Regulatory overhaul is crypto’s path toward revival, if not survival
The FTX collapse, preceded by the Terra Luna crash, has shaken the confidence of investors in cryptocurrency, prompting a louder call for crypto regulatory reforms.
Economy Middle East held an exclusive interview with Jehanzeb Awan, CEO of J. Awan & Partners, an international governance risk and compliance consulting firm.
Jehanzeb, also the Chairman of the Middle East, Africa, and Asia Crypto and Blockchain Association, provided key insights into the sector performance or lack of, Terra and FTX crash, and the need to create the right, trusted environment for customers and governments to take full advantage of what crypto and blockchain have to offer.
What were the inherent structural risks in TerraUSD and FTX that millions failed to see or accept?
TerraUSD’s inherent risk originates from two factors. The first being its algorithm which drives the arbitrage to maintain a peg with the reserve currency and two, investor confidence in the algorithm to maintain the peg. Simply, it was risky because it wasn’t backed by cash or other traditional assets.
The stability of Terra was derived from algorithms that linked its value to the value of Luna. For Terra to retain its peg, it had to rely on the assumption that enough traders would buy the coin to exchange it for 1$ worth of Luna. Another structural flaw was the unrealistic returns promised to depositors of Terra in the Anchor protocol which did not have a productive use.
Once the investor confidence was lost and considering that there was no lender of last resort, it was near impossible to bring confidence back to TerraUSD which ultimately led to its demise.
As for FTX, and based on what has been made public, it is a case of fraud and poor governance. What most people don’t realize is that in a typical exchange like Nasdaq, the process of buying and selling (execution) and the process of paying currency and receiving securities (clearing) is handled by two separate entities. This means that an independent party retains custody of the securities and that the exchange cannot use consumer assets for its own benefit. In the case of FTX and most crypto exchanges, the buying, selling and custody are provided by the exchange which effectively means that the exchange controls the assets in question. If there is a bad actor (as it appears to be in the case of FTX), the exchange can use client securities and money without having relevant permissions from the client, which is illegal and considered securities fraud in the traditional world.
Could these crashes have been avoided? What was the single point of failure that led to this?
For TerraUSD, it is a difficult question to answer. The only way to avoid the crash was for it to have the USD peg backed by a 1:1 cash reserve. However, since the stablecoin was driven by an underlying algorithm and reliance on Luna, the damage probably could have been minimized if it was not referred to as a stablecoin but as a securities instrument so investors can determine the risk as they would for a derivative.
In the case of FTX, part of the problem lies in the fact that it is a centralized exchange. The meltdown of FTX could not and would not have happened to a decentralized and transparent exchange. Decentralized exchanges operate without an intermediary organization for executing transactions and rely on self-executing smart contracts to facilitate trading. Customers retain custody of their cryptocurrencies and manage their own private keys for their wallets. This eliminates any possibility of misuse of client assets as was the case with FTX. However, if we are to accept the centralized exchange model, robust regulations could have helped in identifying issues early in the process. The key challenge here is that the focus in crypto regulations has been on anti-money laundering and countering of terrorist financing with little to no focus on how crypto firms conduct their business and their obligations towards customers. I don’t believe that there was a single point of failure for these events. There were several factors including funding by VCs without proper due diligence, partial regulatory cover, poor governance, and in FTX’s case, plain and simple fraud.
How will these incidents reshape the crypto industry?
I think these events have focused the industry’s attention on ensuring that they are properly regulated. Regulators are also realizing that crypto is not going away and that they need to control the industry in its entirety and not just for anti-money laundering and countering terrorist financing. The VCs have realized that they will need to conduct more due diligence before funding crypto projects and people involved in governing these firms will be focused on better governance. Additionally, these events can potentially shift the focus on cryptocurrencies from being speculative instruments to more productive use cases.
From your perspective, is the top crypto Bitcoin the future of money? Has it outlived its original purpose?
Not sure what is meant by the top being truly decentralized but the mere existence of centralized exchanges and intermediaries that provide custodial services suggests that the top is not decentralized. Whether it will ever be is a large and complex question, the answer to which depends on how quickly cryptocurrencies can replace the uses cases for FIAT currency and whether various regulators and governments will allow the use of cryptocurrencies to become mainstream, and how easy it will be for a 10-year-old or a 90-year-old to use a cold wallet.
In addition to being tied to a dismal global economic outlook and tech struggles, what are the underlying reasons behind this crypto winter? Do you see an end in sight?
A lot of money was printed in the post-financial crisis era of 2008. In addition, various governments’ reacting to the Covid-19 pandemic, printed even more money flooding the global economy with liquidity. This flux of liquidity inflated asset prices including equities, real estate, fixed income, and obviously crypto. Covid-19 also led to great resignation, one of the reasons was the liquidity (spending power) available to retail investors. As inflation increased in 2022, asset prices started to decline including cryptocurrencies. Obviously, the events around TerraUSD and FTX exacerbated the liquidity crisis in crypto. Another issue is that cryptocurrencies are not suited for leverage and margin trading and unfortunately, most retail investors had opted to use leverage which led to further downward pressure on already declining cryptocurrency prices.
Regarding when this downcycle will end, it is nearly impossible to predict. However, one should keep in mind that the fundamental use cases for cryptocurrencies have significant value. What has happened in previous crypto winters, particularly the current one, is akin to cleansing the system from poorly managed and governed companies, extreme leverage, and is now moving towards improved and fit-for-purpose regulations. One can think of the 2008 financial crisis as an analogy.
One thing is for sure the industry is moving towards better systems and controls and there is increased focus on enhancing regulations which in the medium term should lead to a turnaround.
Let’s talk value creation: What customer protection and transparency are needed to protect retail, government, and institutional investors in cryptocurrency trading?
It is important for regulators to create crypto-specific regulations. It will be ideal if key regulators can reach a global consensus on treating cryptocurrencies as securities or commodities (not as currencies) and regulate the crypto companies accordingly. Conduct of business issues, such as protecting client assets, conflicts of interest, proper corporate governance, and real-time (or near-real time) regulatory reporting are needed to provide a baseline for companies to operate correctly and to protect consumers.
Most importantly, international regulatory cooperation is a must to minimize regulatory arbitrage. The race to attract crypto firms through relaxed regulations is a zero-sum game and recent events have clearly evidenced this scenario.