without having to comply with the regulatory authority’s requirements. As time passed, an increasing number of incidents proved otherwise. Last August, the US Treasury Department imposed sanctions on Tornado Cash due to allegations it was laundering virtual currencies. Aave and DAO Maker, who are members of decentralized autonomous organizations, did not remain indifferent and decided to act in conformity with the sanctions. Last December, the decentralized crypto 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’s liquidators are trying to pick up the pieces, DeFi platforms are continuing to operate, attract users, offer non-custodial trading services, and quickly liquidate risky positions. FTX’s collapse prompted users to look for non-custodial crypto trading alternatives. Thus, as the largest and most liquid DeFi exchange in the market, it captured a larger volume of the trading. Last month, one of the non-custodial hardware wallet providers reported a series of record-breaking sales.
On the one hand, it seems the crypto 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 platforms and DeFi platforms are currently operating in a way that is inconsistent with the 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 collapses of major crypto players highlight the importance and urgency of enacting adequate regulations.
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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